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OUM Business School

BMAC5203
Accounting for Business
Decision Making

Copyright © Open University Malaysia (OUM)


BMAC5203
ACCOUNTING FOR
BUSINESS
DECISION MAKING
Dr Jaspal Singh

Copyright © Open University Malaysia (OUM)


Project Directors: Prof Dato’ Dr Mansor Fadzil
Prof Dr Wardah Mohamad
Open University Malaysia

Module Writer: Dr Jaspal Singh

Moderator: Baldev Singh Pertab Singh


Open University Malaysia

Developed by: Centre for Instructional Design and Technology


Open University Malaysia

First Edition, April 2016


Copyright © Open University Malaysia (OUM), April 2016, BMAC5203
All rights reserved. No part of this work may be reproduced in any form or by any means without
the written permission of the President, Open University Malaysia (OUM).

Copyright © Open University Malaysia (OUM)


COURSE GUIDE  ix

COURSE GUIDE DESCRIPTION


You must read this Course Guide carefully from the beginning to the end. It tells
you briefly what the course is about and how you can work your way through
the course material. It also suggests the amount of time you are likely to spend in
order to complete the course successfully. Please keep on referring to Course
Guide as you go through the course material as it will help you to clarify
important study components or points that you might miss or overlook.

INTRODUCTION
BMAC5203 Accounting for Business Decision Making is one of the courses
offered by the Business School at Open University Malaysia (OUM). This course
is worth 3 credit hours and should be covered over 8 to 15 weeks.

COURSE AUDIENCE
This course is offered to all learners taking the Master in Business Administration
programme. This module aims to impart the fundamentals of accounting,
designed for business students without any exposure to basic accounting. This
module intends to describe the importance of Accounting Information in
business decisions, to discuss the basic concepts, principles of financial and
management accounting, and apply accounting in planning, control and decision
making which will be useful for subsequent courses.

As an open and distance learner, you should be acquainted with learning


independently and being able to optimise the learning modes and environment
available to you. Before you begin this course, please confirm the course material,
the course requirements and how the course is conducted.

STUDY SCHEDULE
It is a standard OUM practice that learners accumulate 40 study hours for every
credit hour. As such, for a three-credit hour course, you are expected to spend
120 study hours. Table 1 gives an estimation of how the 120 study hours could be
accumulated.

Copyright © Open University Malaysia (OUM)


iv  TABLE OF CONTENTS

3.4 Ratios and Sharia-Compliant Companies 42


Summary 43
Key Terms 44
Self-Test 44
References 44

Topic 4 Cost Concepts Classifications 45


4.1 Product and Period Costs 46
4.2 Direct and Indirect Costs 47
4.3 Cost Behaviour 48
4.3.1 Fixed Cost 48
4.3.2 Variable Cost 49
4.3.3 Mixed Cost/Semi-variable Costs 49
4.3.4 Step Cost 50
4.3.5 Sunk Cost 51
4.3.6 Avoidable and Unavoidable Costs 51
4.3.7 Opportunity Cost 51
4.4 Cost Terms and Concepts 53
4.4.1 Cost Objects 53
4.4.2 Prime Cost (Direct Cost) and Indirect Cost 54
Summary 56
Key Terms 58
Self-Test 58
References 59

Topic 5 Cost-volume-profit Analysis 60


5.1 Essentials of CVP Analysis 60
5.2 Contribution Margin 61
5.3 Break-even Points 62
5.3.1 Equation Method 62
5.3.2 Contribution Margin Method 63
5.3.3 Graph Method 63
5.4 Assumptions of Cost-Volume-Profit 64
5.5 Break-even Point and Target Income 65
5.5.1 Target Operating Income 66
5.6 Using CVP Analysis for Decision Making 68
5.7 Sensitivity Analysis and Uncertainty 69
5.7.1 Margin of Safety 69

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TABLE OF CONTENTS  v

5.8 Effects of Sales Mix on Income 70


Summary 73
Key Terms 74
Self-Test 74
References 75

Topic 6 Short-term Decision-Making 76


6.1 Information and the Decision Process 76
6.2 Concept of Relevance 77
6.2.1 Relevant Costs and Relevant Revenues 77
6.2.2 Qualitative and Quantitative Relevant
Information 78
6.3 Relevance ă Decision on Output 80
6.3.1 Accept or Reject a Short-term Special Order 81
6.3.2 Insourcing-outsourcing Decisions and
Make-buy Decisions 83
6.3.3 Product Mix Decisions with Capacity Constraints 86
6.3.4 Customer Profitability and Relevant Costs 86
Summary 91
Key Terms 91
Self-Test 92
References 92

Topic 7 Budgets and Budgetary Controls 93


7.1 Benefits of Budgeting 94
7.2 Budgets and the Budgeting Cycle 95
7.2.1 Strategic and Operating Plans 95
7.2.2 Budgeting Cycle and Master Budget 96
7.2.3 Sales and Production Budget 98
7.2.4 Materials, Labour and Manufacturing
Overheads Budget 99
7.2.5 Income Statement Budget 100
7.2.6 Cash Budget and Statement of Financial
Position Budget 101
7.3 Budgets and Behaviour 115
7.4 Limitations of Budgeting 116
Summary 118
Key Terms 119
Self-Test 119
References 120

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vi  TABLE OF CONTENTS

Topic 8 Flexible Budgets 121


8.1 Standard Cost 121
8.1.1 Need for Variances 122
8.2 Fixed (Static) Budget 122
8.3 Flexible Budget 123
8.3.1 Flexible Budget and Sales-Volume Variances 124
8.4 Comparison between Fixed and Flexible Budgets 128
Summary 130
Key Terms 130
Self-Test 131
References 132

Topic 9 Standard Costing and Variance Analysis 133


9.1 Standard Cost and Variance Analysis 134
9.2 Flexible Budget Variance 134
9.2.1 Materials Price and Efficiency Variances 135
9.2.2 Labour Rate and Efficiency Variances 136
9.2.3 Overheads Variances 137
9.2.4 Variable Overheads Flexible-Budget Variances 139
9.2.5 Fixed Overheads Flexible-Budget Variances 140
9.2.6 Production Volume Variance 140
9.3 Variance in Decision Making 141
Summary 143
Key Terms 144
References 144
Self-Test 145

Topic 10 Responsibility Accounting 146


10.1 Responsibility Centres 147
10.2 Balanced Scorecard 148
10.2.1 Financial Perspective 149
10.2.2 Customer Perspective 149
10.2.3 Internal Business Processes Perspective 150
10.2.4 Learning and Growth Perspective 150
10.2.5 Critical Success Factors 151
10.2.6 Advantages of a Balanced Scorecard 153
10.2.7 Disadvantages of a Balanced Scorecard 153
10.3 Return on Investment (ROI) 154
10.4 Residual Income (RI) 155
Summary 159
Key Terms 160
Self-Test 160
References 160

Copyright © Open University Malaysia (OUM)


COURSE GUIDE

Copyright © Open University Malaysia (OUM)


Copyright © Open University Malaysia (OUM)
COURSE GUIDE  ix

COURSE GUIDE DESCRIPTION


You must read this Course Guide carefully from the beginning to the end. It tells
you briefly what the course is about and how you can work your way through
the course material. It also suggests the amount of time you are likely to spend in
order to complete the course successfully. Please keep on referring to Course
Guide as you go through the course material as it will help you to clarify
important study components or points that you might miss or overlook.

INTRODUCTION
BMAC 5203 Accounting for Business Decision Making is one of the courses
offered by the Business School at Open University Malaysia (OUM). This course
is worth 3 credit hours and should be covered over 8 to 15 weeks.

COURSE AUDIENCE
This course is offered to all learners taking the Master in Business Administration
programme. This module aims to impart the fundamentals of accounting,
designed for business students without any exposure to basic accounting. This
module intends to describe the importance of Accounting Information in
business decisions, to discuss the basic concepts, principles of financial and
management accounting, and apply accounting in planning, control and decision
making which will be useful for subsequent courses.

As an open and distance learner, you should be acquainted with learning


independently and being able to optimise the learning modes and environment
available to you. Before you begin this course, please confirm the course material,
the course requirements and how the course is conducted.

STUDY SCHEDULE
It is a standard OUM practice that learners accumulate 40 study hours for every
credit hour. As such, for a three-credit hour course, you are expected to spend
120 study hours. Table 1 gives an estimation of how the 120 study hours could be
accumulated.

Copyright © Open University Malaysia (OUM)


x  COURSE GUIDE

Table 1: Estimation of Time Accumulation of Study Hours

Study
Study Activities
Hours
Briefly go through the course content and participate in initial discussions 5
Study the module 60
Attend 4 tutorial sessions 10
Online participation 12
Revision 15
Assignment(s), Test(s) and Examination(s) 20
TOTAL STUDY HOURS ACCUMULATED 120

COURSE OUTCOMES
By the end of this course, you should be able to:

1. Explain the basic aims (viz. stock valuation, profit determination, decision
making, planning and control) of management accounting (managerial)
information systems in an organisation;

2. Explain the role of ethics in the managerial decision making process; and

3. Apply management accounting concepts, principles and techniques that are


fundamental to effective planning and control, and efficient business
decisions.

COURSE SYNOPSIS
This course is divided into ten topics. The synopsis for each topic is listed as
follows:

Topic 1 begins with an introduction to accounting, especially the financial and


management accounting systems and standards as well as the process of
identifying, measuring, reporting, and analysing information on the economic
events of organisations used by management to plan, evaluate, control and make
decisions.

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COURSE GUIDE  xi

This topic will help you understand how accounting information is created and
how decision makers, both internal and external, use this information to make
decisions. You will also realise that there is a standard set of rules and regulatory
framework governing how to record and report financial information.

Topic 2 looks at the accounting concepts and assumptions. This is followed by


the common ways to measure income which are the accrual basis and cash basis
methods. Although both cash and accrual basis have their merits, the accountants
have conventionally measured income on an accrual basis. Some of the other
basic accounting principles and concepts that are implicit in financial statements,
such as, the separate entity concept, reliability concept, going concern
convention, materiality convention, monetary unit assumption, historic cost
assumption, time-period concept, consistency principle, disclosure principle and
conservatism principle, are also discussed in this topic.

Topic 3 introduces a number of additional analytical techniques to complement


the ratio analysis, and these techniques include common size vertical analysis
and horizontal analysis. Financial ratios are computed and discussed, where the
prime purpose of each analytical method is to identify potential areas facing
financial distress. Once these areas have been identified, thorough investigations
are carried out to determine the cause of each irregularity, which includes
selecting additional ratios.

Topic 4 begins with a discussion on the concept of cost in decision making. There
can be multiple categories of cost or expenses or organisations, such as,
administrative cost and distribution cost and costs can be classified in different
ways for different purposes for decision making.

Topic 5 examines the concept of the Cost-Volume-Profit (CVP) analysis model


and illustrates how managers use that model to help answer important „what-if‰
business questions. The CVP analysis also helps management accountants alert
managers to the risks and rewards of decisions they are considering, by
illustrating how the bottom-line is affected by changes in activity levels and/or
key pricing or cost components.

Topic 6 discusses the decision-making process and the concept of relevant


information in short-term decision making. The terms Sunk Cost and
Opportunity Cost will also be discussed in understanding the concept of
relevance for decision making.

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xii  COURSE GUIDE

Topic 7 touches on budgets and discusses the Budgeting Process from the
conception of the plan to the expected execution of it. „What‰ and „How‰
resources are to be used over a specified time period including control that uses
feedback on actual operating results to compare with the plan to evaluate
performance in achieving the plan and goals will also be discussed.

Topic 8 discusses the Flexible Budget and its importance. Using the Fixed
Budgets and Flexible Budgets, Variance Analysis will be discussed.

Topic 9 describes the Variance Analysis such as Direct Materials Price and
Efficiency Variances, Direct Labour Price and Efficiency Variances, Variable
Overhead Spending and Efficiency Variance, and Fixed Overhead Spending and
Production-Volume Variances.

Topic 10 describes the responsibility accounting and responsibility centres of an


organisation. Balanced scorecards, as well as performance measurement tools
will be applied such as return on investment and residual income.

TEXT ARRANGEMENT GUIDE


Before you go through this module, it is important that you note the text
arrangement. Understanding the text arrangement will help you to organise your
study of this course in a more objective and effective way. Generally, the text
arrangement for each topic is as follows:

Learning Outcomes: This section refers to what you should achieve after you
have completely covered a topic. As you go through each topic, you should
frequently refer to these learning outcomes. By doing this, you can continuously
gauge your understanding of the topic.

Self-Check: This component of the module is inserted at strategic locations


throughout the module. It may be inserted after one sub-section or a few sub-
sections. It usually comes in the form of a question. When you come across this
component, try to reflect on what you have already learnt thus far. By attempting
to answer the question, you should be able to gauge how well you have
understood the sub-section(s). Most of the time, the answers to the questions can
be found directly from the module itself.

Activity: Like Self-Check, the Activity component is also placed at various


locations or junctures throughout the module. This component may require you to
solve questions, explore short case studies, or conduct an observation or research.
It may even require you to evaluate a given scenario. When you come across an
Activity, you should try to reflect on what you have gathered from the module and

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COURSE GUIDE  xiii

apply it to real situations. You should, at the same time, engage yourself in higher
order thinking where you might be required to analyse, synthesise and evaluate
instead of only having to recall and define.

Summary: You will find this component at the end of each topic. This component
helps you to recap the whole topic. By going through the summary, you should
be able to gauge your knowledge retention level. Should you find points in the
summary that you do not fully understand, it would be a good idea for you to
revisit the details in the module.

Key Terms: This component can be found at the end of each topic. You should go
through this component to remind yourself of important terms or jargon used
throughout the module. Should you find terms here that you are not able to
explain, you should look for the terms in the module.

References: The References section is where a list of relevant and useful


textbooks, journals, articles, electronic contents or sources can be found. The list
can appear in a few locations such as in the Course Guide (at the References
section), at the end of every topic or at the back of the module. You are
encouraged to read or refer to the suggested sources to obtain the additional
information needed and to enhance your overall understanding of the course.

PRIOR KNOWLEDGE
This is an introductory course. There is no prior knowledge needed.

ASSESSMENT METHOD
Please refer to myINSPIRE.

REFERENCES
Garrison, R. H., Noreen, E. W., Brewer, P. C., Cheng, N. S., & Yuen, K. C. K.
(2012). Managerial accounting, an asian perspective (13th ed.). McGraw-
Hill Companies, Inc.

Ronald, W. H. (2008). Managerial accounting creating value in a dynamic


business environment (7th ed.). McGraw Hill Higher Education.

Hansen, D. R., & Mowen, M. M. (2003). Management accounting (6th ed.). South
Western College Publishing.

Copyright © Open University Malaysia (OUM)


xiv  COURSE GUIDE

Brandon, C. H., & Drtina, R. E. (1997). Management accounting strategy and


control. McGraw-Hill Companies, Inc.

Weygant, J. J, Kieso, D. E., & Kimmel, P. D. (1999). Managerial accounting: Tools


for business decision-making. John Wiley and Sons, Inc.

Zimmerman, J. L. (2000). Accounting for decision making and control (3rd ed.).
McGraw Hill Companies, Inc.

TAN SRI DR ABDULLAH SANUSI (TSDAS) DIGITAL


LIBRARY
The TSDAS Digital Library has a wide range of print and online resources for
the use of its learners. This comprehensive digital library, which is accessible
through the OUM portal, provides access to more than 30 online databases
comprising e-journals, e-theses, e-books and more. Examples of databases
available are EBSCOhost, ProQuest, SpringerLink, Books247, InfoSci Books,
Emerald Management Plus and Ebrary Electronic Books. As an OUM learner,
you are encouraged to make full use of the resources available through this
library.

Copyright © Open University Malaysia (OUM)


Topic  Introduction to
1 Accounting

LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Describe how accounting information supports managerial
accounting and financial accounting;
2. Explain how management accountants affect strategic decisions;
3. Describe the financial accounting framework and the Managerial
Accounting System (MAS);
4. Describe the set of business functions in the value chain and identify
the dimensions of performance that customers are expecting of
companies;
5. Explain how management accounting fits into an organisationÊs
structure; and
6. Recognise what ethical behaviour means to managers and
management accountants.

 INTRODUCTION
Accounting for decision making is the process of identifying, measuring,
reporting, and analysing information about economic events of organisations
used by management to plan, evaluate, control and make decisions. Therefore,
accounting is an information system and seen as an integral part of the total
information system of an organisation.

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2  TOPIC 1 INTRODUCTION TO ACCOUNTING

As marketing is the tool for business, accounting is the language of business. It is


the method companies use to communicate information to its stakeholders. This
information is used by various parties for making various decisions. For instance,
if you want to buy some shares from an organisation, you will want to know the
financial health and future prospects of that organisation. To be able to make a
decision one will need to know accounting and be able to read the financial
statements of that organisation.

This topic will help you understand how accounting information is created and
how decision makers, both internal and external and use this information to
make decisions. You will also realise that there is a standard set of rules and
regulatory framework governing how to record and report financial information.

ACTIVITY 1.1

What do think accounting is all about?

1.1 ACCOUNTING INFORMATION


Accounting is often called as the language of business in an information system.
This system measures business activities, processes the data into reports, and
communicates the results to decision makers, in alignment with the organisationÊs
mission, vision, and values.

1.1.1 The Users of Financial Information


Internal users, such as, marketing, production, finance, human resources,
research and development, information systems, and general managers utilise
accounting information to determine the allocation of resources within the
organisation. The management will also use these information to decide on new
products launches or budgets, for example.

External stakeholders, such as, creditors, customers, unions, investors and


government agencies are the users of financial accounting information, primarily
to make decisions on the allocation of their own resources, such as, granting
investments, credit, purchasing goods and services, including complying with
tax laws and other regulatory requirements.

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TOPIC 1 INTRODUCTION TO ACCOUNTING  3

Since the decision-making process for each stakeholder involves choosing from
among alternative courses of action in order to achieve their respective
objectives, each group requires different kinds of information. There are different
sections of accounting that provide different kinds of information, namely,
financial accounting and management accounting.

A customer will want a continuous supply of materials or parts for the finished
goods. Therefore, the financial information becomes vital in making decisions, as
to how stable the entity is and its track record. The creditors will want to know
the financial strength of the entity to decide the amount to be loaned out to an
entity.

SELF-CHECK 1.1

Choose a listed company and list down all the possible users of its
financial information and discuss their needs.

1.2 MANAGEMENT ACCOUNTING AND


FINANCIAL ACCOUNTING
Accounting systems consider economic events including transactions and
process the data into information helpful to decision makers. The accounting
information system draws on two major branches of accounting, namely:

(a) Financial Accounting; and

(b) Management Accounting.

Management accounting analyses, measures and reports financial and non-


financial information which helps managers to make decisions and fulfil the
goals of an organisation. Managers apply management accounting information to
select, communicate and implement strategies. They also use management
accounting information to coordinate product design, production, marketing
decisions and to evaluate performance. Cost accounting, which is a subset of
management accounting, measures, analyses, and reports financial and non-
financial information relating to the costs of acquiring or using resources in an
organisation. Cost analysis data are primarily used for internal management
purposes.

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4  TOPIC 1 INTRODUCTION TO ACCOUNTING

Financial accounting focuses on reporting to external parties, such as,


government agencies, investors, banks, and suppliers. It records historical
financial transactions and furnishes financial statements that are based on
Generally Accepted Accounting Principles (GAAP). Table 1.1 shows the
differences between the two main branches of accounting.

Table 1.1: Differences between Financial Accounting and Management Accounting

Key Points Management Accounting Financial Accounting


Purpose Decision making Communicate financial position
to outsiders
Primary Users Internal users External users
Focus Future-oriented Past-oriented
Rules Need not follow GAAP GAAP compliant & Audited
Time Span Current to very long Historical monthly, quarterly
time horizons reports

Behavioural Issues Designed to influence Indirect effects on employee


employeeÊs behaviour behaviour

ACTIVITY 1.2

Why do you think Management Accounting is more forward looking


compared to Financial Accounting?

1.3 FINANCIAL ACCOUNTING FRAMEWORK


The accounting profession is also governed by regulations, as the profession is by
membership and is responsible to the public. Let us take a look at the
organisations that govern the accounting profession and financial reporting in
Malaysia.

(a) Companies Commission of Malaysia


The incorporation or registration of Malaysian business organisations is
effected by the Companies Commission of Malaysia (CCM), also known as
Suruhanjaya Syarikat Malaysia (SSM). The activities and financial reporting
by Malaysian business organisations are governed by the Securities
Commission Act 1993 for organisations listed on the Bursa Malaysia, apart
from adhering to the regulations of SSM.

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TOPIC 1 INTRODUCTION TO ACCOUNTING  5

The Companies Commission of Malaysia is a statutory body which


regulates companies and businesses. It is a statutory body which was
formed on 16 April 2002, as a result of the merger of the Registrar of
Companies and the Registrar of Businesses in Malaysia. Its main activity is
to ensure that the numerous companies and businesses in Malaysia
conform to the provisions of the Companies Act 1965 and Registration of
Business Act 1956. Malaysian companies are required to file their financial
statements and documents pertaining to significant decisions or
transactions with the CCM for public inspection.

(b) Malaysian Accounting Standards Board (MASB)


The Malaysian Accounting Standards Board (MASB) which is established
under the Financial Reporting Act 1997 is the technical body responsibles
for the development, review of, and the empowerment to issue legally
binding accounting standards in Malaysia, known as Malaysian Financial
Reporting Standards (MFRS).

MASB has adopted the global set of accounting standards which is known
as the International Financial Reporting Standards (IFRS). This was issued
by the International Standards Board (IASB), with effect from 1st January
2012.

(c) Financial Reporting Foundation


The Financial Reporting Foundation (FRF) is the trustee body which is
responsible for the supervision of the performance and funding
arrangements for the MASB. Although FRF has no direct accountability to
standards setting, the MASB would seek the views of FRF on all proposed
accounting standards and pronouncements.

(d) Professional Accounting Bodies


There are two professional accounting bodies in Malaysia, namely, the
Malaysian Institute of Certified Public Accountants (MICPA) which has
been developing the accounting profession in Malaysia for over five
decades by providing accounting graduates with an avenue to become a
Certified Public Accountant (CPA), and the Malaysian Institute of
Accountants (MIA) which regulates the accounting profession in Malaysia.

The MICPA was formed in 1958 as „The Malayan Association of Certified


Public Accountants‰. Later the Association became „The Malaysian
Association of Certified Public Accountants‰ (MACPA) in 1964, and
subsequently „The Malaysian Institute of Certified Public Accountants‰
(MICPA) in 2002.

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6  TOPIC 1 INTRODUCTION TO ACCOUNTING

The MIA is a statutory body established under the Accountants Act, 1967 to
regulate and develop the accountancy profession in Malaysia. Under the
Accountants Act, all practicing accountants have to register themselves as
members of the MIA. The MIAÊs responsibilities include education and
quality assurance, as well as enforcement, to ensure that the credibility of
the accounting profession is maintained, and that public interest is
continuously upheld.

In addition, the MICPAÊs Code of Professional Conduct and Ethics and the
MIAÊs By-Laws (on Professional Ethics, Conduct and Practice) provide
guidance to the accounting professions on their professional and ethical
conduct.

1.3.1 Types of Business Entities in Malaysia


A business can be organised as a:

(a) Sole Proprietorship;

(b) Partnership;

(c) Corporation; and

(i) Private Limited Company (Sendirian Berhad); and

(ii) Public Limited Company (Berhad).

(d) Limited Liability Partnership (LLP).

The major differences between the types of entities above are its:

(a) Liability; whether it is limited or unlimited liability;

(b) Ability to get funding; sourcing funds via Initial Public Offer (IPO); and

(c) Need to be audited.

Table 1.2: Differences between the Types of Entities

Types of Entities Liability Funding Ability Audit Requirement


Sole Proprietorship Unlimited Non-IPO No
Partnership Unlimited Non-IPO No
Private Limited Company Limited Non-IPO Yes
Public Limited Company Limited IPO Yes
Limited Liability Partnership Limited Non-IPO No

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TOPIC 1 INTRODUCTION TO ACCOUNTING  7

SELF-CHECK 1.2

In the development of the financial reporting framework in Malaysia,


what are the roles and responsibilities of each of the following:

(a) Malaysian Accounting Standards Board (MASB);

(b) Malaysian Institute of Accountants (MIA); and

(c) Securities Commission of Malaysia (SSM).

1.4 MANAGERIAL ACCOUNTING SYSTEM (MAS)


Managerial Accounting System (MAS) collects financial data from various
business operations and uses these data to assist the organisation in making
decisions and creating strategies.

Strategies are set out to allow an organisation to match its own capabilities with
the opportunities in the marketplace to accomplish its objectives, be it short,
medium or long term. Management accountants are involved in formulating
strategies by providing information on the sources of competitive advantage
of the organisation, as well as, general costing information. Management
accounting assists in formulating strategy by helping the managers to answer
critical decision making questions regarding the value chain, supply chain
analysis and the key success factors of the organisation.

A customer demands quality products or services that are provided to them


efficiently and effectively to fulfil their business needs and not just merely a
competitive pricing. This information is attainable by the organisation from their
management accountant, with reference to the value chain and supply chain.

The value chain is a set of activities which requires designing, developing,


producing, marketing and delivering products and services to customers. Thus, it
stresses customer value which compels managers to specify which activities in
the value chain are crucial to customers.

The supply chain depicts the flow of goods, services, and information beginning
from the sources of materials and services, to the conveyance of products to
consumers, regardless of whether those activities occur in the same organisation
or in different organisations.

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8  TOPIC 1 INTRODUCTION TO ACCOUNTING

1.4.1 Management Accounting and Value Creation


Creating value is an important part of planning and implementing strategy for any
organisation to be sustainable in the long term. Value is the usefulness a customer
gains from an organisationÊs product or service. Therefore, organisations needs to
ascertain their value chain and improve their competitiveness. Generally value-
chains consist of the following.

Figure 1.1 describes the relationship between management accounting and value
chain. It covers six areas of concern in maintaining the efficiency and
effectiveness of a business to be sustainable. These six domains need to be well
coordinated to establish a profitable and sustainable business.

Figure 1.1: Management accounting and value chain

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TOPIC 1 INTRODUCTION TO ACCOUNTING  9

1.4.2 Management Accounting and Business Strategy


Management accounting assists in answering critical inquiries, such as, the
following vital questions that need to be addressed in a timely manner:
(a) We need to know who the important customers for the organisation are and
how these customers are served by us;
(b) Are there any substitute products in the market and how do we stand out
from our competitors?;
(c) What are our special abilities and capabilities?; and
(d) Are the strategies well-funded financially or are outside funds required?

Thus, organisations are able to maintain an edge over their competitors. The two
major strategies in a managerial accounting system are namely, Cost Leadership
Strategy, for example, used by Air AsiaÊs as Low cost and No Frills and DominoÊs
Pizza, and the next strategy is Product Differentiation Strategy, for example, used
by Ferrari as specialised in high performance cars and also by Starbucks.

1.4.3 Key Success Factors


The key success factors are the measurements of performance that customers
expect from the organisation which are vital to their success. There are four key
success factors, which are (refer to Figure 1.2):

Figure 1.2: The four key success factors

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10  TOPIC 1 INTRODUCTION TO ACCOUNTING

Decision making is a vital step to be addressed and to make informed and


calculated decisions. Provided below are the steps that need to be taken to
ascertain that an organisation makes the correct decision in solving an issue. The
flow for the management accountant to use in decision making is listed below:

(a) Identify the problem and uncertainties;

(b) Obtain information;

(c) Make predictions about the future;

(d) Make decisions by filtering alternatives;

(e) Make decisions by choosing an alternative;

(f) Implement the chosen alternative;

(g) Evaluate performance based on the chosen alternative; and

(h) Provide feedback and re-look at the prior decision made.

These steps form the planning where the selection of organisational goals and
forecasting their results under numerous alternative ways of attaining those
goals are carried out. The decision on how to attain the anticipated goals,
communicating those goals and the mechanism of applying it to the entire
organisation are done. These are where the proper planning, control and making
decisions are essential in making future decisions.

ACTIVITY 1.3

Assume the role of a Management Accountant in a manufacturing


environment. Discuss how the value chain can be used to make the
organisation more efficient and effective in attaining its goals.

Copyright © Open University Malaysia (OUM)


TOPIC 1 INTRODUCTION TO ACCOUNTING  11

1.5 ETHICAL BEHAVIOUR FOR MANAGERS


AND MANAGEMENT ACCOUNTANTS
Organisations usually create standards of conduct for their managers and
employees. Professional associations also establish ethical standards known as
the code of conduct. This code of conduct in ethical behaviour that assists the
organisations in explaining what ethical behaviour means to managers and
Management Accountants. Management Accountants are responsible for
maintaining ethical behaviours

In general, there are four standards of ethical conduct that needs that to be
adhered by managers and Management Accountant namely:

(a) Integrity;
(b) Objectivity;
(c) Competence; and
(d) Confidentiality.

Integrity is based on the basics of honesty and preforming entrusted tasks


without favouritism, nepotism and fraud. Objectivity focuses on the core
description of the task that has been entrusted in which the outcome and the
method of performing the task have to be at the level equal to efficiency and
effectiveness. Competence is the ability to perform the task at a high level of
expertise as required by the professional or technical knowledge requirement, for
example, the accounting profession. Confidentiality is maintaining the privacy
and confidentiality of the trade secrets of the entity or the details of the clientele.

 Accounting information is a system that measures business activities,


processes the data into reports and communicates the results to decision
makers.

 The users of financial information are internal and external users.

 Management accounting measures, analyses and reports financial and non-


financial information that helps managers make decisions to fulfill the goals
of an organisation. Managers use management accounting information to
choose, communicate and implement strategy.

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12  TOPIC 1 INTRODUCTION TO ACCOUNTING

 Financial accounting focuses on reporting to external parties, such as,


investors, government agencies, banks and suppliers.

 The incorporation or registration of Malaysian business organisations is


effected by the Companies Commission of Malaysia (SSM).

 Malaysian Accounting Standards Board (MASB), established under the


Financial Reporting Act 1997, is the technical body responsible for the
development and review of and the empowerment to issue legally binding
accounting standards in Malaysia, known as Malaysian Financial Reporting
Standards (MFRS).

 Malaysian Institute of Accountants (MIA) is a statutory body established


under the Accountants Act, 1967 to regulate and develop the accountancy
profession in Malaysia. Under the Accountants Act, all practicing accountants
have to register themselves as members of the MIA.

 Managerial Accounting System collects financial data from various business


operations and uses these data in assisting the organisation make decisions
and create strategies.

Conceptual framework Partnership


Corporation Securities Commission of Malaysia
Financial accounting Standards Board (MASB)
Malaysian Accounting Sole proprietorship
Malaysian Institute of Accountants Value chain
Management accounting

Assume the role of a Management Accountant, assist the Chief Executive in a


private university and discuss how ethics can be promoted at every level of the
university, taking into account the various departments and levels of reporting.

Copyright © Open University Malaysia (OUM)


TOPIC 1 INTRODUCTION TO ACCOUNTING  13

Drury, C. (2015). Management and cost accounting (9th ed.). Cengage Learning.

Horngren, C. T., Datar, S. M., & Rajan, M. V. (2015). Cost accounting: A


managerial emphasis (Global Edition 15th ed.). Pearson Education Limited.

Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J. O.
(2014). Introduction to management accounting (Global Edition 16th ed.).
Pearson Education Limited.

Copyright © Open University Malaysia (OUM)


Topic  Accounting
2 Concepts and
Principles
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Identify the concepts underlying income measurement;
2. Differentiate between accrual and cash-basis accounting; and
3. Discuss the accounting concepts and principles implicit in financial
statements.

 INTRODUCTION
Measuring income is crucial to businesses because there is a need to know how
well the entity is doing economically and financially. Businesses need to be able
to measure the success of their operations. However, the only way to be certain
of a businessÊs success is by liquidating the entity by selling its assets and
liabilities. The remaining cash will be a measure of the entityÊs worth. For
accounting purposes, accountants measure the performance of business entities
over discrete time periods, commonly a fiscal year, explained as the accounting
time period concept.

Copyright © Open University Malaysia (OUM)


TOPIC 2 ACCOUNTING CONCEPTS AND PRINCIPLES  15

The most common ways to measure income are the accrual basis and cash basis
methods. Although both cash and accrual basis have their merits, the accountants
have conventionally measured income on an accrual basis. Generally, governments
conduct their accounting using the cash basis, unless the government has
reverted to the accrual basis. Based on the accrual basis, expenses are recognised
in the same period as their related income, known as the matching principle.

Some of the other basic accounting principles and concepts that are implicit in
financial statements, such as, the separate entity concept, reliability concept,
going concern convention, materiality convention, monetary unit assumption,
historic cost assumption, time-period concept, consistency principle, disclosure
principle and conservatism principle will also be discussed in this topic.

ACTIVITY 2.1

Think about any financial ratio that you have come across before and
what it means.

2.1 FUNCTIONS OF ACCOUNTING CONCEPTS


AND PRINCIPLES
The accounting concepts and conventions are needed as building blocks for the
accounting framework. Let us understand what a framework is all about first. A
framework is defined as the course of action of booster pillars that speaks of a
buildingÊs general shape and estimate; therefore, a framework is a set of
assumptions, concepts, values and practices that constitutes a way to view the
real situation.

The framework will guide the building of the ideology of whatever that is to
be built. The conceptual framework is a framework that is broad based and
predominantly conceptual in nature, to guide the users of this framework to
carve out more specific rules and regulations.

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16  TOPIC 2 ACCOUNTING CONCEPTS AND PRINCIPLES

Conceptual framework refers to basic definitions and explanations of the


underlying logic behind financial information that determine the shape of
information supplied to the users of financial information. The objective of
financial statements is to provide material information to many users on the
financial position, financial performance and changes in financial position of an
organisation to make economic decisions.

The conceptual framework is utilised by the standard setters, namely the


International Accounting Standards Board (IASB) to create accounting standards.
The accounting standards that explain the definition, recognition, measurement
and disclosure provide insights of a certain area of interest for the organisation.
The presentation of the financial statements using the accounting standards is
to fulfil the purpose of common purpose financial reporting, that is, to provide
financial information on the reporting entity that is useful to existing and future
investors, lenders and any other creditors in making informed decisions on
providing funding to the organisation.

Qualitative characteristics identify the types of information that have possibilities


to be useful to the existing and future investors, lenders and stakeholders for
decision making on the reporting entity based on information in its financial
reports. If financial information is to be useful, the main qualities to look for are
that it must be relevant, reliable, and faithfully represented and the usefulness of
financial information is enhanced if it is comparable, verifiable, timely and
understandable.

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TOPIC 2 ACCOUNTING CONCEPTS AND PRINCIPLES  17

2.1.1 Accrual Accounting and Cash-Basis Accounting


The two most common methods to measure income are (refer to Figure 2.1):

Figure 2.1: The two most common methods to measure income

(a) Accrual Accounting


Accrual accounting is one of the two underlying assumptions in
accounting. In accrual accounting, transactions are recorded as it occurs.
Revenue is recorded when earnings and expenses incurred are recorded.

For example, when a credit sale is made, the double entry is a debit to
Accounts Receivable and a credit to sales accounts, to record the particular
sales at the same time, not when the cash is collected from the customer.

(b) Cash-basis Accounting


In cash-basis accounting, only cash receipts and payments are recorded.
It ignores all transactions that do not involve cash. A Cash Budget is
primarily using Cash-Basis for its recording and presentation.

Generally, accountants have used the accrual basis as a basis to record the
business transactions of an organisation. Accrual accounting gives rise to the
usage of accruals, prepayments and other adjustments.

SELF-CHECK 2.1

Discuss the accounting basis that is used in private entities and the
public sector in Malaysia.

Copyright © Open University Malaysia (OUM)


18  TOPIC 2 ACCOUNTING CONCEPTS AND PRINCIPLES

2.2 ACCOUNTING CONCEPTS AND PRINCIPLES


To develop an understanding of the financial statements, we have to understand
the concepts used in preparing the statements. The accounting concepts (see
Figure 2.2) are explained in the following:

Figure 2.2: Accounting concepts

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TOPIC 2 ACCOUNTING CONCEPTS AND PRINCIPLES  19

(a) Relevant
Information is relevant when it is useful in making an impact on decision
making. When an accounting system provides relevant information, the
decision making becomes easier and meaningful. Relevance involves
the content of the information and its timeliness for decision making.
The impact of complying with relevant is to confirm a decision that a
stakeholder has made or is planning to make in the future.

An example of how relevant information is used in accounting is when we


are deciding on the recognition of costs to make decisions. For example let
us say goods are to be transported to Kuala Lumpur, either by train or by
car. The relevant information to assist us are the train fare versus the fuel
cost for the car, but the road tax paid for the car is irrelevant for making
decisions.

(b) Reliability
Reliability promotes that information is to be based objectively on correct
data. The information presented to the stakeholders is represented
faithfully without any form of biasness or error and the specific transactions
and/or events that are reported in the financial statements are true and fair.
Reliability is maintained with the ability to verify the financial information.
For example, preparing the financial statement based on accounting
standards establishes the reliability of the accounts and its value
representations.

(c) Matching Concept


This concept is about maintaining the cause and effect of transactions.
Assets are used up and liabilities incurred in order to earn revenues.
When assets are used up, they become expenses. The matching principle
calculates and uses all the expenses that happened during a given time
frame and match them against the revenues of the period. For example, the
depreciation of a plant asset is matched against the usage of the asset over
time to generate revenue for the entity.

Copyright © Open University Malaysia (OUM)


20  TOPIC 2 ACCOUNTING CONCEPTS AND PRINCIPLES

(d) Timeliness
Timeliness is vital to plan and control business processes of an organisation.
Timely information will be helpful for organisations to be competitive.
Organisations use huge data analyses to be able to forecast and respond to
the ever changing business environment and be competitive. Timely
information for pricing, planning and costing purposes are important to
serve the customers and also to enjoy significant savings from informed
decision making and risk taking. The preparation of budgets on a timely
manner, say two months before the year end and the variance analysis
prepared before the formulation of the budgeting parameters, are some
examples of the need of timeliness to make useful decisions .

(e) Prudence
Prudence is when preparing financial statements, organisations are to
exercise caution and ensure that the reported figures are realistic. In a
prudent approach, the rules of thumb are not to expect any gains, but to
provide for possible losses and to record an asset at the lowest reasonable
amount and a liability at the reasonably highest amount. In the event of a
loss if unsure recognise it, but in the event of a gain do not recognise unless
it is realised, and when doubtful, record expense not an asset. The inclusion
of provision of doubtful debts is to be prudent, in case some amount from
the accounts receivables is uncollectible.

(f) Completeness
Completeness means that organisations need to record all items regarding
the affairs of business in the statements. Some items deemed not so
important should be recorded in the notes to accounts, which form a major
part of the annual report.

Generally, completeness can be explained from three different perspectives,


namely, relating to transactions, relating to account balances and relating to
presentation and disclosures. Notes to accounts that appear in all annual
reports are perfect examples of that to be complete, all information need to
be included.

(g) Comparability/Consistency
Business entities should apply similar accounting methods for different
time frames, for example, the usage the methods of depreciations and
inventory valuations are to be consistently applied over the years.

This is vital to make sure that the financial information is comparable for
analysis purposes.

Copyright © Open University Malaysia (OUM)


TOPIC 2 ACCOUNTING CONCEPTS AND PRINCIPLES  21

For example the method of depreciation, like straight line, needs to be


consistently used to measure depreciation on property, plant and
equipment. It is not recommended for an organisation to switch the method
of depreciation from straight line to reducing balance without any
reasonable justification. Another example of consistency is the usage of the
method to value inventory, say, if an entity uses Weighted Average, it has
to always maintain the same method.

(h) Materiality
Business entities are to follow accounting rules strictly only for significant
items. Items that are not significant for decision making should be ignored.
For example, the depreciation on trivial items like staples or certain
stationeries should be recognised as expenses instead of being depreciated.

(i) Going Concern


Going concern is the second underlying assumption in accounting and here
an assumption is made that, a business will continue for the foreseeable
future and use its assets in operations instead of selling them, unless there
is a doubt to the sustainability of the business.

Financial statements are basically prepared on the assumption that the


organisation is an going concern and will operate for the foreseeable future.
The fact that entities close their accounts on a twelve months period is
conformity to going concern, that there will be another accounting year
ahead as long as the future holds.

(j) Accruals
The impact of transactions and different occasions are perceived when they
happen and they are recorded in the accounting records and reported in the
monetary proclamations of the periods to which they relate. Accrual
accounting portrays the impact of exchanges and different occasions and
circumstances on a reporting entityÊs financial assets and claims in the
periods in which those impacts happen, regardless that the subsequent
money receipts and payments happen in an alternate period. As opposed to
Cash-Basis, when a credit sale is made, the double entry is a debit to
Accounts Receivable account and a credit to Sales account, to record the
particular a sales, not when the cash is collected from the customer.

This is critical because data concerning a reporting entityÊs financial assets


and claims, and changes in its monetary assets and claims in a period, gives
a superior premise to evaluating the elementÊs past and future execution
against singular data on money receipts and payments in that period.

Copyright © Open University Malaysia (OUM)


22  TOPIC 2 ACCOUNTING CONCEPTS AND PRINCIPLES

Other concepts and principles that can be of concern are, namely, separate entity
concept, historic cost assumption, monetary unit assumption, accounting period
assumption, revenue recognition principle and disclosure principle.

The separate entity concept can be explained by understanding that a business


entity is always separate and distinct from its owners. Historical cost assumption
can be explained as the measurement basis that is most commonly used by
organisations in preparing their financial reports, which is known as historical
cost. Historical cost assets are recorded as the amount of cash used to purchase
them at the time of its acquisition. Historical cost liabilities are recorded as the
amount received in exchange for the obligation received.

Monetary unit assumption for Malaysian transactions is recorded in Ringgit


Malaysia, as the ringgit is the medium of exchange. Accountants generally
assume that the ringgitÊs purchasing power is commonly quite stable. On the
contrary for certain too volatile economies, a common strong currency will be
used, predominantly the American dollar.

Accounting period assumption is an assumption that the life of a business is able


to be split and divided into a few time intervals that are equally distributed for a
given reporting time frame. Generally the accounting time frame will be a period
of twelve months ending either on 31 March, 30 June, 30 September or
31 December. Revenue recognition principle is when revenue is to be recorded
only when the revenue has been earned by the organisation.

Revenue is assumed to be earned when the entity has handed over the goods or
service agreed to the legally binding customer. Generally, the invoice date is used
to determine the recognition of revenue. Disclosure principle is when business
entities have reported substantial information for external stakeholders to make
useful decisions on the organisation.

ACTIVITY 2.2

1. Choose a listed company in Malaysia and look at the notes to the


financial statements. Identify the accounting concepts and
principles.

2. Discuss why the prudence concept is at times preferred over


relevance.

Copyright © Open University Malaysia (OUM)


TOPIC 2 ACCOUNTING CONCEPTS AND PRINCIPLES  23

SELF-CHECK 2.2

1. Explain the basic underlying assumptions in accounting.

2. Explain the qualitative characteristics of accounting information


and support your answers with an example of each.

 The accounting information should have the following qualitative


characteristics, namely, relevant, faithful representation, comparability,
verifiability, timeliness, and understandability.

 Important accounting concepts and assumptions to prepare of a financial


statement are:

 Separate entity concept: The assumption that a business entity is separate and
distinct from its owners and from other business entities.

 Reliability: The assumption that accounting information is to be based on


objectively determined and correct data. The information presented
represents faithfully, without bias and error all the transactions that are
reported in the organisationÊs financial statements.

 Going concern: The assumption that an organisation will continue to be in


business in the future and will use its assets to operate the business, not with
the intention to sell the assets.

 Revenue principle: Revenue is to be recorded revenue when it has been


earned but not before. Revenue has been earned when the business has
delivered a good or service to the customer.

 Matching principle: Assets are used up and liabilities incurred in order to


earn revenue. When assets are used up, they become expenses. The matching
principle calculates the expenses that happened in the time frame, and
matches the expenses to the revenues of the same time frame.

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24  TOPIC 2 ACCOUNTING CONCEPTS AND PRINCIPLES

 Time-period concept: This concept ensures that accounting information is


recorded and reported at regular intervals.

 Prudence: Business entities should use the same accounting methods for
different periods.

Accruals Matching concept


Accrual accounting Materiality
Cash-basis accounting Prudence
Comparability/consistency Relevant
Completeness Reliability
Going concern Timeliness

Drury, C. (2015). Management and cost accounting (9th ed.). Cengage Learning.

Horngren, C. T., Datar, S. M., & Rajan, M. V. (2015). Cost accounting: A


managerial emphasis (Global Edition 15th ed.). Pearson Education Limited.

Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J. O.
(2014). Introduction to management accounting (Global Edition 16th ed.).
Pearson Education Limited.

Copyright © Open University Malaysia (OUM)


Topic  Financial
3 Statements
Analysis
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Explain the uses of ratios in a publicly listed company;
2. Identify and discuss the limitations of financial ratios;
3. Discuss horizontal and vertical (common size) analysis; and
4. Explain the uses of ratios in determining sharia compliance.

 INTRODUCTION
The Financial Manager of an organisation uses ratios in making decisions related
to his/her responsibilities (internal use), and they are also used by creditors,
lenders and investors in evaluating an organisation (external use).

The prime purpose of each analytical method is to identify potential areas facing
financial distress. When the areas are established, detailed probing is necessary
to find out the reasons of all differences especially in the process of choosing new
ratios.

Users of financial statements should utilise the interpretative methods of the


ratios. All the methods assist the users to gauge and evaluate the financial
situation and performance of an organisation, as well as, predicting corporate
failure using scores, such as, Z-scores, H-scores and A-scores.

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26  TOPIC 3 FINANCIAL STATEMENTS ANALYSIS

This topic introduces a few other methods to analyse other than the traditional
ratio analysis. The other methods are common size (vertical) analysis and
horizontal analysis. Ratios and its analysis are elaborated to establish compliance
to sharia and to establish borrowings in organisations.

ACTIVITY 3.1

Think about any financial ratio that you have come across before and
what it means.

3.1 RATIO ANALYSIS


There are five main categories of ratios, namely (refer to Figure 3.1):

Figure 3.1: Five main categories of ratios

We will start with profitability ratios, followed by the rest of the categories.

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TOPIC 3 FINANCIAL STATEMENTS ANALYSIS  27

3.1.1 Profitability Ratios


Listed below are profitability ratios and we will be looking into the definitions
and formulas of these ratios individually.

Figure 3.2: Types of Profitability Ratios

(a) Net Profit Margin and Gross Profit Margin


These ratios relate to the firmÊs returns on its sales or equity. Attention is
given towards profitability, since in order to stay in existence, the firm must
be profitable.

It is useful to compare trends in each of these margins within a company,


as well as, to compare net profit margin with gross profit margin to
investigate movements that does not match. It is also useful to look into

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28  TOPIC 3 FINANCIAL STATEMENTS ANALYSIS

the cost elements to decide on the strategies to improve the net profit
margin and gross profit margin, besides looking at the selling price and
quantity levels. These are the formulas for both gross profit margin and net
profit margin:

 Gross Profit 
Gross Profit Margin     100%
 Sales
 PBIT 
Net Profit Margin    100%
 Sales 

(b) Return on Capital Employed (ROCE)


There are many different definitions of capital employed (ROCE). Some
definitions use shareholdersÊ funds plus non-current liabilities. Essentially,
you are trying to find out the return on the money invested in the business
by lenders and shareholders. Sometimes companies will have large non-
current liabilities items, such as, pension funds and deferred tax liabilities.
In these cases, it is probably better to use shareholdersÊ funds plus long-
term debt.

However, it is also essential to investigate the situation of the short term


loans in current liabilities. If there are significant loans that are reaching
maturity, then, you may want to include short-term loans as well. This is
the formula for ROCE:

 PBIT 
ROCE     100%
 Capital Employed 

(c) Return on Equity (ROE)


For return on ownersÊ equity (ROE), Profit after Interest and Tax (PBIT) is
preferred over profit before tax. Some analysts prefer using profit after tax
because this is the profit that is available for shareholders, for example, to
look at the relationship between the profit available for shareholders and
the amount that shareholders have invested. This is the formula for ROE:

 PBAT 
ROE     100%
 Equity Capital 

Copyright © Open University Malaysia (OUM)


TOPIC 3 FINANCIAL STATEMENTS ANALYSIS  29

3.1.2 Efficiency Ratios


Listed (refer to Figure 3.3) are efficiency ratios and we will be looking into the
definitions and formulas of these ratios individually.

Figure 3.3: Types of efficiency ratios

(a) Assets Turnover


Assets turnover measures the efficiency in the use of assets in generating
sales for the organisation. When an organisationÊs total assets turnover is
higher, it means that the assets of the organisation had been used more
efficiently. If we need to have a more severe test of efficiency, we just need
to substitute total assets with non-current assets. Assets turnover reflects
how effectively the firm has utilised its assets to generate sales or cash. This
is the formula for asset turnover:

Sales
Assets Turnover 
Total Assets

Copyright © Open University Malaysia (OUM)


30  TOPIC 3 FINANCIAL STATEMENTS ANALYSIS

(b) Inventory Turnover


A popular belief is that the higher the inventory turnover, the more
efficiently inventory is managed. This is true up to a point; beyond that
point, a high inventory turnover may signal problems. For example one
way to increase inventory turnover is to carry very small inventories.
However, such a strategy could result in a large number of stock outs (lost
sales due to insufficient inventory), which could damage the firmÊs future
sales. Inventory turnover can be easily calculated in terms of days or times,
if in days the lower the better and if in times the higher the better. Dealing
with these ratios requires caution in managing the organisationÊs working
capital, to avoid overtrading with high levels of receivables but no cash, or
the cash is being tied up in excessive levels of inventory, that increases
holding cost of the inventory. This is the formula for inventory turnover:

 Average Inventory 
Inventory Turnover     365 days
 Cost of Sales 

(c) Trade Payables Payment Period [TPPP]


This ratio is not easy to calculate because of the need to find the yearly
purchases value, because this amount is not given in the financial
statements. Commonly, the purchases figure is estimated as a given
percentage of the value of the cost of goods sold. This is the formula for
TPPP:

 Trade Payables 
TPPP     365 days
 Credit Purchases 

(d) Trade Receivables Collection Period [TRCP]


For trade receivables collection period, we need to use a revenue figure if
revenue on credit terms is not available. This ratio explains the average
number of days in a year that an organisation needs to collect its debts from
credit customers. The lower days indicates that the organisation is able to
collect debts faster and frees the cash for other purposes, perhaps making a
payment to the suppliers. The formula for TRCP is as follows:

 Trade Receivables 
TRCP    365 days
 Credit Sales 

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TOPIC 3 FINANCIAL STATEMENTS ANALYSIS  31

3.1.3 Liquidity Ratios


Shown in Figure 3.4 are the types of liquidity ratios and we will be looking into
the definitions and formulas of the ratios individually.

Figure 3.4: Types of liquidity ratios

(a) Current Ratio


The liquidity of an organisation is measured by its liability to satisfy its
short-term obligations when it is to be paid and it refers to the solvency of
the organisationÊs overall financial position.

This figure is useful for internal control, especially when a longer term
borrowing is incurred, specifically when a stated minimum level of net
working capital needs to be established by the organisation. This criterion is
used to force the organisation to establish enough operating liquidity and
helps protect the creditors.

When an organisationÊs current ratio is 1, its net working capital is nil, and
when an organisationÊs current ratio is less than 1, it will have a negative
net working capital. Therefore, the most ideal current ratio should be 2:1,
but again, it all depends on the industry to make a better comparison. The
formula for Current Ratio is as follows:

Current Assets
Current Ratio 
Current Liabilities

(b) Quick Ratio (Acid Test)


This ratio excludes inventory and at times pre-payments from current
assets, since it is assumed that inventory would be the least liquid current
assets. An acid-test ratio of 1 or greater is preferred at times. This ratio
provides a better measure of overall liquidity if the organisationÊs inventory
cannot be easily changed into cash. If the inventory is as liquid as the other
components of current assets, than the current ratio is a method of choice to

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32  TOPIC 3 FINANCIAL STATEMENTS ANALYSIS

measure the overall organisationÊs liquidity. The ideal quick ratio should be
1:1, but it depends on the industry to make a better comparison. The
formula used to find the Acid Test Ratio is as follows:

Acid Test Ratio 


 Current Assets  Inventory
Current Liabilities

3.1.3 Solvency (Debt) Ratios


Listed in Figure 3.5 are solvency (debt) ratios and we will be looking into the
definitions and formulas of these ratios individually.

Figure 3.5: Types of solvency (debt) Ratios

(a) Gearing Ratio (Debt Ratio)


Gearing ratio is used to measure how and to what level the organisation
has financed its assets, using funds that are not from the organisation.
Generally, the financial analyst will be looking at any long-term debt more
seriously, as the organisation needs to pay interests for a longer period and
later repay the borrowed amount. As the claims of creditors, for example,
dividends paid to preferred shareholders or interest to bankers, must be
paid first before any distribution of earnings is given out to the ordinary
shareholders. Present and future shareholders will want to know more
about the debt level of the organisation and its ability for repayments.

Even creditors will be concerned, as more debts results in higher


probability of the organisation being unable to repay their creditors.
Therefore, when the ratio is higher, the possibility that the amount of other
peopleÊs money being used in an attempt to generate profits, is higher as
well. It can also mean that the organisation has more financial leverage.
This ratio also establishes the relationship between the long-term finances
provided by the creditors and funding given by the organisationÊs
shareholders.

Copyright © Open University Malaysia (OUM)


TOPIC 3 FINANCIAL STATEMENTS ANALYSIS  33

The gearing ratio is an indicator of how risky the organisation is in terms of


the ability to pay fixed payments of interest, as opposed to ordinary share
dividends. A gearing ratio of below 50% is preferred and deemed as a less
risky organisation to invest in.

 Long Term Debt 


Gearing Ratio     100%
 Total Capital Employed 

(b) Interest Cover


Besides paying the principal, the organisation has to pay interest. The ratio
would be of great interest to the firmÊs creditors, who are concerned with
the firmÊs ability to service existing debts or any additional debts or both.
This ratio is also known as „total interest coverage ratio‰. An organisation
must generate enough profits to cover interest charges and it must also
have sufficient cash to pay these charges.

PBIT
Interest Cover 
Interest Payable

3.1.4 Investment Ratios


Listed in Figure 3.6 are Investment Ratios and we will be looking into the
meanings and formulas of these ratios individually.

Figure 3.6: Types of investment ratios

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34  TOPIC 3 FINANCIAL STATEMENTS ANALYSIS

(a) Dividend Yield


Dividend yield is a measure of growth of an organisation, as dividend per
share is compared with market price per share (expressed as a percentage).
A low dividend yield denotes that the organisation retains a large
proportion of profits to be reinvested. A high dividend yield denotes that
the organisation is risky or having a slow growth, therefore investors need
to be careful of any factors affecting market price. The formula for Dividend
Yield is as follows:

 Dividend 
Dividend Yield    100%
 Current Market Value of Share 

This shows how safe the dividend payment is, or the extent of profit
retention, for example, profits being reinvested in the business. Variations
may be due to maintaining dividend when profits are declining.

(b) Earnings per Share (EPS)


Earnings per share are calculated by the formula: the profits attributable to
ordinary shareholders divided by the number of ordinary shares issued.
EPS is expressed in „cent‰ per share for an organisation and is used to
identify trends, such as, rate of growth in EPS. A higher EPS denotes that
the organisation is able to distribute more of its residual earnings (Profit
after Interest and Tax [PAIT]) to the ordinary shareholders. The following is
the formula for EPS:

 PAIT 
Earnings per Share (EPS)     100 cents
 Number of Ordinary Shares 

(c) Price Earnings Ratio (P/E)


A high P/E ratio reflects the confidence of the market. A rise in earnings
per share (EPS) will normally cause an increase in P/E ratio. You need to
consider market and industry norms to make a judgement on the P/E ratio.
Generally, a higher P/E ratio shows more market confidence on that share.
The formula for P/E is as shown:

Market Price
Price Earnings Ratio (P/E) 
EPS

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TOPIC 3 FINANCIAL STATEMENTS ANALYSIS  35

Example 3.1
Given below are the financial statements of Syarikat Good Business Berhad for
the year ended 31 December 2015. Financial ratios for Syarikat Good Business
Berhad are calculated based on the formulas that have been discussed
previously.

Syarikat Good Business Berhad


Statement of Comprehensive Income for the Year Ended 31 December 2015
RM RM
Sales 225,000
Less: Cost of goods sold (75,000)
Gross profit 150,000
Less: Operating expenses:
Fixed cash operating expense 30,000
Variable operating expense 45,000
Depreciation 10,000
Total operating expenses (85,000)
Profits before interest and taxes 65,000
Less: Internet expense (5,000*)
Profits before taxes 60,000
Less: Taxes (17,500)
Net Income 42,500

Syarikat Good Business Berhad


Statement of Financial Position as at 31 December 2015
RM RM
Assets:
Non-Current Assets
Property, Plant and Equipment 200,000

Current Assets
Cash at Bank 25,000
Accounts Receivables 50,000
Inventories 75,000 150,000
Total Assets 350,000

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36  TOPIC 3 FINANCIAL STATEMENTS ANALYSIS

RM RM
Equity and Liabilities:
Equity
Ordinary Shares 150,000
Retained Earnings 80,000

Liabilities:
Accounts Payables 70,000
Bank Notes 5,000 75,000

Long Term Liabilities:


Long term debts 45,000
Total Equity and Liabilities: 350,000

Given below are the financial ratio calculations for Syarikat Good Business
Berhad.

Current assets
(a) Current ratio 
Current liabilities
RM150,000

RM75,000
 2:1

This current ratio of 2 : 1 means that that the current assets are double the
current liabilities. Therefore, the liquidity of the entity is deemed to be
sufficient to cover its short-term obligations.

Current assets  Inventories


(b) The acid-test (quick) ratio 
Current liabilities
RM150,000  RM75,000

RM75,000
1:1

This quick ratio of 1 : 1 means that that the current assets (net of inventories)
are equal to the current liabilities. Therefore, as a more severe test of
liquidity, this entity is deemed to be sufficient to cover its short-term
obligations. This is not surprising looking at the favourable current ratio
above.

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TOPIC 3 FINANCIAL STATEMENTS ANALYSIS  37

Cost of goods sold


(c) Inventory turnover 
Average inventories
RM75,000

RM75,000
 1 time

365 days
Average age of inventory 
Inventory turnover

This inventory turnover of 1 time means that that the inventory turns over
in the entity, on average, once a year. Generally, a higher inventory
turnover is preferred as it means that the inventory is following the latest
trend and perhaps it will appeal to better sales. Average age of inventory
will be in days, and a lower figure in days is preferred.

Accounts receivable
(d) Average collection period   365 days
Credit sales
RM50,000
  365 days
RM225,000
 81 days

This average collection period of 81 days means that that the collection of
credit customers of the entity is, on average, collected every 81 days in a
year. Generally, a lower figure in days is preferred, which represents a
more efficient collection policy and practice.

Accounts payable
(e) Average payment period   365 days
Annual purchases
RM70,000
  365 days
RM75,000
 341 days

This average payment period of 341 days means that that the payment to
suppliers is, on average, made once in every 341 days in a year, which is
not an encouraging figure. Generally, a lower figure in days is preferred,
which represents a more efficient payment policy and practice.

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38  TOPIC 3 FINANCIAL STATEMENTS ANALYSIS

Sales
(f) Total assets turnover 
Total assets
RM225,000

RM350,000
 0.64 times

This total assets turnover ratio of 0.64 times means that the total assets of
the entity is utilised 0.64 times to generate the sales of RM225,000.
Generally, a higher figure is preferred, which represents a more efficient
usage of assets.

Long term debt


(g) Gearing Ratio 
Total capital employed
RM45,000

RM275,000
 16.4%

The gearing ratio of 16.4% means that most of the assets of the entity is
funded by equity instead of debts. Generally, a gearing ratio of below 50%
is attractive.

PBIT
(h) Interest cover 
Interest
RM65,000

RM5,000
 13 times

The interest covers of 13 times means that the interest payable can be paid
from the available profits by as many as 13 times. Even though we know
that the entity will only pay once, this a test of the financial ability of the
entity. Generally, a higher interest cover ratio is preferred.

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TOPIC 3 FINANCIAL STATEMENTS ANALYSIS  39

Sales  COGS
(i) Gross profit margin 
Sales
Gross profit

Sales
RM150,000

RM225,000
 67%

The gross profit margin of 67% means that for every RM1 of sales the gross
profit is 67 cents, and generally, a higher gross profit margin ratio is
preferred.

Net income
(j) Net profit margin 
Sales
RM52,500

RM225,000
 23.3%

The net profit margin of 23.3% means that for every one ringgit of sales the
net profit is about 23 cents and generally, a higher net profit margin ratio is
preferred.

Net profit after taxes


(k) Return on Equity (ROE) 
Shareholders equity
RM52,500

RM230,000
 22.8%

The ROE of 22.8% means that for every RM1 of shareholders investment in
the entity, the return is about 23 cents and generally, a higher ROE is
preferred to attract more investments.

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40  TOPIC 3 FINANCIAL STATEMENTS ANALYSIS

3.2 LIMITATION OF RATIOS


Ratios in isolation do not provide enough information to judge an organisationÊs
overall performance. But, a group of ratios is vital to establish the financial health
of an organisation, and can reasonably judge the organisationÊs future.

An analysis should ensure that the time frames of the financial statements of an
organisation or organisations being compared are the same; otherwise, the effects
of seasonality may cause erroneous conclusions and decisions. It is best to use
audited financial statements for ratio analysis. If say, the financial statements of
the organisation are not verified, there is a possibility that the information is not
accurate, and we are unable to establish the organisationÊs true financial health.

The information that is being compared needs to be created on a similar basis.


When the organisation uses different accounting treatment, for example for items
related to depreciation and inventory, it can show a very different result from the
actual.

3.3 ALTERNATIVE ANALYSIS


In this subtopic, we will focus on the ratios that are of interest to the user and use
methods that raise caution which will indicate that the specific ratios might be
particularly relevant to the analysis and assessment of a specific organisationÊs
financial statements.

Common-size statement of financial position is a usual starting point to prepare a


vertical analysis to assess the good points of the statement of financial position,
with assets and liabilities each shown as a percentage of a base figure.

3.3.1 Vertical Analysis: Common-size Statement


This method focuses on the structure of the statement of financial position by
presenting non-current assets, working capital, debt, and equity as percentages of
debt added with equity. This method also lets us form a view on the financing of
the organisation, whatever the size of the organisation might be. When we
prepare the statement of income based on a common size, it also indicates the
cost structure, which is vital to establish the significance of costs in the analyses.

Copyright © Open University Malaysia (OUM)


TOPIC 3 FINANCIAL STATEMENTS ANALYSIS  41

Vertical analysis reports each amount on a financial statement as a percentage of


another item in the same statement. For example, the vertical analysis of the
Statement of Financial Position (Balance Sheet) means every amount on the
balance sheet is restated to be a percentage of total assets. Let us look at the
example below to understand this analysis:

(a) If the Bank figure is RM200,000 and total assets are RM500,000, the Bank
figure is presented as 40 (RM200,000 divided by RM500,000);

(b) If Accounts Receivable is RM50,000 then it will be presented as 10


(RM50,000 divided by RM500,000); and

(c) The total assets will now add up to 100.

Again based on the same Statement of Financial Position:

(a) If the Accounts Payable are RM100,000 it will be presented as 20


(RM100,000 divided by RM500,000); and

(b) Finally, let say that the ownerÊs equity is RM300,000, it will be presented as
60 (RM300,000 divided by RM500,000).

The restated amounts from the vertical analysis of the Statement of Financial
Position (Balance Sheet) will be presented as a „Common-size‰ Statement of
Financial Position (Balance Sheet), and a Common-size Balance Sheet allows you
to compare the organisationÊs Statement of Financial Position (Balance Sheet)
with another in the same industry.

Vertical analysis of a Statement of Income may result in every amount in the


Statement of Income being presented as a percentage of sales:

(a) If sales were RM5,000,000 they would be restated as 100 (RM5,000,000


divided by RM5,000,000);

(b) If the cost of goods sold is RM2,000,000 it will be presented as 40


(RM2,000,000 divided by sales of RM5,000,000); and

(c) If interest expense is RM100,000 it will be presented as 2 (RM100,000


divided by RM5,000,000).

The restated amounts are known as a common-size income statement. A


common-size income statement allows you to compare your organisationÊs
Statement of Income with another organisationÊs or with the industry average.

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42  TOPIC 3 FINANCIAL STATEMENTS ANALYSIS

3.3.2 Horizontal Analysis


This analysis focuses on the percentage changes that have happened and it is
obtained by calculating the percentage changes. Generally, horizontal analysis is
done over a series of years and it will present a trend of the performances
examined.

For example, the amount of cash reported in the Statement of Financial Position
(Balance Sheet) at 31 December of the year 2015, 2014, 2013, 2012, and 2011 will
be expressed as a percentage of the amounts on 31 December 2011.

Let us assume that the cash amount in the year 2011 was RM100,000 and in the
year 2015 it was at RM135,000, therefore, the horizontal analysis will return a
result in a number 135, instead of a monetary value. This shows that the amount
of cash at the end of 2015 is 135% of the amount at the end of 2011.

The same analysis will be done for each item on the Statement of Financial
Position and for each item on the Statement of Income. This will allow you to see
how each item has changed in relationship to the changes in other items. The
term „Trend Analysis‰ is also referred to interchangeably replace Horizontal
Analysis.

3.4 RATIOS AND SHARIA-COMPLIANT


COMPANIES
Sharia-compliant companies are on the rise and it is important to know how to
value sharia-compliant companies for investment purposes. Many multinationals
are part of the list of sharia indices such as the IT giant Google, Exxon-Mobil,
BHP, and Coca-Cola. Muslims do not condone investment in industries dealing
with the consumption of alcohol and pork, deemed as non-halal and hence,
companies are screened to ensure that the activities these businesses engage in
are not prohibited by Islam and to make sure that the financial ratios do not go
beyond certain specified limits for non-sharia businesses within the entity. There
are also some indices established that specifically include sharia-compliant
companies, after the business activity and financial screening, as well as,
dividend purification exercise is completed, such as, Dow Jones Islamic Indexes.

Copyright © Open University Malaysia (OUM)


TOPIC 3 FINANCIAL STATEMENTS ANALYSIS  43

SELF-CHECK 3.1

1. Discuss the difference between vertical and horizontal analysis.

2. Discuss the limitations of financial statements analysis.

ACTIVITY 3.2

1. Choose a listed company in Malaysia, look at the its annual report


and comment on the reported financial statements analysis and
ratios.

2. Based on a listed company in Malaysia, prepare a comparative


ratios analysis for its two most recent years and comment on the
ratios.

 Ratios are described as the relationship between diverse components in


financial statements, and the skill in deciding which ratios to calculate and
examine to provide more information on financial performance, is known as
financial ratio analysis.

 There are five main categories of ratios that can be used to do to compare
various performances of organisations, which includes:

ă Profitability ratios;

ă Liquidity ratios;

ă Efficiency ratios;

ă Solvency (debt) ratios; and

ă Investment ratios.

 Horizontal and vertical (common size) analyses are also analyses that are
based on ratios, but instead of for only one particular year, it focuses on
multiple years or multiple business sizes.

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44  TOPIC 3 FINANCIAL STATEMENTS ANALYSIS

 Ratios are also subjected to certain limitations which make it difficult to make
comparisons between companies. The limitations are difficulties in
identifying a company in the same sector of a similar size, product and
service, different degrees of diversification, and finally different financing
policies.

Efficiency ratios Profit before interest and tax


Financial ratios Profitability ratios
Investment ratios Liquidity ratios
Horizontal analysis Solvency (debt) ratios
Profit after interest and tax Vertical analysis

Based on IOI BerhadÊs 2013 annual report calculate its financial ratios for the year
2013.

Drury, C. (2015). Management and cost accounting (9th ed.). Cengage Learning.

Horngren, C. T., Datar, S. M., & Rajan, M. V. (2015). Cost accounting: A


managerial emphasis (Global Edition 15th ed.). Pearson Education Limited.

Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J. O.
(2014). Introduction to management accounting (Global Edition 16th ed.).
Pearson Education Limited.

Copyright © Open University Malaysia (OUM)


Topic  Cost Concepts
4 Classifications
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Define cost and how costs are assigned to products and services;
2. Classify cost;
3. Prepare cost estimation methods; and
4. Prepare costs of manufacturing products and the various costs
behaviour.

 INTRODUCTION
What does the term „Cost‰ mean? Costs are all payments of cash or cash
equivalents (or the commitment to pay cash in the future) for the purpose of
generating revenues for the organisation. For example, when goods are
purchased for cash or credit, the amount of the payment is the cost of the goods.
There can be multiple categories of costs or expenses for organisations, such as
administrative cost and distribution cost and costs can be classified in different
ways for different purposes.

This topic discusses on the basic cost concepts and itÊs classification. We will also
be looking into preparing the different costs methods which cover preparing
costs of manufacturing products and the various costs of behaviour. Lastly, we
will also be looking into preparing cost of goods manufactured, the cost of goods
sold and a simple income statement.

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46  TOPIC 4 COST CONCEPTS CLASSIFICATIONS

4.1 PRODUCT AND PERIOD COSTS


Product costs are recognised when any goods are purchased or when the goods
are produced to be sold to end users. All the mentioned costs are to be attached
to a specific product; eventually these costs will be part of the inventory
valuation for the final goods known as the finished goods or partly completed
goods. This will remain until the finished goods are sold. For example, carriage
inwards and import duty.

In the case of manufactured goods, these costs consist of direct materials (raw
materials), direct labour and direct manufacturing overheads (production
overheads).

Period costs are excluded from the product costs of a specific product. The period
costs are identified within a given specific time frame and these period costs are
generally not inventoried. This is because the period costs are expensed out from
the income statement, and incurred in the given specific period; this is done
based on the rules of accrual accounting.

Period costs are excluded from the costing of a purchased goods or goods that
are manufactured. For example, office rental and insurance expenses. Rent and
insurance are excluded from the cost of goods that are manufactured or
purchased. Actually, rent and insurance are recognised as expenses in the income
statement in the incurred time frame .

Figure 4.1 shows an example of period costs and product costs.

Figure 4.1

Information given is that half of the output for the year is sold and there is no
opening inventory.

RM
Production costs 100,000
Less: Ending inventory (50%) (50,000)
Cost of goods sold (50%) 50,000
Period costs (100%) 80,000
Total costs recorded as an expense for the period 130,000

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TOPIC 4 COST CONCEPTS CLASSIFICATIONS  47

4.2 DIRECT AND INDIRECT COSTS


Direct costs can be traced to a specific cost objective, for example, a product or a
service. Costs that are unable to be directly traceable to a particular cost object
and attributable to multiple cost objects or objectives, are known as indirect costs.

Manufacturing costs can be classified into three major elements: Direct material,
Direct labour; and Manufacturing overheads. Direct materials consist of all those
materials that can be physically identified with specific products. For example,
the chip used for a microcomputer is a direct material or wood used to produce a
table.

Direct labour includes those labour costs that can be specifically traced to or
identified with a particular product. For example, the wages of operatives who
assemble parts into the finished products such as carpenters or welders.
However, the salary of factory supervisors cannot specifically be identified with
the product is known as indirect labour costs and also manufacturing overheads.
Loose tools, such as, nuts and bolts or welding rods are known to be indirect
material costs.

Manufacturing overheads are neither direct materials nor direct labour costs. It is
referred as indirect manufacturing costs. Manufacturing overheads include
expenses such as, depreciation, utilities, rent, maintenance, indirect materials and
indirect labour. It is difficult or not logical to trace indirect cost to manufacturing,
therefore indirect cost is generally allocated to the total cost of production. The
basis for allocation is using the direct machine hours or direct labour hours. A
more efficient method is applying activity based costing to allocate the
manufacturing overhead costs.

Therefore, it can be summarised (refer to Table 4.1) that direct material and direct
labour are direct costs and manufacturing overheads are all other indirect costs.

Table 4.1: Direct and Indirect Costs

Types of Costs Definition Example


Direct Costs Costs that can be easily and Cost of paint in the paint
conveniently traced to a product department of an automobile
or department. assembly plant.
Indirect Costs Costs that must be allocated in Cost of national advertising for
order to be assigned to a product and airline is indirect to a
or department. particular flight.

Source: Hilton (2011)

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48  TOPIC 4 COST CONCEPTS CLASSIFICATIONS

SELF-CHECK 4.1

List the possible direct and indirect costs for a university and a
manufacturing entity.

4.3 COST BEHAVIOUR


Cost behaviour is the way a specific cost might behave with regards to the
activity level or the production quantity. We will be exploring the numerous cost
behaviours that are pertinent in management accounting to assist the decision
maker in making informed economic decisions in the effort to make the
organisation more efficient and effective.

The different types of cost behaviour that we are going to explore and discuss are
namely: Fixed costs; Variable costs; Mixed costs or Semi-variable costs; Step
costs; Sunk costs; Avoidable costs; Unavoidable costs; and Opportunity costs.

4.3.1 Fixed Cost


A fixed cost is constant in total amount regardless of changes in activity levels.
Examples of fixed costs are costs such as, depreciation, managerÊs salary and
rent. These costs will usually remain fixed regardless of the level of activity.

As total fixed costs are constant, the fixed cost per unit will vary at different
levels of activity. The higher the activity level, the lower the fixed cost per unit;
therefore when a business entity produces a greater number of outputs, the fixed
cost per unit decreases. Figure 4.2 shows the behaviour of fixed cost plotted on a
graph, which is a flat straight line. The fixed cost is fixed at RM1,000 regardless
whether the activity or the output level is zero or 50 units.

Figure 4.2: Behaviour of fixed cost

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TOPIC 4 COST CONCEPTS CLASSIFICATIONS  49

4.3.2 Variable Cost


A variable cost can be defined as a cost that changes in direct proportion to the
change in level of activity of a product. Therefore, when the activity or
production increases, the total variable cost will also increase proportionally and
vice versa.

Direct material costs are usually variable costs because it increases in proportion
to an increase in the number of units manufactured. To better understand this, let
us look at the example of a furniture manufacturer; if the number of chairs
produced doubles so will the cost of raw materials.

As variable cost moves in proportion to activity, the variable cost per unit will be
constant at different levels of activity. Whether the activity level is higher or
lower, the variable cost is a fixed amount per unit. Therefore, when a business
entity produces a greater number of outputs, the total variable cost will increase.
Figure 4.3 shows the behaviour of variable cost plotted on a graph, which is a
linear straight line. The variable cost is RM20 per unit and RM1,000 in total for 50
units of production.

Figure 4.3: Behaviour of variable cost

4.3.3 Mixed Cost/Semi-variable Costs


Mixed costs include both fixed and variable components. It is also known as
semi-variable cost. Example of a mixed cost is utility, such as electricity and
telephone which will normally have a fixed cost element, such as, fixed rental
that is charged regardless of its level of usage. This fixed cost element will be
constant and total cost will go higher progressively as the organisation consumes
above the fixed amount. Figure 4.4 shows the behaviour of mixed cost plotted on
a graph, that is a linear straight line increasing proportionately from the above
zero point. The mixed cost is at RM1,000 at the minimum level and will go higher
proportionately based on the units of production.

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50  TOPIC 4 COST CONCEPTS CLASSIFICATIONS

Figure 4.4: Behaviour of mixed cost

4.3.4 Step Cost


Step cost is an increment of cost based on a specific activity range. Activity can
increase without an increase in cost. However, at some activity level, additional
fixed cost must be incurred to increase capacity. An example of a step cost is
supervisory salaries or even rental expenses. Suppose that one supervisor is
needed for every five machine operators and the cost of the supervisor per
month is RM1,000. If the organisation requires twenty machine operators, then
four supervisors are needed. Thus the cost of supervisors for that month would
be RM4,000. It increases by RM1,000 for every additional five machine operators
employed.

Figure 4.5 shows the behaviour of step cost plotted on a graph, that is, a flat
straight line that shifts upwards based on a range of activity level. The
supervisory expense is at RM1,000 for five machine operators, and doubles up
when the machines operators are six to ten.

Figure 4.5: Behaviour of step cost

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TOPIC 4 COST CONCEPTS CLASSIFICATIONS  51

4.3.5 Sunk Cost


Sunk costs are costs that have been incurred in the past and these costs will not
have any impact on the cost in the future or on decision making. An example of
sunk cost is the acquisition costs of machinery previously purchased. Regardless
of the current usefulness of the machinery, the costs of acquiring the machine
will not change with any action in the future. Therefore, sunk costs are not
relevant to any future decision making and are irreversible.

4.3.6 Avoidable and Unavoidable Costs


Avoidable costs are costs that can be avoided by not adopting them, so avoidable
costs are relevant for the decision making purpose. Alternatively, unavoidable
costs are not relevant in the decision making process because these costs cannot
be avoided and do not give us the option to ignore, and will occur regardless of
anything. Road tax paid for a truck is an unavoidable cost but the toll charged for
the choice of route is avoidable.

4.3.7 Opportunity Cost


Opportunity cost is when one chooses a second alternative over a desired or
preferred alternative. It is the benefit sacrificed when the choice of one course
of action is precluded by adopting an alternative option. Simply put, the
opportunity cost is the next best option which is sacrificed.

For example, assuming that you are thinking of registering for this MBA course
on a full-time basis, then the relevant cost of going to Open University Malaysia
(OUM) for a MBA degree is not only the cost of tuition fees, books and lodging,
but also the income forgone (opportunity cost) by studying full-time instead of
working.

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52  TOPIC 4 COST CONCEPTS CLASSIFICATIONS

ACTIVITY 4.1
1. You are required to establish the best possible classification for the
relevant cost data in the items below:

(a) Sunk cost;

(b) Incremental cost;

(c) Variable cost;

(d) Fixed cost;

(e) Semi-variable cost;

(f) Semi-fixed cost; and

(g) Controllable cost.

2. For all the costs that are discussed above, list and explain those
costs that are evident for a furniture manufacturer.

3. Answer the following questions.

(a) An organisation wants to sell an aging machine and it has a


net book value of RM20,000. When the manager evaluates
the decision to sell the machine, the RM20,000 is
_____________ cost.

(b) An organisation is able to rent a new machine, which


will cost RM3000 a year, as a replacement for the old
machine. After analysing the given scenario, the rental is
_____________ cost.

(c) There are two possible choices to operate the machines of an


organisation. In this scenario only one option is given, that is
to pay the operator a base salary plus a small amount per
unit produced. Therefore, the total cost of the operators is
_____________ cost.

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TOPIC 4 COST CONCEPTS CLASSIFICATIONS  53

(d) Extending from the scenario in c) above, the organisation


pays the operators a fixed salary. It would then use one
machine when volume is low, two when it increases and
three when demand is at its highest. Therefore, the total
operator cost would now be a _____________ cost.

(e) If the machine in (a) can be sold for RM8000, and given that
the organisation decides to retain and use the machine, the
RM8000 is a _____________ cost.

(f) Given that the organisation decides to use the machine in the
future, it has to be repaired. For the decision to retain the
usage of the machine, the repair cost is a _____________ cost.

(g) Each machine is charged to the technician of each


department at a rate of RM3000 a year. When the technician
is being evaluated, the charge is a _____________ cost.

4.4 COST TERMS AND CONCEPTS


In the following subtopics, we will look into cost terms and itÊs concepts. We will
discuss on the stages of cost collection system and later the categories of
Manufacturing costs in a manufacturing organisation.

4.4.1 Cost Objects


A cost object is any activity that requires a separate measurement of cost, for
example, it can be the cost of a product or the cost of providing a service to the
end user. To collate the cost for an object, two broad stages of cost collection
system are normally applied, as shown in Figure 4.6:

Figure 4.6: Broad stages of cost collection system

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54  TOPIC 4 COST CONCEPTS CLASSIFICATIONS

4.4.2 Prime Cost (Direct Cost) and Indirect Cost


In a manufacturing environment, direct costs are prime costs that can be
specifically identified with a given cost object. Indirect costs is naturally the
opposite of direct costs in which they are not specifically identified with a given
cost object. Examples of direct costs are direct materials and direct labour, that
are costs directly attributable to a cost object.

A very common example of indirect costs is production overheads. Production


overheads are assigned to cost objects on the basis of cost allocations. The reason
of such allocation is that the production overheads are difficult or unable to be
specifically or accurately traced to the product. Cost allocations can be explained
as a process of assigning costs to cost objects that involve the use of surrogate,
instead of direct measures. The distinction between direct and indirect cost
depends on what is identified as the cost object.

Figure 4.6 shows the categories of manufacturing costs in a manufacturing


organisation. The following format (see Figure 4.7) is a traditional cost system to
accumulate product costs.

Figure 4.7: The categories of manufacturing costs in a manufacturing organisation

RM RM
Direct material xx
Direct labour xx
Prime costs xx
Manufacturing overheads xx
Total manufacturing costs xx
Non-manufacturing overheads xx
Total costs xx

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TOPIC 4 COST CONCEPTS CLASSIFICATIONS  55

ACTIVITY 4.2
This organisation manufactures and sells curtains. You are expected to
categorise the given costs listed below as (i) to (viii), and numbered (1)
to (20) into classifications of cost:

(Hint: each of the cost in (1) to (20) has one classification only)

(i) Direct material;

(ii) Direct labour;

(iii) Direct expenses;

(iv) Indirect production overheads;

(v) Research, development costs;

(vi) Selling and distribution costs;

(vii) Administration costs; and

(viii) Finance costs.

(1) Spare parts for machines;

(2) Hard drive for office computer;

(3) Maintenance of office fax machine;

(4) Telephone rental plus calls based on usage;

(5) Interest on loan;

(6) Food charges for production operators;

(7) Market research before new product launch;

(8) Salary of factory security personal;

(9) Transportation cost for purchase of basic raw material;

(10) Royalty payment for the production of a designer curtain;

(11) Road tax for delivery trucks;

(12) Delivery cost of curtains to customers;

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56  TOPIC 4 COST CONCEPTS CLASSIFICATIONS

(13) Cost of advertising the curtains on radio;

(14) AuditorÊs fees;

(15) ManagerÊs salary;

(16) Salary of operators in design department;

(17) Painting of advertising on delivery trucks;

(18) Head of materials departmentÊs salary;

(19) Salary of labourers who shift raw materials; and

(20) Cost of developing new products in the research centre.

 Cost is sacrificing the resource to achieve a specific objective. In management


accounting there are many different uses of and concepts for the cost. It is
essential that management accountants understand the nature and relevance
of different cost terms for use in relation to varied reporting and decision
making purposes.

 A cost object is any item, such as, a product, customer, department or an


activity for which the given costs are assigned and measured. The process of
determining the cost of cost object is called costing.

 Typically costs of various cost objects are determined in two basic stages;
Accumulation of costs into classified ledger accounts (cost pools), such as,
raw materials, wages, advertising or utility; and assigns cost to cost objects.

 Cost drivers are observable casual factors that measure a cost objectÊs
resource consumption. They are factors that cause changes in resource usage
and thus have a cause-and-effect relationship with the costs associated with a
cost object.

 Direct and indirect costs are determined by their traceability to a cost object.

 Direct Costs are those costs that can be traced to a cost object in an
economically feasible way.

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TOPIC 4 COST CONCEPTS CLASSIFICATIONS  57

 Indirect Costs are costs that cannot be traced to a given cost object in an
economically feasible way.

 Cost behaviour refers to how a cost will react when there is a change in the
level of activity in a business function; as and when the level of activity goes
up or down, or a particular cost may fluctuate or remain static. Cost
behaviour patterns are important in costing, because decisions differ based
on these. Costs are often categorised as variable and fixed.

 Variable cost will differ in total and in direct proportion to changes in the
level of activity. The activity can be expressed in units, such as units
produced or sold, miles driven or hours worked.

 Fixed cost remains always constant for a given range, regardless of changes
in the level of activity. Examples of fixed costs are rental, salary, and
insurance.

 The relevant range is a range of activity within which the assumptions about
variable and fixed costs are valid.

 Normally, the decision makers should consider the costs in terms of total
rather than unit costs. However, in many decision contexts, considering unit
costs is useful. A unit cost, also called an average cost, is computed by
dividing total cost by the number of units. Accounting systems typically
report both total costs and average cost per unit.

 Period costs are all costs that are excluded from manufacturing costs. These
costs are expensed in the income statement in the time frame in which they
are incurred. Examples of period costs include management salaries, office
rent, office insurance, administration costs, and marketing costs.

 Direct labour combined with direct materials is called prime cost.


Manufacturing overheads combined with direct labour is called conversion
cost. This term originate from the fact that direct labour costs and overhead
costs are incurred to convert materials into finished goods.

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58  TOPIC 4 COST CONCEPTS CLASSIFICATIONS

Avoidable cost Period cost


Cost driver Product cost
Cost object Prime cost
Direct cost Relevant range
Fixed cost Step cost
Indirect cost Sunk cost
Mixed cost Unavoidable cost
Opportunity cost Variable cost

Question 1
Wonder Bakery manufactures two types of bread, which it sells as wholesale
products to various specialty retail bakeries. Each loaf of bread requires a three-
step process. The first step is mixing. The mixing department combines all of the
necessary ingredients to create the dough and processes it through high-speed
mixers. The dough is then left to rise before baking. The second step is baking,
which is an entirely automated process. The baking department moulds the
dough into its final shape and bakes each loaf of bread in a high-temperature
oven. The final step is finishing, which is an entirely manual process. The
finishing department coats each loaf of bread with a special glaze, allows the
bread to cool, and then carefully packages each loaf in a specialty carton for sale
in retail bakeries.

Question 2
If the Cost Object were the „mixing department‰ instead of units of production of
each kind of bread, which preceding costs would now be direct instead of
indirect costs?

Copyright © Open University Malaysia (OUM)


TOPIC 4 COST CONCEPTS CLASSIFICATIONS  59

Drury, C. (2015). Management and cost accounting (9th ed.). Cengage Learning.

Horngren, C. T., Datar, S. M., & Rajan, M. V. (2015). Cost accounting: A


managerial emphasis (Global Edition 15th ed.). Pearson Education Limited.

Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J.
O. (2014). Introduction to management accounting (Global Edition 16th
ed.). Pearson Education Limited.

Copyright © Open University Malaysia (OUM)


Topic  Cost-Volume-
5 Profit Analysis

LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Explain the assumptions and derivation of Cost-Volume-Profit
(CVP);
2. Apply and account for changes in CVP variables and calculate its
impacts; and
3. Apply multiple-product CVP and extension to the CVP.

 INTRODUCTION
This topic discusses the concept of Cost-Volume-Profit (CVP). In this topic, we will
also be conducting analysis and also illustrate how decision makers will use the
CVP model to assist the „what-if‰ queries. The CVP analysis assists the
management to direct the decision makers to the possible risks and rewards of
decisions that are to be made, by looking at how changes in activity level affects
pricing or costs.

5.1 ESSENTIALS OF CVP ANALYSIS


Cost-Volume-Profit (CVP) analysis is an excellent tool for planning and decision
making. This is because CVP analysis emphasises the interrelationships of costs,
quantity sold and price. The CVP analysis is defined as assessment of total
revenues, total costs and operating income in response to changes in the volume
of sales, the selling price, variable cost, or fixed costs of production. The CVP
analysis is a good method for identifying the extent and level of business distress
an organisation is facing, and assists to direct attention to a possible solution.

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TOPIC 5 COST-VOLUME-PROFIT ANALYSIS  61

5.2 CONTRIBUTION MARGIN


The contribution margin is the amount remaining after the sales revenue is
deducted by the variable expenses. Contribution margin is derived to show the
extent the fixed expenses are covered and also the level of profits for the period.
Contribution Margin can be given in units (CM) and also as a percentage or ratio
(contribution margin ratio).

Contribution Margin (CM) per unit is calculated as:

CM  SP  VC
SP  Selling price per unit
VC  Variable cost per unit

The contribution margin ratio can be computed either on a per unit basis or on a
total basis. The term contribution ratio is also referred to as the contribution
margin percentage.

CM per unit
CM Ratio 
Sales per unit

or

Total CM
CM Ratio 
Total Sales Revenue

SELF-CHECK 5.1

What is the difference between contribution margin per unit and


contribution margin ratio.

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62  TOPIC 5 COST-VOLUME-PROFIT ANALYSIS

5.3 BREAK-EVEN POINTS


Break-even is a critical concept to cost-volume-profit analysis. Computation of
the Break-even Point is discussed in the following section. The Break-even Point
shows the level of activity where the total revenue equals total cost. Shown in
Figure 5.1 are the three methods that can be used to derive the Break-even Point:

Figure 5.1: The three methods that can be used to derive the Break-even Point

5.3.1 Equation Method


The following formula represents the equation method:

 Selling price 
Operating income    Quantity sold (in units)  
 Unit 
 Variable cost 
  Quantity sold (in units)   Fixed costs
 Unit 

Given that the condition for the Break-even Point is that the revenue equals cost,
which means that the profit or loss will be nil. This is based on the formula above
where the operating income will be zero.

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TOPIC 5 COST-VOLUME-PROFIT ANALYSIS  63

5.3.2 Contribution Margin Method


Contribution Margin (CM) method is the most commonly and easily used. CM
method is the best method to get insights into the minimum level of sales to meet
the cost.

The formula is next obtained by substituting the contribution margin per unit for
„selling price per unit‰ minus „variable cost per unit‰ in the operating income
equation. The answer derived from the equation will be the Break-even in units.

Total Fixed Cost


Units 
Contribution Margin per Unit

5.3.3 Graph Method


The CVP graph shows the relationship between cost, volume and profits. This
graph looks at CVPÊs relationship with multiple ranges of activities (refer to
Figure 5.2). CVP is able to provide decision makers an outlook that will be very
useful in the decision making process. These perspectives of cost, volume and
profits are useful in the process of decision making, especially when a feasibility
study was conducted prior to deciding to embark on a business venture.

Figure 5.2: Break-even Point (BEP)

SELF-CHECK 5.2

Which method is the best to compute the Break-even Point? Justify your
answer.

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64  TOPIC 5 COST-VOLUME-PROFIT ANALYSIS

5.4 ASSUMPTIONS OF COST-VOLUME-PROFIT


The Profit-Volume and Cost-Volume-Profit graphs rely on some important
assumptions. It is important that these limitations are considered so that
decisions made are realistic in terms of the business facts.

Listed are the most common and relevant limitations for Cost-Volume-Profit
Analysis. These five assumptions that follow are not exhaustive:

(a) Changes in the levels of revenues and costs arise only because of changes in
the number of units sold. The number of units sold is the only revenue and
given cost driver is the only cost driver;

(b) Total costs can be separated into fixed and variable components;

(c) The behaviours of total revenues and total costs are linear; that is, when
graphed they will be represented by a linear line in relation to units sold
within a given relevant range;

(d) Selling price per unit is known and is constant; and

(e) Variable cost per unit and total fixed costs are known and are constant.

It is important to know and understand these assumptions because the decisions


based on CVP is not necessarily perfect and the decision maker and user of that
information need to know its parameters.

SELF-CHECK 5.3

List all the assumptions for CVP analysis.

ACTIVITY 5.1

Do you think these assumptions are the limitations of a Cost-Volume-


Profit analysis?

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TOPIC 5 COST-VOLUME-PROFIT ANALYSIS  65

5.5 BREAK-EVEN POINT AND TARGET


INCOME
We will be discussing three main areas under this subtopic for CVP; the three
areas are (see Figure 5.3):

Figure 5.3: The three main areas under BEP and target income

Cost-Volume-Profit (CVP) analysis is commonly used to calculate the level at


which a product will just Break-even. In other words, it means that total revenue
earned is exactly equal to total expenses incurred.

Knowledge of the Break-even Point (BEP) is a useful management information as


it is beyond this point that profit will be earned. The BEP tells decision makers
how much is needed to sell and/or to dismiss a possible loss. However, CVP
analysis provides much more information than only the Break-even volume. By
manipulating the elements in the CVP analysis model, the organisationÊs decision
makers can choose the optimum price, cost structure and volume necessary to
earn a target profit.

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66  TOPIC 5 COST-VOLUME-PROFIT ANALYSIS

5.5.1 Target Operating Income


The main objective of an organisation is to make profits. Therefore, the needs to
have a target income in any business venture or project is just natural. The CVP
Equation method is a very versatile method, where just adding the desired
income to the fixed cost will be able to assist the decision maker, from the profit
requirement element and the required sales in units or in value.

Given next is an example of CVP to illustrate the different types of management


decisions that can be resolved using the CVP analysis.

Example 5.1
Monica is planning to open a food stall at the campus cafeteria and the estimated
costs and revenues are given.

Space Rental per month RM500


Cost per burger RM3
Selling price per burger RM5

In addition to the above information, Monica decides that she must have a profit
of RM300 to motivate her to be in business.

The first thing that Monica needs to determine is the number of burgers that need
to be sold to earn her target profit. The solution may be attained directly from the
information in the example applied in a CVP graph, by an equation or by using
the contribution margin approach.

Equation Method
The contribution margin per unit is available to first recover fixed costs and then
to generate the target profit. In Example 5.1, the volume of burgers that must be
sold to earn a profit of RM300 can be calculated as follows:

Contribution Margin  CM  Selling Price  SP  Variable Cost  VC 


     
Unit  U  Unit U Unit  U 
CM SP VC
 
U U U
 RM5  RM3
 RM2
TP  Target Profit
FC  Fixed Costs

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TOPIC 5 COST-VOLUME-PROFIT ANALYSIS  67

Given the fixed cost as RM500 and based on the calculation below, the sales units
that are required are 250 units to break even. At this point there will be no profit
or loss incurred by Monica.

CM RM500

U RM2
 250 burgers

Going back to the question above, if Monica desires to pocket a profit of RM300,
she needs to increase her sales volume and this is shown in the calculations
below.

CM  RM500  RM300

U RM2
(with target profit)  400 burgers

Monica, as the business owner, can now evaluate the likelihood of the venture to
be successful with the desired profit by estimating the probability of selling at
least 400 burgers to the students. That is, she must determine whether there will
be sufficient demand for the burgers that she plans to sell.

If it is considered unlikely that 400 burgers could be sold, Monica can use Cost-
Volume-Profit analysis to evaluate numerous alternative strategies. Cost-
Volume-Profit (CVP) analysis can be used to ascertain the number of burger sales
required to break even under the original cost and price strategy, or under any
feasible combination of cost and price alternatives.

ACTIVITY 5.2

Given fixed operating costs is RM2500, the sales price per unit is RM10
and its variable operating cost per unit is RM5. Calculate the BEP.

Solution:

RM2500
BEP 
RM10  RM5
 500 units

Therefore, the organisation will have a profit for sales greater than 500 units and
a loss for sales less than 500 units.

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68  TOPIC 5 COST-VOLUME-PROFIT ANALYSIS

ACTIVITY 5.3

Based on Activity 5.2, calculate the BEP if the organisation wishes to


evaluate the impact of:

(a) Increasing fixed operating costs to RM3,000 independently;

(b) Increasing the sale price per unit to RM12.50 independently;

(c) Increasing the variable operating cost per unit to RM7.50


independently; and

(d) Simultaneously implementing all three of these changes in (a), (b)


and (c).

5.6 USING CVP ANALYSIS FOR DECISION


MAKING
Cost-Volume-Profit (CVP) analysis allows the optimum value of any variable in
the analysis to be determined, given that the other variables are known or
estimated. Based on Example 5.1, the optimum selling price for the burgers can
be determined if variable costs, fixed costs, target profit and sales volume are
known.

For example, assume that Monica estimates the most likely sales volume for
the burgers will be 350 units, that after negotiations with the university facilities
management, cafeteria space rental will be lowered to RM400 and the burgersÊ
patties will be supplied at a cost of RM2.50 each. In addition, Monica decided
that RM300 is the minimum profit required to operate the stall.

Taking into consideration all the information, at what price must the burgers be
sold?

 VC 
TP   * Sales Qty   FC
SP
  U 
U Sales Qty
RM300   RM2.5*350   RM400

350
 RM4.50

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TOPIC 5 COST-VOLUME-PROFIT ANALYSIS  69

5.7 SENSITIVITY ANALYSIS AND


UNCERTAINTY
Decision makers analyse the sensitivity of their decisions regarding cost or
pricing to the changes anticipated, with the given underlying assumptions. In the
CVP analysis, sensitivity analysis provides solutions to queries, such as:

(a) If the product sold is increased by 5%, what should be the operating
income?; and

(b) If the variable cost per unit decreases by 3%, what will be the operating
income?

5.7.1 Margin of Safety


Margin of safety is the expected units to be sold or the revenue expected to be
earned that is above the Break-even Point.

In other words, if the budgeted revenues are above a given Break-even and it
eventually drops, how far can the revenue drop below the budgeted figure
before the Break-even Point is reached.

Margin of safety can be described using three formulas as shown below. We have
to keep in mind that even though the denominations are different, these three
facets are talking about the same thing, the threshold level.

(a) Margin of safety (value) = Revenues ă Break-even Revenues

(b) Margin of safety (units) = Sales in units ă Break-even units

Margin of safety (in RM)


(c) Margin of safety (%) =
Revenues

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70  TOPIC 5 COST-VOLUME-PROFIT ANALYSIS

5.8 EFFECTS OF SALES MIX ON INCOME


Sales mix is defined as the proportion of multiple products that make up total
unit sales. Organisations may have only two products in their mix or may have
hundreds of products in their mix. If an organisation sells more than one
product, the Break-even analysis becomes a little more complicated. This is
because multiple products will not have the same selling prices, costs and
contribution margins.

CVP analysis for an organisation that sells more than one product or service has
a four-step process (refer to Figure 5.4), which are:

Figure 5.4: Four-step process of CVP analysis for an organisation


that sells more than one product or service

Copyright © Open University Malaysia (OUM)


TOPIC 5 COST-VOLUME-PROFIT ANALYSIS  71

Example 5.2

Ally Babas Bhd.


Fan A1 Light B2
Sales Units 6,000 2,000
Selling Price RM6 RM8
Variable Costs RM3 RM4
Contribution Margins RM3 RM4

Fixed Costs = RM78,000

Determine the Break-even sales volume of Fan A1 and Light B2 at Ally Babas
Bhd.

Step 1: Sales mix of products is 6 units of Fan A1 to 2 units of Light B2,


therefore 75%:25%.

Step 2: Weighted Average Contribution Margin (WACM)


75% @ RM3 = RM2.25
25% @ RM4 = RM1

Step 3:

Fixed Costs
Break-Even Point (BEP) 
WACM
RM78,000

RM3.25
 RM24,000

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72  TOPIC 5 COST-VOLUME-PROFIT ANALYSIS

Step 4:

Break-even sales: Fan A1 = 75% @ 24,000


= 18,000 units @ RM6
= RM108,000

Break-even sales: Light B2 = 25% @ 24,000


= 6,000 units @ RM8
= RM48,000

Total revenue to break even = RM156,000

ACTIVITY 5.4

1. KV Berhad produces potato chips, in which potato is the major


component. The total fixed cost that the company has to incur is
RM1,000,000 per year. The cost of raw materials for every pack of
chips is RM1. The product is sold in the market at the price of
RM2.50 each.

(a) What is the Break-even point in units and sales?; and

(b) What will happen if the company is only able to sell


1,000,000 packets of chips next year? Prove your answer
quantitatively.

2. BHV Berhad has fixed operating costs of RM380,000, with a


variable operating cost per unit of RM16 and a selling price of
RM66 per unit.

(a) Calculate the Break-even point (BEP) in units; and

(b) If BHV BerhadÊs targeted profit is RM20,000, how many


units are to be produced to attain that profit?

Copyright © Open University Malaysia (OUM)


TOPIC 5 COST-VOLUME-PROFIT ANALYSIS  73

 Break-even Analysis is required to measure the level of sales necessary to


cover operating costs.

 The Break-even Point can be measured in units or dollars. It may be


calculated algebraically or determined graphically.

 Below the operating Break-even Point, the organisation experiences a loss;


above the operating Break-even Point it will have a profit.

 Break-even Points are sensitive to changes in fixed costs, the selling price of
the firmÊs product, and variable costs. As fixed costs increase, the Break-even
Point increases, and vice versa.

 As the sale price per unit increases, the Break-even Point decrease, and vice
versa. Increase in the variable cost per unit increases the Break-even Point,
and again, vice versa.

 Break-even Analysis can be performed on a cash basis by deducting any non-


cash expenses, such as, depreciation from fixed costs, and then determining
the Break-even Point.

 The assumptions of Break-even Analysis are the assumption of linearity,


the difficulty of classifying costs as required, the problems caused by
multiproduct situations, and its short-term nature.

 Break-even Analysis, at times known as Cost-Volume-Profit (CVP) analysis,


is important to the firm since it allows the organisation to ascertain the level
of operations to cover operating costs, and to evaluate the profits with
different levels of sales.

 The organisationÊs cost of goods sold and its operating expenses contain
components of fixed and variable operating costs. Using the algebraic
approach, such as:

X  Sales volume in units


SP
 Sales price per unit
U
FC  Fixed operating cost per period
VC
 Variable operating cost per unit
U

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74  TOPIC 5 COST-VOLUME-PROFIT ANALYSIS

 The organisationÊs operating breakeven point is defined as the level of sales,


where the fixed costs and variable operating costs are covered, which means
the point at which profits equals to zero.

FC
The formula for BEP is X 
 SP VC 
  
U U 
Total Fixed Cost
Units 
Contribution Margin per Unit

Break-even Point Fixed Cost per Unit


Contribution Margin per Unit Margin of Safety
Contribution Margin Ratio Selling Price per Unit
Cost-Volume-Profit Variable Cost per Unit

Question 1
Garrett Manufacturing sold 410,000 units of its product for RM68 per unit in
2014. Variable cost per unit is RM60 and total fixed costs are RM1,640,000.

Required:

1. Calculate (a) Contribution margin; and (b) Operating income.

2. GarrettÊs current manufacturing process is labour intensive. Kate Schoenen,


GarrettÊs production manager, has proposed investing in state-of-the-art
manufacturing equipment which will increase the annual fixed costs to
RM5,330,000. The variable costs are expected to decrease to RM54 per unit.
Garrett expects to maintain the same sales volume and selling price next
year. How would the acceptance of SchoenenÊs proposal affect your answers
to (a) and (b) in requirement 1?

3. Should Garrett accept SchoenenÊs proposal? Explain.

Copyright © Open University Malaysia (OUM)


TOPIC 5 COST-VOLUME-PROFIT ANALYSIS  75

Question 2
Brilliant Travel Agency specialises in flights between Toronto and Jamaica. It
books passengers on Ontario Air. BrilliantÊs fixed costs are RM36,000 per month.
Ontario Air charges passengers RM1,300 per round-trip ticket.

Calculate the number of tickets Brilliant must sell each month to

(a) Break-Even; and

(b) Make a target operating income (TOI) of RM12,000 per month in each of the
following independent cases.

Required:

1. BrilliantÊs variable costs are RM34 per ticket. Ontario Air pays Brilliant 10%
commission on ticket price.

2. BrilliantÊs variable costs are RM30 per ticket. Ontario Air pays Brilliant 10%
commission on ticket price.

3. BrilliantÊs variable costs are RM30 per ticket. Ontario Air pays RM46 fixed
commission per ticket to Brilliant. Comment on the results.

BrilliantÊs variable costs are RM30 per ticket. It receives RM46 commission per
ticket from Ontario Air. It charges its customers a delivery fee of RM8 per ticket.
Comment on the results.

Drury, C. (2015). Management and cost accounting (9th ed.). Cengage Learning.

Horngren, C. T., Datar, S. M., & Rajan, M. V. (2015). Cost accounting: A


managerial emphasis (Global Edition 15th ed.). Pearson Education Limited.

Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J.
O. (2014). Introduction to management accounting (Global Edition 16th
ed.). Pearson Education Limited.

Copyright © Open University Malaysia (OUM)


Topic  Short-term
6 Decision-
Making
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Interpret information and the decision process;
2. Apply relevant cost in making decisions;
3. Apply the contribution approach and discuss its benefits; and
4. Apply short-term decision-making tools and make short-term
decision making.

 INTRODUCTION
This topic discusses the decision-making process and the concept of relevant
information. Short-term decision making is essential for the survival of an
organisation. We will begin with the step-by-step approach in decision making
and the application of the relevant cost concept, as well as, the relevant revenue
concept. The terms Sunk Cost and Opportunity Cost, from Topic 4, will also be
discussed in understanding the concept of relevance.

6.1 INFORMATION AND THE DECISION


PROCESS
Decision makers need to look at a decision model to select alternative courses
of action. A Decision Model is a proper method of making decisions, and it
includes both the quantitative analysis and qualitative analysis. The relevant
data required to guide decisions made by the decision maker are provided by
management accountants.
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TOPIC 6 SHORT-TERM DECISION-MAKING  77

To ensure that the decision made is the most accurate possible, the information
provided should be filtered to the extent that all possible information is reliable
to predict or estimate the business needs in the future. In terms of demand from
customers, availability of materials from suppliers, availability of labour force,
and assets required for production. The other qualitative analysis will be the
quality of the materials, and also the efficiency of the work force to run the
production to the highest quality and standards possible.

This information is vital to ensure that objectives of the organisation are being
met with calculated risk taking and planning to achieve the desired quality of the
product, as well as, the desired quantity.

6.2 CONCEPT OF RELEVANCE


Relevance is a concept that focuses on the important items that will make a
difference in the decision making process. The concept of relevance is vital in
understanding the steps that need to be taken in the short term decision-making
process.

Short-term decision-making is made based on items or inputs that are relevant.


For instance, the cost of a new machine that is relevant compared to the cost of
purchase of the old machine which is not important or not relevant in making a
decision. Another example is that the depreciation cost is also not relevant in the
process of decision-making but the cash received in selling of the old machine is
vital to make short term decisions.

It is important to understand that in order to ascertain a good decision, a


decision-making process has been administered for short-term decisions. It is
vital to get a good understanding of relevant costs and relevant revenues and
how these costs and revenues form the qualitative and quantitative information.

6.2.1 Relevant Costs and Relevant Revenues


Relevant Costs and Relevant Revenues are future costs and revenues that will
change or differ under each alternative. These are sometimes known as avoidable
costs and revenues as they are costs incurred or revenues earned only if a
particular course of action is adopted.

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78  TOPIC 6 SHORT-TERM DECISION-MAKING

Management accountants are often required to allocate indirect costs to produce


information on product costs for inventory valuation and financial statement
purposes. However, these allocated costs are not relevant for decision-making.
Costs which are allocated and will not change because of the decision at hand are
not relevant to the evaluation of the decision.

Sunk Costs are also irrelevant for decision-making as sunk costs are past,
historical expenditures with no relevance to present decisions. Decision makers
must focus on future incremental costs and revenues in making decisions.

When an organisation purchases, for example, a new machine, then the cost of
the old machine is recognised as a Sunk Cost for decision-making purpose.
Having said that, the cost of the new equipment is a future cost and thus
relevant; therefore, the incremental increase in future cost, such as, insurance
expenses (due to the increased value of the new machine compared to the old
machineÊs value) is relevant as it differs in the future.

ACTIVITY 6.1

What do you understand by the term avoidable costs?

6.2.2 Qualitative and Quantitative Relevant


Information
It is important to consider relevant quantitative and qualitative factors in the
process of decision-making and the relevance of either factors will depend on the
particular decision under consideration.

Quantitative factors are factors with measurement in numeric terms and this may
encompass not only financial information, for example, the cost of direct
materials but also non-financial information, such as, percentage of down time in
a manufacturing entity.

Qualitative factors are also non-financial factors but measurement of these


outcomes is more difficult and challenging as it involves ambiguity and
perceptions, such as, customer satisfaction and loyalty, employee work
satisfaction and morale, as well as, brand acceptance.

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TOPIC 6 SHORT-TERM DECISION-MAKING  79

ACTIVITY 6.2

(a) Discuss the term relevant cost in a university environment and


provide details in terms of quantitative and qualitative factors.
(b) The following are costs for multiple decision making setups:

Cost
(a) Allocated office overheads;
(b) Cost of an aged machine;
(c) Direct materials;
(d) Salary of human resource director;
(e) Washing machine and dryer installation;
(f) Fixed overheads which are unavoidable;
(g) Research expenditures for a latest product;
(h) RM3.8 million promotion programme; and
(i) Manufactured cost of existing inventory.

Decision
(a) Closing a money-losing department;
(b) Vehicle replacement;
(c) Make or buy a product;
(d) Project discontinuance; manager transferred elsewhere in the
organisation;
(e) Purchase of a new house;
(f) Plant closure;
(g) Product introduction to marketplace;
(h) Whether to promote product A or B with the RM3.8 million
programme; and
(i) Whether to dispose the inventory or sell to another party.

Required:
For all the costs above consider and determine whether the costs are
relevant or irrelevant, based on the decision cited. Explain why.

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80  TOPIC 6 SHORT-TERM DECISION-MAKING

6.3 RELEVANCE – DECISION ON OUTPUT


The issue of relevance applies to all business decision situations, and it discusses
several applications of relevant costing to decision making. Figure 6.1 shows the
decisions making scenarios.

Figure 6.1: Decision making scenarios

(a) Accept or reject a short-term special order;

(b) Make or buy decisions;

(c) Product mix decisions with capacity constraints;

(d) Product, segment/customer evaluation; and

(e) Replacement decisions.

ACTIVITY 6.3

When Proton decided to use MitsubishiÊs engines for its cars, what was
the decision based on?

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TOPIC 6 SHORT-TERM DECISION-MAKING  81

6.3.1 Accept or Reject a Short-Term Special Order


The first application of the concept of relevance assesses the decision to accept or
reject a short-term special order. When there is idle capacity, output levels can be
altered by accepting a special order. For example, a manufacturer is considering
a special, one-time only bulk order from and assumes this order can be produced
with the companyÊs existing capacity. Relevant costing can be applied to assist in
decision making. Example 6.1 shows a decision to accept or reject a special order.

Example 6.1: Special Orders (One-Time Only)


An example for cookies is used for a special order. Below is a further example for
Bahulu Berhad that is producing 2,000 units below its capacity of 10,000 units
and has the following cost and price structure:

Total fixed costs RM32,000


Variable cost per unit RM15 per unit
Selling price per unit RM25 per unit

At 8,000 units of output the average cost per unit is RM19.

15  8, 000  RM32,000


8, 000 units

A catering chain has offered to buy 1,000 units at RM17.50 per unit which is
lower than the normal selling price. Should management accept the special offer
in the short-run?

Solution:

Relevant cost to make and distribute = RM15


Selling price = RM17.50
Incremental contribution margin = RM2.50  1000 units
= RM2,500

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82  TOPIC 6 SHORT-TERM DECISION-MAKING

Proof with Total Cost Analysis: Profit without Special Order

Sales 8,000 @ RM25 RM200,000


Less variable costs 8,000 @ RM15 120,000
Contribution margin 80,000
Less fixed costs 32,000
Profit RM48,000

Profit with Special Order

Sales 8,000 @ RM25 RM200,000


1,000 @ RM17.50 17,500 RM217,500
Less variable costs 9,000 @ RM15 135,000
Contribution margin 82,500
Less fixed costs 32,000
Profit RM50,500

On quantitative grounds, the special order should be accepted as it increases the


companyÊs profit by RM2,500.

It is important to realise that the average cost per unit produced is irrelevant to
the decision as it includes a proportion of the total fixed costs. The fixed costs do
not change with the decision to accept or reject the order and therefore are not
relevant to the Bahulu Berhad decision making process for the example.

In the example, the new average cost to produce and distribute 9,000 units is
RM18.56 (down from RM19 at 8,000 units). The computation is as follows:

 RM135,000  RM32,000   RM18.56


9, 000 units

However, the special order is profitable at any price above RM15, the incremental
(relevant) cost to produce and distribute.

The relevant cost data for pricing this special order will be the variable costs. In
total, these costs will change with the decision to accept the order. Normal
long-term decisions require consideration of both variable and fixed costs. In the
longer term, both total fixed costs and total variable costs may change.

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TOPIC 6 SHORT-TERM DECISION-MAKING  83

For example, a short-term decline in demand will reduce the total variable
distribution costs incurred by an organisation but will have no impact on the
fixed capacity costs, such as warehouse rates. In the longer term, if low-levels of
demand persist, a firm may downsize its warehouse capacity and hence reduce
its fixed capacity costs.

6.3.2 Insourcing-Outsourcing Decisions and Make-Buy


Decisions
Obtaining goods or services externally for use by an organisation is labelled
outsourcing. In contrast, when a company produces the goods or service
internally it is labelled insourcing.

A second decision-making situation for a company exists where a company may


choose to purchase goods and services externally or produce them internally in
the short-term. This type of decision is labelled a make versus buy decision and is
only relevant when idle facilities are available for production.

Decisions to produce a component part in the manufacturing plant, instead of


purchasing from an external supplier, provide an example of a make or buy
decision. Decisions of this nature are in essence, concerned with vertical
integration within an organisation. A major advantage of producing internally is
that the integrated firm has complete control over production quality and supply
of its component parts. Conversely, costs associated with such things as
fluctuations in demand and changes in production technology detract from the
benefits of vertical integration.

To decide whether to make or buy a product, a decision maker must focus on the
differential costs. That is, those costs which differ between the decision
alternatives. In some circumstances, the opportunity cost of revenues foregone
will also be relevant to the decision to make or buy. For example, it would be
important to consider as a cost, the lost rental revenue of production space
withdrawn to internally produce a component part.

Relevant Cost Analysis, such as a make versus buy decision should consider
strategic and qualitative factors, to minimise risk. If the opportunity to make the
product is outside of the strategic plan, the option to produce the product may
jeopardise the long-term strategic plan and decrease the opportunities for
increased profits.

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84  TOPIC 6 SHORT-TERM DECISION-MAKING

Buying externally or outsourcing has some inherent risk in terms of the


dependability, quality and pricing of the external supplier. If the supplier lacks
dependable delivery, the customer base is jeopardised and a competitor may gain
the lost market share. Similarly, if the quality of the product is not consistent,
customers may choose to purchase from other companies. The pricing policies for
quality and delivery of the external supplier may subsequently change so that the
companyÊs costs increase or quality decreases. In addition to quantitative analysis,
decision makers must consider these factors in decision making

Other factors to consider in decision making are Opportunity Costs. These costs
are foregone income as a result of choosing a particular alternative. Opportunity
costs are relevant to not only outsourcing decisions, but to all types of
management decisions. The key with opportunity cost is assessing the
alternatives available for excess capacity, with the related profits.

A further example of Opportunity Cost relates to the carrying cost of inventory.


The opportunity cost in this case is the foregone opportunity of using the money
tied up in inventory for another purpose. Organisations can easily overlook this
opportunity cost since it is not in the accounting records. Although initial
examination of purchasing inventory in higher quantities with a discount
appears advantageous, consideration of opportunity costs may indicate smaller
purchases of inventory to be more cost effective.

Example 6.2: Make versus Buy Decision Making


Ring Berhad currently makes 10,000 units of a part for inclusion in its finished
product. Given below are costs per unit that are incurred:

Direct Materials RM5


Direct Labour 23
Variable Overheads 12
Fixed Overheads Applied 15
RM55

Card Berhad has offered to make the component for Ring Berhad at a price of
RM49 per unit. If the offer were accepted, Ring Berhad could save only 40% of its
fixed overheads as most of the facilities could not be used for other purposes.

(a) Should Ring Berhad accept CardÊs offer? What other factors should they
consider?; and

(b) Would your decision, in (a) above, change if Ring Berhad had the
opportunity to sublet its production facilities if it accepted CardÊs offer.
Rental revenue would amount to RM 50,000 per annum.

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TOPIC 6 SHORT-TERM DECISION-MAKING  85

Solution:

(a) For 10,000 units, Card Berhad will charge RM 490,000.

If it accepts the offer Ring Berhad will save:

Direct Materials RM5


Direct Labour 23
Variable Overheads 12
Fixed Overheads Applied RM40 per unit
RM400,000
RM60,000
RM460,000

Fixed Costs are treated in this way to avoid the implication that they vary
in relation to the number of units produced. Ring Berhad would be
spending RM30,000 more to buy the components than make the component
parts.

There are also other factors to consider in accepting the outsourcing


contract, the common decision-making reasoning are as follows:

(i) The reliability of supply from Card;

(ii) Quality of the component supplied;

(iii) Timeliness of supply;

(iv) Likelihood of suppliers increasing prices later; and

(v) Possibility of industrial disputes in both firms.

(b) The RM50,000 incremental revenue would change the decision. Ring
Berhad will be RM20,000 better off if it buys the component parts from
Card Berhad.

RM30,000 Net loss to buy


RM50,000 Incremental rental revenue
RM20,000 Incremental profit

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86  TOPIC 6 SHORT-TERM DECISION-MAKING

6.3.3 Product Mix Decisions with Capacity Constraints


Organisations may face constraints on capacity in deciding which products to
produce and how much of each product to produce. In the long-run, capacity can
be adjusted but in the short-run decisions must be reached. This type of decision
is labelled a product mix decision. Not all products are equally profitable. Thus, a
decision exists as to which mix should be produced. In this type of situation, the
goal is maximisation of contribution margin. Additionally, the focus for decision
making is a focus on contribution margin per unit of the constrained resource in
comparison to the productÊs contribution margin per unit.

One major challenge faced by a decision maker is when each product or service
has more than one constraining resource. It may require minimum inventory
levels for some products and consideration of the resulting total contribution
margin from the mix chosen. Mathematical programmes, such as linear
programming support this type of complex decision. A bottleneck constraint can
arise in complex situations when the theory of constraints and throughput
contribution analysis assist in decision-making.

6.3.4 Customer Profitability and Relevant Costs


The final two examples of management decisions for ascertaining output level
relate to whether to drop or add a product line/business segment or customer/
branch office. Capacity may constrain the decisions and thus there is no choice
but to drop a product or customer. If excess capacity does not exist, a product
may have to be dropped.

Relevant Revenue Cost Analysis of Dropping a Customer


In contrast, if excess capacity is available, adding product lines or customers is an
alternative. The decision maker should use relevant revenues and costs,
including those that are incremental to assist in decision making and focus on
differences in total costs for the alternatives. Generally, allocated overheads are
ignored and profitability analysis is utilised in making the decision in dropping
an account that is no longer profitable. Often the decision may not be to totally
drop the line but to reduce the level of service.

Relevant Revenue Cost Analysis of Adding a Customer


In contrast, if excess capacity is available, adding product lines or customers is an
alternative. Adding a line may also be beneficial when gains from adding the
product line or customer cover the additional costs. The decision maker should use

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TOPIC 6 SHORT-TERM DECISION-MAKING  87

relevant revenues and costs including those that are incremental to assist in
decision-making. Focus on differences in total costs for the alternatives. Generally,
allocated overheads are ignored. Those costs that will not change are irrelevant to
the decision.

SELF-CHECK 6.1

Scenario 1
SKL Buses is considering the acquisition of two new buses. Because
of improved mileage, these vehicles are expected to have a lower
operating cost per kilometre than the buses the company plans to
replace. Management is studying whether the firm would be better-off
keeping the older vehicles or going ahead with the replacement, and
has identified the following decision factors to evaluate:

(a) Cost and book value of the old buses;

(b) Moving revenues, which are not expected to change with the
acquisition;

(c) Operating costs of the new and old vehicles;

(d) New bus purchase price and related depreciation charges;

(e) Proceeds from sale of the old vehicles;

(f) The 8% return on alternative investments that SKL will forego by


tying up cash in the new buses; and

(g) DriversÊ salaries and benefits.

Required:
Classify the seven decision factors listed into the following categories
(Note: factors may be used more than once):

(a) Relevant costs;

(b) Opportunity costs;

(c) Sunk costs; and

(d) Factors to be considered in the decision.

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88  TOPIC 6 SHORT-TERM DECISION-MAKING

Scenario 2
Pandan Berhad recently discontinued the manufacture of product
PEC1. The standard costs for this product were:

Direct materials RM50


Direct labour RM20
Variable overheads RM14
Fixed overheads RM35
Total RM119

There are 800 units of this product in finished-goods inventory. The


units are technologically obsolete, and the following alternatives are
being considered:

(a) Dispose of as scrap. The proceeds from the sale will equal the cost
of transportation to the disposal site;
(b) Sell to an exporter for sale in a developing country. The sales price
to the exporter would be RM12 per unit; and

(c) Remanufacturing the products to convert them into model PEC2,


a model that normally sells for RM200. The additional cost to
convert the PEC1 units would be RM45; the standard cost to
manufacture PEC2 is RM125. Presently, there is sufficient capacity
to manufacture product PEC2 directly or to do the necessary
conversion work on PEC1.

Required:

(a) Determine the current carrying value of the PEC1 inventory; and

(b) Determine the net benefit to Pandan of each alternative.

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TOPIC 6 SHORT-TERM DECISION-MAKING  89

Scenario 3
Rinnai Berhad manufactures cups. Several weeks ago, the firm received
a special-order inquiry from Fagor Berhad. Fagor desires to market a
special cup similar to RinnaiÊs model CUP35 and has offered to
purchase 3,000 units. The following data are available:

(a) Cost data for RinnaiÊs model CUP35 cup: Direct materials,
RM45; Direct labour, RM30 (2 hours at RM15 per hour); and
Manufacturing overheads, RM70 (2 hours at RM35 per hour);

(b) The normal selling price of model CUP35 is RM180; however,


Fagor has offered Cornell only RM115 because of the large quantity
it is willing to purchase;

(c) Fagor requires a modification of the design that will allow a RM4
reduction in direct-material cost;

(d) RinnaiÊs production supervisor notes that the company will incur
RM8,700 in additional set-up costs and will have to purchase a
RM3,300 special device to manufacture these units. The device
will be discarded once the special order is completed;

(e) Total manufacturing overhead costs are applied to production at


the rate of RM35 per labour hour. This figure is based, in part,
on budgeted yearly fixed overheads of RM624,000 and planned
production activity of 24,000 labour hours; and

(f) Rinnai will allocate RM5,000 of existing fixed administrative costs


to the order as an addition to the existing cost.

Required:
One of RinnaiÊs accountants wants to reject the special order because it
is not in favour of Rinnai. Do you agree with this conclusion if Rinnai
currently has excess capacity? Show calculations to support your answer.

If Rinnai currently has no excess capacity, should the order be rejected


from a financial perspective? Briefly explain.

Assume that Rinnai currently has no excess capacity, would outsourcing


be an option that Rinnai could consider if management truly wanted to
do business with Fagor? Briefly discuss, citing several key considerations
for Rinnai in your answer.

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90  TOPIC 6 SHORT-TERM DECISION-MAKING

Scenario 4
Rudy Berhad produces two switches: SW1 and SW2. Data regarding
these two swithes follow.

SW1 SW2
Machine hours required per unit 2hrs 2.5hrs
Standard cost per unit:
Direct material RM2.50 RM4
Direct labour 5 4
Manufacturing overhead:
Variable* 3 2.50
Fixed** 4 5
Total RM14.50 RM15.50

* Applied on the basis of direct labour hours.


** Applied on the basis of machine hours.

The company requires 8,000 units of SW1 and 11,000 units of SW2.
Recently, management decided to devote additional machine time to
other product lines, resulting in only 31,000 machine hours per year that
can be dedicated to production of the switches. Another company has
offered to sell to Rudy Berhad the switches at prices of RM13.50 for
SW1 and RM13.50 for SW2.

Required:

Assume that Rudy Berhad decided to produce all SW1 and purchase
SW2 only as needed. Determine the number of SW2s to be purchased.

(a) Compute the net benefit to the firm of manufacturing (rather than
purchasing) a unit of SW1. Repeat the calculation for a unit of
SW2; and

(b) Rudy lacks sufficient machine time to produce all of the SW1
and SW2 needed. Which component (SW1 or SW2) should Rudy
manufacture first with the limited machine hours available? Why?
Provide all supporting computations.

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TOPIC 6 SHORT-TERM DECISION-MAKING  91

 A Decision Model is a formal method of making a choice often involving both


quantitative and qualitative analyses and decision makers use multiple
variation techniques to assist them in making decisions.

 Relevant information has two characteristics, it occurs in the future and it


differs among the alternative courses of action whereas relevant cost is
expected Future costs and Relevant revenues are expected Future revenues.

 Historical costs may be helpful as a basis for making predictions. However,


Past Costs themselves are always irrelevant when making decisions.

 Different alternatives can be compared by examining differences in expected


total future revenues and expected total future costs. Not all expected future
revenues and expected future costs are relevant. Expected future revenues
and expected future costs that do not differ among alternatives are irrelevant,
and hence can be eliminated from the analysis.

 Appropriate weightage must be given to qualitative factors and quantitative


non-financial factors and costs that have already occurred and cannot be
changed are classified as sunk costs.

 Sunk Costs are excluded because it cannot be changed by future actions, were
incurred in the past, and not recordable. Sunk costs are also irrelevant for
decision making as sunk costs are past, historical expenditures with no
relevance to present decisions. Decision makers must focus on future
incremental costs and revenues in making decisions.

Capacity constraints Outsourcing


Contribution margin Relevant revenue
Relevant costs Sunk cost
Make or buy decision

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92  TOPIC 6 SHORT-TERM DECISION-MAKING

Question 1
The Dalton Company manufactures slippers and sells them at RM12 a pair.
Variable manufacturing cost is RM5.00 a pair and allocated fixed manufacturing
cost is RM1.25 a pair. It has enough idle capacity available to accept a one-time-
only special order of 5,000 pairs of slippers at RM6.25 a pair. Dalton will not
incur any marketing costs as a result of the special order. What would the effect
on operating income be if the special order could be accepted without affecting
normal sales?:

(a) RM0;

(b) (RM6,250 increase;

(c) RM28,750 increase; or

(d) RM31,250 increase?

Show your calculations.

Question 2
DeCesare Computers makes 5,200 units of a circuit board, CB76, at a cost of
RM280 each. Variable cost per unit is RM190 and fixed cost per unit is RM90.
Peach Electronics offers to supply 5,200 units of CB76 for RM260. If DeCesare
buys from Peach it will be able to save RM10 per unit in fixed costs but continue
to incur the remaining RM80 per unit. Should DeCesare accept PeachÊs offer?
Explain.

Drury, C. (2015). Management and cost accounting (9th ed.). Cengage Learning.

Horngren, C. T., Datar, S. M., & Rajan, M. V. (2015). Cost accounting: A


managerial emphasis (Global Edition 15th ed.). Pearson Education Limited.

Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J.
O. (2014). Introduction to management accounting (Global Edition 16th
ed.). Pearson Education Limited.

Copyright © Open University Malaysia (OUM)


Topic  Budgets and
7 Budgetary
Controls
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Describe the Budgeting Process;
2. Prepare Operational/Functional Budgets;
3. Prepare Financial Budgets; and
4. Discuss behavioural dimensions of budgeting.

 INTRODUCTION
Budgeting is so universal that it covers all types of entities, be it manufacturing,
services, or governments. Majority of small, medium and large organisations
formalise their planning and control process using a budgetary control system.
Budgets and the Budgetary Control System have therefore become a primary
management accounting technique for the planning and controlling business
operations.

Planning is essential for the successful execution of almost any project as


planning is vital to avoid failures. People plan their holidays, travels, weddings,
elections and even funerals to estimate how much money to spend and so on.
Any attempt to conduct these without proper planning would usually result in
chaos. Therefore, the success of business operations depends on careful planning.

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94  TOPIC 7 BUDEGTS AND BUDGETARY CONTROLS

This topic discusses the budgeting process from the conception of the plan to its
expected execution. Budget is also known as a plan that shows the way we want
to use resources for a given time frame. The Budget System also includes control
using a system known as „feedback‰ on actual results, which is used to compare
with the budget. This is to assist us to evaluate the performance, especially
operating results in order to achieve the plan and goals. One of the goals to
compare the budget and actual is to understand the reasons for the differences,
and to make changes.

7.1 BENEFITS OF BUDGETING


The reasons why organisations prepare and base their decision-making on
budgeting may vary; perhaps it is based on the individual needs of organisations
or preferences of the decision makers. Generally, the main functions of
management accounting tools, such as budgets, are for planning, controlling and
decision-making. Some of the benefits of budgets are as follows:

(a) Formalise the Planning Process


Budget compels decision makers or managers to plan ahead and
systematically anticipate the future. They have to consider the future on the
horizon that compels an organisation to set their targets, look into potential
future problems, as well as, formulate workable strategies.

(b) Create a Plan of Action


The process of planning in an organisation is to combine ideas, availability
of resources and financial ability to create a set of actions to realistically
achieve the goals and objectives of an organisation.

(c) Create a Basis for Performance Evaluation


A budget serves as a useful benchmark where the actual output or result is
compared with the plan to measure and evaluate a managerÊs performance.
Significant variances between actual and planned budget requires
explanation and corrective actions. Furthermore, by having a benchmark,
managers know what is expected of them so that they can work towards
the desired outcome.

(d) Promote Continuous Improvement


Budgeting efforts should strive to improve operations continuously.
Process redesigning, increase in productivity targets, discontinuing useless
business activities and eliminating quality issues are vital ingredients for
future planning.

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TOPIC 7 BUDEGTS AND BUDGETARY CONTROLS  95

(e) Coordination and Integration of the ManagementÊs Role


A budget can be the planning process for the entire organisation
and reflects the coordinated efforts of all managers. It opens lines of
communication within the organisation, top-down and across organisational
lines.

(f) Aid in Resource Allocation


Budgets provide means of allocating resources among competing users and
make managers aware of the scarcity of resources.

(g) Motivate Managers And Employees Positively


Budgets are also used to evaluate the performance of employees. This also
assists in providing the just amount of incentive for employees to excel by
awarding financial and non-financial rewards.

7.2 BUDGETS AND THE BUDGETING CYCLE


Budget is known as the quantitative expression of a plan that is proposed for a
given time frame. It also assists the organisation to coordinate the necessary
implementation steps. We will see that both financial and non-financial aspects of
a plan exist in a budget. It is a method for the organisation to adhere to in future
time frames.

7.2.1 Strategic and Operating Plans


Planning is otherwise known as a formulation of action to achieve a particular
desired outcome. It needs the setting of objectives and also the methods to
achieve the desired objectives. Therefore, prior to planning, it is essential to
clearly define the objectives for a specific future time.

The business strategy of an organisation may set one or more objectives in terms
of a targeted profit level, sales volume or Return on Investment (ROI). Budgeting
becomes most useful when budgets are integrated with an organisationÊs
strategy. Whatever objectives are set, they should be quantifiable, verifiable,
achievable and understandable.

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96  TOPIC 7 BUDEGTS AND BUDGETARY CONTROLS

7.2.2 Budgeting Cycle and Master Budget


Budgeting incorporates the business strategy into the process. A budget also
needs to go through a cycle to make the budget as perfect as possible. The
following are the „doÊs‰ to improve a budget:

(a) Planning for the target budget;

(b) Communicating the budget to all levels of the organisation, with a top
down approach (from the strategic management level to middle
management and operational);

(c) Investigating variances from the budget with reasons and corrective
actions; and

(d) Consideration of feedback from the variances.

Organisation plans are activities to be carried out at a future specific period of


time. The time period, whether short or long, should be clearly specified. The
plan may cover a month, a quarter, a year or 5 years. Often a rolling budget is
implemented where continually one month or a quarter is added to the end of
the current period. Departmental operating budgets clearly set out in detail the
expected performance of each department. The performance of each division can
be monitored by comparing the actual performance with the budget.

Master Budget is the final product of the planning function and the
comprehensive and complete financial planning for an organisation in total and
is generally for a one year period of the fiscal year of an organisation. A Master
Budget is made up of several other budgets. An organisation is made up of
several divisions and departments carrying out different functions. A typical
manufacturing business will usually have the following departments (refer to
Figure 7.1):

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TOPIC 7 BUDEGTS AND BUDGETARY CONTROLS  97

Figure 7.1: Typical manufacturing business departments

These departments or divisions have been set up to organise the activities of the
business in an orderly manner. These are organisational entities each with its
own decision maker or head of department, generally known as a manager, who
is responsible for functions within the organisation. These departments work
together to execute the organisationÊs mission, vision and budgets. Therefore
these important managers will have specific roles in the master plan and will
contribute to it via their departmental budgets.

The various functional divisions, such as, procurement, production, marketing


and finance have to carry out their activities in a well-coordinated manner to
meet business objectives. Therefore, in the budget preparation a separate budget
is prepared for each of these functions, known as operational budgets which is
prepared and measured in numbers and quantified in monetary value.

The budget for a manufacturing organisation is made up of several operational


and financial budgets, consolidated into a master budget. The Master Budget is a
comprehensive financial plan that summarises the financial projections of all the
organisationÊs budgets and plans.

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7.2.3 Sales and Production Budget


For most manufacturing and trading organisations, the starting point for the
operating budget is the Sales Budget. It is so because the level of production and
inventory, as well as, the manufacturing and also non-manufacturing costs
usually depend on the expected level of unit sales or revenues. All the other
operational and financial budgets are dependent on the Sales Budget.

Sales Budget is a detailed schedule that shows the duration of the Sales Budget,
and is given in both units and value. All other components of the master budget
are linked to the Sales Budget. Therefore, an accurate sales budget is vital to the
success of the entire budgeting process. The sales budget assists in determining
how many units will be produced, and other budgets will be prepared based on
this information.

The Sales Budget triggers a chain reaction that leads to the development of other
budgets. Therefore, the sales budget is the most important and crucial budget of
all and if the sales budget is inaccurate, then all of the other budgets will be
misleading. Several factors affect the sales forecast, including the historical data
on sales volume, future trends and global economic conditions, industry
variations, market research output, and government and pricing policies.

The Sales Budget leads to the preparation of the production budget, and it lists
the number of units that have to be produced during each budgeting timeframe
so that sales needs and desired ending inventory are met. The formula for
production quantity is as follows:

Production = Sales Forecast + Desired Closing Inventory ă Opening Inventory


(all in units)

It is important to determine the right amount of inventory levels for the


organisationÊs profitability. Excessive inventory will cause unnecessary costs like
storage and insurance. Inventory shortages may cause loss of sales, customer
dissatisfaction, and production scheduling problems.

The Inventory Budget provides information on desired inventories for each


product. The quantity of inventories held at the end of each period depends on
the sales forecast, time required to produce the products, and management
policy on inventory levels.

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Production Budget is prepared after the forecasting of sales and inventory


via the Respective Budget is completed. Budgeted sales units and budgeted
closing inventory units together equal the budgeted units required for sales
and inventory. The opening inventory units are deducted from this amount to
get the production budget. This figure in units is required to be produced by the
organisation.

Figure 7.2: Production budget formula

7.2.4 Materials, Labour and Manufacturing


Overheads Budget
The Production Cost Budget is made up of three separate budgets (refer
to Figure 7.3). Each of these show the budgeted cost for the production of the
budgeted quantities of the goods.

Figure 7.3: Production cost budget

The Direct Material Requirements and Purchases Budget specifies the


direct materials needed for the production that must be purchased to satisfy the
production requirements, as well as, to maintain adequate inventory levels. To be
competitive, the level of inventories is reduced to a minimum since inventories,
in the short term, are seen as money tied up in a non-productive asset. The
production requirements of direct materials and desired closing inventory levels
provide information to prepare the Direct Materials Purchase Budget.

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100  TOPIC 7 BUDEGTS AND BUDGETARY CONTROLS

The required purchases of raw materials are calculated as follows (see Figure 7.4):

Figure 7.4: Required purchases of raw materials calculation

Direct Manufacturing Labour Cost Budget is used to plan the quantity and the
cost of direct labour is required to facilitate production during the budget period.
It also provides information for planning the cash required to pay direct wages.

The Manufacturing Overhead Expenses Budget is used to plan the total amount
of both variable and fixed manufacturing overheads. Manufacturing overheads
are normally classified into fixed manufacturing overheads and variable
manufacturing overheads for budgetary control purposes. Factory rent, rates and
salaries of factory managers and supervisors are examples of fixed
manufacturing overhead expenses.

7.2.5 Income Statement Budget


Cost of Goods Sold Budget is part of the income statement budget and it is
utilised to compute the cost of goods sold in each period, and is based on the
Sales Budget, the Inventories Budget and the Cost of Goods Manufactured
Budget.

Apart from the cost of Goods Sold Budget, the Selling and Administrative
Expenses budgets also show in detail the selling expenses and administration
expenses during the budget period. Combining the above budgets will give us
the Income Statement Budget, the end product of all the Operating Budgets,
which gives us the forecast of the overall revenue, expenses, and profit of an
organisation. This will be the first snapshot of the profit or loss of the operations
of the organisation.

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7.2.6 Cash Budget and Statement of Financial


Position Budget
Cash Budget is a detailed plan showing how cash resources will be acquired and
utilised over a specified time frame. Cash Budgets also assist organisations to
avoid excessive cash surplus balances, by allowing for advance steps to be
taken to invest in short-term investments. From a different perspective, cash
deficiencies are identified earlier so that loans can be sorted out to address short-
term deficiencies in cash.

The Cash Budget is an extremely important financial budget for any organisation
and its planning is vital for all organisations to ensure that sufficient liquidity is
maintained to meet cash obligations as and when they arise. Schedules such as
cash collections from sales made to customers, cash payments for materials
purchased from suppliers, cash payments for wages and among others are
required to assist in preparing the Cash Budget.

Capital Expenditure Budget can also be part of the Cash Budget, which is
inserted later into the Statement of Financial Position Budget (Balance Sheet).
This is a financial budget which is related to the long-range plan of the
organisation, and it explains the amount and the timing of the planned capital
expenditure of the organisation.

The Statement of Financial Position Budget shows the expected assets and
liabilities of the organisation at the end of the budget period and the Statement of
Cash Flows budget shows the expected changes in cash flows, the inflows and
outflows resulting from operations, investment activities and financing activities.

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The components of the Master Budget and Financial Budget are as follows
(Figure 7.5):

Figure 7.5: Components of master budget and financial budget

Example 7.1 is a comprehensive example of Guard Berhad for its product G1 that
requires us to prepare all the budgets discussed previously.

Example 7.1
Guard Berhad manufactures and sells product G1 and is about to prepare
budgets for the months of April, May and June 2016. The following information
is available:

Product Data:

Standard Unit Selling Price RM150


Standard Cost Data per Unit of Product
Raw Materials Name Units Unit Price Cost
(RM) (RM)
M1 4 2 8
M2 1 3 3
M3 2 5 10
RM21

Hours Rate per Hour


(RM)
Direct Labour Type 2 10 20
Manufacturing 1 12 12
Assembly RM32
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Hours Rate per Hour


(RM)
Variable Manufacturing Overheads 3 6 18

Fixed Manufacturing Overheads Budgeted Normal


Total RM Output Units
per month per Month
RM300,000 10,000

Selling and Administration Costs

Variable cost per unit of Product sold RM3


Fixed ă Total per month RM80,000

Depreciation

Included as part of Fixed Manufacturing Overhead Costs RM60,000

Budgeted Sales Units

Month Units
April 9,000
May 12,000
June 11,000
July 10,000
August 12,000

Other Information:

Cash Collections (sales):

Sales collected in month of sale 20%


Sales collected in month after sale 78%
Sales as bad debts 2%

Inventories:

Finished Goods of next monthÊs sales 50%


Raw materials of next monthÊs production 80%

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Cash Payments:

Purchase of Raw Materials:


Paid in the month of purchase 60%
Paid in the month after purchase 40%
Production costs (Labour & Overheads)
Paid in month incurred 80%
Paid in the following month 20%
Selling and administration costs ă Fixed
Paid in the month incurred
Selling and administration costs ă Variable
Paid in the month incurred 0%
Paid in the following month 100%
Tax payable in June
Tax rate 33%

Statement of Financial Position as at the Beginning of the Budget Period

Statement of Financial Position as at 31 March 2016 (not based on standards)

Assets:

Cash RM52,000
Accounts Receivable, (net of bad debts) 940,000
Finished Goods Inventories:
Units 4,500
Unit Cost RM101
Amount 454,500
Raw Materials Inventories: Units Value
M1 33,600 RM67,200
M2 8,400 25,200
M3 16,800 84,000
RM176,400

Plant and Equipment: RM2,460,000


Cost 940,000
Accumulated Depreciation RM1,520,000
Net RM3,142,900

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Equities:

RM
Accounts Payable (Raw Materials) 150,000
Taxes Payable 140,000
Selling and Administration Costs-accrued 30,000
Production Costs-accrued 145,000
Paid up Capital 1,700,000
Retained Earnings 977,900
RM3,142,900

Required:
Prepare the following budgets for Guard Berhad for the months of April, May
and June 2016, and for the quarter:

Sales Budget
Production Budget (in units)
Materials Cost Budget
Wages Cost Budget
Production Overheads Cost Budget
Production Cost Budget
Raw Materials Purchases Budget
Marketing and Administration Cost Budget
Cash Receipts Budget
Cash Payments Budget
Summary Cash Budget
Budgeted Income Statement
Budgeted Financial Position

Solution for Example 7.1

Guard Berhad
Comprehensive Budgets for April, May and June 2016

Schedule A: Sales Budget

April May June Quarter


Sales units 9,000 12,000 11,000 32,000
Standard unit price RM150 RM150 RM150
Budgeted Sales RM1,350,000 RM1,800,000 RM1,650,000 RM4,800,000

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Schedule B: Production Budget (Units)

April May June Quarter July August


Budgeted sales units (Schedule A) 9,000 12,000 11,000 32,000 10,000 12,000
Add Desired ending inventory* 6,000 5,500 5,000 5,000 6,000
Total requirements 15,000 17,500 16,000 37,000 16,000
Less Beginning inventory** 4,500 6,000 5,500 4,500 5,000
Budgeted production units 10,500 11,500 10,500 32,500 11,000

* Required ending inventory is 50% of the following monthÊs units of sales.


** The ending inventory in a month is the opening inventory of the following month.
Please see the Statement of Financial Position for opening inventories for April (4,500).

Schedule C: Materials Cost Budget

Unit
April May June Quarter
Cost
Budgeted production units
10,500 11,500 10,500 32,500
(Schedule B)
Material M1 RM8 RM84,000 RM92,000 RM84,000 RM260,000
M2 RM3 31,500 34,500 31,500 97,500
M3 RM10 105,000 115,000 105,000 RM325,000
RM21 RM220,500 RM241,500 RM220,500 RM682,500

Schedule D: Wages Cost Budget

Hours
April May June Quarter
per Unit
Budgeted production units
10,500 11,500 10,500 32,500
(Schedule B)
Manufacturing labour hours 2 21,000 23,000 21,000 65,000
Cost @ RM10/hour RM210,000 RM230,000 RM210,000 RM650,900
Assembly labour hours 1 10,500 11,500 10,500 32,500
Cost @ RM12/hour RM126,000 RM138,000 RM126,000 RM390,000
Total hours 31,500 34,500 31,500 97,500
Total wages cost RM336,000 RM368,000 RM336,000 RM1,040,000

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Schedule E: Production Overheads Cost Budget

Per
April May June Quarter
Unit
Budgeted production units
10,500 11,500 10,500 32,500
(Schedule B)
Variable overheads RM18 RM189,000 RM207,000 RM189,000 RM585,000
Fixed overhead 300,000 300,000 300,000 900,000
Total overhead costs RM489,000 RM507,000 RM489,000 RM1,485,000

Schedule F: Production Cost Budget

April May June Quarter


Budgeted production units
10,500 11,500 10,500 32,500
(Schedule B)
Per
Costs: Unit
Raw materials RM21 RM220,500 RM241,500 RM220,500 RM682,500
Direct labour 32 336,000 368,000 336,000 1,040,000
Variable 18
189,000 207,000 189,000 585,000
overheads
Fixed overheads 30 300,000 300,000 300,000 900,000
Total production RM101
RM1,045,500 RM1,115,500 RM1,045,500 RM3,207,500
cost

Workings Required for Cash Budget

April May June Quarter


Total production cost RM1,045,500 RM1,116,500 RM1,045,500 RM3,207,500
Less depreciation RM60,000 RM60,000 RM60,000 RM180,000
Cash production costs RM985,500 RM1,056,500 RM985,500 RM3,027,500
Less raw materials costs RM220,500 RM241,500 RM220,500 RM682,500
Other cash production
costs (labour and RM765,000 RM815,000 RM765,000 RM2,345,000
overheads)

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Schedule G: Materials Purchases Budget

Material M1

Per
April May June Quarter July
Unit
Budgeted production units
10,500 11,500 10,500 32,500 11,000
(Schedule B)
Production requirements 4 42,000 46,000 42,000 130,000 44,000
Add Ending inventories* 36,8000 33,600 35,200 35,200
Total units required 78,800 79,600 77,200 165,200
Less Beginning inventories** 33,600 36,800 33,600 33,600
Purchases units 45,200 42,800 43,600 131,600
Purchases cost @ RM2.00 RM90,400 RM85,600 RM87,200 RM263,200

* Ending inventories are 80% of the following monthÊs production requirements.


** The ending inventory in any month is the beginning inventory of the next month.
Please see the SFP for beginning inventories for April RM33,600.

Material: M2

Per
April May June Quarter July
Unit
Budgeted production units
10,500 11,500 10,500 32,500 11,000
(Schedule B)
Production requirements 1 10,500 11,500 10,500 32,500 11,000
Add Ending inventories 9,200 8,400 8,800 8,800
Total units required 19,700 19,900 19,300 41,300
Less Beginning inventories 8,400 9,200 8,400 8,400
Purchases units 11,300 10,700 10,900 32,900
Purchases cost @ RM3 RM33,900 RM32,100 RM32,700 RM98,700

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Material: M3

Per
April May June Quarter July
Unit
Budgeted production units
10,500 11,500 10,500 32,500 11,000
(Schedule B)
Production requirements 2 21,000 23,000 21,000 65,000 22,000
Add Ending inventories 18,400 16,800 17,600 17,600
Total units required 39,400 39,800 38,600 82,600
Less Beginning inventories 16,800 18,400 16,800 16,800
Purchases units 22,600 21,400 21,800 65,800
Purchases cost @ RM5 RM113,000 RM107,000 RM109,000 RM329,000

Total Materials Purchases Budget

April May June Quarter


Material M1 RM90,400 RM85,600 RM87,200 RM263,200
Material M2 33,900 32,100 32,700 98,700
Material M3 113,000 107,000 109,000 329,000
Total purchases cost RM237,300 RM224,700 RM228,900 RM690,900

Schedule H: Marketing and Administration Costs Budget

Per
April May June Quarter
Unit
Budgeted sales units
9,000 12,000 11,000 32,000
(Schedule A)
Variable overheads RM3 RM27,000 RM36,000 RM33,000 RM96,000
Fixed overheads 80,000 80,000 80,000 240,000
Total overhead costs RM107,000 RM116,000 RM113,000 RM336,000

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Schedule I: Cash Receipts Budget

April May June Quarter


(RM) (RM) (RM) (RM)
Sales (Schedule A) 1,350,000 1,800,000 1,650,000 4,800,000
From current monthÊs sales
270,000 360,000 330,000 960,000
20%
From prior monthÊs sales 78% 940,000 1,053,000 1,404,000 3,397,000
Total budgeted receipts 1,210,000 1,413,000 1,734,000 4,357,000
Net month end accounts
RM1,053,000 RM1,404,000 RM1,287,000
receivable

* Please see Statement of Financial Position (SFP) for Accounts Receivable in April
RM940,000.

Schedule J: Cash Payments Budget

April May June Quarter


(RM) (RM) (RM) (RM)
Materials purchases (Schedule G): 150,000 94,920 89,880 334,800
Prior month* 40% 142,380 134,820 137,340 414,540
Current 60%
Other production cash costs:
Prior month* 20% 145,000 153,000 163,000 461,000
Current 80% 612,000 652,000 612,000 1,876,000
Variable selling & admin. costs:
Prior month* 100% 30,000 27,000 36,000 RM93,000
Fixed selling & admin. costs:
80,000 80,000 80,000 240,000
Paid in month incurred
Tax (Tax payments Schedule ă see below) 0 0 539,630 539,630
Total payments 1,159,380 1,141,740 1,657,850 3,958,970

Amounts paid in April for March ă Please see Statement of Financial Position (SFP).

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Schedule K: Cash Budget

April May June Quarter


(RM) (RM) (RM) (RM)
Beginning balance 52,000 102,620 374,880 52,000
Receipts (Schedule I) 1,210,000 1,413,000 1,734,000 4,357,000
Total cash available 1,262,000 1,515,620 2,107,880 4,409,000
Less disbursements (Schedule J) 1,159,380 1,141,740 1,657,850 3,958,970
Ending Balance 102,620 373,880 450,030 450,030

Schedule L: Budgeted Income Statement

April, May and June ă 2016

April May June Quarter


(RM) (RM) (RM) (RM)
Sales (Schedule ă A) 1,350,000 1,800,000 1,650,000 4,800,000
Less Standard cost of sales @ RM101 909,000 1,212,000 1,111,000 3,232,000
Standard gross margin 441,000 588,000 539,000 1,568,000
Fixed overheads volume variance* 15,000 45,000 15,000 75,000
Budgeted gross margin 456,000 633,000 554,000 1,643,000
Less Selling & admin. expenses:
Variable 27,000 36,000 33,000 96,000
Fixed 80,000 80,000 80,000 240,000
Bad debts 27,000 36,000 33,000 96,000
Total 134,000 152,000 146,000 432,000
Net profit before tax 322,000 481,000 408,000 1,211,000
Less Tax @ 33.00% 106,260 158,730 134,640 399,630
Net profit after tax 215,740 322,270 273,360 811,370

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* Computation of Production Volume Variance

April May June


(RM) (RM) (RM)
Normal capacity production units 10,000 10,000 10,000
Budgeted production units (Schedule B) 10,500 11,500 10,500
Excess (shortfall) in production 500 1,500 500
Fixed overheads volume variance @ RM30 per unit 15,000 45,000 15,000

Tax Payments Schedule (Workings)

Months April May June


(RM) (RM) (RM)
Balance at beginning 140,000 246,260 404,990
Tax for the month 106,260 158,730 134,640
Total tax payable 246,260 404,990 539,630
Tax paid 0 0 539,630
Balance at end 246,260 404,990 0

Schedule M: Pro Forma Statement of Financial Position as at the end of Assets:

April May June Quarter


(RM) (RM) (RM) (RM)
Cash 102,620 373,880 450,030 450,030
Accounts receivable (net) 1,053,000 1,404,000 1,287,000 1,287,000
Inventories:
Finished goods 606,000 555,500 505,000 505,000
Raw materials M1 73,600 67,200 70,400 70,400
M2 27,600 25,200 26,400 26,400
M3 92,000 84,000 88,000 88,000
Plant & equipment 2,460,000 2,460,000 2,460,000 2,460,000
Accumulated depreciation (1,000,000) (1,060,000) (1,120,000) (1,120,000)
Total 3,414,820 3,909,780 3,766,830 3,766,830

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April May June Quarter


Equities:
(RM) (RM) (RM) (RM)
Accounts payable (materials) 94,920 89,880 91,560 91,560
Accrued selling & admin. costs 27,000 36,000 33,000 33,000
Accrued production costs 153,000 163,000 153,000 153,000
Tax payable 246,260 404,990 0 0
Paid-up capital 1,700,000 1,700,000 1,700,000 1,700,000
Retained earnings 1,193,640 1,515,910 1,789,270 1,789,2790
3,414,820 3,909,780 3,766,830 3,766,830

The following Example 7.2 of Darix Berhad is an example that requires us to


prepare the Cash Budget discussed above.

Example 7.2:
Darix Berhad is a tea distributor and its Statement of Financial Position as at
31 March 2016 is given below:

Darix Berhad
Statement of Financial Position as at 31 March 2016

Assets RM
Property, Plant & Equipments 338,000
Inventory 42,000
Accounts receivable 75,000
Cash at Bank 11,000
466,000
Liabilities and Equity
Accounts payable 89,000
Bank Loan 35,000
OwnersÊ Capital 342,000
466,000

The company is in the process of preparing the Budget Data for April. A number
of budget items have already been prepared, as stated as follows:

(a) Sales are budgeted at RM300,000 for April. Of these sales, RM120,000 will
be for cash; the remainder will be credit sales. 35% of a monthÊs credit sales
are collected in the month the sales are made, and the remainder is
collected in the following month. All of the 31 March receivables will be
collected in April;

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114  TOPIC 7 BUDEGTS AND BUDGETARY CONTROLS

(b) Purchases of inventory are expected to total RM216,000 during April. These
purchases will all be on account. 60% of all purchases are paid in the month
of purchase; the remainder is paid in the following month. All of the 31
March accounts payable to supplier will be paid during April;

(c) Operating expenses for April are budgeted at RM71,000. These expenses
will be paid in cash;

(d) The loan on the 31 March Balance Sheet was taken up in December 2011,
with an interest commitment of 6% per annum and will be paid off in April,
together with its interest;

(e) In April a new brewing equipment costing RM10,000 will be purchased for
50% cash and the remainder borrowed from the bank at 5% annual interest.
The first interest payment is to be paid at the end of the month of purchase.
Depreciation of the brewing equipment is at 10% per annum and the life of
the equipment is five years. The borrowed amount will be paid back after
six months; and

(f) During April, the company will borrow RM70,000 from its bank at 5%
annual interest and the first interest payment is due in May.

You are required to prepare a cash budget for the month of April 2016.

Solution for example 7.2

CASH BUDGET FOR APRIL

CASH INFLOWS: RM
Cash Sales 120,000
Credit Sales 63,000
Accounts receivable 75,000
Bank Loan for Equipment purchase 5,000
Bank Loan at month end 70,000
TOTAL CASH INFLOW 333,000

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TOPIC 7 BUDEGTS AND BUDGETARY CONTROLS  115

CASH OUTFLOWS: RM
Purchases 129,600
Accounts Payables 89,000
Operating expenses 71,000
Loan repayment 35,000
Loan interest payment 875
Purchase brewing equipment 10,000
Interest paid for Equipment Loan 21
335,496
TOTAL CASH OUTFLOW
Surplus/Deficit (2,496)

Opening Balance of Cash at Bank 11,000


Closing Balance of Cash at Bank 8,504

7.3 BUDGETS AND BEHAVIOUR


Budgets tend to have a substantial impact on the behaviour of both management
and employees and budgets. Budgetary control can result in both favourable and
unfavourable behavioural consequences. In most situations a participative
approach to budget preparation, challenging budget targets, enlightened
performance evaluation and appropriate reward systems will usually improve
motivation, job satisfaction and morale of managers and employees. However,
budgets which are imposed by top management with very tight budget targets.
The use of budgets as a fault-finding technique, may lead to dissatisfaction, loss of
morale and other adverse behavioural consequences.

Budgets do not automatically ensure success without the people that make it
work. All individuals affected by the budget, especially management at all levels
must support the budget to provide an organisational environment conducive to
the success of the budget.

Budgets are most effective with the application of participative budgets instead
of imposed budgets, whilst authoritative budgets are normally faced with
difficulties in implementation. A good budget is prepared and communicated to
all managers for its successful implementation. A participative budget is when
employees from all levels of the organisation take part in the preparation of the
budget by making decisions together. This process facilitates the communication
between the decision maker, the senior management, the middle management
and operations.

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Budgetary slack exists when budgets are underestimated for revenues or


overestimated for costs, so that budget targets are easily achievable. This occurs
most often when budgets are used in performance evaluation. The budgetary
slack provides a ÂroomÊ for adjustments in case of a negative or any unexpected
situation.

ACTIVITY 7.1

Use OUM as an organisation and plan its possible budgets and controls
for next year ending 31 December.

7.4 LIMITATIONS OF BUDGETING


With all the planning and forward looking ideas based on an organisations
vision, mission and objectives, a budget tends to oversimplify the facts of a real-
world situation and does not truly represent the complexities faced by the
management, such as labour market and impact of competition.

A budget may emphasise results but not the reasons, when both are important.
Therefore we need to do a variance analysis of all the differences between the
budgeted figures and the actual figures. The participative theme of budgeting
demands complete management support and involvement, and if managers are
not convinced of budgetingÊs benefits, they are not likely to cooperate in the
Budgeting Process.

The budget may also undermine managementÊs initiative by discouraging new


developments and actions not covered in the budget. Therefore, the budgeting
process is not an exact science, because its preparation is based on the best
information available, and thus good judgment plays an essential role for its
success. To be competitive and sustainable, constant revision to the budget is
required as and when new facts become known to the decision maker.

SELF-CHECK 7.1

What do you understand by the term budgetary controls?

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TOPIC 7 BUDEGTS AND BUDGETARY CONTROLS  117

ACTIVITY 7.2

YAP Berhad provides the following budgeted sales for the next seven
months period:

Month Unit Sales


January 90,000
February 120,000
March 210,000
April 150,000
May 180,000
June 120,000
July 100,000

There were 30,000 units of finished goods in inventory at the beginning


of January. Plans are to have an inventory of finished products that
equal 20% of the unit sales for the next month.

5kg of materials are required for each unit produced. Each material
costs RM8 per kg. Inventory levels for materials are equal to 30% of the
needs for the next month and the materials inventory on January 1 was
15,000kg.

Required:
Prepare production budgets in units for the three months, from
February to April.

Prepare a purchases budget in kilograms for February to April, and


give total purchases in both kilogram and RM for each month.

Copyright © Open University Malaysia (OUM)


118  TOPIC 7 BUDEGTS AND BUDGETARY CONTROLS

 Budgets are a primary financial planning tool used by businesses and other
organisations. The chapter explains how businesses use and prepare budgets
as part of the management process.

 Careful planning is essential for all business organisations to achieve their


objectives in the current changing complex and competitive economic
environment. All successful business organisations plan carefully in detail all
their operations, and use these plans to monitor and control the execution of
these operations.

 The advantages of a budget are numerous relating to coordination,


communication, performance evaluation, and managerial motivation.

 Budgets force managers to set objectives and plan activities.

 Coordination is combining and balancing all aspects of production or service


and all departments in a company in the best way for the company to achieve
its goals.

 Communication is making sure those goals are understood by all employees.

 Budgets allow a companyÊs managers to measure actual performance against


predicted performance, and motivate managers and other employees.

 Challenging budgets improve employee performance, because employees


view falling short of budgeted numbers as a failure.

 Budgeting is a time-consuming process that involves all levels of


management. A budget may be ineffective if not supported by top
management.

 Planning and Control are considered the primary functions of budgeting. The
process of budget preparation involves all the activities of formalised
business planning, and planning is considered a very important management
function in any business enterprise.

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TOPIC 7 BUDEGTS AND BUDGETARY CONTROLS  119

 Master Budget is a set of separate but closely-related budgets representing a


comprehensive plan of action for a specified time period; it is normally
prepared for a 1 year period.

 Master budget is then subdivided into shorter periods, such as, monthly or
quarterly to facilitate timely comparisons of actual and plan results. It
consists of two components, operating/functional budget and financial
budget.

 The Operating Budget is a detailed description of the revenues and costs,


which include the sales budget and production budget.

 Financial Budget shows the cash flows and financial position expected with
the planned operations.

Behaviour Master budget


Budget slack Operating budget
Cash budget Production budget
Financial budget Sales budget
Manufacturing budget Strategic management

Question 1
The Howell Company has prepared a sales budget of 43,000 finished units for a
3-month period. The company has an inventory of 11,000 units of finished goods
on hand at December 31 and has a target finished goods inventory of 19,000 units
at the end of the succeeding quarter.

It takes 4 gallons of direct materials to make one unit of finished product. The
company has an inventory of 66,000 gallons of direct materials at December 31
and has a target ending inventory of 56,000 gallons at the end of the succeeding
quarter. How many gallons of direct materials should Howell Company
purchase during the 3 months ending March 31?

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120  TOPIC 7 BUDEGTS AND BUDGETARY CONTROLS

Question 2
The Mochizuki Co. in Japan has a division that manufactures two-wheel
motorcycles. Its budgeted sales for Model G in 2015 are 915,000 units.
MochizukiÊs target ending inventory is 70,000 units, and its beginning inventory
is 115,000 units. The companyÊs budgeted selling price to its distributors and
dealers is 405,000 yen (æ) per motorcycle.

Mochizuki buys all its wheels from an outside supplier. No defective wheels are
accepted. (MochizukiÊs needs for extra wheels for replacement parts are ordered
by a separate division of the company.) The companyÊs target ending inventory
is 72,000 wheels, and its beginning inventory is 55,000 wheels. The budgeted
purchase price is 18,000 yen (æ) per wheel.

Required:

1. Compute the budgeted revenues in yen.

2. Compute the number of motorcycles that Mochizuki should produce.

3. Compute the budgeted purchases of wheels in units and in yen.

Drury, C. (2015). Management and cost accounting (9th ed.). Cengage Learning.

Horngren, C. T., Datar, S. M., & Rajan, M. V. (2015). Cost accounting: A


managerial emphasis (Global Edition 15th ed.). Pearson Education Limited.

Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J.
O. (2014). Introduction to management accounting (Global Edition 16th
ed.). Pearson Education Limited.

Copyright © Open University Malaysia (OUM)


Topic  Flexible
8 Budgets

LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Describe the characteristics of a Flexible Budget;
2. Describe how a Flexible Budget works;
3. Prepare variances for Flexible Budgets; and
4. Prepare Flexible Budgets with multiple cost drivers.

 INTRODUCTION
This topic will be the transition from budgets to the analysis of the budgets.
Starting from the Fixed Budgets and moving towards Flexible Budgets, we will
also be discussing variance analysis. Under a system of Budgetary Control and
Responsibility Accounting, actual costs and revenues are accumulated for each
responsibility centre and periodically compared with budgetary targets.
Variances from budgets are highlighted, and the person in charge of the
responsibility centre is held accountable for the deviations.

8.1 STANDARD COST


Standard costing and variance analysis is a system which enables such deviations
from the budget to be analysed in greater detail. Thus, enabling costs and
revenues to be controlled effectively. Standard costs are used to prepare the
budgets of an organisation, which is later compared with the actual data to find
the variance between the standard and actual, if any.

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122  TOPIC 8 FLEXIBLE BUDGETS

8.1.1 Need for Variances


Variance is defined as the difference between the actual results of an organisation
and its budgeted figures. The analysis of the variances permits decision makers
to apply management by exception. When decision makers apply management
by exception, they are able to focus on areas that are not performing as they
should, and spending less effort on areas that are meeting targets. Variances also
give the decision makers the necessary ability to make calculated predictions for
the organisation which improves the quality of the decision-making process and
the decision made will be based on the best available information.

SELF-CHECK 8.1

What do you understand by the term standard cost and why do we


need it?

8.2 FIXED (STATIC) BUDGET


A Fixed Budget, also known as a static budget, is prepared at the beginning of a
period and is useful for a given level of activity. This fixed budget is acceptable
for the purpose of planning but it is not adequate for the purpose of cost control
evaluation. Let us say, the actual activity of production is not the same compared
to what was planned, then it would be improper to compare actual costs to the
fixed budget. Therefore, if production is higher than expected, variable costs
should also be higher than expected, and vice versa. Otherwise, it is meaningless
to compare actual costs at one level of activity or production to a budgeted cost
that is at a different level of activity or production. Example 8.1 shows how to
calculate the level of output that will be utilised for both Fixed and Flexible
Budgets.

Example 8.1
Based on the information below, you are required to calculate the level of output
that will be utilised for;

(a) Fixed Budget; and

(b) Flexible Budget.

Planned level of activity 5,000 units


Actual level of activity 4,700 units

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TOPIC 8 FLEXIBLE BUDGETS  123

Budgeted costs at the planned level of activity:

Labour costs 2 hours @ RM15 per hour


Materials costs 3kgs @ RM4 per kg
Overheads costs RM4,000 fixed plus RM8 per unit

Actual costs incurred:

Labour costs 2.1 hours @ RM16 per hour


Materials costs 3.2kgs @ RM4.20 per kg
Overheads costs RM4,100 fixed plus RM8.10 per unit

Solution:
The Static Budget would be based on the planned level of activity of 5,000 units,
while the flexible budget would be based on 4,700 units.

We have to keep in mind that we are to compare the actual figures (based on
4,700 units) with the Flexible Budget figures (based on 4,700 units). It is
important to note that, the Fixed Budget figures (based on 5,000 units) are not to
be used for comparative purposes, as it is meaningless to do so.

SELF-CHECK 8.2

Do you think that a Fixed Budget is useful? Why?

8.3 FLEXIBLE BUDGET


Flexible Budget is a detailed plan for cost control that is valid for a given range of
levels of activity, for example, production level. A common flexible budget
compares actual information to budgeted data. It is important to understand that
the budgeted data is based on the actual output figure, and the flexible budget is
adjusted to the actual level of output that enables assessment of efficiency of
performance.

There are three steps involved in developing a flexible budget, as follows (refer
to Figure 8.1):

Figure 8.1: Three steps in developing a flexible budget


Copyright © Open University Malaysia (OUM)
124  TOPIC 8 FLEXIBLE BUDGETS

A flexible budget gives an estimate of the costs that should be for a given level of
activity within a specified range. A flexible budget has 3 major uses depicted in
Figure 8.2:

Figure 8.2: Three uses of the flexible budget

8.3.1 Flexible Budget and Sales-Volume Variances


Variances represent the difference between the amount of inputs that should be
used to produce the actual output and the amount of inputs actually used.
Control action should be taken when a variance is deemed to be significant, and
the significance depends on several factors, including percentage of standard,
absolute amount, consistency or trend, controllability and nature of item.

It is very important for us to define and discuss Standards, in relation to


variances, as explained in subtopic 8.1. In a standard Costing System, standards
are established for each product or service in relation to selling price, materials
input quantities and prices, labour rates and times and the quantity and cost of
services to be consumed.

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TOPIC 8 FLEXIBLE BUDGETS  125

The term „Standard‰ can represent a price, cost or quantity that is established as
a guide to estimate the performance of an entity, and is normally developed on a
per unit basis. A standard input is the quantity of input for a unit of production,
for example, a litre of material for a chemical product. A standard price is the
price expected to be paid for a unit of input, for example, the price to pay for one
litre of chemicals is RM5 per litre. Following this logic, a standard cost is the cost
of a finished unit of output and the budgeted amounts are based on these
standard prices, costs, and quantities. Example 8.2 shows Dia PostageÊs Fixed
Budget and Flexible Budget:

Example 8.2

DIA POSTAGE
Fixed Budget
For the month ended 31 December 2016
Budgeted Actual Variance
Budgeted number of clients 5,000 5,200 200F

Budget variable overhead costs:


Postage supplies (@RM1.20 per client) RM6,000 RM6,400 RM400U
Government tax (@RM4.00 per client) 20,000 22,300 2,300U
Electricity (@RM0.20 per client) 1,000 1,020 20U
Total variable overhead costs 27,000 29,720 2,720U

Budgeted fixed overhead costs:


Employee salaries 8,000 8,100 100U
Rent 12,000 12,000 0
Insurance 1,000 1,000 0
Utilities other than electricity 500 470 30F
Total fixed overhead cost 21500 21,570 70U
Total budgeted overhead costs RM48,500 RM51,290 RM2,790U

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126  TOPIC 8 FLEXIBLE BUDGETS

DIA POSTAGE
Flexible Budget
For the month ended 31 December 2016
Budgeted number of
5,000
client-visits

Cost (per Activity (in clients)


Overhead Costs
client) 4,900 5,000 5,100 5,200
Variable overhead costs:
Postage supplies RM1.20 RM5880 RM6,000 RM6,120 RM6,240
Government tax RM4.00 19,600 20,000 20,400 20,800
Electricity (variable) RM0.20 980 1,000 1,020 1,040
Total variable overhead
RM5.40 26,460 27,000 27,540 28,080
costs

Fixed overhead costs:


Employee salaries 8,000 8,000 8,000 8,000
Rent 12,000 12,000 12,000 12,000
Insurance 1,000 1,000 1,000 1,000
Utilities other than
500 500 500 500
electricity
Total fixed overhead
21,500 21,500 21,500 21,500
costs
Total overhead costs RM47,960 RM48,500 RM49,040 RM49,580

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TOPIC 8 FLEXIBLE BUDGETS  127

DIA POSTAGE
Flexible Budget Performance Report
For the month ended 31 December 2016

Budgeted number of clients 5,000


Actual number of clients 5,200

Budget Based Actual Costs


Cost (per
Overheads on 5,200 Incurred for Variance
client)
Client 5,200 Client
Variable overhead costs:
Postage supplies RM1.20 RM6,240 RM6,400 RM160U
Government tax RM4.00 20,800 22,300 1,500U
Electricity (variable) RM0.20 1,040 1,020 20F
Total variable overhead
RM5.40 28,080 29,720 1,640U
costs

Budgeted fixed overhead


costs:
Employee salaries 8,000 8,100 100U
Rent 12,000 12,000 0
Insurance 1,000 1,000 0
Utilities other than
500 470 30F
electricity
Total fixed overhead costs 21,500 21,570 70U
Total overhead costs RM49,580 RM51,290 RM1,710U

SELF-CHECK 8.3

Do you think we can prepare a variance analysis with a fixed budget?

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128  TOPIC 8 FLEXIBLE BUDGETS

8.4 COMPARISON BETWEEN FIXED AND


FLEXIBLE BUDGETS
Table 8.1 is the comparison between Fixed Budget and Flexible Budget:

Table 8.1: Comparison between Fixed and Flexible Budget

Fixed Budget Flexible Budget


(a) A budget that is prepared to remain (a) A budget that is prepared to adjust
constant regardless of the volume of the allowed cost levels to match the
output or turnover achieved. actual level of activity.

(b) Used for planning purposes ă as it (b) Used for control purposes
serves to define the general broad
objectives of the specific organisation.
(c) Prepared at the beginning of the (c) Prepared at the end of the period.
period
(d) Based upon one project level of (d) ÂFlexedÊ to accommodate actual level
activity of production
(e) To create a meaningful performance (e) Used to compute what costs should
report, actual costs and expected have been for the actual level of
costs must be compared at the same activity, so that meaningful
level of activity. comparison can be done.
(f) A single budget with no analysis of (f) Cost will be analysed based on fixed
cost. and variable elements, so that the
budget can be adjusted according to
the actual activity.
(g) Not very useful when it comes to (g) Helps managers to factor in any
preparing performance reports. uncertainty by allowing the manager
to look at the expected outcomes for
the given activity range.

Therefore, we can conclude that (refer to Figure 8.3):

Figure 8.3: Conclusion of types of budget

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TOPIC 8 FLEXIBLE BUDGETS  129

ACTIVITY 8.1

Flexible budget is not needed when we have a fixed budget. Discuss.

ACTIVITY 8.2

Nario makes a single product and has an average production of 5,000


units a month, although this varies widely. The following extract from
the overheads statement for the fixing department shows the make-up
of the budget and a monthÊs actual results.

Budget for Actual results


5,000 units at 4,650 units
RM RM RM
Labour:
Fixed labour 3,000 3000
Variable 5,000 4900

Variable overheads 15,000 14,250


Consumables (all variables) 20,000 18,200
Fixed overheads 12,500 12,500
55,500 52,850

Required
Show two budgetary control statements for January, one based on the
fixed budget for 5,000 units and one based on a flexible budget for the
actual level of production.

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130  TOPIC 8 FLEXIBLE BUDGETS

 A Static Budget of a master budget is a detailed budget that relates to a


planned activity level, and it is known as a static budget because it is
prepared for a planned output level. The difference between the actual result
and the related budget amount in the static budget is the budget variance.

 Flexible Budgets are detailed plans that are used for costs control valid for a
given range of activity levels, and it compares actual information with
budgeted data.

 The Sales-Volume Variance is calculated as the difference between the static


budget and flexible budget amounts. It is called a volume variance since it
results from differences in volumes only.

 The Flexible Budget variance is the total variance for each cost item that is
commonly analysed from its price and quantity component.

 The Price Variance is the difference between the actual cost incurred and the
budgeted cost for the actual input used.

 The Quantity Variance is the difference between the budgeted cost and the
standard cost allowable for the actual outputs (of finished product).

Fixed Budget Standard Cost


Flexible Budget Sales-Volume Variances
Flexible Budget Variances

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TOPIC 8 FLEXIBLE BUDGETS  131

Question 1
Based on the scenario below, prepare a static-budget-based variance analysis of
the September performance.

Scenario:
Bank Management Printers, Inc., produces luxury chequebooks with three
cheques and stubs per page. Each chequebook is designed for an individual
customer and is ordered through the customerÊs bank. The companyÊs operating
budget for September 2014 included these data:

RM
Number of chequebooks 15,000
Selling price per book 20
Variable cost per book 8
Fixed costs for the month 145,000

The actual results for September 2014 were as follows:

RM
Number of chequebooks produced and sold 12,000
Average selling price per book 21
Variable cost per book 7
Fixed costs for the month 150,000

The executive vice president of the company observed that the operating income
for September was much lower than anticipated, despite a higher-than-budgeted
selling price and a lower-than-budgeted variable cost per unit. As the companyÊs
management accountant, you have been asked to provide explanations for the
disappointing September results.

Bank Management develops its flexible budget on the basis of budgeted per-
output-unit revenue and per-output-unit variable costs, without detailed analysis
of budgeted inputs.

Question 2
Based on the scenario above, prepare a flexible-budget-based variance analysis of
the September performance, and explain why Bank Management might find the
flexible-budget-based variance analysis more informative than the static-budget-
based variance analysis.

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132  TOPIC 8 FLEXIBLE BUDGETS

Drury, C. (2015). Management and cost accounting (9th ed.). Cengage Learning.

Horngren, C. T., Datar, S. M., & Rajan, M. V. (2015). Cost accounting: A


managerial emphasis (Global Edition 15th ed.). Pearson Education Limited.

Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J.
O. (2014). Introduction to management accounting (Global Edition 16th
ed.). Pearson Education Limited.

Copyright © Open University Malaysia (OUM)


Topic  Standard
9 Costing and
Variance
Analysis
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Identify different types of standards;
2. Compute and interpret materials price and efficiency variances;
3. Compute and interpret labour rate and efficiency variances;
4. Compute and interpret overheads variances analysis; and
5. Conduct and evaluate variance investigation.

 INTRODUCTION
This topic will be based on Flexible Budgets and will conduct multiple variance
analysis, such as, Materials, Labour and Overheads Variances. To be more
specific, variances, such as, Direct Materials Price and Efficiency Variances,
Direct Labour Price and Efficiency Variances, Variable Overheads Spending and
Efficiency Variance, and Fixed Overheads Spending and Production-volume
Variances. We will also be discussing the use of variances to the management of
an organisation. Lastly we will be discussing the importance of variance analysis
in benchmarking where the interrelationship of all the variances will be vital for
an organisationÊs efficiency and sustainability.

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134  TOPIC 9 STANDARD COSTING AND VARIANCE ANALYSIS

9.2 STANDARD COST AND VARIANCE


ANALYSIS
As discussed in Topic 8, Standard Costing and Variance Analysis is a system
which enables us to analyse Flexible Budgets in greater detail. Thus, enabling
costs and revenues to be controlled effectively. Standard Costs are used to
prepare the budgets of an organisation and compared later to the actual data to
find the variance of the standard and actual, if any.

A Standard Cost is generally determined very tactfully as it looks into the price,
cost or quantity used as a benchmark for the purpose of performance evaluation
and is very commonly stated on the basis of per unit. For example, a standard
input can be the quantity of input, such as, 1kg of raw material or one direct
labour hour for the output. A standard input can also be the standard price that
an organisation pays for, perhaps, RM5 per direct labour hour. A standard cost is
a budget for one simple unit of product and it simplifies product costing.

SELF-CHECK 9.1

Do you think that the terms standard cost and budgets are the same?

9.2 FLEXIBLE BUDGET VARIANCE


The total variance for each cost item is commonly analysed from its price and
quantity component. The price variance is the difference between the actual cost
incurred and the budgeted cost based on the actual input. The Quantity Variance
is the difference between the Budgeted Cost and the Standard Cost allowed for
the actual outputs of the finished goods.

Direct Material and Direct Labour Variances can be further divided into price
variance and efficiency variance. These two variances assist in explaining the
reasons why the actual cost will differ from the budgeted cost figures.

SELF-CHECK 9.2

Can we do variance analysis using static-budgeted information?

Copyright © Open University Malaysia (OUM)


TOPIC 9 STANDARD COSTING AND VARIANCE ANALYSIS  135

9.2.1 Materials Price and Efficiency Variances


Figure 9.1 shows the types of Materials Variances.

Figure 9.1: Types of materials variances

The price variance reflects the difference between an actual input price and a
(standard) budgeted input price. The equation for the materials price variance is
as follows. The quantity of materials should be the actual purchased quantity.

 
Materials price Actual Price Standard Price  Actual Quantity of
variance    Input
 Unit Unit 

The efficiency variance shows the difference of the actual input quantity and the
standard quantity of input. At times, the Direct Material Variance is known as
the Usage Variance. The quantity of materials should be the actual used quantity.
The equation for the material efficiency variance is as shown:

Materials efficiency variance = (Actual Quantity of Input ă Budgeted Quantity


of Input)  Standard Price of Input

ACTIVITY 9.1

1. Use McDonaldÊs as an example and let us assume that the material


price variance and material usage variance are favourable. Give
your justifications for the favourable variances.

2. Take Proton Berhad as an example and let us assume that the


material price variance and material usage variance are
unfavourable. Give your justifications for the unfavourable
variances.

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136  TOPIC 9 STANDARD COSTING AND VARIANCE ANALYSIS

9.2.2 Labour Rate and Efficiency Variances


Figure 9.2 shows the types of Labour Variances.

Figure 9.2: Types of Labour variances

The Rate Variance shows the difference between an actual input of labour rate
and a (standard) budgeted input of labour rate. The equation for the Labour Rate
Variance is as follows:

Labour rate  Actual Rate Standard Rate  Actual Hours of Labour


variance      (such as direct labour hours
 Hour Hour 
applied)

The Efficiency Variance shows the difference between an actual input of labour
hours and a standard input of labour hours. The equation for the Labour Price
Variance, also at times known as Labour Rate Variance, is:

Labour efficiency variance = (Actual Labour Hours ă Budgeted Labour Hours) 


Standard Rate of Labour applied)

ACTIVITY 9.2

1. Take Samsung Electronics as an example, let us assume that the


Labour Rate Variance and Labour Efficiency Variance are
favourable. Give your justifications for the favourable variances.

2. Use OUM as an example, let us assume that the Labour Rate


Variance and Labour Efficiency Variance are unfavourable. Give
your justifications for the unfavourable variances.

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TOPIC 9 STANDARD COSTING AND VARIANCE ANALYSIS  137

9.2.3 Overheads Variances


Managing Overhead Costs is not as simple as managing the other Direct Cost,
such as, materials and labour. Decision makers must understand how overhead
costs behave, plan for the overhead costs, perform variance analysis and act on
the feedback of the variances. Figure 9.3 depicts the overview of the Overheads
Variance:

Figure 9.3: The overview of the overheads variance

In planning Variable Overhead Costs, decision makers have to direct the


attention to creating quality product or service, and also to reduce any non-value
added activities. Examining how every item of variable overheads delivers a
quality product or service is part of this process. Therefore an effective plan for
fixed overhead costs is also vital for planning the variable overheads.

Deciding on the appropriate level of capacity that benefits the organisation in the
long run, and timing is an important issue in this planning. Normally, most
decisions regarding fixed costs will have already been made at the beginning of
the budget time frame. But for variable costs, the daily operating decisions affect
the level of variable costs incurred in a given time frame. It is important to note
that the level of fixed costs must be determined in advance of the budget time
frame and this fixed cost is locked in for a medium to long term; therefore; the
decision making process may impact an organisationÊs profitability when fixed

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138  TOPIC 9 STANDARD COSTING AND VARIANCE ANALYSIS

cost is involved. A common definition for fixed overhead costs is total costs that
remain constant for a specific time frame even though there is a change in the
level of activity within a given relevant range. In other words, Fixed Costs are
fixed in the sense that they donÊt really increase or decrease in a straight line with
the activity level within a given relevant range.

The method of Standard Costing tracks the direct costs of a product to the output
of the product. This is achieved by multiplying the standard prices of the inputs
for the actual outputs produced, by the standard quantities for the actual outputs
produced.

Figure 9.4 shows the common steps to develop budgeted variable overheads
when information is available for standard quantities of inputs for actual
outputs.

Figure 9.4: The common steps to develop budgeted variable overheads when information
is available for standard quantities of inputs for actual outputs

Firstly, we need to decide the time frame for the budget, generally a 12 monthsÊ
time frame for budgeting, but a shorter time frame may also be applied. Then, we
need to determine the cost allocation of required based variable overhead costs to
produced output. It is also common to find a cause and effect relationship
between the cost and its base or the cost driver, when we are selecting the cost
allocation bases. The third step is to find the variable overhead costs linked to
each of the allocation bases. Finally, we need to calculate the per unit rate for all
cost allocation bases used to allocate the variable overhead costs to the produced
output.

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TOPIC 9 STANDARD COSTING AND VARIANCE ANALYSIS  139

9.2.4 Variable Overheads Flexible-Budget Variances


The Variable Overheads Flexible-budget Variance measures the difference between
actual variable overhead costs incurred and the Flexible-budget Overhead
amounts.

Variable overheads flexible-budget variance = Actual costs incurred ă Flexible


budget amount

This variance reveals how much variable overhead costs differ from the flexible
budget amount. However, it does little to explain why this difference has
occurred. To learn why the variance arose, it needs to be divided into two
components, namely variable overheads efficiency variance and the variable
overheads spending variance.

The Variable Overheads Efficiency Variance measures the difference between


actual quantities of the cost-allocation base used and budgeted quantities of the
cost-allocation base that should have been used to produce actual output. It is
important to note that. The Variable Overheads Efficiency Variance measures the
efficiency with which the cost allocation base is used. The Variable Overheads
Efficiency Variance is as shown:

Variable overheads efficiency variance = (Actual Quantity of Allocation Base ă


Standard Quantity of Allocation Base
allowed for actual output)  Standard
Price

The variable overheads spending variance is the difference between actual


variable overhead cost per unit of the cost allocation base and budgeted variable
overhead cost per unit of the cost allocation base. The variable overheads
spending variance arises because the items that make up variable overhead cost
are either more or less than what was budgeted. The Variable Overheads
Spending Variance is as shown:

Variable overheads spending variance = (Actual Price of Allocation Base ă


Standard Price of Allocation Base) 
Actual Quantity

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140  TOPIC 9 STANDARD COSTING AND VARIANCE ANALYSIS

9.2.5 Fixed Overheads Flexible-Budget Variances


As Fixed Costs are not affected by the changes in the output level, the Flexible
Budget value for Fixed Costs is the part of the static budget, is commonly
prepared at the beginning of a given time frame.

The variance of the Fixed Overheads Flexible-Budget is formed by calculating the


difference between the Actual Fixed Overhead Costs and Budgeted Fixed
Overhead Costs in the Flexible Budget (see the following equation).

Fixed overheads flexible-budget variance = Actual costs incurred ă Flexible


budget amount

The equation (formula) for the fixed overheads spending variance is given as
follows:

Fixed overheads spending variance = Actual costs incurred ă Flexible budget


amount

9.2.6 Production Volume Variance


The Production Volume Variance is calculated only for the Fixed Overhead
Costs, and this variance is calculated by finding the difference between the
Budgeted Fixed Overheads and the Fixed Overheads allocated based on the
number of units produced. The equation is as follows:

Production Volume Variance = Budgeted fixed overheads ă Fixed overheads


allocated for actual output

The Production Volume Variance indicates the usage of capacity. If the


organisation exceeds planned capacity, the variance becomes favourable. This is
because when this happens it is understood that the fixed overheads is divided
by a larger number of production units. On the other hand, if the organisation
falls short of planned capacity, the variance is unfavourable, as there is unused
capacity. If the Production Volume Variance is a favourable variance, it indicates
that overheads are over-allocated, and if unfavourable, it means that overheads
are under-allocated.

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TOPIC 9 STANDARD COSTING AND VARIANCE ANALYSIS  141

9.3 VARIANCE IN DECISION MAKING


The management or decision makers in an organisation are able to use variance to
make key decisions pertaining to costs, especially materials, labour and overhead
costs. Variance can be used by management to evaluate the performance of the
executive or the decision maker after a specific decision is implemented.

The feedback received for the reasons for the variances can also assist the
knowledge of the organisation, the department and the specific decision maker in
improving future decision-making. This ability of knowing and acting on the
feedback will enable the organisation to continuously apply improvements in the
processes of buying and using materials, hiring and paying labour, as well as,
overheads planning.

This continuous improvement is a feeder for benchmark setting by the


organisation, as a continuous process of comparing the different levels of
performance in producing products and services with the best practices among
similar competitors. The organisation and decision makers will be able to assess
the level of their competitiveness against the rivals in the industry by comparing
standards set in the benchmarks.

It is important to note that variances are not supposed to be interpreted


individually; it is vital for it to be discussed within a whole group of variances for
better understanding of the organisationÊs costs, because the reason of a
particular variance, let us say, Materials Usage Variance, may be linked to
another, the Labour Rate Variance.

As a more specific example, a Favourable Materials Price Variance may give rise
to an Unfavourable Efficiency Variance if the cheaper material of lower quality is
used. This may result in an Unfavourable Labour Efficiency Variance, as the
labour may find the lower quality material consumes more time and hence
higher usage of the material. A favourable Direct Materials Efficiency Variance
may be due to an experienced workforce but experienced workers are paid more
and there may be an Unfavourable Direct Labour Price Variance.

Variances should be investigated if they are favourable or unfavourable, as


results are obviously different from expectations. There is no hard and fast rule
on this, but a concept of „Management by Exception‰ (MBE) can be applied here.
Therefore, it is also important to investigate favourable variances, as well as,
unfavourable variances. For example, all variances resulting from higher hours of
labour have to be investigated, even though the amount is relatively small.

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142  TOPIC 9 STANDARD COSTING AND VARIANCE ANALYSIS

SELF-CHECK 9.3

Why Is Variance Analysis important?

ACTIVITY 9.3

Baba Berhad is a manufacturing firm.


Given below are the products standard costs per-unit for the year 2016:

RM
Direct materials ă 2 kilograms of plastic at RM5 per kilogramme 10
Direct labor ă 2 hours at RM12 per hour 24
Variable manufacturing overheads 12
Fixed manufacturing overheads 6
Total standard cost per unit 52

Actual costs for the month ending January 2016 in producing 7,400 units
were as follows.

RM
Direct materials (15,000 kilograms) 73,500
Direct labour (14,900 hours) 181,780
Variable overheads 88,990
Fixed overheads 44,000
Total manufacturing costs 388,270

Required:
Materials Price and Materials Usage Variances, and Labour Rate and
Labour Efficiency Variances.

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TOPIC 9 STANDARD COSTING AND VARIANCE ANALYSIS  143

 In a Standard Cost System, inputs are recorded as standard. The impact of


this is that the variances are isolated and recorded in the accounting system.
In addition to simplifying product costing, this procedure draws attention to
the variances.

 Managerial performance evaluation occurs in two dimensions, that is,


effectiveness and efficiency, and what becomes visible (variances) is more
likely to receive management attention.

 Effectiveness is the level where planned objectives or targets are met, and
efficiency is when considerable amount of inputs are used to achieve a given
output level.

 Variances assist organisational learning and managers need to understand


why variances happen, learn from them, and improve future performance.

 Variances are used to establish a loop of continuous improvement by


identifying what causes variances, initiating corrective actions, and finally
evaluating the results of those actions.

 Most companies utilise a mix of financial and non-financial measures for


planning and control. Focusing on one or the other can result in an undue
emphasis on that measure.

 A variance is defined as the difference between the actual results and


budgeted targets. An analysis of the variances allows decision makers to
apply management by exception.

 When decision makers apply management by exception, they are able to


focus on areas that are under-performing from expected and put in lesser
efforts on areas that are operating well. Variances can assist decision makers
predict the future with calculated understanding, and improve the decision-
making process, so that the decisions made are based on the best available
information.

 Variance and its analysis are formed for materials purchases, materials usage,
labour rate, labour efficiency, variable overheads and fixed overheads.

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144  TOPIC 9 STANDARD COSTING AND VARIANCE ANALYSIS

Fixed Overheads Variance Materials Price Variance


Flexible Budget Materials Usage Variance
Flexible Budget Variances Standard Cost
Labour Efficiency Variance Sales-Volume Variances
Labour Rate Variance Variable Overheads Variance

Question 1
Based on the scenario below, compute the price and efficiency variances for the
three categories of direct materials, and for direct manufacturing labour in July
2014.

Sunto Scientific manufactures GPS devices for a chain of retail stores. Its most
popular model, the Magellan XS, is assembled in a dedicated facility in
Savannah, Georgia. Sunto is keenly aware of the competitive threat from smart
phones that use Google Maps, and has put in a standard cost system to manage
production of the Magellan XS. It has also implemented a just-in-time system so
that the Savannah facility operates with no inventory of any kind.

Producing the Magellan XS involves combining a navigation system (imported


from SuntoÊs plant in Dresden at a fixed price), an LCD screen made of polarised
glass, and a casing developed from specialty plastic. The budgeted and actual
amounts for Magellan XS for July 2014 were as follows:

Budgeted Amounts Actual Amounts


Magellan XS units produced 4,000 4,400
Navigation system cost RM81,600 RM89,000
Navigation systems 4,080 4,450
Polarised glass cost RM40,000 RM40,300
Sheets of polarised glass used 800 816
Plastic casing cost RM12,000 12,500
Ounces of specialty plastic used 4,000 4,250
Direct manufacturing labor costs RM36,000 RM37,200
Direct manufacturing labor-hours 2,000 2,040

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TOPIC 9 STANDARD COSTING AND VARIANCE ANALYSIS  145

The controller of the Savannah plant, Jim Williams, is disappointed with the
standard costing system in place. The standards were developed on the basis of a
study done by an outside consultant at the start of the year. Williams points out
that he has rarely seen a significant unfavourable variance under this system. He
observes that even at the present level of output, workers seem to have a
substantial amount of idle time. Moreover, he is concerned that the production
supervisor, John Kelso, is aware of the issue but is unwilling to tighten the
standards because the current lenient benchmarks make his performance look
good.

Question 2
Based on the scenario above describe the types of actions the employees at the
Savannah plant may have taken to reduce the accuracy of the standards set by
the outside consultant. Why would employees take those actions? Is this
behaviour ethical?

Drury, C. (2015). Management and cost accounting (9th ed.). Cengage Learning.

Horngren, C. T., Datar, S. M., & Rajan, M. V. (2015). Cost accounting: A


managerial emphasis (Global Edition 15th ed.). Pearson Education Limited.

Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J.
O. (2014). Introduction to management accounting (Global Edition 16th
ed.). Pearson Education Limited.

Copyright © Open University Malaysia (OUM)


Topic  Responsibility
10 Accounting

LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Describe the different types of responsibility centres;
2. Compute and evaluate performance measurement and reporting;
and
3. Discuss and evaluate the Balance Scorecard.

 INTRODUCTION
This topic will be based on the responsibility accounting budgets that are common
and budgets created with responsibility accounting. Responsibility accounting is
the practice of holding managers or decision makers responsible for the activities
and performance of responsibility centres, for example, a department. Where there
are significant variations from the budget, the manager of the Responsibility
Centre is accountable for such variations. A responsibility accounting system is
built around a framework of responsibility centres and a responsibility centre is a
subunit in an organisation whose decision maker is responsible and accountable
for his or her activities and performance.

Organisation structure shows the order of responsibility lines within an


organisation and these lines of responsibility differ according to the type of
organisation structure.

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TOPIC 10 RESPONSIBILITY ACCOUNTING  147

10.1 RESPONSIBILITY CENTRES


A responsibility centre is a part of an organisation where the decision maker is
accountable for a specified given task. We can subdivide responsibility centres
into Cost Centre, Revenue Centre, Profit Centre and Investment Centre.

Cost Centre is a subunit where the decision maker is held accountable for any
costs incurred in that subunit. Most factory departments and the warehouse are
typical cost centres. Revenue Centre is a subunit where the decision maker is
held responsible for revenue generated by that subunit. Profit Centre is a subunit
where the decision maker is held responsible for the profit of that subunit. A
Profit Centre may have cost and revenue centres as subordinate divisions or
departments. Investment Centre is a subunit where the decision maker is held
responsible for any profit generated, and any capital invested to generate a
profit in that subunit of a large organisation. A division of an organisation is
responsible for manufacturing, pricing and marketing products, and making
decisions regarding purchase of equipment, expansion of capacity and
introducing new products.

A responsibility accounting system focuses on the two major dimensions of


budgeting (refer to Figure 10.1):

Figure 10.1: The two major dimensions of budgeting

The first is the mechanics of budgeting that is concerned with the methods
of preparing the budget, and the second is the behavioural implication of
the budgetary control system, which is concerned with how managers and
employees are affected by performance appraisal through budgets.

SELF-CHECK 10.1

What are Responsibility Centres?

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148  TOPIC 10 RESPONSIBILITY ACCOUNTING

10.2 BALANCED SCORECARD


Management Control System is a method applied to source out and use
information to assist and coordinate planning and control decisions throughout
an organisation. Many organisations design the management control system by
using the balanced scorecard concept where the financial and non-financial
information in each of the four perspectives of the scorecard are applied.

Figure 10.2 shows the four perspectives with examples under the Balanced
Scorecard, namely:

Figure 10.2: The four perspectives of a balanced scorecard

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TOPIC 10 RESPONSIBILITY ACCOUNTING  149

10.2.1 Financial Perspective


Financial perspective will evaluate the level of profitability generated by
implementing a strategy. For example, the financial perspective looks into the
amount of operating income and return on capital employed that is generated by
cutting costs and by increasing sales.

Financial perspective is focused on the financial gain and also survival of an


organisation. Therefore, Ratio Analysis will be a common tool used to address
the financial well-being of an organisation. Ratios, such as, liquidity, return on
capital, gross profit margin and interest cover will be utilised to ascertain the
level of readiness of an organisation to maintain or to achieve the desired level of
growth, funding, profitability and efficiency.

The financial perspective of an organisation is linked to the other three


perspectives of the balanced scorecard and the customer perspective is discussed
next.

10.2.2 Customer Perspective


Customer perspective identifies the targeted market segments and measures
the companyÊs success in these segments. For example, a university may use
measures, such as, market share in the adult education segment, number of new
students, and studentsÊ level of satisfaction.

By looking at the goals of the organisation and the predictors of achieving those
goals, customer perspective looks at the ability of the organisation to respond to
the needs of the customers, in a time line that is acceptable to the industry or the
organisationÊs standards. To satisfy the needs and demands of the customer, the
organisation might want to look into the reliability of the delivery network to
reach its customers within the agreed contract terms.

These positive responses will enhance the image of the organisation in its
customersÊ sphere, as well as, improving the demand for its products in the
market that the organisation serves, or create new markets when the quality of
the services and products surpass the normal standards.

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150  TOPIC 10 RESPONSIBILITY ACCOUNTING

10.2.3 Internal Business Processes Perspective


Internal business process perspective focuses on internal operations that
improves the customer perspective by creating value for customers and also
improves the financial perspective by increasing the wealth of the shareholder.
The internal business process perspective includes three principals (refer to
Figure 10.3):

Figure 10.3: Three principals of the internal business processes perspective

10.2.4 Learning and Growth Perspective


Learning and growth perspective looks into which abilities the organisation
should improve, to achieve better internal processes that will create value for
customers and shareholders. For example, learning and growth perspective can
be emphasised on three different capabilities, as follows:

(a) Employees ă based on level of education and skill, surveys of employee


satisfaction, the level of employee turnover and employee productivity;

(b) Information System ă based on the level of on-line access to customersÊ


information and level of on-line interaction with customers with quick
responses; and

(c) Motivation and Empowerment ă based on the number of suggestions given


by employees and its implementation, as well as, any incentives given.

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10.2.5 Critical Success Factors


Each goal in improving the performance is monitored by unique performance
indicators, where each indicator, known as Critical Success Factors (CSFs) or Key
Performance Indicators (KPIs), has its own target. Specific targets are set for the
desired performance level of each indicator. The indicated targets are generally
on the higher side but attainable, and if the targets are not appropriately set,
it can also have a negative impact on employeesÊ motivation and their
performance. All these efforts are required to be in a proper written design so
that the execution of it is easy and traceable.

It is not necessary to have four objectives for all of the perspectives, as the focus
is to manage the objectives and follow through to successfully attain them.
Balanced scorecards are supposed to be flexible and need to fit the organisation
using them. Duplication of indicators should be avoided; therefore no indicators
should be used more than once on the scorecard.

The goals listed should give a broad perspective of activities. Table 10.1 shows
the four perspectives of the balanced scorecard with examples of their possible
application.

Table 10.1: Four Perspectives of the Balanced Scorecard with Examples of Their Possible
Application

Perspective Corporate Goal Performance Indicator Target


Financial Survival Liquidity ratio Increase to 1.6: 1.0.
Profitability Return on capital Improve by 8% over the
employed year.
Growth Sales revenue Increase by 5% a year
Self-funding Interest cover ratio Reduce interest payment
to 5% of operating profit
Customer Responsiveness Sales order processing Reduce to 24 hours
period
Reliability On-time deliveries 99% each month.
Product quality Complaints received 0.5% of goods delivered
each month
Image Ranking by customer CustomerÊs preferred
choice

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152  TOPIC 10 RESPONSIBILITY ACCOUNTING

Internal Satisfied Staff turnover ratio 1% per year.


business employees
Production Output per employee Increase by 2%/year.
efficiency
Working capital Cash cycle period Reduce by 1 day/year.
management
Quality of Value of defective Reduction of 1%/year.
production production
Learning and Continuing Proportion of sales 10% of annual sales from
growth introduction of from new products products launched in
new products current year.
Staff Number of training 40 hours per
development hours per employee year/employee
Product Number of new At least one new market
diversification markets per year.
Product Funding on research Minimum of 5% a year
improvement and development of after-tax profits.

SELF-CHECK 10.2

What are the four perspectives of a Balanced Scorecard?

ACTIVITY 10.1

List down two performance indicators for each of the four perspectives
of a Balanced Scorecard.

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TOPIC 10 RESPONSIBILITY ACCOUNTING  153

10.2.6 Advantages of a Balanced Scorecard


A well-prepared Balanced Scorecard describes the strategies of an organisation
by articulating multiple cause and effect relationships. All the measures in the
scorecard form a part of a cause and effect link, and a connection to come out
with strategies towards the financial outcomes. A Balanced Scorecard also helps
to communicate the strategy to all members of the organisation by making the
strategy an interconnected set of attainable and measurable operational targets.
Based on the scorecard, employees of the organisation can make decisions that
will achieve the strategy of the organisation.

The Balanced Scorecard puts strong emphasis on financial objectives and its
measures. A Balanced Scorecard emphasises non-financial measures as part of a
program to achieve future financial performance. When financial and non-
financial performance measures are connected, it is able to measure the non-
financial attributes as the main indicators of future financial performance.

Only the most critical areas need to be focused on and used in the process of
implementing the organisationÊs strategies. The scorecard also highlights any
improper decisions that decision makers make if they were unsuccessful in
considering operational and financial measures coherently. Let us say, an
organisation, for which innovation is vital for its survival may attain desired
short-term financial performance by cutting down research and development
expenditure. Therefore, a good balanced scorecard will indicate that the short-
term financial performance is attained by implementing decisions that impacts
future financial performance negatively because a leading indicator of that
performance that is the research and development expenditure and research and
development output has reduced.

10.2.7 Disadvantages of a Balanced Scorecard


Cause and effect are just hypotheses and it is easy to identify the strength and
speed of the causal connections among the non-financial and financial measures.
With experience, organisations should change their scorecards to include those
non-financial objectives and measures that are the best leading indicators of
subsequent financial performance.

We are unable to expect improvements across all the measures all the time. This
approach may not be appropriate because trade-offs are required to be made
across many strategic goals. For example, emphasising quality and speed of
response beyond an expected target might not be needed, as greater
improvement in these objectives may not be consistent with maximising the
profit agenda.
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154  TOPIC 10 RESPONSIBILITY ACCOUNTING

The use of subjective measures are common in a balanced scorecard but the
management should also be concerned with the benefits trade-off of more
information in the decision-making process, as these measures might be
subjected to possible manipulation and mislead the users of the information.

If one is not careful, a Balanced Scorecard might not consider both costs and
benefits of initiatives, such as, spending on information technology and research
and development, as well as, the possibility that the balanced scorecard might
ignore the non-financial measures when evaluating managers and employees.
When non-financial measures are excluded, the decision makers will also give
lesser importance to non-financial scorecard measures when they evaluate the
performance of the organisation.

10.3 RETURN ON INVESTMENT (ROI)


The rate of Return on Investment (ROI) is a common measurement tool applied
to evaluate Investment Centres; that is, profits divided by investment. The
purpose of doing so is to give incentives so that the level of profits can be
increased and at the same time manage the resources that are attached to an
organisation.

An average operating asset which is the denominator in the ROI formula should
be net of operating assets, such as, cash, accounts receivable, inventory, property,
plant and equipment and all other assets that are used for operations in an
organisation.

Based on the format, the ROI shows important information on the conduct of an
entity. On a general note, the ROI across a given industry should be similar in the
long term, as it will always reach equilibrium and even out. Whenever the ROI is
above the industry average, funding will flow in to that particular industry,
which will eventually equal the ROI of other industries. Commonly, margins of
an industry with huge turnovers are comparatively small, and vice versa.

The ROI formula is as follows:

ROI  Margin  Turnover

 Net Operating Income   Sales 


ROI      
 Sales   Average Operating Assets 

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TOPIC 10 RESPONSIBILITY ACCOUNTING  155

Example 10.1 represents the results of operations for the most recent month.

Example 10.1

Net operating income RM10,000


Sales RM100,000
Average operating assets RM50,000

RM10,000 RM100,000
ROI  
RM100,000 RM50,000
 10%  2 times
 20%

A decision maker or a manager is able to expand the ROI of an organisation by


increasing sales or reducing expenses or reducing assets. The organisation can
also have all the three combinations to improve the ROI further. Due to the
element of fixed cost, the margin and turnover increase due to the increase in
sales. Generally the Fixed Cost will not increase in tandem with the sales
increment; therefore, the margin should increase as the net operating income
increases faster than sales. A decrease in expenses will result in an increase in net
operating income which in return also increases the margins. Putting into
perspective the real economic climate, decision makers regularly utilise this cost
cutting measure during times of distress. By cutting costs the morale of
employees might decline, and the way forward is to be always lean and mean
from the very beginning.

10.4 RESIDUAL INCOME (RI)


Residual Income (RI) is the accounting measurement method of income minus an
amount for a required return of investment. Therefore, RI can be understood as a
net income minus a charge for the use of the organisationÊs or departmentÊs
assets. The required rate of return is the minimum return that the organisation is
able to accept on the amount the organisation has invested on the asset. The cost
of the investment can be derived by multiplying the required rate of return with
the invested amount.

Sometimes, residual income is preferred as RI allows us to focus on an absolute


amount (in money value) of return instead of a percentage return.

Residual Income (RI) = Income ă (Required rate of return  Investment)

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156  TOPIC 10 RESPONSIBILITY ACCOUNTING

Example 10.2 shows an example of ROI and RI, as well as, Rate of Return.

Example 10.2
Selected sales and operating data of three divisions of the three different services
companies are given below:

Division A Division B Division C


Sales (in RM) 6,000,000 10,000,000 8,000,000
Average operating assets (in RM) 1,500,000 5,000,000 2,000,000
Net operating profit (in RM) 300,000 900,000 180,000
Minimum required rate of return 15% 18% 12%

(a) Compute the Return on Investment (ROI) for each division.

(b) Compute the Residual Income for each division.

(c) Assume that each division is given an investment opportunity that would
yield a 17% Rate of Return.

(i) If the performance is being measured by ROI, explain and discuss


which division or divisions would accept and which would reject the
opportunity; and

(ii) If the performance is being measured by residual income, explain and


discuss which divisions would probably accept and which would
reject the opportunity.

Solution to Example 10.2

(a) Computation of ROI

Division A:

RM300,000
ROI   100  20%
RM1,500,000

OR

RM300,000 RM6,000,000
  5%  4  20%
RM6,000,000 RM1,500,000

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TOPIC 10 RESPONSIBILITY ACCOUNTING  157

Division B:

RM900,000
ROI   100  18%
RM6,000,000

OR

RM900,000 RM10,000,000
  9%  2  18%
RM10,000,000 RM5,000,000

Division C:

RM180,000
ROI   100  9%
RM2,000,000

OR

RM180,000 RM8,000,000
  2.25%  4  18%
RM8,000,000 RM2,000,000

(b) Computation of Residual Income

Division A Division B Division C

Average operating assets RM1,500,000 RM5,000,000 RM2,000,000


Required rate of return  15%  18%  12%
Required operating income RM225,000 RM900,000 RM240,000
Actual operating income RM300,000 RM900,000 RM180,000
Required operating income RM225,000 RM900,000 RM240,000
Residual income RM75,000 0 (60,000)

(c) Accept or Reject

(i) Based on the ROI method in measuring performance, Division A and


Division B will most likely reject the 17% investment opportunity.
This is because both these divisions are currently able to earn returns
higher than 17%, and therefore the proposed investment will reduce
the overall rate of return and have a negative impact on the divisional
managerÊs reputation as a manager;

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158  TOPIC 10 RESPONSIBILITY ACCOUNTING

(ii) On the other hand, division C most likely will accept the 17%
investment opportunity, as Division CÊs level of acceptance will
increase the DivisionÊs overall rate of return;

(iii) Let us say residual income is the measurement of performance, then


Division A and Division C will most likely accept investment
opportunity of 17%, as the rate of return of 17% indicated by the
proposed investment is higher than the required rate of return of 15%
and 12% set by the respective divisions. This will therefore increase
the accumulated figure of the residual income of the divisions; and

(iv) On the other hand, division B will most likely reject the opportunity,
as the return on the proposed investment of 17% is lower compared to
Division BÊs required rate of return of 18%.

ACTIVITY 10.1

LaRo Sdn Bhd has two offices in business that operate in Singapore and
HK. Given the data below, you are required to:

Offices
Singapore HK
Sales RM20,000,000 RM50,000,000
Average operating assets RM15,000,000 RM25,000,000
Net operating income RM1,300,000 RM1,500,000

(a) Compute the Return on Investment (ROI) for each office, clearly
showing the Margin and Turnover; and

(b) If the organisation evaluates performance by the use of residual


income, and the lowest required return for any office is 8%,
calculate the residual income for both offices.

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TOPIC 10 RESPONSIBILITY ACCOUNTING  159

 Responsibility accounting is a concept that measures the plans, budgets,


actions, and actual results of each responsibility centre.

 In a Cost Centre the decision maker is only responsible for costs, and the
accounting department would be a cost centre.

 In a Revenue Centre the decision maker is only responsible for revenues.

 In a Profit Centre the decision maker is only responsible for revenues and
costs.

 In an Investment Centre the decision maker is not only responsible for


revenues and costs but also the investment (or assets) under the decision
makerÊs control. A single division in an organisation can be an investment
centre.

 A divisionalised organisation structure is one where the organisation is split


into divisions in accordance to the products it produces/services it provides.
Each division manager is then responsible for all the operations relating to a
particular product/service.

 The Balanced Scorecard is a tool used to assist decision makers to improve an


organisationÊs performance in tandem with the goals of an organisation.

 Investment refers to the resources or assets used to generate income.


Comparison of operating income is an insufficient measure; managers must
determine if the division is able to earn enough operating income compared
to the investment made.

 Return on Investment (ROI) is a method used in accounting to measure the


required return on a given investment. ROI is derived when income is
divided by the amount of investment, also given as „ROI = Return on sales 
Investment turnover‰.

 ROI helps the manager to see if the divisionÊs need is to improve the return
on sales or if they need to work on the efficiency in using their assets.

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160  TOPIC 10 RESPONSIBILITY ACCOUNTING

Balanced Scorecard Residual Income (RI)


Cost Centre Responsibility accounting
Investment Centre Return on Investment (ROI)
Profit Centre Revenue Centre

Selected sales and operating data of three departments of the three different
services companies are given below:

Corning Devices Display


Sales (in RM) 16,000,000 20,000,000 32,000,000
Average operating assets (in RM) 3,500,000 8,000,000 10,000,000
Net operating profit (in RM) 900,000 2,000,000 3,000,000
Minimum required rate of return 10% 12% 15%

(a) Compute the return on investment (ROI) for each department; and

(b) Compute the residual income for each department.

Drury, C. (2015). Management and cost accounting (9th ed.). Cengage Learning.

Horngren, C. T., Datar, S. M., & Rajan, M. V. (2015). Cost accounting: A


managerial emphasis (Global Edition 15th ed.). Pearson Education Limited.

Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J.
O. (2014). Introduction to management accounting (Global Edition 16th
ed.). Pearson Education Limited.

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