ACCA FIA MA2.pdf

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FIA – MA2

Management Accounting – 2For exams in 2014

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ExPress NotesFIA MA2 Management Accounting

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Contents

About ExPress Notes 3

1. Management Information 7

2. Cost Recording 14

3.

Costing Techniques 20

4. Decision making 33

5. Cash management 47

6. Spreadsheets 50


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Chapter 1

Management Information

KEY KNOWLEDGEManagement Information Requirements

Purpose of Management Information

Planning: has to do with the formulation of objectives within the organization, both in the

short- and long-term (see below).

Decision-making: refers to conclusions drawn once all relevant information has been

analysed. Implementation of decisions taken (.e. the decision to take action) follows.

Control: Post-implementation, actual results are analysed in order to determine whether

planning and decisions taken need to be revised or to implement corrective actions.

The control step acts as a feedback loop into the previous processes. Remember, look at

theses systems dynamically: we learn from experience and need to take corrective steps and

to improve processes continuously!

The Features of useful management information


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The qualities of good information can be summarized in the word “ ACCURATE”:

Accurate,

Complete, Cost-beneficial,

User-targeted,

Relevant,

Authoritative,

Timely and

Easy to use

Financial and Non-financial information for managers

In addition to financial information which can be extracted from the financial accounting

records, managers rely for their decision-making on a host of information that is derived

from non-financial sources. These can range from industry data (overall size, market shares

of different competitors) to customer opinions about the products and services offered.

Internally, non-financial information can embrace a host of operational statistics which are

relevant to managerial decision-making: examples include the rate of staff turnover; the

time it takes to cook a hamburger (in a restaurant business); the rate of defects in a

production process; the set-up time necessary between different production batch runs; or

measurements of service/product quality.

Planning at different levels of the organisation

Strategic: Covers the “big view” of the organization and itsobjectives. Long-term in nature.

Tactical: Planning over the short-term (usually one year), and

typically in connection with budgeting processes.

Operational: Day-to-day decisions, implemented on-the-spot

and directly involving all levels of the organization.


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Management responsibilities

Responsibilities correspond to specific areas and functions within an organisation. They are

best understood in relation to the following diagram:

“Responsibility” centres

Cost centres: Responsible for current expenses only

Revenue centres: Responsible for revenues, but not current expenses other than marketing

expenses

Profit centres: Responsible for revenues and current expenses

Investment centres: Responsible for revenues, current expenses and capital expenditure

In order to competently manage his/her area of responsibility, a manager needs to have

relevant information (and authority) pertaining to their job function.

Relevant information not only supports decision-making, but also allows the performance of

the respective responsibility centre to be monitored, both by the (direct) managers in charge

as well as by the levels (above) to which they report.

The Role of Information technology

Information technology has had a dramatic and far-reaching impact on the structure andconduct of business. IT has also been frequently poorly employed at great cost tocompanies.

When implemented well, IT has made it possible for companies to exploit the benefits ofincreased accuracy of information and faster decision-making.

Cost Centres Profit Centres Investment CentresRevenue Centres


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Suitable formats for the presentation of management information according to purpose

Managerial accounting is a free-style form of accounting in which format and structure of

information are not prescribed externally, but conform to the requirements of the users(management and staff).

KEY KNOWLEDGE

Cost Accounting Systems

In order to understand the relationship between Management accounting and Financial Accounting systems, it is useful to summarize the differences between the two. Managementaccounting is:

Aimed at internal users (as opposed to financial accounting, which is aimed atexternal stakeholders)

Focused on present and future performance (as opposed to financial accounting,which reports past performance)

Not required by law and not regulated by accounting frameworks (as opposed tofinancial accounting, which is a legal requirement and is regulated by accountingframeworks)

Focused on specific areas or activities (as opposed to financial accounting, whichprovides a holistic view of company’s performance)

Employs non-financial indicators as well financial, while financial accounting usesonly financial measures.

Since the management accounting system is based on (or derived from) a company’sfinancial accounting system, the two are usually combined (or integrated) for reasons of

cost and efficiency, i.e. to avoid duplications.

Coding transactions

Transactions in a business are more easily processed by use of a coding system. This

involves assigning to a particular transation a code, i.e. a kind of symbolic label, which

identifies the nature of the transaction in a systematic and unambiguous way. In doing so,

this allows transactions to be grouped together in information systems, processed, added up

and analyzed in a manner that permits checking and reconciliation (against original records).


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The characteristics of a coding system shares some of the features of good information: it

must be standardized, logical, objective, brief (i.e. capable of being summarized), verifiable,

comprehensive and yet flexible (allowing development to cover all relevant situations in a

relevant manner).

Cost units: The units are the discreet items to be measured, such as packs of nails (batches)

or a student.

KEY KNOWLEDGE

Cost Classification

There are a variety of ways in which one can classify costs:

Production vs. Non-Production

Production costs: These are costs (both direct and indirect, also variable and fixed) which

relate to the production of goods; this is also referred to as manufacturing or factory cost. It

is these costs, accumulated, which provide the value at which goods are placed in inventory

(prior to sale) and form the “cost of goods” value when sold.

Non-production costs: These are expenses that are incurred independent of production and

include administrative, selling, distribution and finance costs. These costs can have the

character of “period” costs, as they relate to the period of time in which they occur.

Direct vs. Indirect

Direct costs: are costs that can be directly attributable to a product.

Indirect costs: these are costs that cannot be directly attributable to a product.

Fixed vs. variable


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Fixed costs: are costs that remain constant regardless of the volume of production. A variety

of indirect costs are fixed.

Variable costs: vary in proportion with the volume produced. Direct costs are by their naturevariable in behaviour.

Other types of costs

Mixed costs: these are costs that contain a fixed and a variable element.

Step costs: costs that remain fixed within a defined range of production, but at a certain

level of output increase in a significant way to a new (fixed) level.

High/Low Method

Analyze the following operating costs as a function of output:

Output Costs(units) ($)

1,000 250,000

1,200 295,0001,400 325,000

1,600 370,000

Take the maximum and minimum levels of output (the independent variable) and the

associated costs (dependent variable) and calculate the differences:

Output CostsMax 1,600 370,000Min 1,000 250,000Diff. 600 120,000

The variable cost per unit is: 200 (120,000/600)

Given the formula:

Total cost = Fixed cost + (Variable cost per unit x No. of units)

We can calculate the fixed cost

Fixed cost = 50,000


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The high-low method can also be applied to the following situations:

When fixed costs change (“step”) along the output range; and

When the variable cost per unit changes


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Chapter 2

Cost Recording

KEY KNOWLEDGE

Accounting for materials

Every company which buys, processes and sells materials will have established proceduresfor ordering, receiving and issuing (such materials) which are generically similar. Some mayhave highly automated systems in place, while others record the steps manually.

The key documents one should be familiar with are:

Purchase requisition form: This is an internal form that provides the authorization formaterials to be ordered from a supplier (external).

Purchase order (PO): The buyer issues a PO to the seller, indicating the

Description Quantity Price

of the product ordered.

The PO is a legal offer. Its acceptance by the seller creates a contractual commercialrelationship for the intended transaction.

http://en.wikipedia.org/wiki/Vendor_(supply_chain)http://en.wikipedia.org/wiki/Contracthttp://en.wikipedia.org/wiki/Contracthttp://en.wikipedia.org/wiki/Vendor_(supply_chain)


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Goods Received Note (GRN): This is completed by the buyer upon delivery to verify whetherthe order has been properly fulfilled. It will contain:

Order No. Description Quantity ordered Quantity delivered

Materials issuance (or requisition) form: This is the form necessary to authorize the releaseof materials from inventory into the production process at the company.

Materials

The ordering, receiving and issuing of materials from inventory must be controlled accordingto procedures and documented at all stages with forms appropriate to the purpose.

The controls and procedures are designed to monitor inventory movements so as to

minimise discrepancies and losses and theft.

Accounting entries

Materials Inventory

Debit (Dr) entries Credit (Cr) entries

= =

Increase in

inventory

Decrease in

inventory

Economic Order Quantity

Within a company, there is a natural temptation to accumulate buffer stocks (raw materials

and semi-finished goods) so that production is never interrupted.

Similarly, in order to avoid stock-outs, sales managers will insist on maintaining a plentiful

level of finished goods. All of this costs money.

The EOQ is a method which seeks to minimize the costs associated with holding inventory.

To determine the total costs, the following data is required:

Q = order quantity


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D = quantity of product demanded annually

P = purchase cost for one unit

C = fixed cost per order (not incl. the purchase price)

H = cost of holding one unit for one year

The total cost function is:

Total cost = Purchase cost + Ordering cost + Holding cost

which can be expressed algebraically as follows:

TC = P x D + C x D/Q + H x Q/2

It is this total cost function which must be minimized.

Recognizing that:

PD does not vary;

Ordering costs rise the more frequently one places (during the year); and

Holding costs rise the fewer times one places orders (due to larger quantities being

ordered each time),

It follows that there is a trade-off between the Ordering and the Holding costs.

The optimal order quantity (Q*) is found where the Ordering and Holding costs equal each

other, i.e.

C x D/Q = H x Q/2

Rearranging the above and solving for Q results in

EXAMPLE

A trucking company uses disposable carburettor units with the following details:


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Weekly demand 500 units

Purchase price USD 15 / unit

Ordering cost USD 40 / order

Holding cost 7% of the purchase price

Assume a 50 week year. What is the optimal order quantity?

The EOQ = 1,380 units

KEY KNOWLEDGE

Accounting for labour

Direct and Indirect Labour

Direct labour refers to work which is directly involved in the manufacture of a product.

Indirect labour (e.g. the supervisor’s salary, or that of a security guard) forms part ofoverhead costs.

It is important to note that the basic pay portion of direct labour costs is included in theprime cost of a product.

Overtime premiums, bonuses, employers’ contributions, sick pay and idle time costs relatingto direct workers are all accounted for as overheads (indirect costs). One exception:Overtime performed as a result of a client request is recorded as a direct labour cost.

Accounting for labour costs

Labour account

Debit (Dr) entries Credit (Cr) entries

= =Labour costsincurred Transfer to P&L

Note: The transfer to the P&L takes place via the Work-In-Progress (WIP) account for directlabour costs and the production overheads account in the case of indirect labour costs.


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Remuneration methods

There are two basic forms of remuneration:

Time-based, and

Output –based (e.g. piecework)

Effective incentive schemes are designed to ensure that the interests and behaviour ofindividual employees and groups of employees are in-line (i.e. consistent) with thecompany’s objectives.

Managerial metrics relating to labour

The key ratios to learn are:

Labour turnover

= No. of departing employees requiring replacement Average no. of employees

Labour efficiency

= Standard hours of output Actual hours worked

Labour capacity

= Actual hours workedTotal budgeted hours

Labour production volume

= Standard hours of outputTotal budgeted hours

This last ratio is the result of multiplying the labour efficiency with the labour capacity ratio.


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KEY KNOWLEDGE

Accounting for other expenses

Direct and Indirect costs

Traditionally, accountants maintain that costs have to be charged to whatever is being

costed – the goal is ultimately to link costs to the units of product themselves:

Direct costs are not a problem as they are directly attributable to the product.

Indirect costs – in this context referred to as “overheads” -- are more difficult to link toproducts (e.g. a supervisor’s salary or a security guard).


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Chapter 3

Costing Techniques

KEY KNOWLEDGE

Absorption costing

This is one method which seeks to make the link between overheads and (product) cost

units. The diagram below provides a useful roadmap.

Total Production Costs

Direct Costs Indirect costs (overheads)

2. Allocate/Apportion to Cost Centres

Production A Production B Service C

1. Allocate

3. Reapportion fromService to Production

Production A Production B

4. Absorb

Cost Unit


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The focus (above) is production. Overhead costs that are not incurred at the time of

production do not find their way into inventory.

It is useful to think of production costs as being those that end up as part of the inventory

(valuation) while other (non-production) costs are incurred outside, and normally after the

product leaves inventory.

Allocation and Apportionment

Allocate, Apportion and Re-apportion indirect production costs (shown on the right side of

the diagram) to cost units.

Our focus is on the first category (production); the other overhead costs are not incurred at

the time of production and do not find their way into inventory. Always think of the costs

going into inventory and those that occur after the product leaves inventory!

EXERCISE

A company producing refrigerators and toasters has identified the following overhead costs

relating to production:

$Rent 8,000Indirect materials 1,500Power 3,000Equipment insurance 2,500

15,000

The company has 3 cost centres, 2 production workshops (A & B) and 1 warehouse (C,service centre).

1. Suggest the basis on which the costs shown above might be charged to the various cost

centres.

Basis A B CRent 8,000 sq.m. 4000 2500 1500Indirect materials 1,500 Specific 600 700 200Power 3,000 kWh 1500 1000 500Equipment 2,500 Book 1000 1400 100


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insurance value

15,000 sq.m. 7100 5600 2300

As a manager with cost centre responsibility, what could be your concerns with respect

to the bases selected above?

2. Re-apportion the service centre costs to the production workshops.

Assumption: C is used by A (65%) and B (35%):

A B C

Costs apportioned to A, B, C: 7,100 5,600 2,300

Costs re-apportioned from C: 1,500 800 (2,300)

Total overheads: 8,600 6,400

3. Absorb the overheads into the units produced.

Assumption: The company absorbs overhead costs on the basis of direct labour hours

Total labour Overheads Overhead AbsorptionHrs $ Rate (OAR) $

Workshop A 1,400 8,600 6.14Workshop B 950 6,400 6.74

Each workshop uses its OAR to keep track of overhead costs as it produces.

Alternatively, the company can use a “blanket” or company-wide OAR, calculated as:

Total overhead costs = 15,000 = 6.38Total labour hours 2,350

A company’s cost cards for two products (toasters and refrigerators) could look as follows:

Refrigerator (cost per unit) $

Direct materials (15kg @ $2/kg) 30.00Direct labour (1.75hrs @ $15/hr) 26.25 Variable OHs 5.00

Fixed OHs (1.75hrs @ $6.38/hr) 11.17

Total 72.42


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Toaster (cost per unit) $

Direct materials (1kg @ $3/kg) 3.00Direct labour (0.30hrs @ $15/hr) 4.50 Variable OHs 2.00

Fixed OHs (0.30hrs @ $6.38/hr) 1.91

Total 11.41

Summary – Absorption costing

Method of measuring the cost of products or services by including a fixed overhead “fair”

share into the product manufacturing/service provision cost

Results in reporting higher ending inventories and higher operating profits (as fixed

factory overheads are taken to inventory cost instead of being expensed as incurred)

It addresses the problem of allocating factory overheads per product lines

Step 1: Identify total factory overheads to be absorbed

Step 2: Take the total quantity recorded for the absorption base

o

The absorption base should be highly correlated with incurrence of overhead

o Most common absorption bases selected: direct labour hours, machine hours,

units of output

Step 3: Compute overhead absorption rate (OAR) as Step 1 / Step 2 ($/unit of

absorption base)

Step 4: Obtain unit overhead cost per product line, by multiplying the OAR with the

absorption base quantity recorded per unit

Step 5: For each product, multiply Step 4 by total output to determine factoryoverhead to absorb in the production cost.

Over- and under-absorbed factory overheads

o In practice, OARs are pre-determined on an annual basis, making

assumptions on total activity levels for selected absorption bases. Such

assumptions can be based on manufacturing technical capacity, normal

capacity, or expected capacity.


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When actual activity levels differ from those used in pre-determining absorption

rates, this results in over- or under-absorption.

KEY KNOWLEDGE

Marginal costing

Features of Marginal Costing

A marginal approach to costing focuses on the variable (marginal) costs generated in a

business and considers fixed costs as period costs. This allows the company to be able toquantify the amount by which its costs rise, if it produces/sells an additional unit of output.

Marginal costing:

Is an alternative costing method, with variable costs only being charged as a cost of

sale (excludes fixed factory overheads from manufacturing costs)

Results in reporting lower ending inventories and lower operating profits (as fixed

factory overheads are fully expensed as incurred instead of being absorbed in

inventory cost)

Recognizes that fixed costs become irrelevant for short term production decisionmaking based on product profitability (sunk costs)

Avoids arbitrary bases for fixed overhead absorption into the production cost

Contribution

Contribution is defined as the difference between Sales revenue and the marginal cost of

sales, or

Contribution = Sales – Variable costs (both production and non-production)

Example

Below is data on a manufacturing company.

Selling price (per unit): 120

Cost card (per unit):Direct materials 45Direct labour 18


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Variable production O/Hs 9Total variable costs 72

There is a variable selling cost of $2 per unit

Year 1 Year 2(units) (units)

Budget (normal) production 1,100 1,100

Actual Production 1,000 1,100 Actual Sales 950 1,150

Actual fixed production O/Hs $16,500 $16,500

Actual SGA costs $ 7,000 $ 7,000Based on the above data, a profit and loss statement for the Years 1 and 2 is prepared.

Assume that the beginning inventory is zero.

Profit/Loss (Marginal costing)

Year 1 Year 2$ $

Sales (950/1,150 units) 114,000 138,000

Less: Variable cost of sales

Opening inventory 0 3,600

Production costs:

o Variable(1,000 x $72) 72,000(1,100 X $72) 79,200

Less: closing inventory(50 x $72) (3,600) 0

(68,400) (82,800)Less: Variable selling costs

(950 x $2) (1,900)(1,150 x $2) (2,300)

Contribution 43,700 52,900

Less: Fixed production O/Hs (16,500) (16,500)


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Less: SGA costs (7,000) (7,000)

Profit 20,200 29,400

Inventory is valued at variable production costs.

Absorption Costing

This method argues that focusing on marginal costs is potentially misleading in the longer

run because fixed production costs have also to be covered. Accounting conventions require

that fixed production costs be reflected in each unit produced.

Revised cost card (Absorption costing)

Cost card (per unit):Direct materials 45Direct labour 18 Variable production O/Hs 9Fixed production O/Hs 15

Total production costs 87

Year 1 Year 2Profit/Loss (Absorption costing) $ $

Sales (950/1,150 units) 114,000 138,000

Less: Variable cost of sales

Opening inventory 0 4,350

Production costs:

o Variable(1,000 x $72) 72,000

(1,100 X $72) 79,200

o Fixed(1,000 x $15) 15,000(1,100 X $15) 16,500

Less: closing inventory(50 x $87) (4,350) 0

Over/(under) absorption 1,500 0(84,150) (100,050)


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Gross Profit 29,850 37,950

Less: Variable selling costs

(950 x $2) 1,900(1,150 x $2) 2,300

Less: SGA costs 7,000 (8,900) 7,000 (9,300)Profit 20,950 28,650

Inventory is valued at the full production costs.

Summary of Absorption costing and Marginal costing formats

Absorption Costing Marginal Costing

Revenue

Less: Cost of Sales

Variable/Fixed Variable production/

production costs non-production costs

Gross profit Contribution

Less: Expenses

Variable/Fixed Fixed production/

non-production costs non-production costs

Net Profit

Reconciliation of the two methods

The different profit figures calculated under Absorption costing and Marginal costing can bereconciled thus:

The difference in profit = Net change in inventory (no. of units) X the fixed cost per unit

It follows that:

If the level of inventory increases in a given period, then profits (for that period)

under the Absorption costing system will be greater than under Marginal costing; and


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If the level of inventory decreases, then profits under the Absorption costing system

will be smaller than under Marginal costing

If the inventory level does not change, then the profit calculated under both methods

will be equal.

KEY KNOWLEDGE

Job costing / Batch costing

This refers to the calculation of costs associated with a specific job or customer order. This

is appropriate in situations where each product or service is distinct, and possibly unique, inits delivery.

Batch costing is similar to job costing; the distinction lies in the identification of costs withspecific batches, which are numbered (separately identified) for this purpose.

KEY KNOWLEDGE

Process costing

Process costing is a technique that applies to the mass production of a large number of

identical products, moving through a series of processing stages. The accumulated costs of

production can be averaged over the number of items produced.

Illustration 1

Process B

units $ units $

Input units 1,000 20,000 Output to 1,000 30,000

from Process A Process C

Additional:

Materials 5,000

Labour 3,000

Overheads 2,000

1,000 30,000 1,000 30,000

Avg.cost/unit: 30


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The average cost is determined by the following formula:

Average cost per unit = Total cost of inputs – Scrap value of rejected units

No. of units of input – Normal loss

The total cost of inputs refers to labour, materials and overhead costs of production. Iflosses occur along the way that necessitate the scrapping of defective units, then to theextent that these items fetch a scrap value, then that (scrap) value will reduce the totalcosts.

Similarly, an accounting is made of the number of units introduced into a process with theexpectation that a normal loss will be incurred. The number of good units emerging from aprocess will therefore be the number of units entering it, minus the expected number lost inprocessing.

Illustration 2

Normal loss

10% of input

1,000 = 900 + 100

good NL

Avg. cost / unit 33.3

Conclusion:

Average cost per unit = Total cost of inputsNo. of units of input – Normal loss

Process B

units $ units $

Input units 1,000 20,000 Output to 900 30,000from Process A Process C

Additional:

Materials 5,000 Normal loss 100 0

Labour 3,000

Overheads 2,000

1,000 30,000 1,000 30,000


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Illustration 3

Scrap value

scrap/unit 5Avg cost/unit 32.78

Conclusion:

Average cost per unit = Total cost of inputs – Scrap value of normal loss unitsNo. of units of input – Normal loss

Process B

units $ units $

Input units 1,000 20,000 Output to 900 29,500from Process A Process C

Additional:

Materials 5,000 Normal loss 100 500

Labour 3,000

Overheads 2,000

1,000 30,000 1,000 30,000

Abnormal gains and losses are accounted for as an adjustment to the accounts using thesame value as the “good” output (deducted in the case of loss and added in the case ofgains).

Illustration 4

Abnormal loss

1,000 = 850 + 100 - 50

good NL AL

Conclusion:

Average cost per unit = Total cost of inputs – Scrap value of normal loss unitsNo. of units of input – Normal loss

Process B

units $ units $

Input units 1,000 Output to 850


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20,000 27,861

from Process A Process C

Additional:

Materials 5,000 Normal loss 100 500Labour 3,000 Abnormal loss 50 1,639

Overheads 2,000

1,000 30,000 1,000 30,000

Joint products / By-products

Joint products are two or more products that share a common processing path until thepoint of separation. Until they go their own (separate) ways, the costs of production duringthe joint processing cannot be physically distinguished.

There are different methods used to apportion common costs to such products at the pointof separation:

Market value (based on expected sales price)

Number of units (litres, tons, or some other objective physical measurement)

Net realizable value = Final sales value – Incremental processing costs

By-products are goods which are incidental to the production process and which generatecash from sales, though the amount is modest in comparison to the overall revenues of thefirm. The cash received for by-products can be viewed as a bonus that reduces productioncosts.

Joint processing and further processing

Decisions need to be taken as to the further processing of products after their point of

separation.

Care must be taken to focus on the incremental (relevant) values.

EXAMPLE


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Determine which of the following products should be sold immediately (at the indicated

price) or processed further (for later sale):

Cost at point of Immediate Further (variable) Post-processingSeparation Price processing cost Price

A 25,000 27,000 5,000 30,000B 30,000 28,000 5,000 32,000C 40,000 45,000 4,000 50,000

KEY KNOWLEDGEService costing

Services distinguish themselves from products in the following ways:

Heterogeneity: The quality of the service is rarely exactly the same, due to the human “touch”; e.g. hair cuts;

Intangibility: Services are not tangible;

Perishability: One cannot place a service in inventory;

Simultaneity: Services are produced and consumed at the same time

(Think of “HIPS”)

Cost units

Finding an appropriate cost unit is a challenge in service costing. In many cases, a

Composite cost unit is identified; e.g.

Student – lunches, or Man-days

The cost per service unit is found by dividing the total cost of the service by the number ofservice units involved.


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Chapter 4

Decision-making

KEY KNOWLEDGECost-Volume-Profit (CVP) Analysis

The breakeven formula

Total Costs = Fixed Costs + Unit Variable Cost x Number of Units

Total Revenue = Sales Price x Number of Units

If

TC = Total Costs,

FC = Fixed Costs,

V = Unit Variable Cost,

X = Number of Units,

TR = Total Revenue,

SP = Selling Price,

C = SP – V = Unit Contribution and


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CM%= C/SP = Contribution Margin,

Then the break-even point (the output level at which TR=TC) is:

In units sold: X = FC/C

In dollar sales: TR = FC/CM%

Safety Margin = Budgeted Sales – Break-even point (units/dollars)

C is an important indicator, as it shows the contribution of each unit sold towards

covering fixed costs. Therefore, in the short run, the firm may prefer to produce/sellbelow break-even in order to recover some of its fixed costs.

KEY KNOWLEDGEBreak-Even Analysis

Marginal costing is useful in calculating the “break -even” level of sales.

The break-even point is the level where the company achieves zero profit (neither gainnor loss). It just manages to cover its fixed costs.

Below is data on a manufacturing company.

http://en.wikipedia.org/wiki/File:CVP-TC-FC-VC-Sales-Contrib-VC-PL-compat.s


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Cost per unit (of product): $

Direct materials 45

Direct labour 18 Variable production O/Hs 9Total variable production costs

Distribution & selling (variable)

Additional info:

Selling price per unit

72

2

120

Fixed production costsFixed Selling, General, Admin

costs

16,500

7,000

EXAMPLE

Based on the data in the previous example, calculate the break-even point of thecompany.

Total fixed costs: 23,500

Contribution per unit: 46

Break-even point: 23,500/46 = 511 units

Contribution per sale – C/S ratio

This is understood as the amount of contribution generated by every dollar sold.

In the previous example, the company’s C/S ratio is: $ 0.3833 (120/46)

The break-even level of sales can be calculated as: Fixed costsC/S ratio

Break-even point (sales) = $ 61,310


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KEY KNOWLEDGEShort-term decision-making

Limiting factors

When a single limiting factor is present in a production plan, then it is necessary to identify

it and to plan production around it.

Take the following example:

Product X Y Z

Selling price 30 40 50Labour cost per unit ($) 10 16 20Material cost per unit ($) 5 8 10

Contribution 15 16 20

It appears that in the face of unlimited demand for all three products, Product Z would begiven priority as it maximizes the contribution per unit.

Now, assume that labour hours are limited to 500 and that labour costs $2 per hour(demand remains unlimited for all three products).

In the above case,

Product X Y ZLabour cost per unit ($) 10 8 20No. of hours per unit 5 8 10

Contribution per hour 3 2 2

Now it becomes clear that Product X is favoured for the full number of hours available (500).100 units of X can be produced.

If demand for X were limited to, say, 80 units (requiring 400 labour hours), then theremaining available hours (100) could be used to produce either Y or Z (in this case there isindifference between the two).

The steps to be followed in working out the optimal production plan are:

(1) Calculate the contribution per unit of product;(2) Calculate the contribution per unit of limited resource;(3) Rank the products according to Step 2;


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(4) Produce according to the priority established in Step 3, up to the demand limit ofeach product or until the limited resource is exhausted

Make-Buy

A make-buy decision requires the determination of all relevant costs.

EXAMPLE

An automotive components producer can supply itself externally with car heaters for USD

210 per unit. In considering whether to make these internally, the company calculates thatan equivalent unit can be made in 2 labour hours using USD 100 worth of materials.

Labour is currently at full capacity producing carburettors which generate contribution of

USD 100. A carburettor takes 2.5 hours to produce. Labour costs USD 10 per hour. The

carburettor also absorbs fixed overhead costs at the rate of USD 20 per labour hour.

The relevant costs are ($):

Materials: 100

Contribution lost

(carburettors): 80

Labour (added-back): 20

200

It is cheaper to produce internally.

Relevant costs

One of management’s responsibilities involves making decisions affecting the firm in the

short-run based on relevant costs.

What is relevance?

A relevant cost is a cash cost which is uniquely incurred (or avoided) as a consequence of

taking a decision; cash, because it is the main determinant of value (unlike accounting

profit); and unique in the sense that is not common to the alternative choices that are under

consideration.


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EXAMPLE

A company seeking to determine whether to continue to transport its products by truck or to

switch to the railroad discovers that insurance costs are identical in both choices; in that

case, insurance costs are not relevant to the decision.

If, however, there is a difference in the two insurance costs, then one can speak as the

difference between the two choices as being “incremental”; this difference (referred to in

some places as the “differential”) is relevant to the decision under consideration.

Future

Relevant costs refer to the future, i.e. they can be influenced prospectively by choice. It

follows that:

Sunk costs are not relevant: They have already taken place and cannot be reversed.

Committed costs, if they cannot be avoided, are likewise not relevant, even if the timing of

their occurrence is in the future. Their “unavoidability” has already been established in the

past (making them effectively the equivalent of sunk costs).

In keeping with the above logic, relevant costs therefore involve cash, are incremental and

relate to the future.

Costing projects

It is a standard management accounting practice to determine the relevant costs of a new

project in order to come up with a price quotation. Setting a price without having an

accurate understanding of costs can put a company at a competitive disadvantage,

particularly if there is intense competition.

EXAMPLE

A proposed project lasting 6 months requires the following inputs:

1) Labour


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The following resources are needed:

A specialist specifically qualified for this work needs to be hired at a cost of USD

10,000 per month;

The specialist will be assisted by two subordinates who are existing employees, each

paid USD 40,000 p.a. One is not working on anything else for the foreseeable future,

while the other is fully involved on another project and would need to be replaced for

the duration of the proposed one at a cost of USD 5,000 per month;

A division manager has agreed to supervise the project and estimates that 5% of his

time (equivalent to USD 6,500) be allocated for this purpose.

2)

Materials

The project calls for the use of 200 litres of Agent Q and 50 kg. of Compound P.

Additional data: In stock Historical price Current price Scrap value

Agent Q 150 litres USD 7 USD 5 USD 1

Compound P 100 kg. USD 12 USD 15 USD 2

Agent Q is no longer in use.

Compound P is in regular use at the company.

3) R&D

The project manager notices that R&D relevant to this project had been performed for

another contract (later abandoned) at a cost of USD 15,000. He sees an opportunity to

recover that cost now.

4) Equipment

The company needs equipment for the project which would cost USD 15,000 to buy.

Alternatively, it has some existing unused equipment that could be deployed. The used

equipment is in good condition and could have been scrapped for USD 8,000 now or for USD

5,000 in 6 months. (Note: Ignore time adjustments of monetary values)

Prepare the costs for the proposed project.


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Relevant costs need to be identified with care, as they may include opportunity costs.

EXAMPLE

A company considers building a storage facility on the site of a parking lot. If the parking lot

had been generating parking fees which will now be lost, then this foregone revenue is an

opportunity cost.

Shut Down decisions

Whether to close a plant making (accounting) losses depends on relevant costs:

Revenues (m) 40

Costs (m) (44)

Profits (m) (4)

If 25% of the costs are fixed costs allocated by H.O., then it appears that closing the plant

will leave the company worse off, as 40m in revenues and only 33m in costs will be

disappear. A careful examination of all costs needs to be made before arriving at a final

decision.

KEY KNOWLEDGE

Principles of discounted cash flow

Simple vs. Compound interest

Simple interest is the calculation of interest applied to the principal amount only. If $100 are

lent at a simple interest of 5% p.a. then interest payments will be based only on the

principal, as for example, an annual interest payment of 5% of $100, or $5 p.a.

If interest is payble semi-annually on a compunded basis, then at the end of the first year,

the interest will be $5.0625, calculated as:


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5% on $100 for the 1st half of the year, plus 5% on $102.50 for the 2nd half (i.e. the interest

of $2.50 from the 1st half of the year is added to the principal amount and forms the basis

for the interest calculation in the 2nd half).

Nominal vs. Effective interest

In the example above, 5% serves as the nominal interest rate, while the effective interest

rate is 5.0625%; this is the total interest achieved on a compounded basis ($2.50 plus

$2.5625).

The preeminence of cash

Cash, both its receipt and possession, lies at the basis of economic value. Cash is used to

pay the bills and bonuses. It is a better indicator of wealth when compared with measures

defined by accounting conventions, such as accounting profit.

The relevance of cash flow to capital investment appraisal

The appraisal process is predicated on the fact that capital expenditures are investments

which will (hopefully) confer future benefits referred to as the payback. The payback may be

a lengthy (and risky) one.

Timing and value

Tracking and measuring cash flows on a time-adjusted basis is critical: cash received quickly

can be used to repay debt (avoiding interest costs) or invested (earning interest). Cash paid

with a delay can reduce costs (as long as penalties are not incurred).

It follows that the longer one waits for a receipt of cash, the less that cash is worth in

today’s terms. Among other factors, its purchasing value may diminish due to the effects of

inflation.

Compounding

Instead of receiving USD 100 today, assume it will be received after one year. To

compensate for the delay, what should the value be after one year?

Present Value (PV) Future Value (FV)

100 100 x (1+r)


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In the above example, if r = 5% p.a. then the FV after one year will be USD 105.

This process can be repeated year after year.

Discounting

The above relationship between PV and FV: PV x (1+r) = FV

can be re-arranged to: PV = FV(1+r)

with r representing the discount rate.

The above refers to “one-period” discounting, with r corresponding to the period.

If discounting is done over more than one period, then the discounting effect will be:

PV = FV(1+r)n

where “n” refers to the number of periods.

Thus, 100 received after two years, discounted at 10% p.a. will be

PV = 100 = 82.6(1.10)2

This reflects t

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