INTRODUCTION

TO

MANAGEMENT ACCOUNTING
Lesson 1 Introduction to Management Accounting

What is 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) formulating the policies - strategic planning

(b) planning the activities of the organisation - corporate planning

(c) controlling the activities of the organisation

(d) decision-making - long-term and tactical

(e) 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

2
 £ £
Sales 30,000
Cost of sales 24,000
--------
Gross profit 6,000
--------
Deduct
Administration expenses 2,000
Selling and distribution expenses 1,000
-------- 3,000
--------
Net profit 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.

3
A cost system should be

cost effective

appropriate for the organisation

encourage managerial action.

Example Management Accounts

Products
A B C Total
Materials £4,800 £3,700 £6,500 £15,000
Wages 1,500 2,500 3,000 7,000
Prod. overhead 500 600 900 2,000
------- ------- ------- -------
Prod. cost 6,800 6,800 10,400 24,000
Admin. costs 700 800 500 2,000
Selling costs 300 400 300 1,000
------- ------- ------- -------
Total cost 7,800 8,000 1,200 27,000
Sales 10,240 10,800 8,960 30,000
Profit 2,240 2,800 ---- 3,000
(Loss) ---- ---- (2,240) ----
Net profit margin 24% 26% ---- 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 to ascertain the cost of a product. This information is used to value stock

which is required for external reporting .

2 to assist management in the decision-making process.

4
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

(b) By type of cost

(i) Direct Costs

(ii) Indirect Costs - Overheads

(c) By function

Production, Administration, Selling and Distribution

(d) By the behaviour of costs

(i) Fixed or Periodic Costs

(ii) Variable Costs
(iii) Semi-fixed, or Semi-variable Costs

Cost Objectives

(a) Product costing

It is essential for an organisation to ascertain the cost of manufacturing a

product. The information is used for two purposes:

1 to determine the value of closing stock which is required for the

financial statements viz. the profit and loss account and the
balance sheet.

Direct materials £X
Direct labour £X
Direct expense £X
-----
Prime cost £X
Production overheads £X
-----
Production cost £X
-----

2 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.

5
(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.

1 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 By inspecting the accounts the accountant can classify costs as

being variable or fixed.

3 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.

Example
Output 10000units £30000
15000units £40000

£40000 - £30000 = £10000/

15000units - 10000= 5000units = £2per unit.

The fixed costs therefore are £10000.

4 The scattergraph or regression chart.

6
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.

7
MARGINAL COSTING

FOR

DECISION MAKING

8
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 short-
term 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

Products A B C Total
Sales revenue X X X X
Less Variable costs (X) (X) (X) (X)
------ ------ ------ ------
Contribution X X X X
------ ------ ------ ------
Fixed costs (X)
------
X
------

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 non-
production 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) 0 1 1,000 10,000

£ £ £ £
Variable costs --- 2 2,000 20,000
Fixed costs 5,000 5,000 5,000 5,000
------- ------- ------- -------
Total cost 5,000 5,002 7,000 25,000
------- ------- ------- -------

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

10
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 £120,000
Marginal costs( 80p per unit) 64,000
--------
Contribution 56,000
Fixed costs 26,000
--------
Profit 30,000
--------

Special order:

Sales(20,000 units @ £1.10) £22,000

Less Variable costs(20,000 @ 80p) 16,000
----------
Extra contribution 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?

2 Shut-down decisions

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

divisions.

11
Consider the following example.

Example:

Product A B C Total
£ £ £ £
Sales 20,000 50,000 25,000 95,000
Less
Direct materials 1,000 15,000 10,000 26,000
Direct labour 3,000 16,000 14,000 33,000
Fixed overheads 2,000 7,000 9,000 18,000
-------- -------- -------- --------
6,000 38,000 33,000 77,000
-------- -------- -------- --------
Profit/(Loss) 14,000 12,000 (8,000) 18,000

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 A B C Total
£ £ £ £
Sales 20,000 50,000 25,000 95,000
Less
Variable costs 4,000 31,000 24,000 59,000
-------- -------- -------- --------
Contribution 16,000 29,000 1,000 36,000
Fixed costs 18,000
--------
Net profit 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.

3 Make or Buy

Sometimes management may have to consider whether it is best to manufacture

products or components or to sub-contract them out and purchase them
externally.

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 £2
Direct wages £3
Variable overheads £2
------
Variable cost of production £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 £16

Direct materials £6
Direct labour £4
Variable overhead £2
------
Contribution £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:

Marginal cost of production £7

Plus Opportunity cost of £2
-----
The effective cost is £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.

4 Limiting factor decisions

Often a company finds that there is a limiting factor or constraint which inhibits
its capacity to meet the desired production level. 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 X Y Z
Desired production (units) 1,000 2,000 500
£ £ £
Selling price per unit 35 25 15
Variable cost per unit 15 10 5
----- ----- -----
Contribution per unit 20 15 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 Y Z
Contribution per unit 20 15 10
No. of machine hrs. 20 5 2
Contribution per machine hr. 1 3 5
Ranking (3) (2) (1)

Desired production level

Product Z 500 units x 2 hrs. 1,000 hrs

Product Y 2,000 x 5 hrs 10,000 hrs
Product X 200 x 20 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
----------

5 Profit Planning or cost profit volume analysis

Management feels it helpful to ascertain the level of profits earned at certain

levels of output and sales.

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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 ------- ------ ------- ------- --------
£ £ 3 £ £
Sales revenue 20,000 40,000 60,000 80,000 100,000
Variable costs 10,000 20,000 30,000 40,000 50,000
-------- -------- -------- -------- --------
Contribution 10,000 20,000 30,000 40,000 50,000
Fixed costs 20,000 20,000 20,000 20,000 20,000
-------- -------- -------- -------- --------
Net profit (loss) (10,000) --- 10,000 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

15
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) find the break-even point

(b) determine the margin of safety

(c) determine a target volume

(d) establish the profit volume ratio or contribution volume ratio

(e) determine the operating gearing

It is possible to ascertain these by using a break-even chart or by using formulae.

16
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 Break-even point = Fixed costs/ Contribution per unit

2 Margin of safety = Break-even point(units) - The Expected Sales

3 Sales(units) to achieve a profit Fixed costs + Target profit

-----------------------------------
Contribution per unit

4 Profit volume ratio = Contribution x 100

----------------------------
Sales revenue

5 The Operating Gearing = Contribution / Profit

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)
18
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.

2 There is a linear relationship between output and costs and revenues.

The economists view tends to dispute this and presents a curvilinear
model.

3 The business has only one product or there is a specific constant product
mix.

4 The only factor influencing costs and revenues is output. Other factors
such as production efficiency and production methods may impact on
output.

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.

19
 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 cost-

consciousness

Administration of the budget.

20
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 Sales units Unit selling price

Dag 20,000 £25
Mag 18,000 £20
Pag 15,000 £22

The opening stocks at the beginning of the year 19x0

Product Product units Component Part units
Dag 3,000 A 40,000
Mag 3,000 B 50,000
Pag 2,000 C 60,000
D 40,000
E 10,000

The marketing director intends to run a marketing campaign towards the end of
19x0 and has requested that product unit stocks should be increased at the end
of 19x0 above the commencement stocks by the following

Dag increased by 20%

Mag increased by 50%
21
 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:

Component part A B C D E
Part cost (each) 50p 35p 60p 55p £1.0
Product Component
parts
per product
Dag 3 4 6 2 1
Mag 2 3 4 2 1
Pag 5 2 3 3 1

The newly appointed managing director asks you to prepare the following
budgets and to explain the linkage between them.

1 Sales budget in product units and value

2 Production budget in product units
3 Material usage budget in component parts.
4 Materials purchase budget in component parts and value.

1. Sales Budget 19x0

Product Units Price Total sales

Dag 20,000 £25 £500,000
Mag 18,000 £20 360,000
Pag 15,000 £22 330,000
-------- ------------
53,000 £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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 Dag Mag Pag
Sales units (from the sales budget) 20,000 18,000 15,000
Add closing stock 3,600 4,500 2,400
-------- -------- --------
23,000 22,500 17,400
Less opening stock 3,000 3,000 3,000
------- -------- --------
Budgeted output 20,600 19,500 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 Prod. units A B C D E

Dag 20,600 61,800 82,400 123,600 41,200 20,600
Mag 19,500 39,000 58,500 78,000 39,000 19,500
Pag 15,400 77,000 30,800 46,200 46,200 15,400
-------- -------- -------- -------- -------- --------
55,500 177,000 30,800 171,700 247,800 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 E
Material usage budget 177,800 171,700 247,800 126,400 55,500
Closing stock 32,000 40,000 48,000 32,000 8,000
---------- ---------- --------- ---------- ----------
209,800 211,700 295,800 158,400 63,500
Opening stock 40,000 50,000 60,000 40,000 10,000
--------- --------- --------- --------- ---------
169,800 161,700 235,800 118,400 53,500
Price per component 50p 35p 60p 55p £1.00
£84,900 £56,595 £141,480 £65,120 £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.

23
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.

(b) 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.

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 600,000
Less Leasehold premises (20 years) 300,000
Plant (est. life 10 years) 80,000
Equipment (est. life 10 years) 160,000
Tools 20,000
Raw materials 10,000 570,000
---------- ----------
Cash balance available 30,000
======

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.

(b) 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.

24
(c) The company intends to keep a stock of raw materials of £10,000
throughout the year.

(d) 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 Feb Mar Apr May Jun Memo

£000 £000 £000 £000 £000 £000 £000
Opening balance 30 4 (14) 16 70 124
Cash inflow
Cash sales 40 80 120 120 120 120
Credit sales 40 80 120 120 120 120Dr
------ ------ ------ ------ ------- -------
Total 70 124 186 256 310 364
------ ------ ----- ----- ------ ------

Cash outflow
Raw mats. -cash 16 32 48 48 48 48
Raw mat. -credit 16 32 48 48 48 48Cr
Direct wages 50 50 50 50 50 50
Other expenses 40 40 40 40 40 40Cr
------ ------ ------ ------ ------ ------
Total 66 138 170 186 186 186
------ ------ ------ ------ ------ ------
Closing balance 4 (14) 16 70 124 178
=== === === === === ===

Students should note that:

(a) Depreciation never appears in a cash budget as it is a non-cash expense.

(b) 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 480,000 Sales 1,200,000
Direct wages 300,000 780,000

25
 ----------
Operating profit 420,000
---------- -----------
1,200,000 1,200,000
======= =======
Depreciation Operating profit 420,000
Premises 7,500
Plant 4,000
Equipment 8,000
Tools 2,000
------- 21,500
Other expenses 240,000
Net profit 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
Fixed assets Cost Dep. NBV
600,000 Ord. shares £1 600,000 Premises 300,000 7,500 292,500
each
Reserves Plant 80,000 4,000 76,000
Profit and loss account 158,500 Equipment 160,000 8,000 152,000
Tools 20,000 2,000 18,000
--------- -------- ---------
560,000 21,500 538,500
--------- ---------
Current Liabilities Current
assets
Creditors 48,000 Materials 10,000
Accrued expenses 40,000 Debtors 120,000
Cash 178,000 308,000
-------- --------- ----------
-
846,000 846,000
====== =====

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:

26
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 Monthly Budget Report February

Cost Descripti Budget Actual Variance Budget Actual Variance
code on
010 Superviso £58,000 £65,000 £7,000 £116,00 £125,0 £9,000
rs’ salary (A) 0 00 (A)

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 Actual costs incurred

units) (17,600 units)
£ £
Materials - variable 21,000 20,000
Labour - variable 1,000 980
27
Maintenance - variable 3,000 2,680
Fixed production costs 10,000 10,000
Selling costs - fixed 5,000 6,000
-------- --------
40,000 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 Flexed budget Variance

(17,600 units)
£ £ £
Materials 20,000 18,480 1,520 (A)
Labour 980 880 100 (A)
Maintenance 2,680 2,640 40 (A)
Fixed productioon 10,000 10,000 -----
costs
Selling costs 6,000 5,000 1,000 (A)
------- ------- -----------
39,660 5,000 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.

28
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.

2 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.

3 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.

4 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.

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.

2 In the process of preparing the budgets managers are compelled to co-

ordinate the various activities of the organisation and to be less
‘departmental minded’ and to be more ‘company minded’.

3 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.

4 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.

5 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.

29
INVESTMENT APPRAISAL

METHODS

30
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 100,000
Net cash flow
Year 1 20,000
Year 2 30,000
Year 3 40,000
Year 5 20,000 110,000
-------- --------
Net profitability 10,000
-------

Required:
What is the project’s payback period?

31
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 100
Average cost of investment

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 Project B
£ £
Initial outlay 500,000 600,000
Annual profits (Yr. 1-5) 1,000,000 1,000,000
Less depreciation (Yr. 1-5) 500,000 550,000
---------- ----------
Profits after depreciation 500,000 450,000
--------- ---------
Average net profit 100,000 90,000
---------- --------
Accounting rate of return 40% 28%

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

32
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 Cash flow Discount factor Present value Cumulative PV

£ £ £
0 (100,000) 1 (100,000)
1 29,000 0.909 26,361 26,361
2 29,000 0.826 23,954 50,315
3 29,000 0.751 22,939 73,254
4 34,000 0.683 23,222 94,476
5 34,000 0.621 21,114 117,590
6 5,000 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 = 17 days
£117,590

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.

Year Cash flow (£) Discount factor 20% Present Value (£)
0 (100,000) 0 (100,000)
1 29,000 0.833 24,157
2 29,000 0.694 20,126
3 29,000 0.579 16,791
4 34,000 0.482 16,388
5 34,000 0.402 13,668
6 5,000 0.335 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.

34
The formula for interpolation is:

IRR = A + [ a / a -b ] x ( A - B )

10% + £20,410
---------------- X 20% - 10% = 17%
(£20,410 + £7,245)

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 X
+ Direct labour X
+ Direct expense X
--------
Prime cost X
+ Production overheads X
-------
Production cost X
+ Selling & Distribution overheads X
+ Administration overheads X
--------
Total cost 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:

37
 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 £40,000

Indirect materials used in Dept. B £35,000
Rent & Rates £30,000
Light & Heat £15,000
Insurance of machinery £5,000
-----------
£125,000
-----------

Overhead Basis Dept. A Dept. B Total

Salaries Allocate £40,000 £40,000
Ind. materials Allocate £35,000 £35,000
Rent & Rates Floor area £20,000 £10,000 £30,000
Light & Heat Floor area £10,000 £5,000 £15,000
Insurance Value of Mach. £1,000 £4,000 £5,000
---------- ---------- -----------
£71,000 £54,000 £125,000
---------- ---------- -----------

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 Basis

Rent & Rates, Light & Heating
Depreciation, insurance of machinery
Power costs
Canteen expenses
Maintenance costs for premises
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 Dept. A Dept. B Stores Canteen

£ £ £ £
Allocated & Apportioned 10,000 5,000 3,000 4,000
Reapportion Stores costs 2,000 1000 ---

38
Reapportion Maintenance costs 3,000 1,000 ---
--------- -------- -------- -------
15,000 7,000 0 0
-------- ------- ------- -------

In the absorption stage an overhead recovery (absorption) rate (OAR) is

calculated. The formula used is:

Budgeted Production Overheads

OAR = --------------------------------------------
Suitable basis

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 £15,000
OAR = ------------ = £0.50 per machine
hr.
30,000 machine hrs.

Dept. B £7,000
OAR = ------------- = £0.20 per labour
hr.
35,000 labour hrs.

39
Example: The company makes two products X and Y. The following
information is available:

Product X Product Y
£ £
Direct materials 10 12
Direct labour 12 14
(Wage rate £2 per hr.)
Machine hours in
Dept. A 4 6

Required: Calculate the production cost of the two products.

Product X Product Y
£ £
Prime cost 22.00 26.00
+ Production overheads
Dept. A (4 hrs. x 0.50) 2.00 (6 hrs. x 0.50) 3.00
Dept. B (6 hrs. x 0.20) 1.20 (7 hrs. x 0.20) 1.40
--------- ----------
23.20 30.40
--------- ---------

40
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, set-
up, 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:

41
1 Unit level activities which arise each time a product is manufactured eg.
machine power, depreciation of machinery etc.

2 Transaction level activities which arise each time a transaction happens

eg. quality control, inspection costs, set-up costs etc.

3 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 Activity cost driver

Advertising The value of sales in each sales area
Quality control The number of quality tests
Purchasing The number of purchase orders
Set-up costs The number of set-ups/production runs
Stores The number of material requisitions
Despatch 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:

Product X Product Y Total

Production and Sales (units) 25,000 5,000 30,000
-------- ------- --------
Unit cost (£)
Direct labour 25 20
Direct materials 15 5
Operating data
Machine hours 1 2
Labour rate per hour (£) 1 1
Number of set-ups 4 20
Number of inspections 40 80

42
Overheads
Production processing £700,000
Set-up £120,000
Inspections £180,000

Required;

Calculate the product costs using (a) Absorption costing (b) ABC.

(a) Assuming the overheads are absorbed on the basis of direct labour hours.

Budgeted overheads £1,000,000

OAR = --------------------------- = ------------- = £2.50 per hour
Labour hours 400,000

All production overheads are located in one cost pool. The unit costs of products
X and Y are:

£ £
X Y
Direct labour 15.00 5.00
Direct materials 25.00 20.00
Overhead (2.50 per d.l.h.) 37.50 12.50
------- --------
77.50 37.50
------- -------

(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 Basis

Production processing Number of machine hours
Machine set-ups Number of machine set-ups
Inspections Number of inspections

The overheads per cost pool and the rate per cost driver are computed.

Production processing costs:

Production overhead £700,000
----------------------------- = ------------ = £20 per mach.hr.
Machine hours 35,000

Set-up costs:

Cost per set-up Set-up cost £120,000

---------------- = ------------ = £5,000 per set-up.
No. of set-ups 24

Inspection cost:

Cost per inspection Inspection cost

43
 ------------------- = £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 Y
£ £
Direct labour 15.00 5.00
Direct materials 25.00 20.00
Production overhead (1) 20.00 40.00
Set-up costs (2) 0.80 20.00
Inspection (3) 2.40 24.00
------ -------
63.20 109.00
------- -------

1 X =£20 x 1 machine hr. =£20; Y = £20 x 2 machine hours = £40

2 X = (£5,000 x 4 set-ups)/2,500 units = 80p; Y = (£5,000 x 20 set-ups)/5,000

units = £20

3 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:

Product X Product Y
Absorption costing £77.50 £37.50
ABC 63.20 £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.

4 Since ABC produces more accurate product costs, decisions taken by

management are better informed eg. pricing decisions.

5 More accurate product profitability analysis can be produced.

6 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.

44
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 It provides management with a consistent method of comparing actual

performance with planned performance.

2 It provides a means of ensuring that prodution resources are purchased

and used efficiently.

3 In establishing standards management can examine and appraise existing

practices and procedures to ensure cost-effectiveness and efficiency.

4 It can inculcate cost-conciousness in the staff.

5 It helps to motivate staff by setting realistic standards.

6 Using variance analysis performance ca be monitored and improvements

in work methods can result.

Types of Standard
46
• 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

47
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.
2
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

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

48
Problems with Standard Costing

1 Standard setting is a lengthy and costly procedure.

2 Standards are often seen by the staff as restrictions on their behaviour

which can lead to dysfunctionalism.

3 Reporting variances may not be timely, cost effective and encourage

managerial response.

4 Standards invariably produce variances some of which may not be

controllable eg. material prices which can result in unnecessary reporting
and investigation.

5 Standard costing may be inappropriate for certain kinds of

manufacturing eg. Just-in- Time.

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 Actual Costs

£ £
Direct Materials (1 kilo) 10 Sales 319,000
Direct Labour (2 hours) 10 Direct Materials
Variable Overheads 2 11,200 kilos @ £9.8 109,760
Fixed Overheads 5 Direct Labour
21,000 hours @ £5 105,000
-------------- Variable Overheads 21,500
Standard Cost 27
Standard Margin 3 Fixed Overheads 52,000
-------------- --------------
-
Standard Selling Price 30 Net Profit 30,700
-------------- ---------------
-

Budget output for the month 10,000 Actual output 11,000 units
units

49
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)

50
 RESPONSIBILITY

ACCOUNTING

Responsibility Accounting describes the decentralisation of authority with performance of the

decentralised units measured in terms of accounting results.

51
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 Manager has control over Performance Measurement

Cost centre Controllable costs Variance Analysis,
Efficiency measures

Profit centre Controllable costs Profit

Sales volume/prices

Investment Controllable costs Return on Investment

centre
Sales Residual Income
Investment in fixed/ WC Other financial ratios
assets

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.

52
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) As a control technique to compare divisional performance within a company.

(2) 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 Effect on ROI

Reduce level of costs Improvement in
Increase profit mark up on sales Profit element

Reduce net assets employed Improvement in

Increase level of sales Asset use element

Advantages

(1) It is regarded as one of the prime performance measures

(2) It deals with profit and net assets which are concepts well understood in business.

(3) 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 New project New position

position
£’000 £’000 £’000

Investment level 4,000 1.600 5,600

Income from 800 240 1,040
investment
ROI 20% 15% 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.

54
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 New project New position

£’000 £’000 £’000
Investment level 4.000 1,600 5,600
Income from 800 240 1,040
investment
Less interest (400) (160) (560)
charge @ 10%
--------- --------- --------
NRI 400 80 480
====== ===== =====

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.

55