You are on page 1of 55

MANAGEMENT ACCOUNTING

INTRODUCTION TO MANAGEMENT ACCOUNTING

Lesson 1 What is accounting?

Introduction to Management Accounting

Accounting is an information system. It e ists to !ro"ide information for t#e end$user. It is !ossi%&e to distinguis# %et'een t'o %ranc#es of accounting. 1 Financial accounting.

T#e !ur!ose of financia& accounting is to re!ort t#e financia& !erformance of t#e com!any. It(s main focus is on e terna& re!orting to a num%er of grou!s "i). O'ners * s#are#o&ders + Loan creditors * %an,s + Trade creditors *su!!&iers + -undry creditors * su!!&iers of ser"ices + Go"ernment agencies * ta aut#orities + Em!&oyees * trade unions + A set of financia& statements $ a !rofit and &oss account. a %a&ance s#eet and a cas# f&o' statement are !re!ared and !u%&is#ed.

Management accounting

T#e main !ur!ose of management accounting is to !ro"ide information to t#e management team at a&& &e"e&s 'it#in t#e organisation for t#e fo&&o'ing !ur!oses0 *a+ *%+ *c+ *d+ *e+ formu&ating t#e !o&icies $ strategic !&anning !&anning t#e acti"ities of t#e organisation $ cor!orate !&anning contro&&ing t#e acti"ities of t#e organisation decision$ma,ing $ &ong$term and tactica& !erformance a!!raisa& at strategic and o!erationa& &e"e&

Definition0 Management accounting is t#e a!!&ication of !rofessiona& ,no'&edge and s,i&& in t#e !re!aration and !resentation of accounting information in suc# a 'ay as to assist management in t#e formu&ation of !o&icies and in !&anning and contro&&ing t#e o!erations of t#e organisation.

Let us &oo, at a sim!&e financia& statement. E am!&e 1inancia& Accounts


2

2 -a&es Cost of sa&es Gross !rofit Deduct Administration e !enses -e&&ing and distri%ution e !enses Net !rofit /.444 1.444 $$$$$$$$

2 34.444 /5.444 $$$$$$$$ 6.444 $$$$$$$$

3.444 $$$$$$$$ 3.444 $$$$$$$$

1inancia& accounts indicate t#e resu&ts of a %usiness o"er a !eriod of time. T#ey dea& 'it# #istoric or !ast costs and are concerned 'it# ste'ards#i! accounting.

A management accounting7 cost statement !ro"ides information to a&&o' managers to !&an. contro& and organi)e t#e acti"ities of t#e %usiness. T#e !ur!ose of a costing7management accounting information system is0
1

to !ro"ide information a%out !roduct costing to %e used in 1inancia& -tatements. to !ro"ide information for !&anning. contro&&ing and organi)ing.

T#e information !ro"ided %y t#e costing system s#ou&d %e0 Re&e"ant Re&ia%&e Time&y Concise 8resented in t#e desired format.

A cost system s#ou&d %e cost effecti"e a!!ro!riate for t#e organi)ation encourage manageria& action. E am!&e Management Accounts 8roducts Materia&s =ages 8rod. o"er#ead 8rod. cost Admin. costs -e&&ing costs Tota& cost -a&es 8rofit *Loss+ Net !rofit margin A 25.:44 1.<44 <44 $$$$$$$ 6.:44 ;44 344 $$$$$$$ ;.:44 14./54 /./54 $$$$ /5? $$$$$$$ 9 23.;44 /.<44 644 $$$$$$$ 6.:44 :44 544 $$$$$$$ :.444 14.:44 /.:44 $$$$ /6? $$$$$$$ C 26.<44 3.444 >44 $$$$$$$ 14.544 <44 344 $$$$$$$ 1./44 :.>64 $$$$ */./54+ $$$$ $$$$$$$ Tota& 21<.444 ;.444 /.444 $$$$$$$ /5.444 /.444 1.444 $$$$$$$ /;.444 34.444 3.444 $$$$ 14? $$$$$$$

T#is !erformance statement is of t#e same %usiness as t#e !re"ious e am!&e of financia& accounts. @o'e"er. it gi"es management muc# more information. It ana&yses t#e cost e&ements in res!ect to materia&s. &a%our and o"er#eads a&&o'ing management to focus on costs '#ic# reAuire in"estigation and contro&. It faci&itates decision$ma,ing. E.g. s#ou&d !roduct C %e discontinuedB Com!ared to t#e financia& accounts t#e management accounting information '#ic# is muc# more com!re#ensi"e 'i&& a&&o' management to %etter carry out t#eir functions of !&anning. contro&&ing organising and decision$ma,ing. Cost c&assification T#e management accountant 'i&& use cost information for t'o main reasons. 1 / to ascertain t#e cost of a !roduct. T#is information is used to "a&ue stoc, '#ic# is reAuired for e terna& re!orting . to assist management in t#e decision$ma,ing !rocess.

De!ending on t#e cost o%Cecti"e t#e costs 'i&& %e c&assified into a num%er of categories. *a+ 9y nature of resource *i+ Materia&s *ii+ La%our *iii+ Ot#er E !enses 9y ty!e of cost *i+ Direct Costs *ii+ Indirect Costs $ O"er#eads *c+ 9y function 8roduction. Administration. -e&&ing and Distri%ution *d+ 9y t#e %e#a"iour of costs *i+ 1i ed or 8eriodic Costs *ii+ Daria%&e Costs *iii+ -emi$fi ed. or -emi$"aria%&e Costs Cost O%Cecti"es *a+ 8roduct costing

*%+

It is essentia& for an organisation to ascertain t#e cost of manufacturing a !roduct. T#e information is used for t'o !ur!oses0 1 to determine t#e "a&ue of c&osing stoc, '#ic# is reAuired for t#e financia& statements "i). t#e !rofit and &oss account and t#e %a&ance s#eet. Direct materia&s Direct &a%our Direct e !ense 8rime cost 8roduction o"er#eads 8roduction cost / 2E 2E 2E $$$$$ 2E 2E $$$$$ 2E $$$$$

A&so some %usinesses use a cost !&us !ricing strategy. T#e !roduct cost is ca&cu&ated and a mar, u! !ercentage is added to arri"e at a se&&ing !rice '#ic# gi"es a reasona%&e gross !rofit '#ic# in turn can co"er t#e non$!roduction o"er#eads and &ea"e a satisfactory net !rofit.

*%+

Decision ma,ing $ Cost %e#a"iour

T#e c&assification of costs into "aria%&e. fi ed and semi$fi ed is im!ortant in terms of decision$ma,ing and cost contro&. acti"ities t#at com!rise t#e fundamenta&s of t#e management accounting function. Variable costs are t#ose costs '#ic# increase7decrease 'it# t#e &e"e& of !roduction and sa&es. In a manufacturing com!any t#e "aria%&e !roduction costs c#ange direct&y 'it# t#e &e"e& of !roduction. Fixed costs can %e eit#er committed fi ed costs or discretionary fi ed costs. 1i ed costs are termed fi ed %ecause t#ey do not c#ange in res!onse to c#anges in t#e &e"e& of acti"ity. It s#ou&d %e noted t#at t#ey are not fi ed %ecause t#ey do not c#ange %ecause cost items &i,e rent is often su%Cect to re"ision. Semi-fixed/semi-variable costs are costs '#ic# mo"e in t#e same direction %ut not at t#e same rate as t#e &e"e& of acti"ity. T#e semi$fi ed7semi$"aria%&e cost contains a fi ed and a "aria%&e e&ement. 1or e am!&e. t#e e&ectricity %i&& contains a fi ed or standing c#arge and and t#e "aria%&e as!ect '#ic# de!ends on usage. Cost ascertainment It is im!ortant t#at t#e management accountant can determine t#e "aria%&e and fi ed costs and t#ere are a num%er of tec#niAues to assist in se!arating t#e fi ed and "aria%&e e&ements of semi$fi ed or semi$"aria%&e costs. Ana&ysing costs %y direct o%ser"ation of t#e resources reAuired to con"ert materia&s into a finis#ed !roduct and a!!&ying costs to t#ese acti"ities. Direct materia&s. direct &a%our and mac#ine time can %e esta%&is#ed Auite easi&y. / 3 9y ins!ecting t#e accounts t#e accountant can c&assify costs as %eing "aria%&e or fi ed. @ig#$&o' met#od. T#is met#od entai&s se&ecting t#e !eriod of #ig#est and &o'est &e"e&s of acti"ity and com!aring t#e c#anges in costs t#at resu&t from t#e t'o &e"e&s. 14444units 1<444units 234444 254444 1

E am!&e Out!ut

254444 $ 234444 F 2144447 1<444units $ 14444F <444units F 2/!er unit. T#e fi ed costs t#erefore are 214444.

T#e scattergra!# or regression c#art.


6

Costs

Out!ut On t#e scattergra!# tota& costs are !&otted against out!ut at a num%er of different acti"ity &e"e&s. T#en a G&ine of %est fit( is dra'n t#roug# some of t#e coordinates. =#ere t#is &ine coincides 'it# t#e H a is t#is re!resents t#e &e"e& of fi ed costs. Once t#is is esta%&is#ed it is sim!&e to ca&cu&ate t#e ot#er costs '#ic# are not fi ed ie. t#e "aria%&e costs. T#e assum!tion is t#at at )ero out!ut t#e %usiness sti&& #as to meet t#e fi ed costs$ t#e !eriodic costs re&ated to time.

MARGINAL

CO-TING

1OR DECI-ION MAIING

Lesson / Margina& Costing $ a tec#niAue for s#ort$run decision$ma,ing One of t#e main functions of management is decision$ma,ing. Many of t#e decisions are of a s#ort$term nature. On&y rare&y is a manager faced 'it# a decision '#ic# #as a &ong term im!act eg. %uying a ne' mac#ine. e !anding t#e factory. ta,e$o"er of anot#er com!any. -ince most of t#e decisions #a"e a s#ort$ term im!act it can %e assumed t#at t#e ca!acity of t#e factory 'i&& not c#ange. T#erefore fi ed or !eriodic costs are not affected %y tactica& s#ort$run decisions. T#e on&y costs '#ic# are affected are "aria%&e costs ie. t#ose costs '#ic# "ary direct&y 'it# t#e &e"e& of acti"ity of t#e factory. T#ese 'ou&d inc&ude direct materia&s. direct &a%our and "aria%&e o"er#eads. A&so a&& t#e decisions com!rise a c#oice %et'een a&ternati"e courses of action. T#erefore. !ast costs can #a"e no re&e"ance for future decisions. 8ast costs can consist of sun, costs or committed costs. In margina& costing a&& costs are c&assified according to #o' t#ey %e#a"e. T#ey are eit#er variable or fixed. T#e fi ed costs are treated as periodic ie. t#ey are re&ated to time . E am!&es of fi ed costs 'ou&d %e rent. rates. insurance. de!reciation etc. T#ese costs stay constant in t#e s#ort$term regard&ess of t#e decision t#at management ta,es. T#erefore. in ma,ing decisions. in c#oosing %et'een different a&ternati"e courses of action management identifies t#e "aria%&e costs and treats t#e fi ed costs as irre&e"ant. To summari)e t#e tec#niAue of margina& costing0 Costs are c&assified as eit#er fi ed or "aria%&e. In t#e s#ort$run a&& fi ed costs remain unc#anged and t#erefore treated as irre&e"ant. T#e on&y re&e"ant costs are "aria%&e costs ie. t#ose costs '#ic# increase7decrease as out!ut increases7decreases. Definition0 Margina& costing is a costing !rinci!&e '#ere%y "aria%&e costs are c#arged to cost units and t#e fi ed costs attri%uta%&e to t#e re&e"ant !eriod are 'ritten off in fu&& against t#e contri%ution for t#at !eriod. *ICMA+ Margina& cost F "aria%&e cost F direct materia&s direct &a%our direct e !ense "aria%&e o"er#ead Contri%ution F sa&es re"enue $ "aria%&e*margina&+ costs

Contri%ution is t#e amount '#ic# #e&!s to !ay off t#e fi ed costs and any e cess re!resents !rofit. Contri%ution is not !rofit.

E am!&e

1ormat of a Margina& Costing Income -tatement A E *E+ $$$$$$ E $$$$$$ 9 E *E+ $$$$$$ E $$$$$$ C E *E+ $$$$$$ E $$$$$$ Tota& E *E+ $$$$$$ E $$$$$$ *E+ $$$$$$ E $$$$$$

8roducts -a&es re"enue Less Daria%&e costs Contri%ution 1i ed costs

Margina& cost is t#e amount at any gi"en "o&ume of out!ut %y '#ic# tota& costs are c#anged if t#e "o&ume of out!ut is increased or decreased. It is t#e cost of ma,ing one e tra unit of out!ut. T#e definition stesses t#e manner in '#ic# costs %e#a"e in re&ation to t#e "o&ume of acti"ity. It concerns t#e identification of "aria%&e and fi ed costs ie. t#e costs t#at increase or decrease as out!ut increases or decreases. On&y t#e "aria%&e costs %ot# !roduction and non$ !roduction c#ange as t#e out!ut c#anges. E am!&e0 A com!any manufacture units 'it# a"aia%&e cost !er unit of 2/ and fi ed costs of 2<.444. Do&ume *costs+ Daria%&e costs 1i ed costs Tota& cost 4 2 $$$ <.444 $$$$$$$ <.444 $$$$$$$ 1 2 / <.444 $$$$$$$ <.44/ $$$$$$$ 1.444 2 /.444 <.444 $$$$$$$ ;.444 $$$$$$$ 14.444 2 /4.444 <.444 $$$$$$$ /<.444 $$$$$$$

Note 2/ is t#e margina& cost or "aria%&e cost !er unit.

10

A!!&ications of margina& costing *a+ Acce!tance of a s!ecia& order. E Ltd. ma,es a !roduct '#ic# se&&s for 21.<4. T#e out!ut for t#e !eriod is :4.444 units of !roduct '#ic# re!resents :4? ca!acity . Tota& costs are 2>4.444 and of t#ese it is estimated t#at 2/6.444 are fi ed costs. A !otentia& customer offers to %uy /4.444 units at 21.14 and t#is 'i&& use u! t#e com!any(s s!are ca!acity. -#ou&d management acce!t t#is s!ecia& orderB -a&es Margina& costs* :4! !er unit+ Contri%ution 1i ed costs 8rofit 21/4.444 65.444 $$$$$$$$ <6.444 /6.444 $$$$$$$$ 34.444 $$$$$$$$

-!ecia& order0 Less -a&es*/4.444 units J 21.14+ Daria%&e costs*/4.444 J :4!+ E tra contri%ution 2//.444 16.444 $$$$$$$$$$ 6.444 $$$$$$$$$$

8rofits can %e increased %y an additiona& 26.444 since fi ed costs are a&ready co"ered. @o'e"er management must consider ot#er re&e"ant factors in arri"ing at t#e fina& decision. @o' 'i&& e isting customers reactB T#ey may 'is# to %uy at 21.14 !er unit. Cou&d t#e s!are ca!acity %e used more !rofita%&y rat#er t#an acce!ting t#e s!ecia& orderB

-#ut$do'n decisions

Often management 'is# to ana&yse t#e !erformance of t#eir !roducts. %ranc#es. di"isions.

11

Consider t#e fo&&o'ing e am!&e. E am!&e0 8roduct -a&es Less Direct materia&s Direct &a%our 1i ed o"er#eads A 2 /4.444 1.444 3.444 /.444 $$$$$$$$ 6.444 $$$$$$$$ 15.444 9 2 <4.444 1<.444 16.444 ;.444 $$$$$$$$ 3:.444 $$$$$$$$ 1/.444 C 2 /<.444 14.444 15.444 >.444 $$$$$$$$ 33.444 $$$$$$$$ *:.444+ Tota& 2 ><.444 /6.444 33.444 1:.444 $$$$$$$$ ;;.444 $$$$$$$$ 1:.444

8rofit7*Loss+

=it# !roduct C ma,ing a &oss management mig#t consider discontinuing t#is !roduct. @o'e"er. using margina& costing !rinci!&es. 'it# fi ed costs treated as irre&e"ant for s#ort$run decision$ma,ing t#e income statement can %e reformatted. 8rtoduct -a&es Less Daria%&e costs Contri%ution 1i ed costs Net !rofit A 2 /4.444 5.444 $$$$$$$$ 16.444 9 2 <4.444 31.444 $$$$$$$$ />.444 C 2 /<.444 /5.444 $$$$$$$$ 1.444 Tota& 2 ><.444 <>.444 $$$$$$$$ 36.444 1:.444 $$$$$$$$ 1:.444 $$$$$$$$

-ince !roduct C ma,es a contri%ution it may %e inad"isa%&e to c&ose it do'n. If 8roduct C is c&osed do'n t#e com!any 'i&& &ose 21.444 contri%ution and t#e o"era&& effect 'ou&d %e to reduce !rofits to 21;.444.

Ma,e or 9uy

-ometimes management may #a"e to consider '#et#er it is %est to manufacture !roducts or com!onents or to su%$contract t#em out and !urc#ase t#em e terna&&y. E am!&e0
12

A com!any ma,es !roduct 8. A com!onent K used in t#e manufacture of 8 can %e !urc#ased from a su!!&ier for 2:. T#e costs to ma,e t#e com!onent are as fo&&o's0 Direct materia&s Direct 'ages Daria%&e o"er#eads Daria%&e cost of !roduction 2/ 23 2/ $$$$$$ 2; $$$$$$

Assume s!are ca!acity and t#e fi ed costs remain unc#anged. O%"ious&y it is c#ea!er to ma,e t#an to %uy. @o'e"er. if t#e firm is 'or,ing at fu&& ca!acity and to ma,e com!onent K in"o&"es mo"ing some of t#e ca!acity from !roduct 8 t#en t#e decision is a &itt&e more in"o&"ed. T#e fo&&o'ing data a!!&ies to !roduct 8. -e&&ing !rice Direct materia&s Direct &a%our Daria%&e o"er#ead Contri%ution 216 26 25 2/ $$$$$$ 25 $$$$$$

T#e !roduction rate for !roduct 8 is < units !er #our and for com!onent K is 14. T#e effecti"e cost of ma,ing a unit of com!onent K is0 8&us Margina& cost of !roduction O!!ortunity cost of T#e effecti"e cost is 2; 2/ $$$$$ 2> $$$$$

9y s'itc#ing ca!acity from !roduct 8 to com!onent K t#ere is 2/ contri%ution &ost. T#is is an o!!ortunity cost ie. it is t#e %enefit foregone %y c#oosing one course of action o"er t#e ot#er.

Limiting factor decisions

Often a com!any finds t#at t#ere is a &imiting factor or constraint '#ic# in#i%its its ca!acity to meet t#e desired !roduction &e"e&. T#e &imiting factor may %e any resource eg. materia&s. &a%our or mac#ine #ours. Management #as to decide '#at is t#e %est 'ay to a&&ocate t#e scarce resource among t#e !roduct range in t#e most effecti"e 'ay so t#at !rofits are ma imised. E am!&e0
13

8roduct Desired !roduction *units+ -e&&ing !rice !er unit Daria%&e cost !er unit Contri%ution !er unit

E 1.444 2 3< 1< $$$$$ /4

H /.444 2 /< 14 $$$$$ 1<

L <44 2 1< < $$$$$ 14

A s!ecia& mac#ine is used to manufacture t#e t#ree !roducts and t#ere are on&y 1<.444 mac#ine #ours a"ai&a%&e. 8roduct E uses /4 mac#ine #ours !er unit. 8roduct H uses < mac#ine #ours !er unit. 8roduct L uses / mac#ine #ours !er unit. E /4 /4 1 *3+ H 1< < 3 */+ L 14 / < *1+

Contri%ution !er unit No. of mac#ine #rs. Contri%ution !er mac#ine #r. Ran,ing Desired !roduction &e"e& 8roduct L 8roduct H 8roduct E <44 units / #rs. /.444 < #rs /44 /4

1.444 #rs 14.444 #rs 5.444 #rs

8roduct L earns <44 units 214 F 2<.444 contri%ution 8roduct H earns /.444 units 21< F 234.444 contri%ution 8roduct E earns /44 units 2/4 F 25.444 contri%ution $$$$$$$$$ 23>.444 contri%ution $$$$$$$$$$

<

8rofit 8&anning or cost !rofit "o&ume ana&ysis

Management fee&s it #e&!fu& to ascertain t#e &e"e& of !rofits earned at certain &e"e&s of out!ut and sa&es. E am!&e0 A com!any ma,es !roduct E '#ic# #as a se&&ing !rice of 214 !er unit and "aria%&e costs of 2< !er unit 'it# fi ed costs of 2/4.444.

-a&es *units+

/.444

5.444

6.444

:.444

14.444
14

-a&es re"enue Daria%&e costs Contri%ution 1i ed costs Net !rofit *&oss+

$$$$$$$ 2 /4.444 14.444 $$$$$$$$ 14.444 /4.444 $$$$$$$$ *14.444+ $$$$$$$$

$$$$$$ 2 54.444 /4.444 $$$$$$$$ /4.444 /4.444 $$$$$$$$ $$$ $$$$$$$$

$$$$$$$ 3 64.444 34.444 $$$$$$$$ 34.444 /4.444 $$$$$$$$ 14.444 $$$$$$$

$$$$$$$ 2 :4.444 54.444 $$$$$$$$ 54.444 /4.444 $$$$$$$$ /4.444 $$$$$$$

$$$$$$$$ 2 144.444 <4.444 $$$$$$$$ <4.444 /4.444 $$$$$$$$ 34.444 $$$$$$$$

At sa&es of 5444 units t#e com!any is at %rea,$e"en !oint ie. contri%ution is eAua& to t#e fi ed costs.

CO-T DOLUME 8RO1IT ANALH-I-

15

Lesson 3 Cost Do&ume 8rofit Ana&ysis

T#e CD8 mode& ma,es t#e assum!tions t#at costs can %e sim!&y di"ided into fi ed and "aria%&e costs. It assumes t#at o"er a range of out!ut &e"e&s $ t#e re&e"ant range $ fi ed costs remain constant and "aria%&e costs increase direct&y 'it# out!ut. T#e "aria%&e costs %e#a"e in a &inear fas#ion. T#e fi ed costs are !eriodic costs so t#at cost items suc# as rent. rates. insurance. de!reciation etc. are constant at a&& &e"e&s of out!ut. T#ere is a&so an assum!tion t#at t#e sa&es re"enue %e#a"e in a &inear fas#ion ie. t#e se&&ing !rice is constant !er unit of out!ut. Economists ta,e a more rea&istic "ie' of cost %e#a"iour. T#ey contend t#at "aria%&e costs do not %e#a"e in a &inear fas#ion %ut are effected %y economies of sca&e. Com!anies can %enefit from discounts for %u&, !urc#ases of materia&s and t#e economies from t#e di"ision of &a%our. T#e economists( mode& re!resented in a cur"i&inear gra!# s#o's t#e tota& cost &ine rises stee!&y at &o' out!ut &e"e&s. &e"e&s off 'it#in a range of out!ut and fina&&y rises stee!&y again as t#e %enefits of economies of sca&e dec&ine. T#e tota& re"enue &ine rises stee!&y. &e"e&s off and t#en dec&ines. T#is cur"i&inear tota& re"enue &ine ref&ects t#e fact t#at to ac#ie"e more sa&es t#e com!any may #a"e to reduce t#e se&&ing !rice and does not increase !ro!ortiona&&y 'it# out!ut. As a com!romise it is !ossi%&e to acce!t t#e assum!tions t#at t#e CD8 mode& is %ased on 'it#in a certain range of out!ut $ t#e re&e"ant range. T#erefore. t#e CD8 mode& can %e used as a !&anning tec#niAue to0 *a+ *%+ *c+ *d+ *e+ find t#e %rea,$e"en !oint determine t#e margin of safety determine a target "o&ume esta%&is# t#e !rofit "o&ume ratio or contri%ution "o&ume ratio determine t#e o!erating gearing

It is !ossi%&e to ascertain t#ese %y using a %rea,$e"en c#art or %y using formu&ae.

16

Let us &oo, at a %asic accounting eAuation ie. -a&es $ Tota& costs F 8rofit or -a&es $ * Daria%&e costs $ 1i ed costs + F 8rofit t#en -a&es $ Daria%&e costs F Contri%ution

ontribution is t#e e cess of sa&es o"er "aria%&e costs and it re!resents t#e sur!&us a"ai&a%&e to meet t#e fi ed costs. Once t#e fi ed costs #a"e %een met any contri%ution &eft is !rofit.

At t#e %rea,$e"en !oint t#e sa&es re"enue generated co"ers t#e tota& costs and no more.

At t#e %rea,$e"en !oint t#e contri%ution is sufficient to meet t#e fi ed costs. Contri%ution F 1i ed costs

9E8 F

1i ed Costs Contri%ution !er Unit

87D or C7- ratio F Contri%ution E 144 -a&es

T#e 87D ratio indicates t#e ? of contri%ution to sa&es.

17

1ormu&ae0 1 / 3 9rea,$e"en !oint F 1i ed costs7 Contri%ution !er unit Margin of safety F 9rea,$e"en !oint*units+ $ T#e E !ected -a&es -a&es*units+ to ac#ie"e a !rofit 1i ed costs M Target !rofit $$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$ Contri%ution !er unit 8rofit "o&ume ratio F Contri%ution 144 $$$$$$$$$$$$$$$$$$$$$$$$$$$$ -a&es re"enue T#e O!erating Gearing F Contri%ution 7 8rofit

<

It is !ossi%&e to !resent t#e !rofit "o&ume re&ations#i! in a c#art. a profit-volume chart. T#is c#art dis!enses 'it# t#e need to dra' cost and re"enue &ines and concentrates on t#e re&ations#i! %et'een !rofit and out!ut. Re"enues and Costs *2+

Out!ut *units+

A %rea,$e"en c#art

8rofit

Out!ut *units+
18

Loss

Limitations of cost "o&ume !rofit ana&ysis.

CD8 ana&ysis is %ased on a num%er of sim!&istic assum!tions a%out cost %e#a"iour '#ic# undermine t#e mode&(s effecti"eness. 1 Costs can %e di"ided into fi ed and "aria%&e costs %ut in rea&ity many costs #a"e a fi ed and "aria%&e e&ement*semi$"aria%&e+ and may not %e easy to di"ide. T#ere is a &inear re&ations#i! %et'een out!ut and costs and re"enues. T#e economists "ie' tends to dis!ute t#is and !resents a cur"i&inear mode&. T#e %usiness #as on&y one !roduct or t#ere is a s!ecific constant !roduct mi . T#e on&y factor inf&uencing costs and re"enues is out!ut. Ot#er factors suc# as !roduction efficiency and !roduction met#ods may im!act on out!ut.

3 5

E am!&e0 A com!any #as sa&es of 1/4.444 units '#ic# se&& for 21 'it# t#e "aria%&e costs <4! !er unit. T#e fi ed costs are 254.444. T#e management 'ant to ,no' t#e 978 !oint. t#e margin of safety and t#e !rofit. -o&"e gra!#ica&&y and %y formu&a.

19

9UDGETING T#e 8&anning 8rocess A&& organisations #a"e t#eir o%Cecti"es. -ome of t#e o%Cecti"es may not %e e !ressed in accounting terms for e am!&e o%Cecti"es to im!ro"e t#e 'e&fare of t#e staff or to im!ro"e t#e im!act on t#e &oca& en"ironment. @o'e"er. in t#is c#a!ter t#e em!#asis is on o%Cecti"es usua&&y e !ressed in Auantitati"e terms eg. increase in mar,et s#are. !rofit gro't#. increase in t#e asset "a&ue etc '#ic# t#ey 'is# to ac#ie"e. T#ere are t#ree &e"e&s of !&anning $ cor!orate &ong term !&anning. medium term !&anning and annua& !&anning or %udgeting. T#e annua& %udgets are ste!s a&ong t#e 'ay to ac#ie"e t#e &ong$range !&an of t#e organisation. To ensure t#at t#e o%Cecti"es are ac#ie"ed !&ans or %udgets must %e !re!ared. Definition0 A %udget is a financia& or Auantitati"e inter!retation !rior to a defined !eriod of time. of a !o&icy to %e !ursued for t#at !eriod. to attain a gi"en o%Cecti"e. 9udgets are !art of t#e !&anning and contro& !rocess. T#ey #e&! to define t#e o%Cecti"es of t#e organisation. 9udgeting is !ro%a%&y t#e most im!ortant contri%ution t#at t#e accounting de!artment ma,es to t#e ro&e of management. T#e accountant dra's u! a !&an '#ic# integrates t#e "arious functiona& areas of t#e %usiness. Contro& is e ercised %y first&y. de&egating res!onsi%i&ity to de!artmenta& managers for t#e attainment of t#e %udgets and t#en t#e regu&ar com!arison of t#e actua& resu&ts 'it# t#e !&anned outcomes. 9udgets assists an organisation to !&an and contro& !rofita%i&ity to !&an and contro& !roduction resources to !&an and contro& ca!ita& e !enditure to !&an and contro& finance An organisation '#ic# engages in %udgeting can o%tain t#e %enefits of %etter !&anning and a'areness of '#at #as to %e ac#ie"ed greater coordination of t#e different functiona& areas %etter communication 'it# staff contri%uting to t#e targets to t%e set moti"ation of t#e staff 'it# staff assigned t#eir res!onsi%i&ities efficient and effecti"e use of scarce resources and an a'areness of cost$ consciousness

Administration of t#e %udget.


20

T#e administration of t#e %udget is t#e res!onsi%i&ity of t#e %udget officer '#o is usua&&y t#e accountant . T#e accountant 'or,s in conCunction 'it# t#e %udget committee com!rised of t#e de!artmenta& management. -enior management out&ine t#e %road strategic o%Cecti"es of t#e organisation and communicate t#ese to t#e functiona& managers. T#e %udget committee identifies t#e ,ey %udget factor '#ic# determines '#at acts as a constraint on t#e organisation(s acti"ities. T#is ,ey %udget factor decides t#e ,ey %udget ie. t#e one '#ic# sets t#e o%Cecti"es for t#e su%ordinate %udget. T#e su%ordinate %udgets are constructed %y as,ing t#e Auestions $ '#en are t#e goods to %e so&d. '#ere are t#e goods to %e so&d and #o' are t#e goods to %e !roduced.It may %e t#e sa&es "o&ume '#ic# dri"es t#e ot#er su%sidiary %udgets. 1or instance. if t#e sa&es de!artment forecasts t#e annua& sa&es at /4.444 units t#en t#e !roduction %udget must %e integrated 'it# t#is figure. A&ternati"e&y. !roducti"e ca!acity may %e t#e ,ey %udget factor . T#e com!any may #a"e t#e ca!acity to !roduce on&y 1:.444 units a year so t#is figure sets t#e o%Cecti"es for t#e ot#er %udgets. T#e accountant #e&!s t#e managers to set t#e %udgets %y !ro"iding information as reAuired. -a&es forecasting may !roceed %y means of statistica& met#ods '#ic# are %ased on economic indicators or %y carrying out an interna& forecast %y can"assing t#e sa&es staff. T#e current sa&es &e"e&. !ast trends. mar,et researc# can !ro"ide usefu& information. On recei!t of t#e "arious %udgets t#e accountant notifies managers of re"isions to t#eir %udget. Once t#e accountant and t#e committee agree t#e master %udget '#ic# is a forecasted !rofit and &oss account and %a&ance s#eet can %e dra'n u!. In terms of contro& t#e accountant is res!onsi%&e for t#e regu&ar monitoring of t#e %udgets. for re!orting %ac, to t#e %udget committee regu&ar&y* dai&y.'ee,&y or mont#&y %asis+ t#roug# "ariance re!orts and for re"ising t#e %udgets if necessary. 8re!aring %udgets E am!&e T#e %udgeted sa&es of Magee Engineering Lt. for 1> 4 is as fo&&o's0 8roduct Dag Mag 8ag -a&es units /4.444 1:.444 1<.444 Unit se&&ing !rice 2/< 2/4 2// 8art units 54.444 <4.444 64.444 54.444 14.444

T#e o!ening stoc,s at t#e %eginning of t#e year 1> 4 8roduct 8roduct units Com!onent Dag 3.444 A Mag 3.444 9 8ag /.444 C D E

T#e mar,eting director intends to run a mar,eting cam!aign to'ards t#e end of 1> 4 and #as reAuested t#at !roduct unit stoc,s s#ou&d %e increased at t#e end of 1> 4 a%o"e t#e commencement stoc,s %y t#e fo&&o'ing Dag increased %y /4? Mag increased %y <4?
21

8ag increased %y /4? T#e !urc#asing director #as reAuested t#at a&& com!onents !art stoc,s %e reduced %y /4? at t#e end of 1> 4 %ecause of im!ro"ed de&i"ery times from su!!&iers. T#e !roduct materia& s!ecification and com!onent cost for eac# of t#e !roducts are as fo&&o's0

8roduct Dag Mag 8ag

Com!onent !art 8art cost *eac#+ Com!onent !arts !er !roduct

A <4!

9 3<!

C 64!

D <<!

E 21.4

3 / <

5 3 /

6 5 3

/ / 3

1 1 1

T#e ne'&y a!!ointed managing director as,s you to !re!are t#e fo&&o'ing %udgets and to e !&ain t#e &in,age %et'een t#em. 1 / 3 5 -a&es %udget in !roduct units and "a&ue 8roduction %udget in !roduct units Materia& usage %udget in com!onent !arts. Materia&s !urc#ase %udget in com!onent !arts and "a&ue. 1. -a&es 9udget 1> 4 8roduct Dag Mag 8ag Units /4.444 1:.444 1<.444 $$$$$$$$ <3.444 $$$$$$$$ 8rice 2/< 2/4 2// Tota& sa&es 2<44.444 364.444 334.444 $$$$$$$$$$$$ 21.1>4.444 $$$$$$$$$$$$

Comment0 t#e sa&es %udget is com!uted from t#e sa&es information stated. t#e %udget s#o's t#e t#e indi"idua& !roduct sa&es units.sa&es "a&ue and tota& sa&es "a&ue. T#e %udgeted sa&es for 1> 4 are <3.444 units 'it# a tota& sa&es "a&ue of 21.1>4.444. 8roduction %udget 1> 4
22

-a&es units *from t#e sa&es %udget+ Add c&osing stoc, Less o!ening stoc, 9udgeted out!ut

Dag /4.444 3.644 $$$$$$$$ /3.444 3.444 $$$$$$$ /4.644 $$$$$$$$

Mag 1:.444 5.<44 $$$$$$$$ //.<44 3.444 $$$$$$$$ 1>.<44 $$$$$$$$

8ag 1<.444 /.544 $$$$$$$$ 1;.544 3.444 $$$$$$$$ 1<.544 $$$$$$$$

Comment0 t#e !roduction %udget is t#e reAuired !roduction to meet sa&es %udget reAuirements and c#anges in stoc,s. t#us since c&osing stoc, reAuirements are greater t#an o!ening stoc,s t#en !roduction must %e increased to co!e 'it# reAuired !roduction for sa&es and increased c&osing stoc, reAuirements. 3. Materia&s Usage 9udget 1> 4 *Com!onent usage+ 8roduct Dag Mag 8ag 8rod. units /4.644 1>.<44 1<.544 $$$$$$$$ <<.<44 $$$$$$$$ A 61.:44 3>.444 ;;.444 $$$$$$$$ 1;;.444 $$$$$$$$$ 9 :/.544 <:.<44 34.:44 $$$$$$$$ 34.:44 $$$$$$$$ C 1/3.644 ;:.444 56./44 $$$$$$$$ 1;1.;44 $$$$$$$$$ D 51./44 3>.444 56./44 $$$$$$$$ /5;.:44 $$$$$$$$$ E /4.644 1>.<44 1<.544 $$$$$$$$ <<.<44 $$$$$$$$

Comment0 t#e materia& usage %udget is t#e com!onent usage. T#is is sim!&y t#e !roduction units from t#e !roduction %udget eAuated to t#e com!onent s!ecification in eac# !roduction unit eg. materia& usage of com!ont A is t#e tota& usage of com!onent A in Dag. Mag and 8ag. 5. T#e Materia& 8urc#ase 9udget 1> 4 Com!onent A 9 C D Materia& usage %udget 1;;.:44 1;1.;44 /5;.:44 1/6.544 C&osing stoc, 3/.444 54.444 5:.444 3/.444 $$$$$$$$$$ $$$$$$$$$$ $$$$$$$$$ $$$$$$$$$$ /4>.:44 /11.;44 /><.:44 1<:.544 O!ening stoc, 54.444 <4.444 64.444 54.444 $$$$$$$$$ $$$$$$$$$ $$$$$$$$$ $$$$$$$$$ 16>.:44 161.;44 /3<.:44 11:.544 8rice !er com!onent <4! 3<! 64! <<! 2:5.>44 2<6.<>< 2151.5:4 26<.1/4

E <<.<44 :.444 $$$$$$$$$$ 63.<44 14.444 $$$$$$$$$ <3.<44 21.44 2<3.<44

Comment0 T#e materia& !urc#ase %udget gi"es t#e cost and Auantity of eac# com!onent t#at is needed to %e !urc#ased and t#e o"era&& cost of a&& fi"e com!onents. T#is %udget is %ased on t#e materia& usage %udget adCusted for o!!ening and c&osing stoc,s.

23

Cas# 9udgets T#e cas# %udget s#o's t#e forecasted cas# inf&o's and outf&o's of a %usiness and measure t#e estimated %a&ance or deficit of cas#for a !articu&ar !eriod. T#e ad"antages of !&anning for cas# resources is essentia& since a %usiness cannot sur"i"e 'it#out cas#. Ad"antages0 T#e cas# %udget ensures adeAuate cas# !&anning and contro& *a+ Cas# deficits are re"ea&ed and management can res!ond %y ta,ing a!!ro!riate action. Remedia& action can %e ta,en %y inCecting more ca!ita& into t#e %usiness. %y %orro'ing. %y e amining t#eir credit !o&icy or %y deferring ca!ita& e !enditure. Cas# sur!&uses are indicated and once recognised need to %e managed. Management can in"est cas# in t#e s#ort$term. or a"ai& of trade discounts %y %u&, !urc#asing materia&s or finance ca!ita& !roCects.

*%+

E am!&e T#e London Toy Co. Ltd. commenced o!erations in Decem%er 1> 4 'it# a ca!ita& of 2644.444 '#ic# 'as raised t#roug# an issue of 644.444 ordinary s#ares of 21 eac#. T#e !roceeds of t#e s#are issue 'ere !aid into t#e com!any %an, account. During t#e course of Decem%er a num%er of transactions too, !&ace and t#ese are summari)ed %e&o'. Cas# summary Decem%er 1> 4 2 8roceeds from s#are issue Less Lease#o&d !remises */4 years+ 8&ant *est. &ife 14 years+ EAui!ment *est. &ife 14 years+ Too&s Ra' materia&s Cas# %a&ance a"ai&a%&e Hou are gi"en t#e fo&&o'ing additiona& information. *a+ -a&es are %udgeted as fo&&o's0 2:4.444 in NanuaryO 2164.444 in 1e%ruary and 2/54.444 in su%seAuent mont#s. 1ifty !er cent of t#e sa&es 'i&& %e cas# sa&es and t#e ot#er fifty !er cent credit sa&es. T#e !eriod of credit e tended to customes 'i&& %e one mont#. T#e cost of ra' materia&s 'i&& amount to 54? of t#e sa&es re"enue. @a&f t#e materia&s cost for any one mont# 'i&& %e !aid in cas#O t#e ot#er #a&f 'i&& %e !aid for during t#e mont# of !urc#ase. 344.444 :4.444 164.444 /4.444 14.444 $$$$$$$$$$ 2 644.444

<;4.444 $$$$$$$$$$ 34.444 FFFFFF

*%+

24

*c+ *d+

T#e com!any intends to ,ee! a stoc, of ra' materia&s of 214.444 t#roug#out t#e year. Direct 'ages 'i&& %e incurred at t#e rate of 2<4.444 !er mont#. No time &ag is e !ected #ere.

Ot#er e !enses$ de!reciation on !remises. !&ant and eAui!ment 'i&& %e ca&cu&ated on a straig#t$&ine %asis. T#e too&s 'i&& %e re$"a&ued annua&&y and it is e !ected t#at annua& &osses 'i&& amount to /4 !er cent. A&& ot#er e !enses 'i&& %e incurred at t#e rate of 254.444 !er mont# $ t#e time &ag #ere 'i&& %e one mont#. Hou are as,ed to !re!are t#e com!any(s Cas# %udget. a %udgeted 8rofit and Loss account for t#e first si mont#s of o!erations and a %udgeted 9a&ance -#eet as at 34 Nune 1> 1. Nan 2444 34 54 $$$$$$ ;4 $$$$$$ 16 <4 $$$$$$ 66 $$$$$$ 5 FFF 1e% 2444 5 :4 54 $$$$$$ 1/5 $$$$$$ 3/ 16 <4 54 $$$$$$ 13: $$$$$$ *15+ FFF Mar 2444 *15+ 1/4 :4 $$$$$$ 1:6 $$$$$ 5: 3/ <4 54 $$$$$$ 1;4 $$$$$$ 16 FFF A!r 2444 16 1/4 1/4 $$$$$$ /<6 $$$$$ 5: 5: <4 54 $$$$$$ 1:6 $$$$$$ ;4 FFF May 2444 ;4 1/4 1/4 $$$$$$$ 314 $$$$$$ 5: 5: <4 54 $$$$$$ 1:6 $$$$$$ 1/5 FFF Nun 2444 1/5 Memo 2444

O!ening %a&ance Cas# inf&o' Cas# sa&es Credit sa&es Tota& Cas# outf&o' Ra' mats. $cas# Ra' mat. $credit Direct 'ages Ot#er e !enses Tota& C&osing %a&ance

1/4 1/4 1/4Dr $$$$$$$ 365 $$$$$$ 5: 5: <4 54 $$$$$$ 1:6 $$$$$$ 1;: FFF

5:Cr 54Cr

-tudents s#ou&d note t#at0 *a+ *%+ De!reciation ne"er a!!ears in a cas# %udget as it is a non$cas# e !ense. In res!ect to credit transactions time &ags #a"e to %e %ui&t into t#e cas# %udget

It is usefu& to #a"e a memo co&umn to record items '#ic# 'i&& a!!ear in t#e %a&ance s#eet if reAuired.

9udgeted 8rofit and Loss Account for si mont#s ending 34 Nune 1> 1 Cost of sa&es Direct 'ages 2 5:4.444 344.444 2 -a&es ;:4.444
25

2 1./44.444

$$$$$$$$$$ O!erating !rofit 5/4.444 $$$$$$$$$$ 1./44.444 FFFFFFF O!erating !rofit ;.<44 5.444 :.444 /.444 $$$$$$$ $$$$$$$$$$$ 1./44.444 FFFFFFF 5/4.444

De!reciation 8remises 8&ant EAui!ment Too&s Ot#er e !enses Net !rofit

/1.<44 /54.444 1<:.<44 $$$$$$$$$$ 5/4.444 FFFFFF

$$$$$$$$$$ 5/4.444 FFFFFF

T#e !rofit and &oss account is !re!ared on an accrua&s %asis un&i,e t#e cas# %udget '#ic# is !re!ared on a recei!ts and !ayments %asis. A&so. de!reciation a!!ears as an e !ense in t#e !rofit and &oss account. 9udgeted 9a&ance -#eet as at 34 Nune 1> 1 Aut#orised and Issued Ca!ita& 644.444 Ord. s#ares 21 eac# Reser"es 8rofit and &oss account 2 1i ed assets 644.444 8remises 8&ant 1<:.<44 EAui!ment Too&s 2 Cost 344.444 :4.444 164.444 /4.444 $$$$$$$$$ <64.444 $$$$$$$$$ 14.444 1/4.444 1;:.444 $$$$$$$$$ $ 2 De!. ;.<44 5.444 :.444 /.444 $$$$$$$$ /1.<44 $$$$$$$$$ 2 N9D />/.<44 ;6.444 1</.444 1:.444 $$$$$$$$$ <3:.<44

Current Lia%i&ities Creditors Accrued e !enses

Current assets 5:.444 Materia&s 54.444 De%tors Cas# $$$$$$$$ :56.444 FFFFFF

34:.444 $$$$$$$$$$ :56.444 FFFFF

9udgeted de%tors. creditors and cas# %a&ance is o%tained from t#e cas# %udget. Detai&s of fi ed assets can %e o%tained from t#e ca!ita& e !enditure %udget. Information a%out s#are ca!ita&. de%entures etc. can a&so %e o%tained from t#e !re"ious %a&ance s#eet. 9udgeting $ t#e Contro& 8rocess Definition0

26

9udgetary contro& is t#e esta%&is#ment of de!artmenta& %udgets re&ating t#e res!onsi%i&ities of e ecuti"es and t#e continuous com!arison of actua& 'it# %udgeted resu&ts. eit#er to secure %y indi"idua& action t#e o%Cecti"e of t#at !o&icy or to !ro"ide a %asis for its re"ision. T#e %udget itse&f is mere&y a !&an on !a!er '#ic# of itse&f 'i&& not %e effecti"e un&ess t#ere is a system of contro& '#ic# can monitor t#e organisation(s !rogress to ac#ie"ing t#e o%Cecti"es. 9y means of com!aring actua& resu&ts 'it# t#e %udgets and identifying any differences *"ariances+ '#ic# occur management can ta,e remedia& action or re"ise t#e %udget if necessary. T#e annua& %udgets are %ro,en do'n into mont#s so t#e com!arison is !erformed regu&ar&y and resu&ts in a %udget re!ort i!resented to t#e de!artmenta& managers. To ensure t#at management are not o"er%urdened 'it# accounting data e ce!tion re!orts may %e furnis#ed. T#ese re!orts identify on&y significant "ariances t#at reAuire management(s attention and conseAuent&y are more user friend&y and s#ou&d encourage an a!!ro!riate manageria& res!onse. 8ersonne& De!t Cost Descri!ti code on 414 -u!er"iso rs( sa&ary 1&e i%&e 9udgeting U! to t#is !oint t#e %udget #as %een fi ed. T#is is Auite a!!ro!riate for !&anning !ur!oses %ut of &itt&e use for contro& !ur!oses. T#e fi ed %udget does not res!ond to t#e actua& &e"e& of acti"ity. =#en organisations com!i&e t#e master %udget it is %ased on a certain &e"e& of out!ut and sa&es. In most instances. t#e com!any may find t#at t#is o!erating &e"e& is not set at t#e actua& &e"e& of acti"ity. Indeed most organisations find it difficu&t to forecast t#e actua& &e"e& of acti"ity eg. t#ere may %e a seasona& c#aracteristic to t#e com!any( trading. In suc# cases t#e %usiness may find it more usefu& to !re!are f&e i%&e %udgets. A f&e i%&e %udget is Gdesigned to c#ange in accordance 'it# t#e &e"e& of acti"ity attained( *CIMA+ A fi ed %udget is not designed to c#ange 'it# different &e"e&s of acti"ity. It does not a&&o' for t#e !re$determination of costs and re"enues at different &e"e&s of out!ut '#ic# 'ou&d faci&itate com!arison 'it# actua& costs and t#e identification of "ariances. A f&e i%&e %udget is designed to recognise cost %e#a"iour at different &e"e&s of out!ut so actua& resu&ts can %e com!ared 'it# t#e e !ected resu&ts and t#e com!utation of "ariances and "ariance ana&ysis is made !ossi%&e. E am!&e0 A com!any !roduces garden furniture '#ic# e !eriences f&uctuations in !roduction &e"e&s %ecause of its seasona& nature. T#e fo&&o'ing costs for t#e %udgeted &e"e& of acti"ity of /4.444 units and t#e actua& !roduction costs f!r t#e !eriod are gi"en. 9udget Costs */4.444 units+ 2 /1.444 1.444 Actua& costs incurred *1;.644 units+ 2 /4.444 >:4
27

Mont#&y 9udget Re!ort 1e%ruary 9udget Actua& Dariance 9udget Actua& 2<:.444 26<.444 2;.444 *A+ 2116.44 4 21/<.4 44

Dariance 2>.444 *A+

Materia&s $ "aria%&e La%our $ "aria%&e

Maintenance $ "aria%&e 1i ed !roduction costs -e&&ing costs $ fi ed

3.444 14.444 <.444 $$$$$$$$ 54.444 $$$$$$$$

/.6:4 14.444 6.444 $$$$$$$$ 3>644 $$$$$$$$

During t#e re&e"ant !eriod. t#e actua& num%er of units !roduced 'as 1;.644. Hou are reAuired to !re!are a %udget f&e ed at t#e actua& &e"e& of acti"ity. In !re!aring t#e f&e ed %udgets it is im!ortant to identify fi ed and "aria%&e costs to forecast costs at different &e"e&s of acti"ity. Actua& costs Materia&s La%our Maintenance 1i ed !roductioon costs -e&&ing costs 2 /4.444 >:4 /.6:4 14.444 6.444 $$$$$$$ 3>.664 $$$$$$$$ 1&e ed %udget *1;.644 units+ 2 1:.5:4 ::4 /.654 14.444 <.444 $$$$$$$ <.444 $$$$$$$ Dariance 2 1.</4 *A+ 144 *A+ 54 *A+ $$$$$ 1.444 *A+ $$$$$$$$$$$ /.664 $$$$$$$$$$

T#e "ariance re!ort #ig#&ig#ts t#at in res!ect to actua& materia&s. &a%our. maintenance and se&&ing costs. t#ese are #ig#er t#an e !ected. Management can e amine and ana&yse t#e "ariances and ta,e a!!ro!riate action. Many %usinesses !re!are fi ed %udgets for de!artments '#ere e !enditure may %e more !redicta%&e suc# as t#e administration de!artment. 1&e i%&e %udgets can %e com!i&ed for t#ose de!artments '#ose e !enditure is c&ose&y &in,ed to t#e &e"e& of o!erations suc# as t#e !roduction de!artment.

T#e @uman E&ement in 9udgeting -o far t#e em!#asis #as %een on t#e tec#nica& as!ects of %udgeting "i). t#e !re!aration and administration of %udgets. @o'e"er. t#e %e#a"ioura& conte t deser"es mention. One of t#e main com!onents of %udgeting is contro& '#ic# is a&& a%out a&tering t#e %e#a"iour of t#e #uman resources in t#e organisation. ConseAuent&y. t#ere may %e some staff '#o regard %udgets as a constraint on t#eir freedom and may try to su%"ert t#e effecti"eness of t#e %udget. @o' can senior management ensure t#at t#e %udgeting system can %e most effecti"eB Researc# findings assert t#at managers !refer to 'or, to'ards ac#ie"ing o%Cecti"es '#ic# moti"ate t#em. It a!!ears t#at moti"ation is t#e g&ue '#ic# #o&ds t#e %udgeting and contro& systems toget#er so creating t#is moti"ation is t#e ,ey. T#ere a!!ear to %e a num%er of factors in"o&"ed.
28

9udgets *targets+ s#ou&d %e set at a &e"e& '#ic# are stringent and c#a&&enging %ut attaina%&e. If set too #ig# to %e unattaina%&e t#e staff may %e demora&ised and may not try to ac#ie"e t#e targets. De!artmenta& managers in consu&tation 'it# t#eir staff s#ou&d %e !ermitted to !artici!ate in t#e setting of t#eir %udgets %y so doing t#ey 'i&& #a"e o'ners#i! of t#em and 'i&& stri"e to attain t#em. 8artici!ation c&arifies res!onsi%i&ities. increases communication t#roug#out t#e organisation and can #e&! to !romote &ine$staff re&ations. @o'e"er. it is 'e&& to ac,no'&edge !ossi%&e dysfunctiona& %e#a"iour as a conseAuence of !artici!ation in %udget$setting suc# as G%udgetary !adding( or G%udgetary s&ac,(. It may ser"e t#e manager to %ui&d Gs&ac, into t#e %udget ie. to #a"e a G!ad( %et'een t#e forma& !&an and t#e e !ected actua& resu&ts so t#at t#ey #a"e a cus#ion in case unantici!ated e"ents cause t#eir !erformance to dec&ine. -ince %udgets tend to %e used as a management !erformance criteria t#ere s#ou&d %e a re'ard system in !&ace. Too often %udgets are used as a mec#anism to focus on !oor !erformance so is it any 'onder t#at t#e staff #a"e negati"e fee&ing a%out t#em. O"erem!#asis on !erformance7"ariance re!orts may encourage negati"e attitudes to %udgeting. @o!'ood referred to t#e G%udget constrained( sty&e of management 'it# !erformance in meeting t#e %udget as t#e main criteria.

T#e organisation s#ou&d %e concerned 'it# ot#er management !erformance criteria suc# as concern 'it# Aua&ity. good industria& re&ations. coo!eration 'it# co&&eagues etc. T#ere are significant %enefits for organisations '#ic# engage in %udgeting. 1 9udgeting forces management to focus on t#e future. to consider t#e dynamics of t#e e terna& en"ironment and identify t#e !otentia& o!!ortunities and t#reats. In t#e !rocess of !re!aring t#e %udgets managers are com!e&&ed to co$ ordinate t#e "arious acti"ities of t#e organisation and to %e &ess Gde!artmenta& minded( and to %e more Gcom!any minded(. It tends to encourage communication t#roug#out t#e organisation. -taff are a'are of '#at t#ey are e !ected to ac#ie"e and regu&ar %udget re!orts and %udget meetings ,ee! t#em informed. 9y assigning manageria& res!onsi%i&ity for t#e attainment of t#e %udgets and t#e regu&ar com!arison of actua& resu&ts and e !ected outcomes indi"idua& manageria& !erformance can %e ascertained. Researc# #as indicated t#e ro&e %udgets #a"e in moti"ating managers to ac#ie"e t#e com!any(s o%Cecti"es. Good !erformance can &ead to career ad"ancement so t#e managers desire to %e successfu& is &in,ed to t#e success of t#e com!any.

<

29

INDE-TMENT A88RAI-AL MET@OD-

30

Lesson 5 Most of t#e decisions management #a"e to dea& 'it# are tactica& and s#ort$run %ut on occasion t#ey may #a"e to consider a decision t#at re&ates to a &ong !eriod of time. Once t#e decision is ta,en t#e %usiness #as to &i"e 'it# it and may find it difficu&t to disin"est or re"erse so a great dea& of care #as to %e ta,en in t#ese decisions.. In t#e !&anning !rocess t#e com!any may #a"e decided to !ersue a gro't# strategy so t#ere may #a"e to %e in"estment in ca!ita& !roCects to sustain t#e gro't# in sa&es and !roducti"e ca!acity. Ca!ita& e !enditure on ne' %ui&dings. !&ant and mac#inery may %e needed from time to time. Again t#e com!any may decide rat#er t#an gro' organica&&y a strategy of merger or ta,eo"er is %est. =#ate"er t#e stategy t#e "arious in"estment !roCects #a"e to %e !ro!er&y a!!raised. Ca!ita& !roCects #a"e to c#osen and decisions as to t#e financing of t#em #as to %e determined. Definition0 Ca!ita& in"estment a!!raisa& is t#e !rocess of e"a&uating t#e cost and %enefits of a !ro!osed in"estment in o!erating assets. T#e a!!raisa& !rocess consists of measuring t#e inf&o's of cas# against t#e outf&o's of cas# '#ic# arise as a conseAuence of t#e decision. T#ere are fi"e main a!!raisa& tec#niAues0 1 8ay%ac, T#is tec#niAue considers t#e &engt# of time it ta,es to reco"er t#e initia& in"esment out&ay and t#e !roCect starts to !ay for itse&f. If a com!any in"ests 2144.444 on a ca!ita& !roCect t#e Auestion is #o' &ong does it ta,e to get %ac, 2144.444 cas# from t#e !roCect. Cas# f&o' does not inc&ude any non$cas# items suc# as de!reciation. T#erefore. if t#e in"estment returns are gi"en in !rofit after de!reciation terms t#e annua& de!reciation is added %ac,. Net cas# f&o' is t#e difference %et'een cas# recei"ed and cas# !aid during a defined !eriod of time. E am!&e0 A com!any is considering in"esting in a ne' mac#ine '#ic# costs 2144.444. T#e fo&&o'ing information is a"ai&a%&e0 2 Initia& out&ay Net cas# f&o' Hear 1 Hear / Hear 3 Hear < Net !rofita%i&ity ReAuired0 =#at is t#e !roCect(s !ay%ac, !eriodB /4.444 34.444 54.444 /4.444 $$$$$$$$ 2 144.444

114.444 $$$$$$$$ 14.444 $$$$$$$

31

T#e !roCect !ays for itse&f after 517/ years. At t#e end of t#at !eriod t#e !roCect !roduces net cas# f&o's of 2144.444 eAua& to t#e cost of t#e origina& in"estment. T#e !ay%ac, met#od #as uni"ersa& a!!ea& %ecause of its sim!&icity and t#e fact t#at it tends to fa"our &ess ris,y ca!ita& !roCects. 8roCects t#at ta,e too &ong to !ay for t#emse&"es are ris,ier and t#is met#od tends to reCect t#ese. / Accounting rate of return

T#is met#od esta%&is#es t#e re&ations#i! %et'een t#e ca!ita& cost of a !roCect and t#e !rofits accruing. T#e accounting rate of return is ca&cu&ated %y t#e fo&&o'ing formu&a. A"erage annua& !rofit $$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$ A"erage cost of in"estment

144

An a"erage !rofit is ca&cu&ated o"er t#e &ife of t#e !roCect. T#e a"erage cost of in"estment is ca&cu&ated %y adding t#e initia& cost of t#e in"estment and t#e "a&ue at t#e end of its usefu& &ife di"ided %y t'o. E am!&e0 A com!any #as t'o a&ternati"e !roCects A and 9. eac# in"o&"ing an out&ay of 2<44.444 and 2644.444 Eac# !roCect #as an economic &ife of < years. 8roCect A #as a residua& "a&ue of 2<4.444. Annua& !rofits %efore de!reciation is 2/44.444 %efore de!reciation. 8roCect A 2 <44.444 1.444.444 <44.444 $$$$$$$$$$ <44.444 $$$$$$$$$ 144.444 $$$$$$$$$$ 54? 8roCect 9 2 644.444 1.444.444 <<4.444 $$$$$$$$$$ 5<4.444 $$$$$$$$$ >4.444 $$$$$$$$ /:?

Initia& out&ay Annua& !rofits *Hr. 1$<+ Less de!reciation *Hr. 1$<+ 8rofits after de!reciation A"erage net !rofit Accounting rate of return

T#e ARR met#od is easy to administer and is understood %y %usiness in genera& %ecause of is simi&arity 'it# t#e return on in"estment *ROCE+ ratio.

T#e main disad"antage 'it# !ay%ac, and accounting rate of return is %ot# ignore t#e time "a&ue of money. Money #as a "a&ue in time. name&y. a rate of
32

interest. If 21 is in"ested for 1 year at a rate of interest of 14? t#e in"estment gro's to 21.14 at t#e end of year 1. If 21.14 is in"ested in year / t#e in"estment gro's to 21./1 at t#e end of year /. T#is !rocess is ca&&ed compounding '#ic# is re!resented %y t#e formu&a 21*1 M r+n. T#e o!!osite of com!ounding is discounting. T#is ans'ers t#e Auestion G '#at is 21 recei"a%&e in a year(s time 'ort# in today(s "a&ueB( In !resent "a&ue terms 21 recei"a%&e in a years time *assuming t#e rate of interest is 14?+ is 24.>4>. T#e formu&a for discounting is0 21 $$$$$$$$$$$ *1 M r+n In"estment a!!raisa& com!ares t#e cas# outf&o's 'it# t#e cas# returns from t#e !roCect and t#ese cas# f&o's ta,e !&ace o"er a &engt#y !eriod of time. Discounting a&&o's a&& t#e cas# f&o's to %e con"erted to !resent day "a&ues '#ic# !ermits meaningfu& com!arison. T#e fo&&o'ing in"estment a!!raisa& met#ods em!&oy t#e discounting of cas# f&o's. 3 Net 8resent Da&ue

A !articu&ar rate of interest is used to discount future f&o's of cas# to !resent "a&ues. T#e discount rate used mig#t ref&ect t#e cost of o%taining ca!ita&. or a target rate7cut$off rate.or a ris,$adCusted rate. Once t#e future cas# f&o's are discounted to !resent$day "a&ues t#ey are tota&&ed and com!ared 'it# t#e cost of t#e !roCect. If t#e discounted cas# f&o's e ceed t#e cost t#e difference is t#e net cas# f&o'. In genera&. if t#e N8D is !ositi"e t#e !roCect is 'ort# considering. E am!&e0 A com!any 'is#es to e"a&uate a ca!ita& !roCect %ased on t#e fo&&o'ing information. T#e initia& out&ay is 2144.444 and t#e !roCect #as an economic &ife of < years and rea&ises 2<.444 '#en it is so&d at t#e end of year <. T#e !rofits after de!reciation #a"e %een estimated as year 1$3 214.444 and 21<.444 in t#e fina& t'o years. T#e rate of interest is 14?.

Hear 4 1 / 3 5 < 6

Cas# f&o' 2 *144.444+ />.444 />.444 />.444 35.444 35.444 <.444

Discount factor 8resent "a&ue Cumu&ati"e 8D 2 2 1 *144.444+ 4.>4> /6.361 /6.361 4.:/6 /3.><5 <4.31< 4.;<1 //.>3> ;3./<5 4.6:3 /3./// >5.5;6 4.6/1 /1.115 11;.<>4 4.<65 /.:/4 1/4.514 $$$$$$$$$ N8D F/4.514 $$$$$$$$

-ince t#eN8D is M2/4.514. t#e !roCect is 'ort#'#i&e.

Discounted !ay%ac,
33

In t#e ca&cu&ation of t#e N8D in t#e !re"ious e am!&e a co&umn records t#e cumu&ati"e !resent "a&ue of t#e cas# f&o's. -ince t#e !ay%ac, met#od is criticised for ignoring t#e time "a&ue of money it is !ossi%&e to remedy t#is s#ortcoming %y using t#e discounted cas# f&o's to ascertain t#e !ay%ac, !eriod. In t#is e am!&e. t#e !ay%ac, !eriod is Cust o"er 5years. T#ere is a s#ortfa&& of 2<.</5 '#ic# #as to %e generated in year <. 2<.</5 $$$$$$$$$ 211;.<>4 36< days F 1; days

T#e discounted !ay%ac, !eriod is 5yrs. 1; days. < Interna& Rate of Return

-ometimes t#e com!any 'is#es to ,no' t#e interna& rate of return *IRR+ ie. t#e yie&d of a ca!ita& !roCect. T#e com!any may o!erate a cut$off !oint in res!ect to !roCects and s#ou&d a !roCect(s yie&d %e %e&o' t#is target or t#res#o&d it 'i&& %e reCected. T#e met#od is to discount cas# f&o's using different discount rates unti& t#e N8D F 4. At t#at !oint t#e tota& !resent "a&ue of t#e cas# f&o's is eAua& to t#e out&ay on t#e !roCect. T#e discount rate '#ic# !roduces a N8D F 4 is t#e interna& rate of return of t#e !roCect. In effect. t#e com!any cou&d %orro' money at a rate of interest eAua& to t#e interna& rate of return to finance t#e !roCect and t#e returns from t#e !roCect 'ou&d a&&o' t#e com!any to %rea, e"en. If t#e com!any(s target rate of return for ca!ita& !roCects is &ess t#an a !roCect(s yie&d *IRR+ t#e !roCect is 'ort# consideration. E am!&e0 Using t#e data from t#e !re"ious N8D e am!&e 'or, out t#e !roCects IRR. At a discount rate of 14? t#e N8D F M2/4.514. To !roduce a negati"e N8D a #ig#er discount rate needs to %e c#osen. T#e met#od !roceeds on a tria& and error %asis. =#at is t#e resu&t if a discount rate of /4? is used. 8resent Da&ue *2+ *144.444+ /5.1<; /4.1/6 16.;>1 16.3:: 13.66: 16;< $$$$$$$$ N8DF $ ;./5< $$$$$$$ To determine t#e discount rate '#ic# !roduces N8D F 4 a !rocess of inter!o&ation is used. A&ternati"e&y. it may %e so&"ed gra!#ica&&y. Hear 4 1 / 3 5 < 6 Cas# f&o' *2+ *144.444+ />.444 />.444 />.444 35.444 35.444 <.444 Discount factor /4? 4 4.:33 4.6>5 4.<;> 4.5:/ 4.54/ 4.33<

34

T#e formu&a for inter!o&ation is0 IRR F A M P a 7 a $% Q 14? M *A$9+ E /4? $ 14? F 1;?

2/4.514 $$$$$$$$$$$$$$$$ *2/4.514 M 2;./5<+

T#e yie&d or IRR of t#e !roCect is 1;?. If t#is is #ig#er t#an t#e com!any(s target rate for !roCects it is 'ort# consideration. 6 8rofita%i&ity Inde

In t#e case '#ere a com!any #as a num%er of a&ternati"e !roCects and #as &imited resources it is usefu& to find a 'ay of ran,ing t#ese in re&ation to t#eir !otentia& !rofita%i&ity. T#e met#od is to di"ide t#e discounted cas# f&o's %y t#e initia& cost of t#e !roCect. 8rofita%i&ity inde for !roCect E F 21/4514 $$$$$$$$$$$ F 1./ 2144.444 1or e"ery 21 in"ested 21./ 'ort# of cas# f&o' is generated.

35

T@E CO-TING O1 ODER@EAD-

36

Lesson <

A%sor!tion Costing

Definition0 O"er#eads are e !enses ot#er t#an direct e !enses. T#ey inc&ude indirect materia&s. indirect &a%our and ot#er indirect e !enses. T#e !rime costs $ direct 'ages cost and t#e cost of materia&s consumed can %e easi&y ascertained and c#arged to a Co% or !rocess. @o'e"er. many costs are incurred so t#at t#e %usiness can o!erate eg. rent. rates. de!reciation. #eat and &ig#t etc. T#e tec#niAue for c#arging o"er#eads to !roducts. Co%s or !rocesses is ca&&ed a%sor!tion costing. A%sor!tion costing is concerned 'it# t#e ty!e and nature of costs rat#er t#an cost %e#a"iour. T#ere are t'o main !ur!oses of a%sor!tion costing0 *1+ to ascertain t#e cost of a !roduct. Co% or !rocess. */+ to assist %usiness 'it# t#eir !ricing $ a cost !&us a!!roac#. Cost ana&ysis consists of t#e fo&&o'ing com!onents Direct materia&s Direct &a%our Direct e !ense 8rime cost 8roduction o"er#eads 8roduction cost -e&&ing R Distri%ution o"er#eads Administration o"er#eads Tota& cost E E E $$$$$$$$ E E $$$$$$$ E E E $$$$$$$$ E $$$$$$$$$

M M M M M

It is re&ati"e&y easy to ascertain t#e !rime cost as t#ey are c&ose&y identified 'it# t#e fina& !roduct. @o'e"er it is more difficu&t to re&ate t#e indirect costs $ t#e o"er#eads to t#e !roduct. A%sor!tion costing is an attem!t to ac#ie"e t#is so t#at o"er#eas can %e c#arged to !roducts. T#ere are t#ree stages in t#e a%sor!tion costing !rocess$ a&&ocation. a!!ortionment and a%sor!tion. A&&ocation is t#e !rocess of &ocating o"er#eads '#ic# can %e identified 'it# a !articu&ar cost centre in t#at cost centre. O"er#ead items '#ic# cannot %e identified 'it# a cost centre %ut are incurred for t#e %enefit of t#e entire %usiness must %e s#ared out or a!!ortioned across a num%er of cost centres. If t#ere are o"er#eads &ocated in non$!roduction or ser"ice cost centres t#ey must %e re$a!!ortioned to !roduction cost centres. 1ina&&y. '#en a&& t#e !roduction o"er#eads are &ocated in !roduction cost centres t#e fina& stage of a%sor%ing or reco"ering t#e o"er#eads and c#arging t#em to a !roduct. Co% or !rocess. E am!&e0
37

T#e fo&&o'ing cost items #a"e %een identified in a com!any 'it# t'o cost centres De!ts. A R 9. T#e f&oor area of De!t. A is /.444 sA. ft. and De!t. 9 is 1.444 sA. ft. T#e "a&ue of mac#inery used in De!t. A is 21.444 and 25444 in De!t. 9. -a&aries of su!er"isors in De!t. A Indirect materia&s used in De!t. 9 Rent R Rates Lig#t R @eat Insurance of mac#inery 254.444 23<.444 234.444 21<.444 2<.444 $$$$$$$$$$$ 21/<.444 $$$$$$$$$$$ De!t. 9 23<.444 214.444 2<.444 25.444 $$$$$$$$$$ 2<5.444 $$$$$$$$$$ Tota& 254.444 23<.444 234.444 21<.444 2<.444 $$$$$$$$$$$ 21/<.444 $$$$$$$$$$$

O"er#ead -a&aries Ind. materia&s Rent R Rates Lig#t R @eat Insurance

9asis A&&ocate A&&ocate 1&oor area 1&oor area Da&ue of Mac#.

De!t. A 254.444 2/4.444 214.444 21.444 $$$$$$$$$$ 2;1.444 $$$$$$$$$$

In a!!ortioning costs a suita%&e %asis is used eg. f&oor area is used to di"ide t#e rent of t#e factory %et'een t#e t'o cost centres. T#e fo&&o'ing %ases of a!!ortionment is usefu& in dea&ing 'it# certain o"er#ead cost items. O"er#ead cost item Rent R Rates. Lig#t R @eating De!reciation. insurance of mac#inery 8o'er costs Canteen e !enses Maintenance costs for !remises 9asis 1&oor area of cost centre Origina& cost or %oo, "a&ue @orse !o'er of mac#inery Num%er of em!&oyees in cost centre 1&oor area

Once o"er#eads are a&&ocated and a!!ortioned among a num%er of cost centre if t#ere are any o"er#eads &ocated in non$!roduction cost centres t#ese #a"e to %e remo"ed and re$a!!ortioned to t#e !roduction de!artments. E am!&e0 A com!any #as t#e fo&&o'ing distri%ution of o"er#eads in t'o !roduction de!artments A and 9 and t'o ser"ice de!artments. a stores and a maintenance de!artment. ReAuisitions from t#e stores %y De!ts. A and 9 are 21.444 and 2<44 res!ecti"e&y. T#e maintenance !ersonne& s!end t#ree$Auarters of t#eir time in De!t. A and t#e remainder in De!t. 9.

O"er#ead A&&ocated R A!!ortioned Rea!!ortion -tores costs

De!t. A 2 14.444 /.444

De!t. 9 2 <.444 1444

-tores 2 3.444 $$$

Canteen 2 5.444
38

Rea!!ortion Maintenance costs

3.444 $$$$$$$$$ 1<.444 $$$$$$$$

1.444 $$$$$$$$ ;.444 $$$$$$$

$$$$$$$$ 4 $$$$$$$

$$$ $$$$$$$ 4 $$$$$$$

In t#e a%sor!tion stage an o"er#ead reco"ery *a%sor!tion+ rate *OAR+ is ca&cu&ated. T#e formu&a used is0 9udgeted 8roduction O"er#eads $$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$ -uita%&e %asis

OAR

A num%er of %ases can %e used to com!ute an o"er#ead rate eg. &a%our cost !ercentage. materia& cost !ercentage. !rime cost !ercentage and cost units. Genera&&y. %usinesses use an acti"ity rate to reco"er o"er#eads. T#is rate is usua&&y &a%our #ours or if a!!ro!riate mac#ine #ours. -ince many of t#e o"er#eads arise as a conseAuence of t#e em!&oyment of &a%our or t#e use of mec#anisation it a!!ears reasona%&e to em!&oy one or ot#er of t#ese %ases.

E am!&e0 Lets assume De!t. A is a mec#anised o!eration and #as 34.444 mac#ine #ours '#ereas De!t. 9 #as on&y 5.444 mac#ine #ours. La%our #ours in De!t. A is <.444 and is 3<.444 &a%our #ours. O"er#eads in De!t. A is 21<.444 and 2;.444 in De!t.9. De!t. A OAR F #r. 34.444 mac#ine #rs. De!t. 9 OAR F #r. 3<.444 &a%our #rs. 2;.444 $$$$$$$$$$$$$ F 24./4 !er &a%our 21<.444 $$$$$$$$$$$$ F 24.<4 !er mac#ine

39

E am!&e0 T#e com!any ma,es t'o !roducts E and H. T#e fo&&o'ing information is a"ai&a%&e0 8roduct E 2 14 1/ 5 8roduct H 2 1/ 15 6

Direct materia&s Direct &a%our *=age rate 2/ !er #r.+ Mac#ine #ours in De!t. A

ReAuired0 Ca&cu&ate t#e !roduction cost of t#e t'o !roducts. 8roduct E 2 //.44 /.44 1./4 $$$$$$$$$ /3./4 $$$$$$$$$ 8roduct H 2 /6.44 *6 #rs. 4.<4+ 3.44 *; #rs. 4./4+ 1.54 $$$$$$$$$$ 34.54 $$$$$$$$$

8rime cost M 8roduction o"er#eads De!t. A *5 #rs. 4.<4+ De!t. 9 *6 #rs. 4./4+

40

Lesson 6

Acti"ity 9ased Costing

In recent years t#ere #as %een criticism of t#e traditiona& system of costing for o"er#eads *Ia!&an R Coo!er+. Traditiona& cost systems 'ere designed '#en0 direct costs 'ere t#e dominant factory costsO o"er#ead costs 'ere re&ati"e&y sma&&O information !rocessing costs 'ere #ig#O t#ere 'as a &ac, of intense g&o%a& com!etitionO a &imited range of !roducts 'as !roduced. Traditiona& !roduct costing measures accurate&y "o&ume$re&ated resources e.g. direct costs %ut t#ey fai& to measure t#e 'ay !roducts consume non$"o&ume re&ated acti"ities e.g. su!!ort ser"ices &i,e materia& #and&ing. set$u! costs. ins!ection costs. Resources are used u! '#en t#ese acti"ities are triggered %y !roduction. It is t#e !roducts '#ic# cause t#ese acti"ities to arise and A9C attem!ts to trace t#e consum!tion of t#ese acti"ities %y t#e "arious !roducts. 8roducts '#ic# demand a &ot of acti"ities and resources are a&&ocated an a!!ro!riate s#are of t#e o"er#eads. 1or e am!&e. a ne' !roduct 'i&& !ro%a%&y %e &o' "o&ume initia&&y. reAuiring a &ot of mac#ine set$u!s. Aua&ity testing etc. so it s#ou&d %ear t#e o"er#eads it is causing to %e created. E am!&e0 T'o !roducts A and 9 are !roduced * <444 units of A and 5<444 units of 9+. Eac# !roduct reAuires t#e same num%er of mac#ine7direct &a%our #ours. Num%er of set$u!s0 A F 14 9F< T#e cost of set$u!s is 21./m. A%sor!tion costing0 8roduct A F 21/4.444 *14? of 21./m.+ 7 <444units F 2/5 !er unit 8roduct 9 F 21.4:m *>4? of 21./m.+ 7 5<.444 units F 2/5 !er unit A9C system0 8roduct A F 2:44.444 *1471< 21./m+ 7 <.444 units F 2164 !er unit 8roduct 9 F 2544.444 *<71< 21./m+ 7 5<.444 units F 2:.:> !er unit -ince !roduct A. t#e &o' "o&ume !roduct is res!onsi%&e for t#e greater s#are of t#e set$u! costs it is on&y rig#t t#at it attracts most of t#is o"er#ead. It is t#e num%er of set$u!s t#at is t#e cost dri"er. T#e traditiona& costing system tends to o"ercost #ig# "o&ume !roducts and undercost &o'$"o&ume %ut com!&e !roducts. Definition0 Acti"ity %ased costing *A9C+ is concerned 'it# Gcost attri%ution to cost units on t#e %asis of %enefit recei"ed from direct acti"ities eg. ordering. set$ u!. assuring Aua&ity(. A9C states t#at acti"ities cause costs and !roducts7cost units consume t#e acti"ities. It is used %y management to determine t#e most !rofita%&e !roducts and to a!!reciate t#e cost im!&ications of t#e o!erationa& acti"ities 'it#in t#e %usiness. It gets management to understand '#at causes costs. T#e tec#niAue uses cost dri"ers to attri%ute costs to acti"ities and cost o%Cects. T#us. o"er#eads can %e re&ated to t#e acti"ities '#ic# cause t#em. A9C di"ides acti"ities into four categories0
41

1 / 3

Unit &e"e& acti"ities '#ic# arise eac# time a !roduct is manufactured eg. mac#ine !o'er. de!reciation of mac#inery etc. Transaction &e"e& acti"ities '#ic# arise eac# time a transaction #a!!ens eg. Aua&ity contro&. ins!ection costs. set$u! costs etc. 8&ant &e"e& acti"ities '#ic# re&ate to costs arising from t#e maintenance and o!eration of t#e %usiness faci&ities.

In a%sor!tion costing o"er#eads are assigned to cost centres and c#arged to cost units %y usua&&y a "o&ume$%ased measure suc# as mac#ine or &a%our #ours '#ereas A9C uses a t'o$fo&d a!!roac# %y &ocating costs in cost !oo&s and identifying cost dri"ers to faci&itate assigning costs to cost units. In !roduct costing it is re&ati"e&y easy to c#arge direct costs to cost units %ut t#e !ro%&em arises in re&ation to indirect costs*o"er#eads+. O"er#ead costs*resource costs+ suc# as rent. rates. maintenance costs. c&eaning materia&s etc. '#ic# can %e identified 'it# a !articu&ar cost !oo& are &ocated t#ere. Ot#er o"er#eads '#ic# cannot %e identified 'it# a cost !oo& are a!!ortioned to t#e cost !oo&s %y means of cost dri"ers '#ic# are t#e main determinants of t#e cost of acti"ities. T#ese o"er#eads are !re$determined in t#at t#ey are !art of t#e %udgeting !rocess. T#ese cost dri"ers mig#t inc&ude t#e num%er of !roduction runs. t#e num%er of customer orders recei"ed. t#e num%er of Aua&ity contro& tests. etc. Acti"ity cost !oo& Ad"ertising Kua&ity contro& 8urc#asing -et$u! costs -tores Des!atc# Acti"ity cost dri"er T#e "a&ue of sa&es in eac# sa&es area T#e num%er of Aua&ity tests T#e num%er of !urc#ase orders T#e num%er of set$u!s7!roduction runs T#e num%er of materia& reAuisitions T#e num%er of des!atc# notes

=#en t#e o"er#eads are &ocated in t#e cost !oo&s an a"erage cost !er transaction is ca&cu&ated %y di"iding t#e tota& cost of an acti"ity %y t#e num%er of transactions !erformed. T#is a"erage cost is t#en used to to c#arge eac# !roduct 'it# t#e amount of ser"ice demanded from eac# acti"ity cost !oo&. ConseAuent&y. !roducts are c#arged 'it# a fairer s#are of t#e o"er#eads t#ey #a"e #e&!ed to create. T#e resu&t is more accurate !roduct costing. %etter decision$ma,ing in res!ect to t#e !roduct out!ut mi and !roduct !ricing. E am!&e0 T#e A9C com!any !roduces t'o !roducts E and H and t#e fo&&o'ing information is gi"en0 8roduction and -a&es *units+ Unit cost *2+ Direct &a%our Direct materia&s O!erating data Mac#ine #ours La%our rate !er #our *2+ Num%er of set$u!s Num%er of ins!ections 8roduct E /<.444 $$$$$$$$ /< 1< 1 1 5 54 8roduct H <.444 $$$$$$$ /4 < / 1 /4 :4
42

Tota& 34.444 $$$$$$$$

O"er#eads 8roduction !rocessing -et$u! Ins!ections ReAuiredO Ca&cu&ate t#e !roduct costs using *a+ A%sor!tion costing *%+ A9C.

2;44.444 21/4.444 21:4.444

*a+ Assuming t#e o"er#eads are a%sor%ed on t#e %asis of direct &a%our #ours. OAR F 9udgeted o"er#eads $$$$$$$$$$$$$$$$$$$$$$$$$$$ La%our #ours F 21.444.444 $$$$$$$$$$$$$ 544.444 F 2/.<4 !er #our

A&& !roduction o"er#eads are &ocated in one cost !oo&. T#e unit costs of !roducts E and H are0 2 E 1<.44 /<.44 3;.<4 $$$$$$$ ;;.<4 $$$$$$$ 2 H <.44 /4.44 1/.<4 $$$$$$$$ 3;.<4 $$$$$$$

Direct &a%our Direct materia&s O"er#ead */.<4 !er d.&.#.+

*%+ In A9C t#ree cost !oo&s are identified "i). !roduction !rocessing. set$u! and ins!ection costs. T#e cost dri"ers are a&so identified eg. Cost Dri"er 8roduction !rocessing Mac#ine set$u!s Ins!ections 9asis Num%er of mac#ine #ours Num%er of mac#ine set$u!s Num%er of ins!ections

T#e o"er#eads !er cost !oo& and t#e rate !er cost dri"er are com!uted. 8roduction !rocessing costs0 8roduction o"er#ead $$$$$$$$$$$$$$$$$$$$$$$$$$$$$ Mac#ine #ours 2;44.444 F $$$$$$$$$$$$ 3<.444

F 2/4 !er mac#.#r.

-et$u! costs0 Cost !er set$u! -et$u! cost $$$$$$$$$$$$$$$$ No. of set$u!s 21/4.444 F $$$$$$$$$$$$ /5 F 2<.444 !er set$u!.

Ins!ection cost0 Cost !er ins!ection Ins!ection cost


43

$$$$$$$$$$$$$$$$$$$ F 21:4.444 F 21.<44 !er No. of ins!ections T#e fina& stage of t#e !rocess is to use t#e cost dri"er rates to assign o"er#ead cost to !roducts. E 2 1<.44 /<.44 /4.44 4.:4 /.54 $$$$$$ 63./4 $$$$$$$ / mac#ine #ours F 254 /4 set$u!s+7<.444 :4 H 2 <.44 /4.44 54.44 /4.44 /5.44 $$$$$$$ 14>.44 $$$$$$$

Direct &a%our Direct materia&s 8roduction o"er#ead *1+ -et$u! costs */+ Ins!ection *3+

1 / 3

E F2/4

1 mac#ine #r. F2/4O H F 2/4

E F *2<.444 units F 2/4

5 set$u!s+7/.<44 units F :4!O H F *2<.444

E F *21.<44 54 ins!ections+7 /<.444 units F 2/.54O H F *21.<44 ins!ections+7 <.444 units F 2/5

T#e com!arison of t#e t'o a!!roac#es is gi"en0 A%sor!tion costing A9C 8roduct E 2;;.<4 63./4 8roduct H 23;.<4 214>.44

Ad"antages of A9C 1 / It recognises t#e rea&ity in ad"anced manufacturing en"ironments t#at o"er#eads are not re&ated to direct &a%our since t#e !ro!ortion of direct &a%our costs is sma&& in t#e tota& costs of a !roduct. Instead acti"ities cause o"er#eads. 3 Traditiona& costing systems tend to understate t#e o"er#ead cost of a &o' "o&ume com!&e !roduct and o"erstate t#e o"er#ead cost of a #ig# "o&ume !roduct. A9C tends to a&&ocate o"er#eads to !roducts '#ic# consume acti"ities '#ic# in turn cause t#e o"er#eads to arise. -ince A9C !roduces more accurate !roduct costs. decisions ta,en %y management are %etter informed eg. !ricing decisions. More accurate !roduct !rofita%i&ity ana&ysis can %e !roduced. It creates an a'areness of t#e "arious acti"ities t#at ta,e !&ace in an organisation and focuses on non$"a&ue added acti"ities to ascertain '#et#er t#ey are needed or not.

5 < 6

44

-TANDARD CO-TING

45

Lesson ;

-tandard Costing

-tandard costing is a management contro& system '#ic# is to %e found in manufacturing industry in !articu&ar. Nust &i,e %udgetary contro&. standard costing is a&so !art of t#e contro& system. 9ot# use "ariance ana&ysis. -tandard costing is a unitary conce!t ie. it uses standard materia& cost or standard &a%our cost. 9udgeting. on t#e ot#er #and uses t#ese unit standard costs to com!i&e tota& costs eg. materia& costs or &a%our costs. Dariances re!resent t#e differences %et'een standard costs and actua& costs. T#e standard cost is '#at t#e cost is estimated to %e and t#is is com!ared to '#at t#e cost is actua&&y. Dariances are c&assified as fa"oura%&e if t#e actua& costs are &ess t#an t#e standard costs and !rofit is increased as a conseAuence. Ad"erse "ariances decrease !rofits. -ome "ariances may %e contro&&a%&e if t#e indi"idua& manager can inf&uence t#e actua& costs. -ome organisations o!erate on t#e !rinci!&e of management b! exception. T#e accountant !resents an e ce!tion re!ort '#ic# #ig#&ig#ts t#e significant "ariances. T#is means management need on&y in"estigate certain "ariances '#ic# &ie outside set to&erance &e"e&s. A -tandard cost is defined as G a !re$determined cost ca&cu&ated in re&ation to a !rescri%ed set of 'or,ing conditions. corre&ating tec#nica& s!ecifications and scientific measurements of materia&s and &a%our to t#e !rices and 'age rates e !ected to a!!&y during t#e !eriod to '#ic# t#e standard cost is e !ected to re&ate. 'it# an addition of an a!!ro!riate s#are of %udgeted o"er#ead(. It is a cost 'or,ed out in ad"ance of !roduction of t#e e !ected cost of a !roduct or ser"ice. Ad"antages of standard costing 1 / 3
4

It !ro"ides management 'it# a consistent met#od of com!aring actua& !erformance 'it# !&anned !erformance. It !ro"ides a means of ensuring t#at !rodution resources are !urc#ased and used efficient&y. In esta%&is#ing standards management can e amine and a!!raise e isting !ractices and !rocedures to ensure cost$effecti"eness and efficiency. It can incu&cate cost$consciousness in t#e staff. It #e&!s to moti"ate staff %y setting rea&istic standards. Using "ariance ana&ysis !erformance ca %e monitored and im!ro"ements in 'or, met#ods can resu&t.

< 6

Ty!es of -tandard
46

Idea& standard $ assumes !erfect !roduction conditions 'it# no mec#anica& fai&ure. no stoc,$outs. no staff a%senteeism etc. It is unattaina%&e %ut is an indication of '#at to stri"e for.

Attaina%&e standard $ is a rea&istic target and is %ased on efficient 'or,ing conditions 'it# a&&o'ance made for mac#ine %rea,$do'n. stoc,$outs etc. 9asic standard $ is a standard set for use o"er a &ong !eriod of time and is used to com!are 'it# current standards to see t#e effect of c#anges in conditions o"er t#e years. Current standard $ is set to ref&ect current conditions so #a"e &imited use in time. In times of inf&ation suc# standards may %e set mont#&y.

Dariance Ana&ysis Direct Materia& Dariance T#e main reason for actua& and estimated costs %eing different are eit#er a c#ange in t#e !rice of materia&s or a c#ange in t#e usage of materia&. 1 Materia&s !rice "ariance is t#e difference in cost t#at resu&ts from t#e !rice %eing different to t#e standard. *-tandard !rice $ Actua& !rice+ / Actua& materia& usage

Materia&s usage "ariance is t#e difference %et'een t#e actua& usage of materia& and t#e standard usage mu&ti!&ied %y t#e standard !rice. *Actua& usage $ -tandard usage+ -tandard !rice

Tota& materia& "ariance F Actua& Materia& cost $ -tandard Materia& cost

Direct La%our Dariances 1 La%our rate "ariance is t#e difference %et'een t#e actua& 'age rate and t#e standard rate of !ay times t#e actua& #ours 'or,ed. *Actua& $ -tandard rate of !ay+ / Actua& #ours 'or,ed

La%our efficiency "ariance is t#e difference %et'een t#e actua& #ours 'or,ed and t#e standard #ours i.e. t#e #ours t#at s#ou&d #a"e %een 'or,ed to !roduce t#e actua& out!ut. *Actua& #ours $ -tandard #ours+ -tandard rate of !ay

Tota& &a%our "ariance F Actua& La%our cost $ -tandard La%our cost

47

Daria%&e O"er#ead Dariances 1 T#e "aria%&e o"er#ead "ariance is t#e difference %et'een t#e "aria%&e o"er#ead cost actua&&y incurred and t#e cost '#ic# s#ou&d #a"e %een incurred for t#e actua& #ours 'or,ed. T#is assumes t#at "aria%&e o"er#eads are direct&y attri%uta%&e to &a%our #ours. Actua& e !enditure $ * -tandard #ours 'or,ed rate + / T#e "aria%&e o"er#ead efficiency "ariance is t#e difference %et'een t#e amount of o"er#eads reco"ered %ased on t#e standard #ours of !roduction and t#e amount '#ic# s#ou&d #a"e %een reco"ered if t#e actua& #ours 'or,ed #ad %een at standard efficiency. *Actua& #rs. 'or,ed $ -tandard #rs. 'or,ed+ 3 Daria%&e O"er#ead rate Daria%&e O"er#ead

Tota& Daria%&e O(@ Dariance F Actua& Daria%&e O(@ cost $ -tandard Daria%&e O(@ cost

1i ed O"er#ead Dariances 1 T#e fi ed o"er#ead e !enditure "ariance is t#e difference %et'een t#e e !enditure actua&&y incurred and t#at actua&&y %udgeted. Actua& e !enditure $ 9udgeted e !enditure / T#e fi ed o"er#ead "o&ume "ariance measure t#e amount of any under or o"er reco"ery of o"er#eads due to actua& out!ut * measure in terms of standard #ours of actua& !roduction + %eing different to t#at %udgeted. Tota& 1i ed O"er#ead Dariance F Actua& Cost $ -tandard Cost -a&es Dariances 1 T#e sa&es margin !rice "ariance gi"es t#e effect on !rofits of a c#ange in se&&ing !rice. * Actua& !rice $ -tandard !rice + / -a&es "o&ume

T#e sa&es margin Auantity "ariance is t#e difference in !rofit '#ic# resu&ts from a c#ange in t#e sa&es "o&ume. * Actua& sa&es $ 9udgeted sa&es + -tandard !rofit margin

Tota& -a&es Dariance F Actua& -a&es $ -tandard -a&es

48

8ro%&ems 'it# -tandard Costing 1


2

-tandard setting is a &engt#y and cost&y !rocedure. -tandards are often seen %y t#e staff as restrictions on t#eir %e#a"iour '#ic# can &ead to dysfunctiona&ism. Re!orting "ariances may not %e time&y. cost effecti"e and encourage manageria& res!onse. -tandards in"aria%&y !roduce "ariances some of '#ic# may not %e contro&&a%&e eg. materia& !rices '#ic# can resu&t in unnecessary re!orting and in"estigation. -tandard costing may %e ina!!ro!riate for certain ,inds of manufacturing eg. Nust$in$ Time.

3 5

<

E am!&e A com!any E Ltd. !roduces a sing&e !roduct. T#e standard cost !er unit and t#e actua& resu&ts for a 5 'ee, !eriod are as fo&&o's0 -tandard Costs Direct Materia&s *1 ,i&o+ Direct La%our */ #ours+ Daria%&e O"er#eads 1i ed O"er#eads -tandard Cost -tandard Margin -tandard -e&&ing 8rice 2 14 14 / < Actua& Costs -a&es Direct Materia&s 11./44 ,i&os J 2>.: Direct La%our /1.444 #ours J 2< $$$$$$$$$$$$$$ Daria%&e O"er#eads /; 3 1i ed O"er#eads $$$$$$$$$$$$$$ $ 34 Net 8rofit $$$$$$$$$$$$$$ $ Actua& out!ut 11.444 units 2 31>.444 14>.;64 14<.444 /1.<44 </.444 $$$$$$$$$$$$$$ 34.;44 $$$$$$$$$$$$$$$

9udget out!ut for t#e mont# 14.444 units

49

-o&ution Materia&s 8rice Dariance * -8 $ A8 + AK * 214 $ 2>.:4+ 11./44 ,i&os F 2//54 *1+ Materia&s Usage Dariance * -K $ AK + -8 * 11444, $ 11/44, + La%our rate "ariance * -R $ AR + A@ * 2< $2< + /1444#rs. F 4 La%our efficiency "ariance * -@ $ A@ + -R * //444#rs. $ /1444#rs. + Daria%&e O"er#ead Dariance * Actua& e !enditure $ * @rs. 'or,ed DOAR+ * 2/1<44 $ * /1444#rs. 21 + F 2<44 *A+ Daria%&e o"er#ead efficiency "ariance O"er#ead actua&&y reco"ered $ O"er#ead reco"ered at standard &a%our efficiency *//444 21 $ /1444 21+ F 21444 *1+ 1i ed o"er#ead e !enditure "ariance * 9udgeted e !enditure $ Actua& e !enditure + * 2<4444 $ 2</444 + F 2 /444 *A+ 1i ed o"er#ead "o&ume "ariance * 9udgeted out!ut $ Actua& out!ut + 1OAR * /4444#rs. $ //444#rs. + 2/.<4S F 2<444 *1+ 1i ed o"er#ead a%sor!tion rate of 2< is eAui"a&ent to 2/.<4 !er #our. -a&es margin !rice "ariance * -tandard se&&ing !rice $ Actua& !rice + * 234 $ 2/> + 11444 F 211444 *A+ -a&es margin Auantity "ariance * Actua& sa&es $ 9udgeted sa&es + -tandard margin * 11444 units $ 14444 units + 23 F 23444 *1+ -a&es "o&ume 2< F 2<444 *1+ 214 F 2/444 *A+

50

RE-8ON-I9ILITH ACCOUNTING

Res!onsi%i&ity Accounting descri%es t#e decentra&isation of aut#ority 'it# !erformance of t#e decentra&ised units measured in terms of accounting resu&ts.

51

Res!onsi%i&ity Accounting recognises "arious decision centres t#roug#out an organisation and trace costs. re"enues. assets and &ia%i&ities to t#e indi"idua& managers '#o are res!onsi%&e for ma,ing decisions a%out t#e costs in Auestion. It is a G system of accounting t#at segregates re"enues and costs into areas of !ersona& res!onsi%i&ity in order to assess t#e !erformance attained %y !ersons to '#om aut#ority #as %een assigned(. Accounting re!orts are !ro"ided so t#at e"ery manager is a'are of a&& t#e items '#ic# are 'it#in #is7#er area of aut#ority so t#at #e is in a !osition to e !&ain t#em. T#ere are t#ree res!onsi%i&ity centres or units. A res!onsi%i&ity centre is( a unit or function of an organisation #eaded %y a manager #a"ing direct res!onsi%i&ity for its !erformance(. Ty!e of unit Cost centre 8rofit centre In"estment centre Manager #as contro& o"er Contro&&a%&e costs Contro&&a%&e costs -a&es "o&ume7!rices Contro&&a%&e costs -a&es In"estment in fi ed7 =C assets 8erformance Measurement Dariance Ana&ysis. Efficiency measures 8rofit Return on In"estment Residua& Income Ot#er financia& ratios

Cost centre0 Ga &ocation function or item of eAui!ment in res!ect of '#ic# costs may %e ascertained and re&ated to cost units for contro& !ur!oses(. 8rofit centreO Ga segment of t#e %usiness entity %y '#ic# %ot# re"enues are recei"ed and e !enditures are caused or contro&&ed. suc# re"enues and e !enditure %eing used to e"a&uate segmenta& !erformanceT( T#e manager of a !rofit centre is made accounta%&e and res!onsi%&e for t#e !rofits ac#ie"ed. T#e manager s#ou&d %e a%&e to ma,e decisions '#ic# may im!ro"e !rofita%i&ity. In organisations '#ere !o'er is centra&ised t#e indi"idua& manager may not #a"e autonomy to ma,e t#ese decisions. In"estment centre0 G a !rofit centre in '#ic# in!uts are measured interms of e !enses and out!uts are measured in terms of re"enues and in '#ic# assets em!&oyed are measured U t#e e cess of re"enue o"er e !enditure t#en %eing re&ated to assets em!&oyed(. T#e in"estment centre or di"isiona& manager is a&&o'ed discretion a%out t#e amount of in"estment underta,en %y t#e di"ision so !rofit measurement a&one is not sufficient to measure !erformance. 8rofit s#ou&d %e re&ated to t#e ca!ita& em!&oyed in t#e di"ision.

52

Di"isiona& Management 8erformance T#ere are t'o main !erformance measures for di"isions U Return on Ca!ita& Em!&oyed or Risidua& Income. ROCE or ROI is a re&ati"e statistic it &oo,s at t#e re&ations#i! %et'een !rofita%i&ity and ca!ita& em!&oyed. Net 8rofit7 Net In"estment in Assets ROI can %e used in t'o 'ays. *1+ */+ As a contro& tec#niAue to com!are di"isiona& !erformance 'it#in a com!any. As a !&anning decision tec#niAue to decide to acce!t or reCect !roCects

ROI can %e &oo,ed at in t'o 'ays0 ROI F Net !rofit 7 Net in"estment in assets OR ROI F Net !rofit $$$$$$$$$$$$$$$$ -a&es -a&es $$$$$$$$$$$$ Net assets

ROI is not on&y a function of profitabilit! %ut is a&so a resu&t of asset utilisation It is essentia& t#at '#en t#e ratio is used for com!arison !ur!oses t#at t#e same accounting ru&es and !rocedures are used to arri"e at !rofit and ca!ita& em!&oyed.

Management action Reduce &e"e& of costs Increase !rofit mar, u! on sa&es Reduce net assets em!&oyed Increase &e"e& of sa&es

Effect on ROI Im!ro"ement in 8rofit e&ement Im!ro"ement in Asset use e&ement

Ad"antages *1+ */+ *3+ It is regarded as one of t#e !rime !erformance measures It dea&s 'it# !rofit and net assets '#ic# are conce!ts 'e&& understood in %usiness. Usefu& for com!arison of one %usiness unit 'it# anot#er !ro"ided t#e same accounting ru&es are used.

Limitations 53

*1+ Can &ead to su%$o!tima& decision$ma,ing. A manager 'i&& %e un'i&&ing to acce!t !roCects and in"estment o!!ortunities '#ic# do not !roduce a ROCE eAua& or %etter to t#e current ROCE %eing earned %y t#at di"ision. *-ee o"er#ead+ */+ Care #as to %e e ercised in terms of #o' t#e ROCE is ca&cu&ated. Net !rofit7 Ca!ita& em!&oyed Net !rofit. Contro&&a%&e contri%ution. Contri%ution. Ca!ita& em!&oyed U net tota& assets. intangi%&e assetsB. &eased or #ired assets

*5+

T#ere can %e mani!u&ation of t#e ratio. It can &ead to an em!#asis on s#ort$termism in res!ect to t#e !rofit figure. T#e tota& asset figure can %e mani!u&ated$ a re&uctance to in"est in ne' assets. &ease rat#er t#an %uy assets.

*<+

Limitations of ROI T#e main dra'%ac, 'it# ROI is it can &ead to su%$o!tima& decision$ma,ing. If a di"isiona& manager(s !erformance is to a!!raised %y ROI #e7s#e 'i&& %e un'i&&ing to acce!t !roCects '#ic# do not rea&ise a return at &east eAua& to t#e current ROI %eing earned %y t#at di"ision. EG. A di"isiona& manager #as in"estment in assets standing at 25 mi&&ion 'it# a current return of 2:44.444 !rofit. A ne' in"estment o!!ortunity !resents itse&f. T#e in"estment 'ou&d in"o&"e 21.6 mi&&ion 'it# an estimated 2/54.444. T#e manager(s !erformance is determined %y ROI. =ou&d t#e manager acce!t t#e !roCectB Current !osition 2(444 In"estment &e"e& Income from in"estment ROI 5.444 :44 /4?
Ne' !roCect Ne' !osition

2(444 1.644 /54 1<?

2(444 <.644 1.454 1:.6?

T#e manager 'ou&d %e inc&ined to reCect t#e !roCect since it 'ou&d di&ute t#e ROI. Let(s su!!ose t#e com!any(s o"era&& cost of ca!ita& is 14?. Any !roCect '#ic# de&i"ers a return in e cess of 14? increases t#e 'ea&t# of t#e com!any. T#is is su%$o!tima& !&anning and decision$ma,ing.

Net Residua& Income

=#ereas ROI is a re&ati"e measure RI is an a%so&ute income measurement. T#e decision ru&e is if a ne' in"estment !roCect generates a !ositi"e return in e cess of t#e com!any(s cost of ca!ita& s#ou&d %e acce!ted %y di"isions 'it#in t#e organisation.
54

T#e RI 'or,s %y c#arging di"isions 'it# an im!uted interest c#arge eAua& to t#e organisation(s cost of ca!ita&. Any ne' !roCects gi"ing a sur!&us of income after %eing c#arged interest or rent s#ou&d %e acce!ted. Using t#e same information as %efore0 Current !osition 2(444 5.444 :44 *544+ $$$$$$$$$ 544 FFFFFF Ne' !roCect 2(444 1.644 /54 *164+ $$$$$$$$$ :4 FFFFF Ne' !osition 2(444 <.644 1.454 *<64+ $$$$$$$$ 5:4 FFFFF

In"estment &e"e& Income from in"estment Less interest c#arge J 14? NRI

T#e manager 'ou&d acce!t t#e !roCect since #is di"isiona& and t#e com!any(s residua& income is increased after a notiona& rent or interest is c#arged for t#e use of assets.

55