1.

1 Management Accounting and Financial Accounting

Management accounting is concerned with the preparation and presentation of accounting information to management to help them plan, control
and make decisions about the operations of the business.

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Financial accounting is concerned with the preparation and presentation of accounting information on the performance and financial position of
the business.
1.2 Comparison

Management Accounting Financial Accounting

Users of Shareholders, banks, lenders and suppliers, potential investors, tax

information Management authorities and governments

Format of Presentation regulated by law and by the profession through

information Can take any form Accounting Standards (e.g. IFRS)

Purpose of Useful to plan, control and make

information decisions Stewardship and investment decisions

Bases of valuation Relevant costs Historical costs

1.3 Planning, Control and Decision Making

Key Point

Planning, control and decision making encompass establishing objectives and evaluating policies and actions required to
achieve them.

1.3.1 Planning
Planning is the setting of goals and the selection of the means of achieving these goals. As businesses become large, these procedures need to
be formalised.
• Short-term plans such as an annual budget show in detail the intended results for the forthcoming year.
• Long-term plans, also called "strategic" plans, are usually documents showing the long-term objectives of a business.
1.3.2 Control
Control means checking that an organisation is on track to meet its long- and short-term objectives, and taking action to correct any deviations from
these.
• Long-term control includes strategic performance evaluation, which aims to measure how an organisation is performing against its
strategic objectives.

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 • Short-term control focuses on comparing the budgeted results with actual results.
• This usually takes the form of an operating statement, which breaks down the difference into its component parts (variances).
1.3.3 Decision Making
• Decision making usually involves using the information provided by the costing system to make decisions.
For example, an organisation deciding the appropriate price to charge for a contract they are tendering for, or whether it would make
financial sense to outsource the production of an essential component.
2.1 Marginal Costing

Exam advice

These traditional costing methods are assumed knowledge from Management Accounting
Under marginal costing:
• Fixed overheads are not included in unit costs but are treated as a period cost (i.e. written off in full in the statement of profit or loss in
the period in which they occur).
• Inventory valuation includes only the variable costs of production.
2.2 Absorption Costing

Under absorption costing, fixed production overhead costs must be allocated, apportioned and absorbed.
2.2.1 Allocation
As overhead costs are incurred, they need to be allocated to the cost centres to which they belong. Costs that relate to a single cost centre are
allocated to that cost centre.
2.2.2 Apportionment
Apportionment is necessary when an overhead is common to more than one cost centre. Such overheads must be shared between the relevant
cost centres using an appropriate method of apportionment.

Example 1 Apportionment

Cost Basis of apportionment

Rent, rates, heat – Floor area

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 Example 1 Apportionment

Supervision, canteen costs – Number of employees

Depreciation, plant insurance – Carrying value of plant

2.2.3 Re-apportionment
Overheads that have been apportioned to service cost centres need to be re-apportioned to production cost centres.
This is achieved by selecting an appropriate re-apportionment basis, that would reflect how service departments support production departments.
Common basis used include:
• Direct labour hours
• Machine hours
• Parts movements
• Variable overheads utilised
All fixed costs apportioned to service cost centres will be re-apportioned to production cost centres for absorption into cost units.
2.2.4 Absorption
The total of the overheads in each production department must now be absorbed into the units of production.
This is achieved using one of the following methods:
• direct labour hour rate;
• direct material cost rate;
• direct labour cost rate;
• prime cost percentage rate;
• machine hour rate; or
• unit of output rate.
Activity 1 Overhead Absorption

X Co estimates that its factory costs for the coming year will be as follows:
$
Direct material 40,000
Direct wages 60,000

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 Prime cost 100,000
Factory overhead 30,000
Total factory cost 130,000

During the year there will be 10,000 direct labour hours, 5,000 machine hours, and 20,000 units will be produced.
Required:
(a) Calculate the overhead absorption rate using each of the following bases:
i.direct labour hour;
ii. direct materials cost;
iii. direct labour cost;
iv. prime cost;
v. machine hour;
vi. unit of output.
(b) Management has decided that the absorption rate per machine hour is the most appropriate method of absorbing overheads. One of the products
manufactured by X Co is the Smidget. Each Smidget costs $5 per unit in materials and $10 per unit of direct labour. Making a Smidget requires half
an hour of machine time.
Calculate the full absorption cost of one unit of Smidget.
*Please use the notes feature in the toolbar to help formulate your answer.
2.2.4 Summary of Absorption Costing
The diagram below depicts the process describing absorption costing:

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3.1 Introduction

Definition

Activity-based costing (ABC) – an approach to the costing and monitoring of activities which involves tracing resource
consumption and costing final outputs. Resources are assigned to activities and activities to cost objects. The latter use cost
drivers to attach activity costs to outputs.
– CIMA Official Terminology
Traditional absorption costing uses one method of apportioning all overhead costs between products, typically labour hours or machine hours. This
"blanket rate" means that product costs may not accurately reflect the true overhead costs of making a product.
When overhead costs accounted for only a small portion of total factory costs, this inaccuracy was not significant. However, in modern factories and
service industries, due to the reduction in the amount of labour used, and the increase in the amount of high technology, overhead costs are often
a significant portion of overall product costs. The inaccuracy of absorption costing is no longer insignificant.
Activity-based costing aims to identify the activities which cause overhead costs to be incurred and to apportion the overhead costs to each product
based on the use of the activities by each product.
This approach for calculating product costs was first written about by Cooper and Kaplan, although many organisations were using such methods
before this.
ABC recognises that traditional ideas of fixed and variable cost categorisations are not always appropriate and that, as the proportion of overhead
costs in manufacture has increased, there is a need for a more accurate method of absorbing these costs into cost units.
It looks for a clearer picture of cost behaviour and a better understanding of what determines the level of costs (i.e. "cost drivers").
3.2 Cost Drivers

Definition

Cost driver – a factor which can cause a change in the cost of an activity.
In absorption costing, it is assumed that the volume of output is the factor which determines costs. However, ABC recognises that the amount of
cost may be determined by factors other than the volume of output. These factors are called cost drivers.
The cost driver for a procurement department, for example, may be the number of purchase orders processed.
An activity could give rise to multiple cost drivers, as it consumes different types of overheads. For example, cost drivers associated with a production
activity may be:
• machine operator(s) hours, for apportionment of human resource costs;

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 • floor space occupied, for apportionment of cost of premises;
• power consumed, as direct overheads; and
• quantity of waste and/or rejected output, for apportionment of recycling and quality costs.
Therefore, rather than use a single absorption rate, different types of overhead cost are absorbed into units of production using more appropriate
rates based on cost drivers. For example, for a particular production department the following rates may be suitable:
• a warehousing cost/kg of material used;
• electricity cost/machine hour;
• production scheduling cost/production order, etc.
These can then be applied and aggregated to calculate an overhead cost per unit as set out in Step 5 of the following section.
3.3 Steps

To find total product costs, overheads are traced to individual production departments, as usual, with common costs being apportioned using suitable
bases. Then the following steps are applied:

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Having discovered the cost drivers within the business, the original production departments may be reorganised to take advantage of potential cost
savings.

Example 2 Activity-Based Cost

A company assembles two models of a product, Basic and Deluxe in batch sizes of 2,000 and 100 units, respectively. Each unit
of the Basic model has 20 components and each unit of the Deluxe model has 30 components. One unit of the Basic model
takes 5 hours to assemble and one unit of the Deluxe model, 6 hours.
20,000 units of the Basic model and 2,000 units of the Deluxe model are budgeted for the next period.
The total fixed overhead budget of $224,000 has been analysed into three activities and cost drivers identified as follows:

Activities /cost pools: $ Cost driver:

1. Batch set-ups 90,000 Number of set ups

2. Stores/material handling 92,000 Number of components

3. Other (rent, etc) 42,000 Labour hours

Total overheads 224,000

Number of units of cost drivers (Step 3)
1. Number of set-ups required: 30 calculated as:
Basic: 20,000/2,000 = 10
Deluxe: 2,000/100 = 20
2. Number of components required: 460,000 calculated as:
Basic: (20,000 × 20) = 400,000
Deluxe: (2,000 × 30) = 60,000
Total components = 460,000
3. Number of labour hours required: 112,000 calculated as:
Basic: (20,000 × 5) = 100,000
Deluxe: (2,000 × 6) = 12,000
Cost per unit of cost driver (Step 4)

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 Example 2 Activity-Based Cost

1. Batch set-ups ($90,000/30) $3,000 per set up

2. Stores/material handling ($92,000/460,000) $0.20 per component

3. Other overheads ($42,000/112,000) $0.375/labour hour

Total overhead for each product (Step 5)
Basic Deluxe Cost Basic Deluxe
No. No. (Step 4) $ $
1. Batch set-ups 10 20 $3,000 30,000 60,000
2. Stores/material handling 400,000 60,000 $0.20 80,000 12,000
3. Other (rent, etc) 100,000 12,000 $0.375 37,500 4,500
Total overheads 147,500 76,500
Overhead cost per unit of product (Step 6)
Number of products 20,000 2,000

Overhead cost per unit $7.375 $38.25

Under traditional absorption costing, using labour hours, the overhead cost of the Deluxe model would be only 20% more than
a Basic model. However, the ABC approach substantially increases the cost of making a Deluxe unit; the set-up costs for each
batch are spread over far fewer units. The effort and cost incurred in producing small batches now reflected in the higher cost
per unit. Deluxe units should have a higher selling price to justify the higher costs incurred.

Activity 2 Activity-Based Costing v Absorption Costing

Total budgeted fixed overheads for a company are $712,000. These have traditionally been absorbed on a machine hour basis. The company makes
two products, A and B.

A B

Direct material cost $20 $60

Direct labour cost $50 $40

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 Machine time 3 hrs 4 hrs

Annual output 6,000 40,000

The company is considering changing to an ABC system and has analysed the overhead cost into three activities:

Activities /cost pools: $ Cost driver:

Machine related 178,000 Machine hours

Set-up related 230,000 Set-ups

Purchasing related 304,000 Purchase orders

Total overheads 712,000

Machine hours/unit Annual output Total machine hours Number of set-ups Number of purchase orders
Product A 3 6,000 18,000 16 52
Product B 4 40,000 160,000 30 100
46,000 178,000 46 152
Required:
a. Calculate the total cost for each product on the assumption that the company continues to absorb overheads on a machine hour
basis.
b. Calculate the cost per unit using the ABC system.
c. Compare the cost per unit of each product using ABC with the cost per unit using absorption costing, and identify the main
reasons for the difference.
*Please use the notes feature in the toolbar to help formulate your answer.
3.4 Analysis of ABC

3.4.1 Advantages
The main advantage of ABC is that the costs per unit are more accurate, as overhead costs are apportioned to products based on their use of the
cost drivers rather than using some arbitrary "blanket rate" as used for absorption costing. This leads to the following benefits:
• Better decision making. Companies will have a more accurate knowledge of cost per unit, and therefore profit per unit. They can
evaluate whether to stop producing loss-making products.
• Where cost plus pricing is used, the use of ABC means that the price will be more likely to achieve the desired margins.

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 • There is a better understanding of what causes costs because of the identification of the cost driver. This enables managers to make
more informed decisions on actions to reduce cost.
Example 3 More Informed Decision

In Activity 2, the cost of Product A could be reduced by having a lower number of production runs. This could be achieved by
producing products in larger quantities − for example, producing 10,000 units in a production run instead of only 5,000 units.
• Control of overheads is easier, as responsibility for incoming costs must be established before ABC can be implemented.
• More accurate performance measurement leads to better performance management.
3.4.2 Disadvantages
Although ABC provides a more accurate treatment of overheads it is not without disadvantages:
• ABC is still based on budgeted overheads on the current period, which may be unsuitable for future strategic decisions.
• It is more complex and the selection of cost drivers may not be straightforward:
o There may be more than one possible cost driver for a particular overhead, so some judgement is required in
selecting an appropriate driver.
o Not all costs will be easily identified with particular cost pools, so some allocations will be arbitrary.
• Additional time and cost will be incurred in setting up and administering the system.
3.5 Comparison of ABC and Traditional Methods

The differences between traditional methods of absorbing overheads and ABC methods can be summarised as follows:

Traditional Absorption Costing Activity-Based Costing

• Initial allocation and apportionment of

• Initial allocation and apportionment of overheads is to overheads is to cost pools. Each cost pool
cost centres. represents a particular activity.

• Absorption of overheads of each cost centre is based • Absorption of overheads of each cost pool is
on volume of output (e.g. number of units or labour based on the "driver" that causes the costs to
hours). As costs may not depend on volume, vary. Product costs reflect more accurately the
allocation of some costs may be inappropriate. activities that cause them.

• Many different types of costs for a particular cost

centre are included in the blanket overhead • Costs for a particular activity will include only
absorption rate of that department. the costs of performing that activity.

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 Traditional Absorption Costing Activity-Based Costing

• Identification of cost drivers allows

• Since costs are assumed to depend on volume of management to understand better the causes
output, limited information is provided to management of costs and to find more appropriate ways to
about ways to reduce costs. control them.

• ABC requires a large project to identify

activities and drivers. The accounting system
may have to be amended or replaced to
• Absorption costing is relatively straightforward. provide the information needed.
3.6 Use of ABC in the Public Sector

In many countries, governments are making greater use of management accounting techniques to:
• allocate government funds more efficiently to areas where they provide the greatest benefits;
• reduce the amount of overall government spending;
• provide greater transparency, so that taxpayers can see where their money is being spent; and
• encourage public sector bodies to become more responsive to their customers.
ABC is useful in helping public sector bodies assess more accurately the costs of the services they provide.
However, the disadvantages of ABC previously mentioned apply also to public sector organisations. Critics also argue that public sector resources
would be better spent improving "front line" services than in developing sophisticated accounting techniques such as ABC.

Example 4 Hospital Operating Theatre

A hospital needs to monitor the costs per patient; part of this is the cost of surgery.
Under traditional methods, the operating theatre might be treated as a cost centre. An absorption cost per minute could be
calculated by dividing the total costs of the theatre by the total number of minutes budgeted to be available. The cost of an
operation would then be calculated by multiplying the number of minutes the operation takes by this absorption rate.
The problem with this approach is that it is not realistic to assume that the cost per minute of all operations is the same. Some
operations may require several surgeons and medical staff; others may require just one or two. Different equipment and different
quantities of consumable materials will be used.
Examples of activities that could be used for an ABC approach to calculating the cost of an operation include:

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 Example 4 Hospital Operating Theatre

Activity Driver

• Preparing the • Number of operations − the cost of preparing the theatre does not vary
operating theatre significantly between different types of operations.

• Number of operations − calculated separately for those requiring a

• Activity of anaesthetist general anaesthetic and those requiring only local anaesthetics.

• Time taken from entering the anaesthetic room until entering the
• Anaesthetic drugs recovery room.

• Time taken from initial incision to closure of incision on completion of

• Activity of the physician surgery.

• Consumable items • Itemised list of consumables used during surgery, captured by a bar-
during surgery coding device.

• Overhead activity • A charge for management administration and staff training.

Syllabus Coverage

This chapter covers the following Learning Outcomes.

B. Specialist Cost and Management Accounting Techniques
1. Activity-based costing
1. Identify appropriate cost drivers under ABC.
2. Calculate costs per driver and per unit using ABC.
3. Compare ABC and traditional methods of overhead absorption based on production units, labour hours or machine hours.

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