INTRODUCTION TO MANAGEMENT ACCOUNTING

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.

2

Management accounting

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
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£ 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.

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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.

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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

(b)

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.

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(b)

Decision making - Cost behaviour

The classification of costs into variable, fixed and semi-fixed is important in terms of decision-making and cost control, activities that comprise the fundamentals of the management accounting function. 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. Fixed costs can be either committed fixed costs or discretionary fixed costs. Fixed costs are termed fixed because they do not change in response to changes in the level of activity. It should be noted that they are not fixed because they do not change because cost items like rent is often subject to revision. Semi-fixed/semi-variable costs are costs which move in the same direction but not at the same rate as the level of activity. The semi-fixed/semi-variable cost contains a fixed and a variable element. For example, the electricity bill contains a fixed or standing charge and and the variable aspect which depends on usage. 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. Analysing costs by direct observation of the resources required to convert materials into a finished product and applying costs to these activities. Direct materials, direct labour and machine time can be established quite easily. 2 3 By inspecting the accounts the accountant can classify costs as being variable or fixed. High-low method. 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. 10000units 15000units £30000 £40000 1

Example Output

£40000 - £30000 = £10000/ 15000units - 10000= 5000units = £2per unit. The fixed costs therefore are £10000.

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The scattergraph or regression chart.
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Costs

Output On the scattergraph total costs are plotted against output at a number of different activity levels. Then a ‘line of best fit’ is drawn through some of the coordinates. Where this line coincides with the Y axis this represents the level of fixed costs. Once this is established it is simple to calculate the other costs which are not fixed ie. the variable costs. The assumption is that at zero output the business still has to meet the fixed costs- the periodic costs related to time.

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MARGINAL

COSTING

FOR DECISION MAKING

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Lesson 2 Marginal Costing - a technique for short-run decision-making One of the main functions of management is decision-making. Many of the decisions are of a short-term nature. Only rarely is a manager faced with a decision which has a long term impact eg. buying a new machine, expanding the factory, take-over of another company. Since most of the decisions have a shortterm impact it can be assumed that the capacity of the factory will not change. Therefore fixed or periodic costs are not affected by tactical short-run decisions. The only costs which are affected are variable costs ie. those costs which vary directly with the level of activity of the factory. These would include direct materials, direct labour and variable overheads. Also all the decisions comprise a choice between alternative courses of action. Therefore, past costs can have no relevance for future decisions. Past costs can consist of sunk costs or committed costs. In marginal costing all costs are classified according to how they behave. They are either variable or fixed. The fixed costs are treated as periodic ie. they are related to time . Examples of fixed costs would be rent, rates, insurance, depreciation etc. These costs stay constant in the short-term regardless of the decision that management takes. Therefore, in making decisions, in choosing between different alternative courses of action management identifies the variable costs and treats the fixed costs as irrelevant. To summarize the technique of marginal costing: • Costs are classified as either fixed or variable. • In the short-run all fixed costs remain unchanged and therefore treated as irrelevant. • The only relevant costs are variable costs ie. those costs which increase/decrease as output increases/decreases. 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. (ICMA) Marginal cost = variable cost = direct materials direct labour direct expense variable overhead Contribution = sales revenue - variable(marginal) costs

Contribution is the amount which helps to pay off the fixed costs and any excess represents profit. Contribution is not profit.

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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. It is the cost of making one extra unit of output. The definition stesses the manner in which costs behave in relation to the volume of activity. It concerns the identification of variable and fixed costs ie. the costs that increase or decrease as output increases or decreases. Only the variable costs both production and nonproduction change as the output changes. Example: A company manufacture units with avaiable cost per unit of £2 and fixed costs of £5,000. Volume (costs) Variable costs Fixed costs Total cost 0 £ --5,000 ------5,000 ------1 £ 2 5,000 ------5,002 ------1,000 £ 2,000 5,000 ------7,000 ------10,000 £ 20,000 5,000 ------25,000 -------

Note £2 is the marginal cost or variable cost per unit.

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Applications of marginal costing (a) Acceptance of a special order. X Ltd. makes a product which sells for £1.50. The output for the period is 80,000 units of product which represents 80% capacity . Total costs are £90,000 and of these it is estimated that £26.000 are fixed costs. A potential customer offers to buy 20,000 units at £1.10 and this will use up the company’s spare capacity. Should management accept this special order? Sales Marginal costs( 80p per unit) Contribution Fixed costs Profit £120,000 64,000 -------56,000 26,000 -------30,000 --------

Special order: Less Sales(20,000 units @ £1.10) Variable costs(20,000 @ 80p) Extra contribution £22,000 16,000 ---------6,000 ----------

Profits can be increased by an additional £6,000 since fixed costs are already covered. However management must consider other relevant factors in arriving at the final decision. How will existing customers react? They may wish to buy at £1.10 per unit. Could the spare capacity be used more profitably rather than accepting the special order?

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Shut-down decisions

Often management wish to analyse the performance of their products, branches, divisions.

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Consider the following example. Example: Product Sales Less Direct materials Direct labour Fixed overheads A £ 20,000 1,000 3,000 2,000 -------6,000 -------14,000 B £ 50,000 15,000 16,000 7,000 -------38,000 -------12,000 C £ 25,000 10,000 14,000 9,000 -------33,000 -------(8,000) Total £ 95,000 26,000 33,000 18,000 -------77,000 -------18,000

Profit/(Loss)

With product C making a loss management might consider discontinuing this product. However, using marginal costing principles, with fixed costs treated as irrelevant for short-run decision-making the income statement can be reformatted. Prtoduct Sales Less Variable costs Contribution Fixed costs Net profit A £ 20,000 4,000 -------16,000 B £ 50,000 31,000 -------29,000 C £ 25,000 24,000 -------1,000 Total £ 95,000 59,000 -------36,000 18,000 -------18,000 --------

Since product C makes a contribution it may be inadvisable to close it down. If Product C is closed down the company will lose £1,000 contribution and the overall effect would be to reduce profits to £17,000.

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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. Example:
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A company makes product P. A component Q used in the manufacture of P can be purchased from a supplier for £8. 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. Obviously it is cheaper to make than to buy. However, 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. The following data applies to 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. 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. This is an opportunity cost ie. it is the benefit foregone by choosing one course of action over the other.

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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. The limiting factor may be any resource eg. materials, labour or machine hours. 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. Example:
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Product Desired production (units) Selling price per unit Variable cost per unit Contribution per unit

X 1,000 £ 35 15 ----20

Y 2,000 £ 25 10 ----15

Z 500 £ 15 5 ----10

A special machine is used to manufacture the three products and there are only 15,000 machine hours available. Product X uses 20 machine hours per unit. Product Y uses 5 machine hours per unit. Product Z uses 2 machine hours per unit. X 20 20 1 (3) Y 15 5 3 (2) Z 10 2 5 (1)

Contribution per unit No. of machine hrs. Contribution per machine hr. Ranking Desired production level Product Z Product Y Product X 500 units x 2 hrs. 2,000 x 5 hrs 200 x 20

1,000 hrs 10,000 hrs 4,000 hrs

Product Z earns 500 units x £10 = £5,000 contribution Product Y earns 2,000 units x £15 = £30,000 contribution Product X earns 200 units x£20 = £4,000 contribution --------£39,000 contribution ----------

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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. 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.

Sales (units)

2,000

4,000

6,000

8,000

10,000
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Sales revenue Variable costs Contribution Fixed costs Net profit (loss)

------£ 20,000 10,000 -------10,000 20,000 -------(10,000) --------

-----£ 40,000 20,000 -------20,000 20,000 -----------------

------3 60,000 30,000 -------30,000 20,000 -------10,000 -------

------£ 80,000 40,000 -------40,000 20,000 -------20,000 -------

-------£ 100,000 50,000 -------50,000 20,000 -------30,000 --------

At sales of 4000 units the company is at break-even point ie. contribution is equal to the fixed costs.

COST VOLUME PROFIT ANALYSIS

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Lesson 3 Cost Volume Profit Analysis

The CVP model makes the assumptions that costs can be simply divided into fixed and variable costs. It assumes that over a range of output levels - the relevant range - fixed costs remain constant and variable costs increase directly with output. The variable costs behave in a linear fashion. The fixed costs are periodic costs so that cost items such as rent, rates, insurance, depreciation etc. are constant at all levels of output. There is also an assumption that the sales revenue behave in a linear fashion ie. the selling price is constant per unit of output. Economists take a more realistic view of cost behaviour. They contend that variable costs do not behave in a linear fashion but are effected by economies of scale. Companies can benefit from discounts for bulk purchases of materials and the economies from the division of labour. The economists’ model represented in a curvilinear graph shows the total cost line rises steeply at low output levels, levels off within a range of output and finally rises steeply again as the benefits of economies of scale decline. The total revenue line rises steeply, levels off and then declines. 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. As a compromise it is possible to accept the assumptions that the CVP model is based on within a certain range of output - the relevant range. Therefore, 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.

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Let us look at a basic accounting equation ie. Sales - Total costs = Profit or Sales - ( Variable costs - Fixed costs ) = Profit then Sales - Variable costs = Contribution

Contribution is the excess of sales over variable costs and it represents the surplus available to meet the fixed costs. Once the fixed costs have been met any contribution left is profit.

At the break-even point the sales revenue generated covers the total costs and no more.

At the break-even point the contribution is sufficient to meet the fixed costs. 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.

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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

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It is possible to present the profit volume relationship in a chart, a profit-volume chart. This chart dispenses with the need to draw cost and revenue lines and concentrates on the relationship between profit and output. Revenues and Costs (£)

Output (units)

A break-even chart

Profit

Output (units)
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Loss

Limitations of cost volume profit analysis.

CVP analysis is based on a number of simplistic assumptions about cost behaviour which undermine the model’s effectiveness. 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. There is a linear relationship between output and costs and revenues. The economists view tends to dispute this and presents a curvilinear model. The business has only one product or there is a specific constant product mix. The only factor influencing costs and revenues is output. Other factors such as production efficiency and production methods may impact on output.

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3 4

Example: A company has sales of 120,000 units which sell for £1 with the variable costs 50p per unit. The fixed costs are £40,000. The management want to know the B/P point, the margin of safety and the profit. Solve graphically and by formula.

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BUDGETING The Planning Process All organisations have their objectives. 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. However, in this chapter the emphasis is on objectives usually expressed in quantitative terms eg. increase in market share, profit growth, increase in the asset value etc which they wish to achieve. There are three levels of planning - corporate long term planning, medium term planning and annual planning or budgeting. The annual budgets are steps along the way to achieve the long-range plan of the organisation. To ensure that the objectives are achieved plans or budgets must be prepared. Definition: A budget is a financial or quantitative interpretation prior to a defined period of time, of a policy to be pursued for that period, to attain a given objective. Budgets are part of the planning and control process. They help to define the objectives of the organisation. Budgeting is probably the most important contribution that the accounting department makes to the role of management. The accountant draws up a plan which integrates the various functional areas of the business. Control is exercised by firstly, delegating responsibility to departmental managers for the attainment of the budgets and then the regular comparison of the actual results with the planned outcomes. 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.
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The administration of the budget is the responsibility of the budget officer who is usually the accountant . The accountant works in conjunction with the budget committee comprised of the departmental management. Senior management outline the broad strategic objectives of the organisation and communicate these to the functional managers. The budget committee identifies the key budget factor which determines what acts as a constraint on the organisation’s activities. This key budget factor decides the key budget ie. the one which sets the objectives for the subordinate budget. The subordinate budgets are constructed by asking the questions - when are the goods to be sold, where are the goods to be sold and how are the goods to be produced.It may be the sales volume which drives the other subsidiary budgets. For instance, if the sales department forecasts the annual sales at 20,000 units then the production budget must be integrated with this figure. Alternatively, productive capacity may be the key budget factor . The company may have the capacity to produce only 18,000 units a year so this figure sets the objectives for the other budgets. The accountant helps the managers to set the budgets by providing information as required. 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. The current sales level, past trends, market research can provide useful information. On receipt of the various budgets the accountant notifies managers of revisions to their budget. 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. In terms of control the accountant is responsible for the regular monitoring of the budgets, for reporting back to the budget committee regularly( daily,weekly or monthly basis) through variance reports and for revising the budgets if necessary. Preparing budgets Example The budgeted sales of Magee Engineering Lt. for 19x0 is as follows: Product Dag Mag Pag Sales units 20,000 18,000 15,000 Unit selling price £25 £20 £22 Part units 40,000 50,000 60,000 40,000 10,000

The opening stocks at the beginning of the year 19x0 Product Product units Component Dag 3,000 A Mag 3,000 B Pag 2,000 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%
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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. 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 £1.0

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. 1 2 3 4 Sales budget in product units and value Production budget in product units Material usage budget in component parts. Materials purchase budget in component parts and value. 1. Sales Budget 19x0 Product Dag Mag Pag Units 20,000 18,000 15,000 -------53,000 -------Price £25 £20 £22 Total sales £500,000 360,000 330,000 -----------£1,190,000 ------------

Comment: the sales budget is computed from the sales information stated, the budget shows the the individual product sales units,sales value and total sales value. The budgeted sales for 19x0 are 53,000 units with a total sales value of £1,190,000. Production budget 19x0
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Sales units (from the sales budget) Add closing stock Less opening stock Budgeted output

Dag 20,000 3,600 -------23,000 3,000 ------20,600 --------

Mag 18,000 4,500 -------22,500 3,000 -------19,500 --------

Pag 15,000 2,400 -------17,400 3,000 -------15,400 --------

Comment: the production budget is the required production to meet sales budget requirements and changes in stocks, 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. 3. Materials Usage Budget 19x0 (Component usage) Product Dag Mag Pag Prod. units 20,600 19,500 15,400 -------55,500 -------A 61,800 39,000 77,000 -------177,000 --------B 82,400 58,500 30,800 -------30,800 -------C 123,600 78,000 46,200 -------171,700 --------D 41,200 39,000 46,200 -------247,800 --------E 20,600 19,500 15,400 -------55,500 --------

Comment: the material usage budget is the component usage. This is simply the production units from the production budget equated to the component specification in each production unit eg. material usage of compont A is the total usage of component A in Dag, Mag and Pag. 4. The Material Purchase Budget 19x0 Component A B C D Material usage budget 177,800 171,700 247,800 126,400 Closing stock 32,000 40,000 48,000 32,000 -----------------------------------209,800 211,700 295,800 158,400 Opening stock 40,000 50,000 60,000 40,000 --------------------------------169,800 161,700 235,800 118,400 Price per component 50p 35p 60p 55p £84,900 £56,595 £141,480 £65,120

E 55,500 8,000 ---------63,500 10,000 --------53,500 £1.00 £53,500

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. This budget is based on the material usage budget adjusted for oppening and closing stocks.

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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. The advantages of planning for cash resources is essential since a business cannot survive without cash. Advantages: The cash budget ensures adequate cash planning and control (a) Cash deficits are revealed and management can respond by taking appropriate action. Remedial action can be taken by injecting more capital into the business, by borrowing, by examining their credit policy or by deferring capital expenditure. Cash surpluses are indicated and once recognised need to be managed. Management can invest cash in the short-term, or avail of trade discounts by bulk purchasing materials or finance capital projects.

(b)

Example The London Toy Co. Ltd. commenced operations in December 19x0 with a capital of £600,000 which was raised through an issue of 600,000 ordinary shares of £1 each. The proceeds of the share issue were paid into the company bank account. During the course of December a number of transactions took place and these are summarized below. Cash summary December 19x0 £ Proceeds from share issue Less Leasehold premises (20 years) Plant (est. life 10 years) Equipment (est. life 10 years) Tools Raw materials Cash balance available You are given the following additional information. (a) Sales are budgeted as follows: £80,000 in January; £160,000 in February and £240,000 in subsequent months. Fifty per cent of the sales will be cash sales and the other fifty per cent credit sales. The period of credit extended to customes will be one month. The cost of raw materials will amount to 40% of the sales revenue. Half the materials cost for any one month will be paid in cash; the other half will be paid for during the month of purchase. 300,000 80,000 160,000 20,000 10,000 ---------£ 600,000

570,000 ---------30,000 ======

(b)

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(c) (d)

The company intends to keep a stock of raw materials of £10,000 throughout the year. Direct wages will be incurred at the rate of £50,000 per month. No time lag is expected here.

Other expenses- depreciation on premises, plant and equipment will be calculated on a straight-line basis.The tools will be re-valued annually and it is expected that annual losses will amount to 20 per cent. All other expenses will be incurred at the rate of £40,000 per month - the time lag here will be one month. You are asked to prepare the company’s Cash budget, a budgeted Profit and Loss account for the first six months of operations and a budgeted Balance Sheet as at 30 June 19x1. 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. -cash Raw mat. -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. 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.

Budgeted Profit and Loss Account for six months ending 30 June 19x1 Cost of sales Direct wages £ 480,000 300,000 £ Sales 780,000
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£ 1,200,000

---------Operating profit 420,000 ---------1,200,000 ======= Operating profit 7,500 4,000 8,000 2,000 ----------------1,200,000 ======= 420,000

Depreciation Premises Plant Equipment Tools Other expenses Net profit

21,500 240,000 158,500 ---------420,000 ======

---------420,000 ======

The profit and loss account is prepared on an accruals basis unlike the cash budget which is prepared on a receipts and payments basis. Also, depreciation appears as an expense in the profit and loss account. Budgeted Balance Sheet as at 30 June 19x1 Authorised and Issued Capital 600,000 Ord. shares £1 each Reserves Profit and loss account £ Fixed assets 600,000 Premises Plant 158,500 Equipment Tools £ Cost 300,000 80,000 160,000 20,000 --------560,000 --------10,000 120,000 178,000 --------£ Dep. 7,500 4,000 8,000 2,000 -------21,500 --------£ NBV 292,500 76,000 152,000 18,000 --------538,500

Current Liabilities Creditors Accrued expenses

Current assets 48,000 Materials 40,000 Debtors Cash -------846,000 ======

308,000 ---------846,000 =====

Budgeted debtors, creditors and cash balance is obtained from the cash budget. Details of fixed assets can be obtained from the capital expenditure budget. Information about share capital, debentures etc. can also be obtained from the previous balance sheet. Budgeting - the Control Process Definition:

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Budgetary control is the establishment of departmental budgets relating the responsibilities of executives and the continuous comparison of actual with budgeted results, either to secure by individual action the objective of that policy or to provide a basis for its revision. 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. 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. 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. To ensure that management are not overburdened with accounting data exception reports may be furnished. These reports identify only significant variances that require management’s attention and consequently are more user friendly and should encourage an appropriate managerial response. Personnel Dept Cost Descripti code on 010 Superviso rs’ salary Flexible Budgeting Up to this point the budget has been fixed. This is quite appropriate for planning purposes but of little use for control purposes. The fixed budget does not respond to the actual level of activity. When organisations compile the master budget it is based on a certain level of output and sales. In most instances, the company may find that this operating level is not set at the actual level of activity. Indeed most organisations find it difficult to forecast the actual level of activity eg. there may be a seasonal characteristic to the company’ trading. In such cases the business may find it more useful to prepare flexible budgets. 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. 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. 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. Example: A company produces garden furniture which experiences fluctuations in production levels because of its seasonal nature. The following costs for the budgeted level of activity of 20,000 units and the actual production costs fpr the period are given. Budget Costs (20,000 units) £ 21,000 1,000 Actual costs incurred (17,600 units) £ 20,000 980
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Monthly Budget Report February Budget Actual Variance Budget Actual £58,000 £65,000 £7,000 (A) £116,00 0 £125,0 00

Variance £9,000 (A)

Materials - variable Labour - variable

Maintenance - variable Fixed production costs Selling costs - fixed

3,000 10,000 5,000 -------40,000 --------

2,680 10,000 6,000 -------39600 --------

During the relevant period, the actual number of units produced was 17,600. You are required to prepare a budget flexed at the actual level of activity. In preparing the flexed budgets it is important to identify fixed and variable costs to forecast costs at different levels of activity. Actual costs Materials Labour Maintenance Fixed productioon costs Selling costs £ 20,000 980 2,680 10,000 6,000 ------39,660 -------Flexed budget (17,600 units) £ 18,480 880 2,640 10,000 5,000 ------5,000 ------Variance £ 1,520 (A) 100 (A) 40 (A) ----1,000 (A) ----------2,660 ----------

The variance report highlights that in respect to actual materials, labour, maintenance and selling costs, these are higher than expected. Management can examine and analyse the variances and take appropriate action. Many businesses prepare fixed budgets for departments where expenditure may be more predictable such as the administration department. Flexible budgets can be compiled for those departments whose expenditure is closely linked to the level of operations such as the production department.

The Human Element in Budgeting So far the emphasis has been on the technical aspects of budgeting viz. the preparation and administration of budgets. However, the behavioural context deserves mention. One of the main components of budgeting is control which is all about altering the behaviour of the human resources in the organisation. Consequently, there may be some staff who regard budgets as a constraint on their freedom and may try to subvert the effectiveness of the budget. 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. It appears that motivation is the glue which holds the budgeting and control systems together so creating this motivation is the key. There appear to be a number of factors involved.
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1

Budgets (targets) should be set at a level which are stringent and challenging but attainable. If set too high to be unattainable the staff may be demoralised and may not try to achieve the targets. 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. Participation clarifies responsibilities, increases communication throughout the organisation and can help to promote line-staff relations. However, it is well to acknowledge possible dysfunctional behaviour as a consequence of participation in budget-setting such as ‘budgetary padding’ or ‘budgetary slack’. It may serve the manager to build ‘slack into the budget ie. 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. Since budgets tend to be used as a management performance criteria there should be a reward system in place. 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. Overemphasis on performance/variance reports may encourage negative attitudes to budgeting. Hopwood referred to the ‘budget constrained’ style of management with performance in meeting the budget as the main criteria.

2

3

4

The organisation should be concerned with other management performance criteria such as concern with quality, good industrial relations, cooperation with colleagues etc. There are significant benefits for organisations which engage in budgeting. 1 Budgeting forces management to focus on the future, to consider the dynamics of the external environment and identify the potential opportunities and threats. 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’. 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. 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. Research has indicated the role budgets have in motivating managers to achieve the company’s objectives. Good performance can lead to career advancement so the managers desire to be successful is linked to the success of the company.

2

3

4

5

29

INVESTMENT APPRAISAL METHODS

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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. 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.. 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. Capital expenditure on new buildings, plant and machinery may be needed from time to time. Again the company may decide rather than grow organically a strategy of merger or takeover is best. Whatever the stategy the various investment projects have to be properly appraised. Capital projects have to chosen and decisions as to the financing of them has to be determined. 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. 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. If a company invests £100,000 on a capital project the question is how long does it take to get back £100,000 cash from the project. Cash flow does not include any non-cash items such as depreciation. Therefore, if the investment returns are given in profit after depreciation terms the annual depreciation is added back. Net cash flow is the difference between cash received and cash paid during a defined period of time. Example: A company is considering investing in a new machine which costs £100,000. 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? 20,000 30,000 40,000 20,000 -------£ 100,000

110,000 -------10,000 -------

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The project pays for itself after 41/2 years. At the end of that period the project produces net cash flows of £100,000 equal to the cost of the original investment. The payback method has universal appeal because of its simplicity and the fact that it tends to favour less risky capital projects. Projects that take too long to pay for themselves are riskier and this method tends to reject these. 2 Accounting rate of return

This method establishes the relationship between the capital cost of a project and the profits accruing. The accounting rate of return is calculated by the following formula. Average annual profit ------------------------------- x Average cost of investment

100

An average profit is calculated over the life of the project. 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. Example: A company has two alternative projects A and B, each involving an outlay of £500,000 and £600,000 Each project has an economic life of 5 years. Project A has a residual value of £50,000. Annual profits before depreciation is £200,000 before depreciation. Project A £ 500,000 1,000,000 500,000 ---------500,000 --------100,000 ---------40% Project B £ 600,000 1,000,000 550,000 ---------450,000 --------90,000 -------28%

Initial outlay Annual profits (Yr. 1-5) Less depreciation (Yr. 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 main disadvantage with payback and accounting rate of return is both ignore the time value of money. Money has a value in time, namely, a rate of
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interest. If £1 is invested for 1 year at a rate of interest of 10% the investment grows to £1.10 at the end of year 1. If £1.10 is invested in year 2 the investment grows to £1.21 at the end of year 2. This process is called compounding which is represented by the formula £1(1 + r)n. The opposite of compounding is discounting. 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 £0.909. 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. Discounting allows all the cash flows to be converted to present day values which permits meaningful comparison. The following investment appraisal methods employ the discounting of cash flows. 3 Net Present Value

A particular rate of interest is used to discount future flows of cash to present values. The discount rate used might reflect the cost of obtaining capital, or a target rate/cut-off rate,or a risk-adjusted rate. Once the future cash flows are discounted to present-day values they are totalled and compared with the cost of the project. If the discounted cash flows exceed the cost the difference is the net cash flow. In general, if the NPV is positive the project is worth considering. Example: A company wishes to evaluate a capital project based on the following information. The initial outlay is £100,000 and the project has an economic life of 5 years and realises £5,000 when it is sold at the end of year 5. The profits after depreciation have been estimated as year 1-3 £10,000 and £15,000 in the final two years. The rate of interest is 10%.

Year 0 1 2 3 4 5 6

Cash flow £ (100,000) 29,000 29,000 29,000 34,000 34,000 5,000

Discount factor Present value Cumulative PV £ £ 1 (100,000) 0.909 26,361 26,361 0.826 23,954 50,315 0.751 22,939 73,254 0.683 23,222 94,476 0.621 21,114 117,590 0.564 2,820 120,410 --------NPV =20,410 --------

Since theNPV is +£20,410, the project is worthwhile.

4

Discounted payback
33

In the calculation of the NPV in the previous example a column records the cumulative present value of the cash flows. 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. In this example, the payback period is just over 4years. There is a shortfall of £5,524 which has to be generated in year 5. £5,524 365 days --------- x £117,590 = 17 days

The discounted payback period is 4yrs. 17 days. 5 Internal Rate of Return

Sometimes the company wishes to know the internal rate of return (IRR) ie. the yield of a capital project. 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. The method is to discount cash flows using different discount rates until the NPV = 0. At that point the total present value of the cash flows is equal to the outlay on the project. The discount rate which produces a NPV = 0 is the internal rate of return of the project. In effect, 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. If the company’s target rate of return for capital projects is less than a project’s yield (IRR) the project is worth consideration. Example: Using the data from the previous NPV example work out the projects IRR. At a discount rate of 10% the NPV = +£20,410. To produce a negative NPV a higher discount rate needs to be chosen. The method proceeds on a trial and error basis. What is the result if a discount rate of 20% is used. Present Value (£) (100,000) 24,157 20,126 16,791 16,388 13,668 1675 -------NPV= - 7,245 ------To determine the discount rate which produces NPV = 0 a process of interpolation is used. Alternatively, it may be solved graphically. Year 0 1 2 3 4 5 6 Cash flow (£) (100,000) 29,000 29,000 29,000 34,000 34,000 5,000 Discount factor 20% 0 0.833 0.694 0.579 0.482 0.402 0.335

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The formula for interpolation is: IRR = A + [ a / a -b ] x ( A - B ) 10% + £20,410 ---------------(£20,410 + £7,245) X 20% - 10% = 17%

The yield or IRR of the project is 17%. If this is higher than the company’s target rate for projects it is worth consideration. 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. The method is to divide the discounted cash flows by the initial cost of the project. Profitability index for project X = £120410 ----------- = 1.2 £100,000 For every £1 invested £1.2 worth of cash flow is generated.

35

THE COSTING OF OVERHEADS

36

Lesson 5

Absorption Costing

Definition: Overheads are expenses other than direct expenses. They include indirect materials, indirect labour and other indirect expenses. The prime costs direct wages cost and the cost of materials consumed can be easily ascertained and charged to a job or process. However, many costs are incurred so that the business can operate eg. rent, rates, depreciation, heat and light etc. The technique for charging overheads to products, jobs or processes is called absorption costing. Absorption costing is concerned with the type and nature of costs rather than cost behaviour. There are two main purposes of absorption costing: (1) to ascertain the cost of a product, job or process. (2) to assist business with their pricing - a cost plus approach. 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. However it is more difficult to relate the indirect costs - the overheads to the product. Absorption costing is an attempt to achieve this so that overheas can be charged to products. There are three stages in the absorption costing process- allocation, apportionment and absorption. Allocation is the process of locating overheads which can be identified with a particular cost centre in that cost centre. 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. If there are overheads located in non-production or service cost centres they must be re-apportioned to production cost centres. Finally, 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, job or process. Example:
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The following cost items have been identified in a company with two cost centres Depts. A & B. The floor area of Dept. A is 2,000 sq. ft. and Dept. B is 1,000 sq. ft. The value of machinery used in Dept. A is £1,000 and £4000 in Dept. B. Salaries of supervisors in Dept. A Indirect materials used in Dept. B Rent & Rates Light & Heat Insurance of machinery £40,000 £35,000 £30,000 £15,000 £5,000 ----------£125,000 ----------Dept. B £35,000 £10,000 £5,000 £4,000 ---------£54,000 ---------Total £40,000 £35,000 £30,000 £15,000 £5,000 ----------£125,000 -----------

Overhead Salaries Ind. materials Rent & Rates Light & Heat Insurance

Basis Allocate Allocate Floor area Floor area Value of Mach.

Dept. A £40,000 £20,000 £10,000 £1,000 ---------£71,000 ----------

In apportioning costs a suitable basis is used eg. floor area is used to divide the rent of the factory between the two cost centres. The following bases of apportionment is useful in dealing with certain overhead cost items. Overhead cost item Rent & Rates, Light & Heating Depreciation, 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. Example: A company has the following distribution of overheads in two production departments A and B and two service departments, a stores and a maintenance department. Requisitions from the stores by Depts. A and B are £1,000 and £500 respectively. The maintenance personnel spend three-quarters of their time in Dept. A and the remainder in Dept. B.

Overhead Allocated & Apportioned Reapportion Stores costs

Dept. A £ 10,000 2,000

Dept. B £ 5,000 1000

Stores £ 3,000 ---

Canteen £ 4,000
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Reapportion Maintenance costs

3,000 --------15,000 --------

1,000 -------7,000 -------

-------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. labour cost percentage, material cost percentage, prime cost percentage and cost units. Generally, businesses use an activity rate to recover overheads. This rate is usually labour hours or if appropriate machine hours. 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. A is a mechanised operation and has 30,000 machine hours whereas Dept. B has only 4,000 machine hours. Labour hours in Dept. A is 5,000 and is 35,000 labour hours. Overheads in Dept. A is £15,000 and £7,000 in Dept.B. Dept. A OAR = hr. 30,000 machine hrs. Dept. B OAR = hr. 35,000 labour hrs. £7,000 ------------= £0.20 per labour £15,000 -----------= £0.50 per machine

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Example: The company makes two products X and Y. The following information is available: Product X £ 10 12 4 Product Y £ 12 14 6

Direct materials Direct labour (Wage rate £2 per hr.) Machine hours in Dept. A

Required: Calculate the production cost of the two products. Product X £ 22.00 2.00 1.20 --------23.20 --------Product Y £ 26.00 (6 hrs. x 0.50) 3.00 (7 hrs. x 0.20) 1.40 ---------30.40 ---------

Prime cost + Production overheads Dept. A (4 hrs. x 0.50) Dept. B (6 hrs. x 0.20)

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Lesson 6

Activity Based Costing

In recent years there has been criticism of the traditional system of costing for overheads ( Kaplan & Cooper ). Traditional cost systems were designed when: • direct costs were the dominant factory costs; • overhead costs were relatively small; • information processing costs were high; • there was a lack of intense global competition; • a limited range of products was produced. Traditional product costing measures accurately volume-related resources eg. direct costs but they fail to measure the way products consume non-volume related activities eg. support services like material handling, set-up costs, inspection costs. Resources are used up when these activities are triggered by production. It is the products which cause these activities to arise and ABC attempts to trace the consumption of these activities by the various products. Products which demand a lot of activities and resources are allocated an appropriate share of the overheads. For example, a new product will probably be low volume initially, requiring a lot of machine set-ups, quality testing etc. so it should bear the overheads it is causing to be created. Example: Two products A and B are produced ( 5000 units of A and 45000 units of B). Each product requires the same number of machine/direct labour hours. Number of set-ups: A = 10 B=5 The cost of set-ups is £1.2m. Absorption costing: Product A = £120,000 (10% of £1.2m.) / 5000units = £24 per unit Product B = £1.08m (90% of £1.2m.) / 45,000 units = £24 per unit ABC system: Product A = £800,000 (10/15 x £1.2m) / 5,000 units = £160 per unit Product B = £400,000 (5/15 x £1.2m) / 45,000 units = £8.89 per unit Since product A, 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 is the number of set-ups that is the cost driver. The traditional costing system tends to overcost high volume products and undercost low-volume but complex products. Definition: Activity based costing (ABC) is concerned with ‘cost attribution to cost units on the basis of benefit received from direct activities eg. ordering, setup, assuring quality’. ABC states that activities cause costs and products/cost units consume the activities. It is used by management to determine the most profitable products and to appreciate the cost implications of the operational activities within the business. It gets management to understand what causes costs. The technique uses cost drivers to attribute costs to activities and cost objects. Thus, overheads can be related to the activities which cause them. ABC divides activities into four categories:
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1 2 3

Unit level activities which arise each time a product is manufactured eg. machine power, depreciation of machinery etc. Transaction level activities which arise each time a transaction happens eg. quality control, inspection costs, set-up costs etc. Plant level activities which relate to costs arising from the maintenance and operation of the business facilities.

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. In product costing it is relatively easy to charge direct costs to cost units but the problem arises in relation to indirect costs(overheads). Overhead costs(resource costs) such as rent, rates, maintenance costs, cleaning materials etc. which can be identified with a particular cost pool are located there. 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. These overheads are pre-determined in that they are part of the budgeting process. These cost drivers might include the number of production runs, the number of customer orders received, the number of quality control tests, etc. 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. This average cost is then used to to charge each product with the amount of service demanded from each activity cost pool. Consequently, products are charged with a fairer share of the overheads they have helped to create. The result is more accurate product costing, better decision-making in respect to the product output mix and product pricing. 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 25,000 -------25 15 1 1 4 40 Product Y 5,000 ------20 5 2 1 20 80
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Total 30,000 --------

Overheads Production processing Set-up Inspections Required; Calculate the product costs using (a) Absorption costing (b) ABC.

£700,000 £120,000 £180,000

(a) Assuming the overheads are absorbed on the basis of direct labour hours. OAR = Budgeted overheads --------------------------Labour hours = £1,000,000 ------------400,000 = £2.50 per hour

All production overheads are located in one cost pool. The unit costs of products X and Y are: £ X 15.00 25.00 37.50 ------77.50 ------£ Y 5.00 20.00 12.50 -------37.50 -------

Direct labour Direct materials Overhead (2.50 per d.l.h.)

(b) In ABC three cost pools are identified viz. production processing, set-up and inspection costs. The cost drivers are also identified eg. 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 £700,000 = -----------35,000

= £20 per mach.hr.

Set-up costs: Cost per set-up Set-up cost ---------------No. of set-ups £120,000 = -----------24 = £5,000 per set-up.

Inspection cost: Cost per inspection Inspection cost
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------------------- = £180,000 = £1,500 per No. of inspections The final stage of the process is to use the cost driver rates to assign overhead cost to products. X £ 15.00 25.00 20.00 0.80 2.40 -----63.20 ------Y £ 5.00 20.00 40.00 20.00 24.00 ------109.00 -------

Direct labour Direct materials Production overhead (1) Set-up costs (2) Inspection (3)

1 2 3

X =£20 x 1 machine hr. =£20; Y = £20 x 2 machine hours = £40 X = (£5,000 x 4 set-ups)/2,500 units = 80p; Y = (£5,000 x 20 set-ups)/5,000 units = £20 X = (£1,500 x 40 inspections)/ 25,000 units = £2.40; Y = (£1,500 x 80 inspections)/ 5,000 units = £24

The comparison of the two approaches is given: Absorption costing ABC Product X £77.50 63.20 Product Y £37.50 £109.00

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. Instead activities cause overheads. 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. ABC tends to allocate overheads to products which consume activities which in turn cause the overheads to arise. Since ABC produces more accurate product costs, decisions taken by management are better informed eg. pricing decisions. More accurate product profitability analysis can be produced. 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.

4 5 6

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STANDARD COSTING

45

Lesson 7

Standard Costing

Standard costing is a management control system which is to be found in manufacturing industry in particular. Just like budgetary control, standard costing is also part of the control system. Both use variance analysis. Standard costing is a unitary concept ie. it uses standard material cost or standard labour cost. Budgeting, on the other hand uses these unit standard costs to compile total costs eg. material costs or labour costs. Variances represent the differences between standard costs and actual costs. The standard cost is what the cost is estimated to be and this is compared to what the cost is actually. Variances are classified as favourable if the actual costs are less than the standard costs and profit is increased as a consequence. Adverse variances decrease profits. Some variances may be controllable if the individual manager can influence the actual costs. Some organisations operate on the principle of management by exception. The accountant presents an exception report which highlights the significant variances. This means management need only investigate certain variances which lie outside set tolerance levels. A Standard cost is defined as ‘ a pre-determined cost calculated in relation to a prescribed set of working conditions, 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, with an addition of an appropriate share of budgeted overhead’. It is a cost worked out in advance of production of the expected cost of a product or service. Advantages of Standard costing 1 2 3 4 5 6 It provides management with a consistent method of comparing actual performance with planned performance. It provides a means of ensuring that prodution resources are purchased and used efficiently. In establishing standards management can examine and appraise existing practices and procedures to ensure cost-effectiveness and efficiency. It can inculcate cost-conciousness in the staff. It helps to motivate staff by setting realistic standards. Using variance analysis performance ca be monitored and improvements in work methods can result.

Types of Standard
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• Ideal standard - assumes perfect production conditions with no mechanical failure, no stock-outs, no staff absenteeism etc. It is unattainable but is an indication of what to strive for. • Attainable standard - is a realistic target and is based on efficient working conditions with allowance made for machine breakdown , stockouts etc. • Basic standard - 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. • Current standard - is set to reflect current conditions so has limited use in time. In times of inflation such standards may be set monthly. 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. 1 Materials price variance is the difference in cost that results from the price being different to the standard. ( Standard price - 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. ( Actual usage - Standard usage ) x Standard price 3 Total material variance = Actual Material cost - 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. ( Actual - 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. the hours that should have been worked to produce the actual output. ( Actual hours - Standard hours ) x Standard rate of pay 3 Total labour variance = Actual Labour cost - Standard L abour cost

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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. This assumes that variable overheads are directly attributable to labour hours. Actual expenditure - ( 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. ( Actual hrs. worked - Standard hrs. worked ) x Variable Overhead rate 3 Total Variable O’H Variance = Actual Variable O’H cost - 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 expenditure - 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. Total Fixed Overhead Variance = Actual Cost - Standard Cost Sales Variances 1 The sales margin price variance gives the effect on profits of a change in selling price. ( Actual price - 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 sales - Budgeted sales ) x Standard profit margin 3 Total Sales Variance = Actual Sales - Standard Sales

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Problems with Standard Costing 1 2 3 4 Standard setting is a lengthy and costly procedure. Standards are often seen by the staff as restrictions on their behaviour which can lead to dysfunctionalism. Reporting variances may not be timely, cost effective and encourage managerial response. Standards invariably produce variances some of which may not be controllable eg. material prices which can result in unnecessary reporting and investigation. Standard costing may be inappropriate for certain kinds of manufacturing eg. Just-in- Time.

5

Example A company X Ltd. produces a single product. 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 11,200 kilos @ £9.8 Direct Labour 21,000 hours @ £5 -------------- Variable Overheads 27 3 Fixed Overheads -------------30 Net Profit -------------Actual output 11,000 units £ 319,000 109,760 105,000 21,500 52,000 -------------30,700 ---------------

Budget output for the month 10,000 units

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Solution Materials Price Variance ( SP - AP ) x AQ ( £10 - £9.80) x 11,200 kilos = £2240 (F) Materials Usage Variance ( SQ - AQ ) x SP ( 11000k - 11200k ) x £10 = £2000 (A) Labour rate variance ( SR - AR ) x AH ( £5 -£5 ) x 21000hrs. = 0 Labour efficiency variance ( SH - AH ) x SR ( 22000hrs. - 21000hrs. ) x £5 = £5000 (F) Variable Overhead Variance ( Actual expenditure - ( Hrs. worked x VOAR) ( £21500 - ( 21000hrs. x £1 ) = £500 (A) Variable overhead efficiency variance Overhead actually recovered - Overhead recovered at standard labour efficiency (22000 x £1 - 21000x £1) = £1000 (F) Fixed overhead expenditure variance ( Budgeted expenditure - Actual expenditure ) ( £50000 - £52000 ) = £ 2000 (A) Fixed overhead volume variance ( Budgeted output - Actual output ) x FOAR ( 20000hrs. - 22000hrs. ) x £2.50* = £5000 (F) Fixed overhead absorption rate of £5 is equivalent to £2.50 per hour. Sales margin price variance ( Standard selling price - Actual price ) x Sales volume ( £30 - £29 ) x 11000 = £11000 (A) Sales margin quantity variance ( Actual sales - Budgeted sales ) x Standard margin ( 11000 units - 10000 units ) x £3 = £3000 (F)

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RESPONSIBILITY ACCOUNTING

Responsibility Accounting describes the decentralisation of authority with performance of the decentralised units measured in terms of accounting results.

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Responsibility Accounting recognises various decision centres throughout an organisation and trace costs, revenues, assets and liabilities to the individual managers who are responsible for making decisions about the costs in question. 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. There are three responsibility centres or units. A responsibility centre is’ a unit or function of an organisation headed by a manager having direct responsibility for its performance’. 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, 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’. Profit centre; ‘a segment of the business entity by which both revenues are received and expenditures are caused or controlled, 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. The manager should be able to make decisions which may improve profitability. In organisations where power is centralised the individual manager may not have autonomy to make these decisions. 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’. 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. Profit should be related to the capital employed in the division.

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Divisional Management Performance There are two main performance measures for divisions – Return on Capital Employed or Risidual Income. ROCE or ROI is a relative statistic it looks at the relationship between profitability and capital employed. Net Profit/ Net Investment in Assets ROI can be used in two ways. (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.

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. Useful for comparison of one business unit with another provided the same accounting rules are used.

Limitations 53

(1) Can lead to sub-optimal decision-making. 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. (See overhead) (2) Care has to be exercised in terms of how the ROCE is calculated. Net profit/ Capital employed Net profit, Controllable contribution, Contribution. Capital employed – net total assets, intangible assets?, leased or hired assets

(4)

There can be manipulation of the ratio. It can lead to an emphasis on short-termism in respect to the profit figure. The total asset figure can be manipulated- a reluctance to invest in new assets, lease rather than buy assets.

(5)

Limitations of ROI The main drawback with ROI is it can lead to sub-optimal decision-making. 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. EG. A divisional manager has investment in assets standing at £4 million with a current return of £800,000 profit. A new investment opportunity presents itself. The investment would involve £1.6 million with an estimated £240,000. The manager’s performance is determined by ROI. Would the manager accept the project? Current position £’000 Investment level Income from investment ROI 4,000 800 20%
New project New position

£’000 1.600 240 15%

£’000 5,600 1,040 18.6%

The manager would be inclined to reject the project since it would dilute the ROI. Let’s suppose the company’s overall cost of capital is 10%. Any project which delivers a return in excess of 10% increases the wealth of the company. This is sub-optimal planning and decision-making.

Net Residual Income

Whereas ROI is a relative measure RI is an absolute income measurement. 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.
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The RI works by charging divisions with an imputed interest charge equal to the organisation’s cost of capital. Any new projects giving a surplus of income after being charged interest or rent should be accepted. Using the same information as before: Current position £’000 4.000 800 (400) --------400 ====== New project £’000 1,600 240 (160) --------80 ===== New position £’000 5,600 1,040 (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.

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