Financial Decision Making (FINM036)

(University of Northampton- MBA)

Lecturer: Arvind Harris
aharris@mauritius.amity.edu

Topic: Cost and Management Accounting

 Scope of management accounting

 Objective of management accounting

 Differences between financial and management accounting

 Information for strategic, operational and management control

 The framework of cost

 Direct and Indirect costs

 Cost classification

 Break-Even Analysis

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The scope of management accounting

There are many definitions of accounting; - American Accounting Association describes accounting
as ‘ the process of identifying, measuring and communicating economic information to permit
informed judgements and decisions by users of the information’.

In other words, accounting is concerned with providing both financial and non-financial information
that will help decision-makers to make good decisions.

CIMA definition:
Management accounting: the process of identification, measurement, accumulation, analysis,
preparation, interpretation and communication of information used by management to plan,
evaluate and control within an entity and to assure appropriate use of and accountability for its
resources.

The above involves participation in management to ensure that there is effective:

(a) formulation of plans to meet objectives (long-term planning);
(b) formulation of short-term operation plans (budgeting/profit planning) ;
(c) recording of actual transactions (financial accounting and cost accounting);
(d) corrective action to bring future actual transactions into line (financial control);
(e) obtaining and controlling finance (treasurership);
(f) reviewing and reporting on systems and operations (internal audit, management
audit).”

Objectives of Management Accounting

(a) Planning: all organisations should plan ahead in order that they can set objectives and decide
how they should meet them. Planning can be short- or long-term and it is the role of the
management accounting system to provide the information for what to sell, where and at
what price. Management accounting is also central to the budgetary process which we shall
look at in more detail later.

(b) Control: production of the company’s internal accounts, its management accounts, enables
the firm to concentrate on achieving its objectives by identifying which areas are performing
and which are not. The use of management by exception reports enables control to be
exercised where it is most useful.

(c) Organisation: there is a direct relationship between the organisational structure and the
management accounting system. It is often difficult to determine which has the greater
effect on the other, but it is necessary that the management accounting system should
produce the right information at the right cost at the right time, and the organisational
structure should be such that immediate use is made of it.

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(d) Communication: the existence of a budgetary and management accounting system is an
important part of the communication process; plans are outlined to managers so that they
are fully aware of what is required of them and the management accounts tell them whether
or not the desired results are being achieved.

Management accounting compared to financial accounting:

 Future oriented v historical

 Financial and non financial information
 No accounting standards
 No legal requirements
 More detailed and more frequent reporting

The framework of cost accounting

Cost may be defined as ‘the amount of expenditure incurred on or attributable to, a specified thing
or activity’

Costs include two components, quantity used and price, i.e.

Cost = quantity X price

Direct costs
Costs may be classified in numerous ways, but a fundamental and important method of
classification is into direct and indirect costs. Direct costs are those costs which can be directly
identified with a job, batch, product or service. Examples are:

 Direct Materials:

 Direct Labour:

 Direct expenses:

The total of direct costs is known as PRIME COST

i.e. Direct Material + Direct Labour + Direct Expenses = Prime Cost

Indirect Costs

All material, labour and expenses costs which cannot be identified as direct costs are termed
indirect costs. The three elements of indirect costs are indirect material, indirect labour and
indirect expenses and they are known as OVERHEADS. Examples:

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Indirect Material:

Indirect labour:

Indirect expenses:

Note: In practice overheads are usually separated in categories such as Production overheads,
Administration overheads, Selling overheads.

Cost Build-up

Direct Material Indirect material

+ +
Direct Labour = Prime Indirect Labour = Overheads
+ Cost +
Direct Expenses Indirect Expenses

PRIME COST + OVERHEADS = TOTAL COST

Cost Classification

Categorisation of costs is an important early step in the decision-making process; if it is carried out
correctly it should become much easier to make decisions.

Fixed and Variable

Costs may be categorised according to the way they behave. This is a very important
distinction which will be developed later and is a major factor in marginal costing and decision
making.

(a) Fixed Costs

Fixed costs are costs that do not change as output either increases or decreases.
Examples would include rent and rates.

(b) Variable Costs

Variable costs are costs that will change in direct proportion with the increase or decrease
in output. For example, direct material costs will increase in direct proportion to any
change in output.

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(c) Semi-Fixed Costs

Semi-fixed costs will change with the increase or decrease in output. However, in this
case there will not be a proportionate relationship. As its name implies, semi-fixed costs
include elements of both fixed and variable costs. For example, telephone costs include a
fixed element (the rental charge) and a variable call cost.

(d) Stepped Costs

Strictly speaking, these costs are fixed but change at a certain point in volume. For
example, we have already seen that rent is a fixed cost but this only applies up to a certain
level of volume; it is likely that new premises would be required when volume exceeds this
optimum point, but then this element of cost would remain fixed until those new premises
were outgrown, and so on.

Relevant and Common Costs

When managers are deciding between various courses of action, the only information which is
useful to them is detail about what would be changed as a result of their decision, i.e. they need to
know the relevant costs (or incremental or differential costs). The CIMA defines relevant costs as
“costs appropriate to aiding the making of specific management decisions”.

Common costs are those which will be the same in the future regardless of which option is favoured,
and they may be ignored. A frequent example of this is fixed overheads which is not attributable to
a specific product or department.

Opportunity Costs
An opportunity cost is “the value of a benefit sacrificed in favour of an alternative course of action”.

Controllable and Uncontrollable Costs

The distinction between these two classifications depends upon management’s ability to
influence cost levels.

Controllable costs include those expenses that can be controlled by the respective manager.
Uncontrollable costs include those expenses that cannot be controlled by the respective
manager. Such expenses may include rent, rates and depreciation.

Classification of a cost as either “controllable” or “uncontrollable” will probably be influenced by

the manager’s position within the business. A director will be able to influence more costs than a
departmental manager.

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Incremental Costs

Incremental costs are the additional costs incurred as a consequence of a decision and can be
used where these options are being considered.

Incremental costing is useful in deciding on a particular course of action where the effect of
additional expenditure can be measured in sales. This is commonly applied to advertising
expenditure and the incremental increase in revenue.

Avoidable Costs
These are defined as “Those costs, which can be identified with an activity or sector of a
business and which would be avoided if that activity or sector did not exist.”. The concept of
avoidable cost applies primarily to shut-down and divestment decisions.

Committed Costs
These are costs already entered into but not yet paid, which will have to be paid at some stage in
the future. An example would be a contract already entered into by an organisation.

Sunk Cost
This is a cost that has already been incurred. The money has been spent and cannot be
recovered under any circumstances.

Example 1
A company manufactures golf bags. Golf bags have the following manufacturing costs:
£ per bag
Labour (5 hours at £5.00/hour) 25
Materials 40
Variable production overheads 10
In addition, the company has monthly fixed production overhead costs of £100,000.
5,000 golf bags are manufactured every month.

Required
Prepare a statement of total product cost for a batch of 5,000 golf bags which shows prime cost
and production overhead cost as subtotals.

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Example 2
Classify each of the following as being fixed, variable, semi fixed and semi variable;
(i) Direct labour
(ii) Depreciation of machinery
(iii) Factory rent
(iv) Supplies and other indirect materials
(v) Advertising
(vi) Maintenance of machinery
(vii) Factory manager’s salary
(viii) Supervisory personnel
(ix) Royalty payments.

MCQ 1

1. Variable costs…
a. are costs that vary with output
b. increase at a constant rate relative to labor and capital
c. per unit remain stable
d. all of the above

2. Fixed costs…
a. are independent of output
b. per unit decrease relatively to the production
c. often include rent, buildings, machinery, etc.
d. all of the above

3. Daryl Corporation reports costs for the year as follows:

$
Direct Materials Used 390,000
Wages to Line Workers 225,000
Office Rent 53,500
Indirect Materials Used 785,000

How much is the total production costs for the year?

a. $785,000
b. $1,400,000
c. $1,453,500
d. $615,000

4. Grimes Company incurred fixed costs of $310,000. Total costs, both fixed and variable, are
$480,000 when 50,000 units are produced. It sold 40,000 units during the year. Calculate the
variable cost per unit.
a. $9.60
b. $4.25
c. $6.20
d. $3.40

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5. The audit fee paid by a manufacturing company would be classified by that company as:
a. A production overhead cost
b. A selling and distribution cost
c. A research and development cost
d. An administration cost

6. Which one of the following would be classified as indirect labour?

a. Assembly workers on a car production line
b. Bricklayers in a house building company
c. Machinists in a factory producing rubber
d. Forklift truck drivers in the stores of an engineering company

7. A 10% increase in production volume will result in a ________.

a. 10% increase in the selling price per unit
b. 10% increase in total Fixed costs
c. 10% increase in total administration costs
d. 10% increase in total variable costs

8. When the total variable costs are deducted from total costs, we obtain ________.
a. Total cost per unit
b. variable cost per unit
c. total revenue
d. total fixed costs

9. Scamy ltd sells glass vases at a wholesale price of $3 per unit. The variable cost of
manufacture is $1.75 per unit. The fixed costs are $18,000 per month. Schmidt sold 5,500
units during this month. Calculate Scamy’s operating profit (loss) for this month.
a. $9,625
b. $11,125
c. $(11,125)
d. $(18,000)

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 Break-Even Analysis/ Cost- Volume-Profit Analysis
Break-even analysis is related to cost-volume-profit (CVP) analysis. CVP analysis examines how
profit and costs change with a change in volume. More specifically, CVP examines the effects of
how profits are affected by changes in such factors as variable cost, fixed costs, selling prices,
volume and mixed products sold. By studying the relationships between costs, sales and net
income management is able to make informed planning decisions.

Typical short decisions where CVP analysis can be useful include: choice of sales mix, pricing
policies, multi-shift working and special order acceptance.

Assumption behind CVP Analysis

The major assumptions are stated as:

 All costs can be resolved into fixed and variable elements

 Fixed costs will remain constant and variable costs vary proportionately with activity.
 Over the activity range being considered costs and revenues behave in a linear fashion.
 That the only factors affecting costs and revenues is volume.
 That technology, production methods and efficiency remain unchanged.
 There are no stock level changes or that stocks are valued at marginal cost only.

CVP Analysis by Formula

(a). Break-even-point(in units) = Fixed Costs

Contribution/unit

(b). Break-even-point (£ Sales) = Fixed costs X Sales price/unit

Contribution/units

(c). C/S ratio = contribution/ unit X 100

Sales price per unit

(d). Level of sales to result = Fixed costs + Target profit

in target profit (in units) contribution/unit

(e). Level of sales to result = (Fixed costs + Target profit) X Sales price/unit
in target profit (£ sales) contribution/unit

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(f). Margin of safety (MOS) = Forecast sales – Breakeven sales

(g). MOS (%) = Forecast sales – Breakeven Sales X 100

Forecast sales

Question 3.
A company makes a single product with a sales price of £10 and a marginal cost of £6. Fixed costs
are £60,000 p.a.

Calculate
(i) Number of units to break-even.
(ii) Sales at break-even-point.
(iii) C/S ratio.
(iv) What number of units will need to be sold to achieve a profit of £20,000 p.a?
(v) What levels of sales will achieve a profit of £20,000p.a?
(vi) What is the margin of safety?
(vii) Because of increasing costs the marginal cost is expected to rise to £6.50 per unit and
fixed costs to £70,000p.a. If the selling price cannot be increased what will be the
number of units required to maintain a profit of £20,000p.a?

The Traditional Break-Even Chart

An alternative to calculating the B/E point is to show the results graphically using what is known as
a B/E chart.
The CIMA definition of such a chart is:
“A chart which indicates approximate profit or loss at diferent levels of sales volume
within a limited range.”
The vertical axis of the chart is for sales revenue and costs; the horizontal axis is for volume of
activity (i.e. output).

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MCQ 2

1. Which of the following are characteristics of B.E.P? 

A) There is no loss and no profit to the firm.
B) Total revenue is equal to total cost.
C) Contribution is equal to fixed cost.
D) All of the above.

2. .Which of the following statements is true of the behavior of total fixed costs, within the relevant
range?
A) They will remain the same as production levels change.
B) They will increase as production decreases.
C) They will decrease as production decreases.
D) They will decrease as production increases.

3. When the total fixed costs increases, the breakeven point ________.
A) increases
B) decreases
C) decreases proportionately
D) remains the same

4. Grimes Company incurred fixed costs of $310,000. Total costs, both fixed and variable, are
$480,000 when 50,000 units are produced. It sold 40,000 units during the year. Calculate the
variable cost per unit.
A) $9.60
B) $4.25
C) $6.20

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D) $3.40

5. A Company has provided the following information:

$
Selling Price per unit 42
Variable cost per unit 16
Fixed costs per month 25,000

Calculate the contribution margin per unit.

A) $26
B) $42
C) $58
D) $10

6. Lori sells hand-knit scarves at a flea market. Each scarf sells for $35. Lori pays $70 to rent a
vending space for one day. The variable costs are $20 per scarf. How many scarves should she sell
each day in order to break even?
A) 35 scarves
B) 5 scarves
C) 7 scarves
D) 4 scarves

7. From the graph given below, identify the fixed costs line.

A) OB
B) AC
C) AD
D) AE

8. Using equation method, Break-even point is calculated as

A) Sales = Variable expenses + Fixed expenses + Profit
B) Sales = Variable expenses + Fixed expenses - Profit
C) Sales = Variable expenses - Fixed expenses + Profit
D) None of the above

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