CIPFA Exam Essentials
Management Accounting
First published 2016 Published by CIPFA Education and Training Centre 77 Mansell St London E1 8AN Email:
[email protected] Website: http://www.cipfa.org.uk/cetc Copyright © 2016 Chartered Institute of Public Finance and Accountancy All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publishers or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London EC1N 8TS. Every possible care has been taken in the preparation of this publication but no responsibility can be accepted for loss occasioned to any person acting or refraining from action as a result of any material contained herein.
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Management Accounting
Contents Introduction ................................................................... 5 CIPFA Exam Essentials .................................................. 5 The Management Accounting Syllabus ............................. 5 The Management Accounting Exam ................................. 5 All questions have equal weighting.................................. 6 Revision strategies ........................................................ 6 Exam technique ............................................................ 7 Abbreviations ............................................................... 9 1. The role and scope of management accounting ...... 10 1.1.
The purpose of management accounting ............ 10
1.2.
Information for management decision making ..... 11
1.3.
The strategic management accountant ............... 14
2. Cost behaviour and cost accounting techniques ..... 15 2.1.
Cost definitions and elements of cost ................. 15
2.2.
Standard costing ............................................. 17
2.3.
Costing materials ............................................ 18
2.4.
Costing labour................................................. 19
2.5.
Costing systems .............................................. 20
2.6.
Absorption costing ........................................... 26
2.7.
Activity based costing ...................................... 31
2.8.
Marginal costing and absorption costing ............. 34
3. Budgeting ............................................................... 39 3.1.
Budgetary control ............................................ 39
3.2.
Budgeting models ............................................ 45
3.3.
Budget preparation .......................................... 54
3.4.
Preparing cost estimates .................................. 60
4. Financial control ..................................................... 65 4.1.
Features of budgetary control ........................... 65
Management Accounting
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4.2.
Budgets used to evaluate performance .............. 68
4.3.
Statistical analysis of variations in performance .. 76
5. Financial decision making ....................................... 80 5.1.
Applying relevant costing to short-term decisions 80
5.2.
Cost volume profit analysis (CVP) ..................... 84
5.3.
Key factor analysis .......................................... 88
5.4.
Costing for production decisions ........................ 89
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1. The role and scope of management accounting
Introduction CIPFA Exam Essentials CIPFA Exam Essentials are the key revision component in CIPFA’s learning material. They are designed to supplement and complement the CIPFA Education and Training Centre workbooks. They provide the basis for the thorough and effective revision on which your CIPFA examination success depends. Key features of the CIPFA Exam Essentials are: •
One revision section for each of the workbooks.
•
Clear and concise revision notes, which expand the key topics and help you to recall the detail you have learnt from the workbooks.
•
Key points, to highlight the most important points to remember for each topic.
•
Exam focus, sections, helping you to improve your exam technique.
•
Exam tips, highlighting tips to help you maximise your marks in the exam and avoid common pitfalls.
•
Definitions highlighted in order that you know which definitions need to be learnt for the exam.
The Management Accounting Syllabus You can find the Management Accounting syllabus on the CIPFA website at www.cipfa.org/students. The Management Accounting Exam The exam is 2 hours long. The examination consists of 60 Objective Tests. These will comprise multiple choice questions (MCQ) and potentially some multiple response questions (MRQ).
Management Accounting
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1. The role and scope of management accounting
The balance of questions will reflect the weightings in the latest MA syllabus. Each examination will cover the full syllabus and include questions of differing levels of complexity: •
Knowledge
•
Understanding
•
Application
•
Analysis.
The latter two levels will often involve some kind of calculation. All questions have equal weighting. Revision strategies You will find that running through the CEE during your revision will help you to revise key facts and hopefully give you the confidence that you know more than you thought you did! You can also use the ‘Exam focus’ and ‘Exam tip’ sections to guide you when practising exam questions. Make sure that you devote plenty of time to practising objective tests, rather than just learning facts. The Management Accounting exam can be time pressurised and you need to be able to quickly and confidently answer the questions given. The examination will always contain a mixture of short numerical questions and discursive questions (testing students’ understanding of the underlying concepts). Past exam papers November 2015 was the first sitting of the new style online MA examination. Although earlier Management Accounting examinations included a Multiple Choice Page 6
Management Accounting
1. The role and scope of management accounting
Question (MCQ) section (worth 40% of the total marks). These questions no longer reflect the style of the new objective tests. Where the previous questions were suitable they have been incorporated into a Question Bank of 240 questions (covering the entire MA syllabus) which will be made available to students. NOTE – the actual November 2015 and subsequent MA examination questions have been / will be drawn from an on-line question bank. As such the actual examination questions will not be made available to students. (The same questions are likely to come up at some point in the future).
Exam technique Feel free to answer the questions in any order that you please (the on-line system allows students to flag unanswered questions). Some students may prefer to answer the discursive questions first, and then turn their attention to the numerical questions. If you are feeling nervous on the day, you might like to look for the easier questions first in order to boost your confidence going forward. These are likely to be spread throughout the examination paper. Based on the most common mistakes that students make in the Management Accounting exam, the following list outlines key areas of exam technique to focus on: Timing You have two hours to answer 60 questions – so in effect two minutes on average per question. Remember, all of the questions have equal weighting.
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1. The role and scope of management accounting
A common issue is for students to get bogged down on one question – don’t forget you can skip forward and back in the exam. Do not persevere on one question for too long. The random nature of the examination means that you may get the most difficult question on the paper as question one. Read the question Do not assume that the question is the same as ones that you have practised. Read the question carefully – especially when asked for true / false or correct / incorrect answers – exam statements can be quite nuanced. Another good example here relates to Standard Costing reconciliations – check whether you are being asked to: •
Reconcile profits OR costs;
•
Reconcile from actual to budget OR vice versa.
Calculations Work out your answer to the numerical questions before looking at the answer options – one of them should match. If none match it may be clear that your answer matches one of the options with a slight correction. Always be clear about the units involved – for example, a question may summarise figures in £’000 – but the answer options may be in £. Think before answering In narrative questions, it is important that you read the requirement carefully. It is quite possible that if asked choose between four answers, one or maybe two will clearly not be correct so…….eliminate the ridiculous.
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Look at the answer options – you may not need to do all of the calculations that you think at first. Answer all of the questions Don’t leave any questions out; if you do you will definitely get no marks for that question. It is always worth having a guess – preferably an informed guess after you have eliminated any clearly incorrect answers.
Abbreviations The following abbreviations are used in this book: ABC: Activity based costing CVP: Cost volume profit analysis IAS: International Accounting Standard KPIs: Key performance indicators MA: Management accounting OAR: Overhead Absorption Rate VFM: Value for Money
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1. The role and scope of management accounting
1. The role and scope of management accounting 1.1.
The purpose of management accounting
The purpose of MA is ultimately to facilitate management in their duties by providing timely and relevant information. Definition Management accountings the provision of useful information to aid management in decision making, planning, control and problem solving.
MA functions 1)
Providing costing information.
2)
Providing information for planning, control and performance measurement.
3)
Providing information to enable management to make better decisions.
MA and financial accounting information Management Accounting
Financial Accounting
Not legally required
Legally required
Approximate figures
Accurate figures
Covers part of organisation
Reports on whole organisation
Management set rules for
Follows external rules and
information presentation
accounting standards
Both historic and future looking
Historic
Produced as required by
Produced annually
management For internal use only
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For outside parties
Management Accounting
1. The role and scope of management accounting
Financial management objectives •
Financial planning
•
Financial control
•
Financial decision making
The impact of non-financial factors MA is more than providing financial data: some items of non-financial information are just as critical, particularly in the public sector. Non-financial information could include: •
Product quality
•
Product innovation
•
Employee morale
•
Customer satisfaction
•
KPIs
1.2.
Information for management decision making
Levels of management •
Strategic – plan for the whole organisation over the next three to ten years.
•
Tactical – plan the organisation’s medium term financial plan for next one to three years.
•
Operational – concerned with day to day running of organisation.
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1. The role and scope of management accounting
Management level
Type of decision
Strategic
Unstructured
Long
Large
Infrequent
Loosely
Medium
Medium
Intermittent
Short
Small
Frequent
Tactical
Timescale Impact on Frequency organisation of decisions
structured Operational
Structured
Distinction between data and information Definitions Data: A collection of non-random facts recorded by observation or research Information: Data that has been processed so that it is more meaningful or useful
Information will be: •
Produced for a purpose
•
Placed in context
•
Logically processed and summarised
Information for management levels Management level
Time frame
Frequency
Source
Strategic
Long
Infrequent
External Less
Operational
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Short
Frequent
Certainty
source
certain
Internal
More
source
certain
Scope
Detail
Wide
Summary
Narrow Detail
Management Accounting
1. The role and scope of management accounting
Qualities of information The cost of providing the information must not exceed the benefit that can be derived from it.
Time dimension
Timeliness
Currency
Frequency
Time period
Content dimension
Accuracy
Relevance
Completeness
Conciseness
Form dimension
Clarity
Detail
Order
Additional characteristics
Reliability
Appropriate
Presentation and media Sent by
Received by
Correct
correct person
channels
Exam focus When you study information it is important that you can apply your knowledge to practical situations that could arise. If you are asked to assess information provided to management within an exam question, use these factors as a guideline. For example, you may be asked which of four stated criteria relates to the time dimension.
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1. The role and scope of management accounting
1.3.
The strategic management accountant
Traditional management accounting focused on costing rather than decision making. However the role of management accountancy has developed a greater strategic focus. Functions of the strategic management accountant •
Tailoring planning and control systems to meet strategic need
•
Integrating financial and non-financial information and quantitative and qualitative data to provide overall picture, inform key strategic decisions and formulate business strategies
•
Analysing external environment including competitive environment and marketing needs
•
Using operating and costing data to pre-empt or diagnose problems and suggest solutions to improve performance
•
Identifying value activities and ensuring delivery of value
•
Interpreting financial and non-financial data to inform key strategic decisions and formulate business strategies
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Management Accounting
2. Cost behaviour and cost accounting techniques
2. Cost behaviour and cost accounting techniques 2.1.
Cost definitions and elements of cost
Definitions Direct costs can be directly attributed to the particular cost objective. Indirect costs are production related items that cannot be directly attributed to a particular cost centre or cost unit.
Note: It is common for the term overheads to be used to describe costs which are not direct. Cost behaviour Costs may also be classified based on their behaviour. Variable costs •
The cost varies as a function of the level of output.
•
Unit variable cost constant for all output levels.
•
Example: direct materials.
Fixed Costs •
Costs that are unchanged regardless of the level of output across wide output ranges.
•
Example: rent of a building per month or year.
Semi-variable costs •
Costs with both a fixed and variable component.
•
Example: telephone bill with a fixed line rental and variable charge per minute used.
Semi-fixed (stepped) Costs •
Fixed within certain activity levels.
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2. Cost behaviour and cost accounting techniques
•
Many items classified more conveniently as variable or fixed costs are often stepped costs in practice.
•
Example: rent, which increases (as more room is required) if activity increases above a certain level?
Exam focus It is quite common for an examination question to ask students to interpret graphical representations of cost behaviours or to be able to interpret narrative descriptions of these. It is essential that you understand these principles as they are the foundations to other topics throughout the module.
Calculating full cost The full cost of a cost objective or cost unit will include various different costs with different classifications. Definition Cost objective is the product or area of the business that the cost is to be established for.
The full cost comprises: •
Total direct costs
•
Total indirect costs and overheads
Why is full cost important? •
Setting selling prices or charges so full costs are covered.
•
Transparency of full cost of service or product.
•
IAS 2 – requires inventory to be valued at full cost.
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2. Cost behaviour and cost accounting techniques
Classification and analysis of overhead costs As well as being classified by behaviour, indirect and overhead costs can be categorised as being: 1.
Committed - those costs that have been committed to regardless of future outcomes.
2.
Engineered - costs that result from the decision to follow a particular course of action.
3.
Discretionary - those costs that can be reduced in the short term without a significant short-term impact on products or services.
Costs for valuation of inventory The cost of a unit of inventory can therefore be broken down as follows: Product A £ Direct materials
x
Direct labour
x
Direct other expenses
x
£
Prime cost
x
Indirect materials
x
Indirect labour
x
Indirect other expenses
x
Factory overhead
x
Production cost
x
2.2. •
Standard costing Standard costing evolved from the manufacturing sector. Based upon the premise that when the same product or service is produced consistently, standards can be set for the costs and revenues associated with it.
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2. Cost behaviour and cost accounting techniques
•
Actual costs incurred and incomes earned are compared with the standards set to evaluate performance using variance analysis.
Advantages •
Accurate budgets
•
Better basis for costing and pricing
•
Cost consciousness
•
Permits detailed control analysis
Disadvantages •
Need to choose appropriate standard
•
Only useful for repetitive production processes
•
Difficult to incorporate inflation
•
Expensive to set up and maintain
2.3.
Costing materials
Methods FIFO – First in First Out •
Assumes oldest used first
•
Method: o
Record each purchase as a new column
o
Record issue as a new row working left to right
LIFO – Last in First Out •
Not permitted under IAS 2
•
Assumes newest used first
•
Method
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o
Record each purchase as a new column
o
Record issue as a new row working right to left
Management Accounting
2. Cost behaviour and cost accounting techniques
Weighted average •
Assumes all purchases indistinguishable
•
Method o
Record each movement in and out of inventory as a new row
o
After each purchase recalculate the total value of inventory and the weighted average cost per unit
Standard cost • 2.4.
A predetermined ‘standard cost’ is used regardless of the actual cost of the specific unit. Costing labour
Basic calculation is hours worked x rate paid per hour. Motivational schemes Piecework •
Workers are paid according to the units of output they produce
Piecework with a guaranteed minimum •
Workers are assured of a minimum payment regardless of the units produced in a shift, with piecework rates applied to earnings above this minimum
Piecework hours •
Where workers are paid piecework but make a number of different items within a shift, each item will be allocated a piecework hour based on the standard time taken to produce one unit. Workers will be paid based on the number of piecework hours their production is worth.
Bonus scheme •
Operate where standard number of hours to complete a particular job has been calculated.
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2. Cost behaviour and cost accounting techniques
•
Workers will receive a bonus payment to reward them for completing the task in less than the standard hours
Exam focus The exact details of a payment scheme for labour will vary from organisation to organisation. Make sure you read the question carefully to identify exactly how the scheme described – in particular whether there is an agreed (guaranteed) level of basic pay.
2.5.
Costing systems
Job / contract costing •
Used where each job is completed separately and costs can be clearly distinguished
•
Common in construction, accounting etc.
•
Each job assigned a separate job code
•
Costs of carrying out tasks related to job recorded against the code
•
A proportion of overhead costs is then charged to the job to reflect the full cost
Process costing Basic principle: Average cost per unit: Total cost of production for a period Number of units produced in a period
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Costs recorded in a process account: Units Costs incurred
£
Units
£
Output
Process costing with losses Normal losses •
Expected to arise under normal operating conditions
•
Part of the cost of good production
Abnormal losses •
Unexpected
•
Valued at the standard cost per unit
Scrap value •
Scrap value of losses provides income
•
Scrap value of normal loss is deducted from the cost of good production
Abnormal gains •
Unexpected efficiency
Average cost per unit therefore becomes: Total cost – Expected scrap value of normal loss Expected good production
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2. Cost behaviour and cost accounting techniques
Process Account showing an abnormal loss Units
£
Costs incurred Inputs from previous process
Units
£
Actual output (@ std. cost per unit) Normal loss (@ scrap value)
x
x
x
x
Abnormal loss (@ std. cost per unit)
x
x
x
x
Units
£
x
x
x
x
x
x
Output x
x
Material
x
Labour
x
Overhead
x x
x
Process Account showing an abnormal gain Units
£
Costs incurred Inputs from previous process
Output x
x
Material
x
Labour Overhead
x x
Abnormal gain (@ std. cost per unit)
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x
x
x
x
Actual output (@ std. cost per unit) Normal loss (@ scrap value)
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2. Cost behaviour and cost accounting techniques
Losses are recorded in a loss account Abnormal loss Units
£
x
x
x
x
x
x
Normal loss (@ scrap value) Abnormal loss (@ std. cost per unit)
Scrap proceeds for actual loss Loss written to income statement
Units
£
x
x
Bal fig
x
x
x
Units
£
x
x
x
x
x
x
Abnormal gain
Normal loss (@ scrap value) Gain written to income statement
Units
£
x
x
Bal fig
x
x
x
Scrap proceeds for actual loss Abnormal gain (@ std. cost per unit)
Process costing with WIP •
Closing WIP has been started but not completed in the period.
•
Costs incurred in production spread over both the finished units and WIP based on their percentage completion
•
Use an Equivalent Unit calculation
•
Cost per unit calculated as:
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2. Cost behaviour and cost accounting techniques
Cost per Equivalent Unit = Costs incurred in production EUs produced in period
Method •
Calculate the actual units of WIP =
•
Calculate the EUs for each type of input
•
Calculate the Cost per EU for each type of cost
•
Value completed units and closing WIP and draw up process account
Input less finished production
Actual units
Material cost
Labour and overhead
Completed
x
x EU
x EU
Closing WIP
x
x EU
x EU
x EU
x EU
Amount spent
£x
£x
Cost per EU
£x
£x
Total EUs
Batch costing •
Found where a number of identical items are manufactured in one batch then alterations are made to the production process before a different batch is produced
•
Each batch is assigned a job and associated costs are recorded against the job number
•
Costs are then spread over units produced.
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Joint costing Where more than one product emerges from a process at the split-off point (SOP). Definitions Joint products: Have significant sales value By-products: Have only a minor sales value relative to the others
•
Costs incurred before the split-off point will be shared between the joint products only
•
By-products are deemed to be incidental and therefore do not take on any joint costs
•
Post separation processing costs are allocated to the product they refer to
Apportioning joint costs between joint products Main methods are: •
Physical units
•
Market value at the SOP
•
NRV of products at final point of sale
Note that the overall profit will be the same under each method, the different cost allocations affect how profitable the products appear. Method
Advantages
Disadvantages
Physical units
Simple,
Some processes
objective
may produce products with different final forms (e.g. liquids and solids)
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2. Cost behaviour and cost accounting techniques
Method
Advantages
Disadvantages
Market value at
Fairer – products
Products may not be
SOP
which earn more
saleable at SOP
take greater
Separable costs can
proportion of
then make products
costs
appear loss making
NRV at final
Most accurate
Multiple split-off
point of sale
reflection of
points in complex
products’ ability to
processes can make
bear costs
calculations complicated
Further processing decisions It is worth processing further if the net realisable value (NRV) is greater than the sales value at the SOP. NRV = final selling price less future processing costs. Costing by-products By-products are valued at their sales value less any separate costs of processing after the split-off point Accounting treatment for by-product income Choice of: •
Treat as miscellaneous income
•
Deduct expected net income from cost of production
•
Deduct actual net income from production costs on sale (will mean unsold by-product inventory has a value)
2.6.
Absorption costing
To obtain full cost, in addition to attributing direct costs, indirect costs must be spread over the units produced.
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Definitions Cost units: Units of a product or service for which organisations require cost information Cost centres: a location or department or person or a function for which costs can be accumulated
Overheads are dealt with in three stages: 1.
Cost allocation - the process by which direct costs are charged directly to that cost unit or cost centre.
2.
Cost apportionment – the process by which indirect costs and overheads are spread over more than one cost objective.
3.
Cost absorption - the process by which those indirect costs and overheads are broken down in order to be included into individual units of output, normally by an OAR.
Exam tip: Remember to undertake absorption costing in the right order of allocation, apportionment and finally absorption.
Service departments Service departments are cost centres which provide a support service to the production cost centres. To obtain the total cost of a product, these service department costs have to be apportioned over the production cost centres. Reciprocal services: Services provided between the service departments must be taken into account prior to apportioning the service department costs to production cost centres.
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2. Cost behaviour and cost accounting techniques
There are 4 methods: 1) Direct apportionment: •
The most commonly used.
•
Ignores the reciprocal issue by charging service costs to production departments only – hence not accurate. Students need to be aware of this approach but will not be tested on it.
2) Repeated distribution: •
Makes no difference which cost centre’s costs are apportioned first.
•
Once support department costs are down to small numbers, the final apportionment is an approximate rounding.
3) Algebraic method •
Uses simultaneous equations.
•
Gives same result as repeated distribution.
4) Specified order of closure The support department undertaking the largest proportion of work for other support departments is closed first, and so on.
•
Exam tip: You need to be able to understand all four methods, but will only need to perform calculations on the final three: If asked to ‘fully’ take account of reciprocal services •
Do not use specified order of closure
•
Either repeated distribution or algebraic is permitted but beware of time required for repeated distribution
If three departments are all giving and receiving services then use Page 28
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2. Cost behaviour and cost accounting techniques specified order of closure. If question specifies approach then use approach requested. Some exam questions on the Algebraic Method simply ask students to create the equations (rather than solving them).
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2. Cost behaviour and cost accounting techniques
Absorption Methods of overhead absorption A number of methods are available, each using a different base such as: •
Unit basis (if all units are identical).
•
Direct labour hour basis (appropriate for a labour intensive production cost centre).
•
Machine hour basis (appropriate for a machine intensive production cost centre).
•
Direct wages basis.
Predetermined OAR A predetermined OAR is based on annual budget and applied to all cost units in the year is used. OAR = Budgeted Overheads of Cost Centre Budgeted Units of Absorption base Predetermined OARs are used because: •
It is unacceptable to organisations to wait until the end of an accounting period to charge overheads to jobs.
•
The number of units of the absorption base may fluctuate seasonally.
•
The amount of overhead itself may fluctuate seasonally.
Under/over absorption Under/over absorption is the consequence of using predetermined overhead absorption rates. It occurs if: •
Actual overheads differ from budgeted overheads and/or
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2. Cost behaviour and cost accounting techniques
•
2.7.
Differences occur between actual and budgeted amount of the absorption base
Activity based costing
ABC has been developed to overcome the inability of absorption costing to deal with features of the modern manufacturing environment. Limitations of traditional absorption costing •
Assumes products consume resources in relation to volume measures (direct labour or machine hours for example).
•
Can give a distorted product cost where a diverse range of products exists, and with a mix of high and low volumes of products.
•
Developed when organisations produced only a narrow range of products and when overheads were only a small fraction of total costs.
Product-cost cross-subsidisation •
Product-cost cross-subsidisation means that at least one mis-costed product is resulting in the mis-costing of other products in the organisation. Often arises when a cost is uniformly spread across multiple users without recognition of their different resource demands.
The ABC process Definitions Cost pool is the costs of an activity grouped together. Cost driver is what actually causes the cost to be incurred or the activity to be undertaken.
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2. Cost behaviour and cost accounting techniques
ABC: •
Is a form of absorption costing
•
Seeks to allocate and apportion costs to activities
•
Seeks to calculate unit costs in relation to cost drivers.
Outline of an ABC system 1.
Identify activities.
2.
Calculate cost pool for each activity.
3.
Identify a cost driver for each cost pool.
4.
Calculate cost driver rate for each activity.
5.
Charge costs to departments based on their consumption of the cost driver.
Absorption costing versus ABC ABC is similar to absorption costing but the pooling of overheads is by activities rather than by departmental level cost centres. •
Absorption costing generally uses two bases to charge overheads to products (direct labour hours and machine hours)
•
ABC uses many cost drivers as absorption bases to charge overheads to products (e.g. number of orders, number of set ups, number of despatches etc.)
Advantages of ABC •
More accurate reflection of resources o
•
•
Recognises that overheads are not always volume related
Provides a better understanding of overhead behaviour o
Improved understanding of cost drivers
o
Identifies actions needed to reduce costs
Better decisions
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o
Improved pricing and product range decisions
o
Encourages closer management integration
o
Is more useful for performance evaluation
Criticisms of ABC •
•
Not completely accurate o
Common costs may still require some arbitrary cost apportionment (e.g. rent, depreciation)
o
A true cost driver is not always easy to identify or measure
o
Some activities are difficult to identify
More expensive o
Costly to set up
o
Costly to run
Exam focus Typical questions can focus on the relative advantages / disadvantages of ABC as against absorption costing or the calculation of costs using a number of cost driver rates.
ABC in the services sectors •
Costs are predominantly overhead costs so ABC can be a useful technique.
•
Encourages focus on causes of overhead costs to allow the organisation to better manage its resources and improve cost management.
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2.8.
Marginal costing and absorption costing
Marginal costing •
Only variable costs are charged as cost of sales.
•
Closing inventories are valued at marginal (variable) production cost.
•
Fixed costs are treated as period costs, deducted from profit and charged in full against profit of the period in which they are incurred.
•
If the volume of sales rises/ falls by one item, profit will rise/ fall by the contribution earned from the item.
•
Contribution per unit is constant at all levels of output and sales (whereas profit per unit varies).
Definition Contribution is the difference between the sale price and variable cost.
In marginal costing decisions, management will look for a product to make a positive contribution towards fixed costs and, once the fixed costs are covered, to profit.
Comparison of marginal and absorption costing Absorption and marginal costing are not mutually exclusive costing methods but they do have significant differences in their approaches. Key point Marginal and absorption costing methods differ in the treatment of fixed manufacturing costs. Absorption costing traces all manufacturing costs to products and treats non-manufacturing overheads as a period cost. Page 34
Management Accounting
2. Cost behaviour and cost accounting techniques Key point Marginal costing traces all variable costs to products and treats fixed manufacturing overheads and non-manufacturing overheads as period costs.
Absorption costing: •
Costs are charged to cost units (including fixed production costs) via -
Allocation
-
Apportionment
-
Absorption (overhead absorption rates)
•
Inventories carried forward between costing periods are valued with fixed elements included.
•
All non-production costs are charged to the time period in which they are incurred
Marginal costing: •
Only variable costs are charged to cost units.
•
Fixed costs are written off or charged in full against contribution.
•
Inventories carried forward between costing periods are valued excluding any fixed costs (i.e. at variable cost).
Arguments for marginal costing •
Useful information for decision making.
•
Useful for planning and control.
•
Does not involve subjective apportionment.
Arguments for absorption costing •
Does not understate the importance of fixed costs.
•
Avoids fictitious losses being reported (seasonal sales).
•
Theoretically superior (matches sales and costs)
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Costing statements Operating statements are produced for marginal and absorption costing with different profits reconciled as relevant. Marginal cost profit statement Period 1
Period 2
Period 3
Sales Less cost of sales: opening inventory variable production cost less closing inventory Less other non-production variable costs Contribution Less production fixed costs Less non-production fixed costs Profit
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Absorption costing profit statement Period 1
Period 2
Period 3
Sales Less cost of sales: opening inventory total production cost less closing inventory (under)/ over absorption Gross profit Less non-production fixed costs Less non-production variable costs Net profit
Exam tip: You must learn the basic pro forma profit statements for both absorption and marginal costing as they will not be provided in the exam.
Comparison of profits •
Profits are the same for both methods when production equals sales (no changes in inventory levels).
•
Where production exceeds sales (increasing inventory levels) absorption costing produces higher profits.
•
Where sales exceed production (declining inventory levels) marginal costing produces higher profits.
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2. Cost behaviour and cost accounting techniques
Reconciliation of profits £ Absorption costing profit
X
Movement in inventory x OAR
(Y)
Marginal costing profit
Z
When to use which costing method? Absorption costing must be used for external reporting purposes and IAS 2 requires that absorption costing is used for financial statements. For internal purposes, either method is allowable depending on the individual circumstance. •
Choice depends on circumstances.
•
Volatile sales, inventory levels and short term decisions favour marginal costing.
•
Seasonal sales with inventory build-up favours absorption costing.
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3. Budgeting 3.1.
Budgetary control
Control systems Controls operating in an organisation include: •
Social controls
•
Administrative control
•
o
Rules and regulations
o
Output controls
Self-control
Budgets are part of an organisation’s control system and require the following conditions: 1)
Set standards/budgets to be measured against.
2)
Measure actual results.
3)
Calculate variance that compares the actual results with the predetermined standards.
4)
Take the necessary actions to control any problem areas.
Feedback and feedforward control
Definition Feedback control compares budgeted costs and revenues with actual results Feedforward control compares forecast costs and revenues with predetermined objectives
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Budgeting objectives Budgets are: • plans • future oriented • a means to achieve particular objectives • control mechanisms Benefits or purposes of budgeting include: •
planning
•
motivation
•
communication
•
control
•
performance measurement/monitoring
•
co-ordination
•
instil financial awareness
Medium Term Expenditure Framework (MTEF) MTEF is a process laid down by the World Bank for transparent planning and budget formulation. MTEF has two main objectives: 1.
Setting fiscal targets
2.
Allocating resources to strategic priorities within these targets
MTEFs help improve budget processes through: •
Clarity of policy objective
•
Improved predictability of budget allocations
•
Comprehensive coverage over public services
•
Improved transparency in the use of resources
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This will only work where focused improvements are mad on improving the areas where budgeting problems exist: •
Unpredictable release of budget funds
•
Budget holders not being held accountable
•
Unclear or inconsistent overall policies
Deriving short-term budgets from the MTEF Strategic, tactical and operational budgets The structure of budgets in an organisation follows the management structure in the organisation and can be classified as strategic, tactical and organisational budgets. Tactical and operational budgets should be consistent with the achievement of strategic goals. The budget period that applies to strategic budgets is longer than the period for tactical and operational budgets. •
Strategic budgets
The scope of strategic budgets is broader, dealing with major issues of organisational development over the specified time horizon. •
Tactical and operational budgets
Tactical and operational budgets must contain sufficient detail to guide short-term operations towards attaining strategic goals. Dangers in not recognising strategic, tactical and operational relationships Three potential dangers are: 1.
Strategic and tactical budgets may not be appreciated at the operational level.
2.
Strategic and operational budgets may not be appreciated at the tactical level.
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3. Budgeting
3.
Tactical and operational budgets may not be appreciated at the strategic level.
Relevant range, operational, tactical and strategic budgets The concept of the relevant range is the range of output/sales volumes over which a given set of assumptions is reasonable. For example: Costs, which are fixed in terms of an annual tactical budget, will exhibit marked step characteristics when placed in a strategic framework. It is important that differences such as these are recognised within the budgeting process. Budget building process The process of building the budget involves: 1)
Establish responsibility for setting the budget.
2)
Communicate guidelines to managers.
3)
Prepare the draft budgets for functions or departments.
4)
Review and co-ordinate budgets to ensure consistency between functions/departments.
5)
Communicate budget.
6)
Monitor performance against budget.
Responsibility accounting Responsibility accounting relates to the financial control procedures reflecting the delegation of decision making authority, for example, in relation to a devolved or decentralised budget. Different responsibility centres give managers varying levels of control: •
Cost centre
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•
Revenue centre
•
Profit centre
•
Investment centre
•
Strategic business unit
Within responsibility accounting, managers should only be held accountable for items within their control. Definitions Controllable items are those within the control of a specific manager. Non-controllable items are items that have a direct impact on a manager’s area of responsibility but are outside their control.
Budget setting There are two main approaches for setting budgets: 1)
Top-down - senior management devise the budget with minimal consultation.
Advantages: •
Senior management can communicate plans to employees.
•
Senior management can co-ordinate the activities of the business.
•
Facilitates setting demanding targets for managers.
Disadvantages: •
2)
Reduced motivation and lower commitment to the budget by those excluded from the budget-setting process. Bottom-up - low level managers set their own budgets which will feed into the budgets of more senior managers.
Advantages: Management Accounting
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•
Involvement of many within the organisation in the budget setting process.
•
Increased commitment to achieving the budget due to increased involvement in setting the targets.
•
Utilises the knowledge and experience of those throughout the organisation.
Disadvantages: •
Time consuming.
•
Individuals may set undemanding budgets for themselves.
Standards used in budget setting Control systems, such as budgeting, need to have standards in place to form the basis against which actual performance or costs are compared. Types of standard •
Basic – original specification.
•
Ideal - 100% efficiency 100% of the time.
•
Attainable – allows for unavoidable inefficiencies.
•
Currently attainable – updated for any changes during the period.
A currently attainable standard should be used, which allows for unavoidable inefficiencies and is up to date. Potential behavioural problems There are a number of behavioural consequences of performance measurement systems and the following problems should be borne in mind when determining which aspects of the budget to use to when monitoring performance: •
Goal incongruence
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•
Tunnel vision and myopia
•
Sub-optimisation
•
Measure fixation and misrepresentation
•
Gaming
•
Ossification
3.2.
Budgeting models
There are a range of different models for developing budgets. Exam tip: You need to be able to describe and compare the various budgeting models, as well as explain their advantages and disadvantages.
Incremental budgeting Incremental budgeting is commonly used in the public sector. The stages of incremental budgets are: 1.
Roll forward the base (this year’s budget).
2.
Amend by adding or removing known growth or savings.
3.
Adjust for changes as a result of inflation.
4.
Aggregate.
Advantages: •
Straightforward to explain.
•
Easy to understand
•
Quick to implement
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Disadvantages: •
Assumes previous budget is correct so past errors may be carried forward
•
May stifle innovation
Zero based budgeting All the activities are justified and prioritised before resources are allocated to each activity. Four steps required: 1)
Define decision units - areas of the organisation to budget for, such as departments.
2)
Develop decision packages - defining objectives to be met and assessing the options for achieving these objectives.
3)
Develop incremental decision packages – assess the effect on the decision packages and decision units of varying the resources available.
4)
Review and rank the packages according to cost/benefit criteria against the organisations objectives. Resources are allocated to the highest ranking packages until resources run out.
Advantages •
Full review of all items
•
Justification of all activities
Disadvantages •
Time consuming
•
Complicated
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Activity based budgeting (ABB) Budgets are set for activities (instead of functional departments), based on cost drivers and may be linked with ABC. ABBs are set in the same five stages used in ABC: 1)
Identify the activities carried out in the organisation.
2)
Calculate the cost pool for each activity.
3)
Identify the cost driver for each cost pool.
4)
Set cost driver rates for each cost pool.
5)
Apportion the costs of each activity to the budget heads according to cost driver occurrences.
Advantages: •
Budgets based on cost drivers should be more accurate.
•
Greater focus on overhead and support costs.
Disadvantages: •
Costing system needed to match (e.g. ABC).
•
Time consuming.
•
Costly.
•
Requires culture change in organisation e.g. to focus on support services and to accept timesheets.
Rolling budgets Rolling budgets are continuously being updated in relation to new information, such as monthly or quarterly. The initial periods are more detailed than the latter periods. It enables a full 12 month budget to always be in place. Advantages Management Accounting
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3. Budgeting
•
Budgets are up to date
•
Budgets are relevant to the current environment
Disadvantages •
Time consuming
•
Probably requires a dedicated budgeting resource which is more costly
•
Budget and therefore targets are changing all the time
Programme planning and budgeting systems (PPBS) Budgets are set based not on traditional departmental structure, but on programmes or groups of activities with common objectives. Involves four key steps: 1)
Review the organisation’s objectives and prioritise them.
2)
Identify programmes of activities to meet the objectives.
3)
Evaluate alternative methods of achieving the objectives.
4)
Select the most cost beneficial option for achieving the objective.
Advantages •
Links budget to organisation’s objectives
•
Improved co-ordination between departments
•
Possibly more efficient due to collaborative working
Disadvantages •
Time consuming
•
Complicated
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•
Output data may not be available
•
Departments may clash over resources
•
Possibly reduced accountability through the involvement of project managers with the budget rather than departmental heads
Project budgets Several specific issues to be considered: •
Project finances and accounting must be kept separate from operational budgets
•
Rolling budgets which regularly reforecast costs based on up to date information will be essential
•
Any cross departmental charges must be agreed in advance
Capital budgets Key point Revenue and capital budgets are often kept separate (always in the public sector). The impact of the capital budget on revenue budgets must be taken into account.
Revenue budgets are for the day to day running of the organisation and are to meet the objectives and service delivery requirements for the current financial year.
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3. Budgeting
Capital budgets are for spending to invest in long term assets for the organisation that will support the on-going delivery of services, such as investing in new schools or new hospitals. An item of capital expenditure, also known as a non-current asset, is defined by: 1.
The nature of the expenditure.
2.
Its materiality.
3.
Whether it provides a benefit beyond the current accounting period.
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Features of capital expenditure •
Expenditure is on assets which have a life in excess of one financial year.
•
Capital projects may begin and end in different financial years, potentially spanning a number of years in duration.
•
Capital projects may involve very large amounts of money relative to the organisation.
•
Capital expenditure may have considerable impact on the revenue budget.
Reasons for capital budgets •
Estimate the total capital expenditure requirements.
•
Produce a co-ordinated programme and set priorities.
•
Identify individual capital schemes and indicate their priority and general status in terms of policy.
•
Co-ordinate the efforts of different departments.
•
Estimate the revenue effects on relevant budgets.
•
Form the basis for physical planning and planning the workload for professional services.
•
Provide the basis for determining cash flow and capital financing requirements.
•
Provide information for external bodies to comply with government requirements.
•
Provide a standard for controlling and monitoring.
Putting together a capital budget 1)
Consider the existing capital programme.
2)
Department heads/managers provide details of proposed new schemes with justification and matched to corporate objectives.
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3)
Alternative schemes should be considered in terms of feasibility and any scheduling concerns should be addressed.
4)
A full financial appraisal should be carried out.
5)
Programmes are reviewed by the organisation’s decision makers.
6)
Programme is prepared for full approval at the highest level such as Committee or the Executive Board.
Contents of a capital budget The content and structure of a capital budget will vary between organisations. As a minimum, a capital budget should contain: •
A description of the scheme with its location, size and other relevant features.
•
The need for the scheme and priority ranking.
•
The scheme’s start time, implementation period and completion date.
•
Capital costs of the scheme broken down over financial periods, showing costs of land, construction etc.
•
The revenue consequences in the year of completion and then the full year effects.
Limiting factors of capital budgets •
Availability of finance
•
Government controls
•
Revenue implications
Beyond Budgeting Beyond Budgeting is an alternative to budgeting, as a response to some of the criticisms of traditional budgeting
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approaches. There are twelve principles of Beyond Budgeting in the following four subsections: Governance and transparency 1)
Values - bind people to a common cause not a central plan.
2)
Governance - govern through shared values and sound judgement rather than detailed rules and regulations.
3)
Transparency - information should be open and transparent, rather than being restricted or controlled.
Accountable teams 4)
Teams - organise around a seamless network of accountable teams rather than centralised functions.
5)
Trust - teams should be trusted to regulate their performance, rather than being micro-managed.
6)
Accountability - accountability should be based on holistic criteria and peer reviews, not hierarchical relationships.
Goals and rewards 7)
Goals - teams should be encouraged to set ambitious goals, without turning goals into fixed contracts.
8)
Rewards – should be based on relative performance not on fixed targets.
Planning and controls 9)
Planning – should be a continuous and inclusive process, rather than a top-down annual event.
10) Coordination - interactions should be co-ordinated dynamically, not through annual budgets. 11) Resources – should be made available just-in-time rather than being held just-in-case needed. 12) Controls – should be based on fast, frequent feedback not budget variances. Management Accounting
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Advantages •
Fast response
•
Innovative strategies
•
Lower costs
•
More loyal customers
Disadvantages •
Making the recommended changes may not result in performance improvements
•
Requires decentralised organisational structure
•
Requires a significant culture shift
Exam focus Questions in this area will often focus on a clear understanding of the models. For example: which of the following is not a feature of PPBS, or a description of a model followed by a choice from 4 of the model options.
3.3.
Budget preparation
Master and functional budgets Functional budgets include: •
Sales Budget
•
Production Budget
•
Materials Usage Budget
•
Materials Purchase Budget
•
Labour Budget
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Sales budget Period 1
Period 2
Period 3
xx
xx
xx
xxx
xxx
xxx
Number of units Sales Revenue (x £x each)
The difference between the sales budget and production budget are changes in inventory levels. Production budget Period 1
Period 2
Period 3
xx
xx
xx
- Opening Inventory (units)
(xx)
(xx)
(xx)
+ Closing Inventory (units)
xx
xx
xx
Production requirement (units)
xx
xx
xx
Period 1
Period 2
Period 3
xx
xx
xx
xx kg
xx kg
xx kg
Sales (units)
Materials usage budget
Production (units) Material usage (x kg per unit)
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Materials purchases budget Period 1 Period 2 Period 3 Materials usage (kg)
xx
xx
xx
Opening Inventory (kg)
(xx)
(xx)
(xx)
Closing Inventory (kg)
xx
xx
xx
Materials purchases (kg)
xx
xx
xx
£xx
£xx
£xx
Materials purchases (x £ per kg)
The difference between the materials usage and materials purchase budget is the difference in inventory. Labour budget
Production (units) Labour hours (x hours per unit) Labour cost (x £ per hour)
Period 1
Period 2
Period 3
xx
xx
xx
xx hours
xx hours
xx hours
£xx
£xx
£xx
Exam tip: Be careful not to confuse your units. Ensure you understand when you are working in units, kg or £.
Master budgets: pulls together these functional budgets from various areas of an organisation.
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Exam focus Preparing elements from within functional and master budgets is a common exam question. Make sure you prepare the functional budgets in the above order. Some examinations question may ask you to work backwards in the sequence.
Cash budgets Key point Cash budgets are prepared on a receipts and payments basis. It is crucial to understand the difference between receipts/payments and income/expenditure.
Income and expenditure are the right to receive or the obligation to pay cash sums. Receipts and payments are when the cash actually arrives in or leaves the organisation.
Period 1
Period 2
Period 3
Opening balance
xx
xx
xx
Cash inflows (receipts)
xx
xx
xx
(xx)
(xx)
(xx)
Net cash flow (receipts – payments)
xx
xx
xx
Closing balance (opening balance + net cash flow)
xx
xx
xx
Cash outflows (payments)
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The objective of cash budget analysis and interpretation is to have advanced warning of cash surpluses and deficits to enable action to be taken such as: •
Investing surplus cash to gain interest
•
Taking out a loan
•
Reschedule timing of receipts or payments
Exam tip: Remember to take care over the timings of the actual cash flows and omit non-cash items from the cash budget, such as depreciation and bad debts.
Profiled budgets Profiling indicates how the total annual budget will be split between months to show the timing of the budget spend over the year.
Item
Annual
Year to date Year to date Year to date
budget
budget
actual
variance
Example 1
xx
xx
xx
xx
Total
xx
xx
xx
xx
Exam focus Exam questions on profiling tend to focus on preparing a part year budget for a specific service. It is important that you read the question in detail and treat the months correctly.
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Inflation and budgets Inflation can negatively impact a budget and there are two basic approaches to incorporating inflation into the budgetary process. 1) Fixed price basis •
Calculate the actual increase in price levels from last year’s base budget up to the current base budget date.
•
Estimate the effects of further price increases to the end of the budget period in overall terms.
•
Provide a contingency for this overall amount.
Advantage: prices are known at a point in time and the degree of change from the base year to this time can be assessed accurately. Disadvantage: further price increases will affect the budget after the fixed-price date and throughout the actual budget period. 2) Outturn method •
Identify known pay and price increases.
•
Estimate future pay and price increases on the basis of best known information and guidance available.
•
Incorporate the above information into budgets through uplifting the base budget.
Advantages: inflation is already built into the budget, the budget is fully determined at the outset and it fits the concept of cash limits. Disadvantage: if inflation is high, there can be inaccuracies in the budget, because predicted pay and price increases will have a high margin of error. (However, in fixed price budgeting any such inaccuracies would need to be reflected in the contingency).
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3. Budgeting Exam tip: Look out for part year adjustments when using the outturn method and applying any percentage increases. For example, if a 2% inflationary pay rise becomes effective from 1 July in an April to March financial year, then the 2% should be multiplied by 9/12 months. Many examination questions ask students to find the contingency / highlight the difference between the two approaches.
Exam focus Ensure that you understand and can calculate elements from within:
3.4.
•
revenue budgets (outturn and fixed price)
•
profiled budgets
•
functional and master budgets
•
cash budgets
Preparing cost estimates
Predicting cost behaviour based on past estimates often involves separating historic costs into their fixed and variable elements. There are two methods for establishing the fixed and variable elements of a semi-variable cost. •
The “high/low” method of cost estimation.
•
Linear regression.
High / low method High/low method stages: 1) Establish the unit variable cost. 2) Calculate the total variable cost. 3) Establish the fixed element of the cost. 4) Estimate cost at required activity level
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The equation of a straight line to forecast costs is: Total costs = Fixed costs + (Units made x variable cost per unit) which can be written as y = a + bx where y is the total cost and x is the number of units made. Using the high-low method we have identified “a” (the fixed cost) and “b” (the variable cost per unit). Exam tip: You are likely to need to use the high/low method to separate fixed and variable elements of semi-variable costs. Some questions will ask you to classify a number of costs as F, V, SV or SF (Stepped) and hence calculate an overall cost.
Correlation •
Correlation techniques are used to determine the strength of the relationship between two variables (x – independent and y - dependent).
•
On a scatter graph the x-axis is used to plot the independent variable (the factor that affects the other) and y-axis is used for the corresponding dependent variable.
Definition Line of best fit is drawn on a scatter graph to show the relationship between the variables and is a straight line which minimises the variances between the data points and the line.
Correlation coefficient •
The correlation coefficient (r) measures the degree of a linear relationship between 2 variables (x and y) and always lies between +1 and –1:
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-
Values close to +1 indicate a strong positive correlation.
-
Values close to –1 indicate a strong negative correlation.
-
A value of 0 indicates no correlation.
The formula is provided in the exam:
r=
n ∑ xy − ∑ x ∑ y n ∑ x 2 − (∑ x )
2
n ∑ y 2 − (∑ y )
2
The coefficient of determination (r2) The coefficient of determination tells us what proportion of the change in y (the dependent variable) can be explained (predicted by) the change in x (the independent variable). (Note that negative numbers are positive when squared so the coefficient of determination is always positive (r = 0.9, r2 = 0.81, r=-0.9, r2 = 0.81) Exam tip: If in the exam you calculate a correlation coefficient (r) outside of -1 to +1 then you have made an error in your calculations. If you cannot spot your error quickly leave this question and return to it later. Other examination questions test students’ understanding of what r and r2 represent along with correct identification of x and y (as independent / dependent).
Regression Regression indicates how two variables would be related if they had perfect correlation (r = +1 or r = -1) and enables estimations or forecasts of other values from the data given. The regression line is the line of best fit and has the equation y = a + bx Page 62
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Two ways to find the line of best fit: 1. Draw a scatter diagram and “line of best fit” by eye. 2. Calculate the line of best fit mathematically using the formulae for a and b: b
=
nΣxy-ΣxΣy n Σ x2 - (Σx)2
a
=
Σy - bΣx n
n
Exam tip: note that you need to be able to calculate ‘b’ first in order to calculate ‘a’.
Interpreting results The validity of the estimates by regression depends on: •
The correlation of the data. If the two variables are found to be closely correlated the forecasts are likely to be reliable (r > 0.7 or r < -0.7).
•
The range of x that the forecast has been applied to. Forecasts should only be made within the range of the original data (interpolation) and not used to forecast values outside it (extrapolation), as the relationship may no longer apply.
High correlation does not prove causation. Learning curves Where employees are introduced to new ways of working or production processes the production time per unit is likely to reduce as they become more familiar with the task. The relationship is not linear, and can be summarised as follows: Management Accounting
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As the cumulative level of output doubles, the cumulative average time per unit falls to a constant percentage of its previous value. •
The constant percentage is known as the learning factor or learning rate and in practice is usually between 70% and 85%.
•
The learning curve can be found in areas of complex, labour intensive production, where workers will be repeating the same task again and again. Examples include aeronautical engineering, construction, ship building etc.
•
Eventually the workers will achieve maximum efficiency and the rate of production will reach a steady state.
Illustration First unit took 10 hours. 90% learning curve Cumulative production (units)
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Cumulative average Total time time (hours) (Production units x reducing by 90% of average time) previous time
1
10
10
2
9
18
4
8.1
32.4
8
7.29
58.3
Management Accounting
0.
Exam focus You may be asked to: •
find how long units took to make by applying the learning rate
•
derive the learning rate using the time taken to make the later units
Remember that the lower the percentage the faster the workers learn.
4. Financial control 4.1.
Features of budgetary control
Virements Definition Virement is the transfer of monies from one budget head to another.
This is a tool that can be used as a means of control. If we did not have virement, budgets would be too rigid and control would be too detailed. Regulations governing the use of virements may include: •
Specify who is allowed to exercise virements and any approval required.
•
Establish the level in the budget where virements are permitted.
•
Specify the maximum amount that could be transferred, either in absolute or percentage terms.
•
Identify funding restricted in terms of virement (i.e. ring fenced).
•
Identify items unsuitable for virement.
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Profiling of budgets Advantages: •
Profiles are based on patterns of known expenditure and income.
•
Not everything is spread evenly over the year, so comparing against twelfths may distort views on performance.
•
Can be used to encourage the budget-holders to get involved (e.g. in deciding the profiling).
•
Enables better budgetary control and performance monitoring to be carried out.
Disadvantages: •
Past expenditure and income patterns may not be typical of the future.
•
Profiling can be dangerous if budget-holders are not educated and involved in the process.
Exam focus Exam questions on profiling may be computational or discursive. Ensure that you can discuss profiling as a budgetary control tool (including having an awareness of its advantages / disadvantages).
Decision makers and budgetary control Budgetary control reports are designed and produced by financial experts. However, the recipients of budgetary control reports are managers who are often nonaccountants.
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It is important that the budgetary control reports provide the information required by the manager in order to facilitate their decision making. Key factors to enhance comprehension of budgetary control reports: •
Avoid any barriers to understanding such as the use of jargon or obscure abbreviations.
•
Keep the content as simple as possible.
•
Be prepared to experiment with different formats until one is found which managers find helpful.
•
Keep it relevant to the recipient.
•
Distinguish between controllable and uncontrollable items within the budget.
•
Provide relevant non-financial information.
•
Provide advice and training on the interpretation of the reports.
Controllable products and services The controllability principle relates to managers being held responsible only for those costs that they can significantly influence. Key guidelines: •
If the manager can control the quantity and price paid for a product or service, then the manager is responsible for all the expenditure incurred for that product or service. This means the product or service would be classed as controllable.
•
If the manager can control the quantity of the product or service but not the price then only the variance between budget and actual for usage (not price) should be identified as being due to the manager responsible.
•
If the divisional manager cannot control the quantity used or price paid, then they should not be held
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accountable for this expenditure. The costs are uncontrollable. Negotiation People involved with an organisation’s budget will need to compromise and negotiate in determining both the budget priorities and individual budgets set. Constructive and destructive behaviour The budget setting and budgetary control processes that an organisation has in place can have significant effects on behaviour. Issues that impact on behaviour include: •
Responsibility versus control of items in budget.
•
Performance assessment of manager.
•
Realistic targets.
•
Participation in setting the budget.
4.2.
Budgets used to evaluate performance
Fixed and flexible budgets Fixed budgets •
Prepared based on estimated production and sales volumes.
•
Stays static throughout budget period (“fixed”).
•
Risk that actual performance (based on actual activity level) gets compared to a budget for a different (fixed) output level – not “comparing like with like”.
Flexible budgets •
Budget updated to reflect actual output or activity levels.
•
Recognises different cost behaviour patterns.
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Used for performance monitoring and control (comparator for actual activity levels).
•
To prepare flexible budgets: •
Separate costs by behaviour – variable, fixed, semivariable or stepped costs.
•
Identify fixed and variable elements of semi-variable costs using either high/low method or regression (only use regression if asked).
•
Flex the budget to required activity level.
Standard cost and variance calculations Standard costing involves comparing budgeted and actual costs, with variances calculated.
Key point In standard costing the flexed budget is called the standard budget and the original budget remains the budget. The standards must be flexed for the usage and efficiency variances in order to be comparing like with like.
Basic variances to calculate include: •
Materials price
•
Materials usage
•
Labour rate
•
Labour efficiency
Exam tip: if there is more than one type of a resource (labour or material), you must produce two sets of variances one for each type of material or labour. For example: •
Material price variance for Material A
•
Material price variance for Material B
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4. Financial control You must never combine all types of materials or all types of labour when calculating variances.
Additional variances include: •
Variable overhead efficiency
•
Variable overhead expenditure
•
Fixed overhead efficiency
•
Fixed overhead expenditure
•
Fixed overhead capacity
•
Sales price variance
•
Sales volume variance
Sales:
Sales price variance
SPV
=
(AP-
Sales volume variance
SVV
=
(AQs-
Materials price
MPV
=
(SP-AP)AQ
MUV
=
(SQ-AQ)SP
SP)AQs BQ)Sπ Materials:
variance Materials usage variance Labour:
Labour rate variance
LRV
=
(SR-AR)AH
Labour efficiency
LEV
=
(SH-AH)SR
VExV
=
(SR-AR)AH
VEfV
=
(SH-AH)SR
FExV
=
BFO-AFO
FVV
=
SFO – BFO
variance Variable
Variable overhead
overheads:
expenditure variance Variable overhead efficiency variance
Fixed
Fixed overhead
overheads:
expenditure variance Fixed overhead volume variance
or (SH-BH)SR
Fixed overhead
FEfV
=
(SH-AH)SR
efficiency variance Page 70
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4. Financial control Fixed overhead
FCV
=
(AH-BH)SR
MMV
=
(AQSM-
capacity variance Mix and
Material mix variance
yield
AQAM)SP
variances: Labour mix variance
LMV
=
Material yield variance
MYV
=
Labour yield variance
LYV
=
(AHSMAHAM)SR (SQSMAQSM)SP (SHSMAHSM)SR
Mix and yield variances Can be calculated where two or more different types of a resource are mixed (in given proportions) to produce the final product or service. •
Mix – the relative proportion or combination of the different inputs (e.g. direct materials or labour).
•
Yield – the quantity of finished output units produced from a budgeted or standard mix of inputs.
These variances can only occur where inputs are substitutable.
Exam tips: The formulae for calculating variances are not included on the examination formulae sheet so make sure you learn and can apply them. The calculation of Mix variances is more common than Yield variances, as you need to complete the Mix workings to calculate the Yield. Avoid rounding during the calculation of variances.
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Standard costing in the service sector For standard costing to be useful in the services sector there are four conditions which must be met: 1)
There must be a standard unit of service that has been identified and can be delivered to all service users.
2)
The resources required for one unit of the service must be identified, standard and measurable.
3)
The actual level of output must be measurable and costs able to be ascertained.
4)
The service must be delivered in high enough volumes to meet cost benefit criteria.
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Profit reconciliation statement £ Budgeted profit
x
Sales volume variance
x
Standard profit
x
Sales price variance
x
Materials price variance
x
Materials usage variance
x
Labour rate variance
x
Labour efficiency variance
x
Variable overhead expenditure variance
x
Variable overhead efficiency variance
x
Fixed overhead expenditure variance
x
Fixed overhead efficiency variance
x
Fixed overhead capacity variance
x
Actual profit
x
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Cost reconciliation statement £ Standard cost
x
Materials price variance
x
Materials usage variance
x
Labour rate variance
x
Labour efficiency variance
x
Variable overhead expenditure variance
x
Variable overhead efficiency variance
x
Fixed overhead expenditure variance
x
Fixed overhead efficiency variance
x
Fixed overhead capacity variance
x
Actual cost
x
Exam tip: Make sure you treat the variances accurately in the profit or cost reconciliation statements. For profits: •
Favourable variances have positive impact on profit
•
Adverse variances have negative impact on profit
For costs: •
Favourable variances decrease cost between budget and
•
Adverse variances increase costs between budget and
actual actual
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Investigation of variances All significant variances should be investigated to establish likely cause and/or learn lessons. However, there are concerns in variance analysis including: •
Defining what constitutes a significant variance.
•
Assessing the impact on variances of random factors.
•
Making allowance for the effect of inflation, especially in volatile areas.
•
Controllability of certain budget lines and their associated variances.
•
Impact of measurement errors.
•
Risk of stressing financial performance and control to the detriment or even exclusion of non-financial considerations.
Determining variance significance Approaches include: •
Absolute amount
•
Percentage of budget
•
Statistical control charts
Planning and operational variances Planning and operational variances are a way to separate variances into areas that are controllable by a manager and those that are not. •
Actual results are compared with a realistically achievable (revised) flexed budget – this is the operational variance
•
Realistically achievable (revised) flexed budget compared with original (initial) budget – this is the planning variance
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4. Financial control Exam tip: You will not be asked to perform calculations of planning and operational variances in the exam but should be able to discuss their usefulness in interpreting the variances produced.
If planning errors are due to unforeseen events, then they are not under management control and should be excluded from a budget/actual comparison. When planning variances arise from circumstances that might have been foreseen, the knowledge can be used to improve future standard-setting and budgeting. Problems of planning and operational variances: •
Interdependencies
•
Setting the standard
•
Interpretations
•
Redundancy
•
Cost
Determining the causes of variances Methods include: •
Pareto diagram - indicates how frequently each type of problem occurs
•
Cause and effect diagram - identifies potential causes of failures or defects. For each category of failure reasons are sought and as additional arrows are added for each cause, the general appearance of the diagram begins to resemble a fishbone.
4.3.
Statistical analysis of variations in performance
Arithmetic mean x
= Σx/n
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Median •
The median of a set of numbers is the value for which half of the numbers in the set are larger and half are smaller.
•
Useful if a distribution is skewed (one or two of the results are very different from the rest) and the arithmetic mean is therefore unrepresentative.
Mode •
The value that occurs most often
Range •
Highest value – Lowest value
Standard deviation •
A measure of dispersal
•
Measures how far on average the individual outcomes deviate from the mean.
The formula for standard deviation The standard deviation of a population (σ) is
σ=
∑ (x − µ)
2
n
Where: μ = arithmetic mean of the population n = number of items in the population Standard deviation of a sample If the data being measured is a sample from a larger population the formula is altered:
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4. Financial control
∑ (x − x)
s=
2
n −1
Where: x
= arithmetic mean of the sample
n = number of items in the sample Coefficient of variation •
Calculated as:
•
Is a measure of relative risk and is useful when comparing projects of differing scale.
Standard deviation / Mean
The normal distribution •
A symmetrical bell curve, which represents an entire population with 50% of the population below the average and 50% above it.
•
Many naturally occurring phenomena are normally distributed, but so are many business processes.
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99.74% 95.44% 68.26%
34.13%
34.13%
13.59%
13.59%
2.15%
2.15% 0.13%
0.13% Standard -3 deviations
-2
-1
0
+1
+2
+3
Average
•
68.26% of a normally distributed population falls within 1 standard deviation of the mean (34.13% above it, 34.13% below), 95.44% of the population falls within 2 standard deviations and 99.74% of the population falls within 3 standard deviations
•
Knowledge of the standard deviation of a normally distributed process can be used to set the investigation limits on a statistical control chart
•
If the outcomes recorded are within three standard deviations of the mean then the process is deemed to be in control. However if they fall outside then an alert is raised and an investigation is carried out.
•
Management may choose to add a warning limit at two or two and a half standard deviations. If results start to fall regularly in this range it is a suggestion that things may not be operating properly.
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5. Financial decision making 5.1. Applying relevant costing to short-term decisions Short-term decision making (STDM) is used to determine management’s response to short-term opportunities and threats that were not planned for in original budgets for the period. Relevant costing: •
Has marginal costing principles at its core
•
Does not reflect the full cost of products and services
•
Is not a sustainable technique in the long term
Definition Relevant costs are receipts and payments that will change as a result of the decision being assessed - i.e. they are differential future cash flows.
Applying relevant and non-relevant costs Relevant costs: •
Must change as a result of the decision
•
Will be future costs / benefits
•
Must be cash flows
Non-relevant costs: •
Will not change as a result of the decision
•
Sunk costs – have already been paid
•
Committed costs – must be paid and cannot be changed
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•
Costs common to all decisions made
•
Non-cash items e.g. depreciation
Opportunity costs Definition
Opportunity cost is the benefit forgone as a result of pursuing one course of action, rather than pursuing the best alternative course of action.
Identification of relevant costs – general rules Variable costs •
Usually relevant
Fixed costs •
Usually non-relevant in short term
•
May be relevant if specifically attributable to the product or area that is the subject of the decision (divisible fixed costs)
Common issues Machinery •
Once bought capital cost is sunk cost.
•
Capital charges on owned machinery are not relevant.
•
Costs for machine hired specifically for a job are relevant.
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Materials •
Historical price paid for materials already in inventory is not relevant (sunk cost).
•
Replacement cost is relevant for materials in inventory that need to be replaced.
•
Relevant cost is the higher of resale value or value in alternative use for materials in inventory and not being replaced.
•
Materials in inventory and having no other use have a relevant cost of zero.
Direct Labour •
Salaries are committed costs.
•
Non-relevant if spare capacity and the labour force are to be maintained in the short term.
•
Casual labour is relevant.
•
Where a special order diverts staff from originally planned tasks but they are replaced by newly recruited staff, it is the cost of the latter that is relevant to the special order.
•
Where at full capacity, and no extra labour supply is available, the opportunity cost of transferring labour from other tasks to a special order becomes relevant.
Common scenarios •
Cessation of an operating unit/business segment
•
(Dis)Continuance of a project
•
Special orders
•
Make or Buy
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Decision making in practical situations Deletion of a Segment/Product •
Calculate the unit contribution for the product/segment.
•
If the product under review makes a positive contribution it should be retained.
•
Be aware of other issues if decide to delete.
Special Sale Price (Order) Decisions •
Calculate the unit contribution associated with the order including all relevant costs (including opportunity cost if some resources scarce and an alternative use would have to be forgone).
•
If the option makes a positive contribution it should be accepted.
•
Consider knock on effects of decision.
Make or Buy Consider: •
Are fixed costs relevant to the decision in that some are saveable if buy as opposed to make?
•
Qualitative issues e.g. staff morale, quality of product etc.
•
Are there any opportunity costs in that internal capacity is scarce and to make would divert resources from other uses?
Issues / Dangers in relevant costing •
Continue treating fixed costs as non-relevant resulting in understatement of costs.
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•
Difficulty in obtaining costs of alternative courses of action.
•
Ignore non-financial issues.
•
Managers not accepting relevant costing concept.
Non-financial issues When making short term decisions it is also important to consider the non-financial implications. For example: •
Using spare capacity to avoid making workers redundant
•
Potential future offers which would be more worthwhile
•
Market perception
•
Long-term implications
Exam focus Exam questions may focus on any of the possible relevant costing scenarios so it is important that you understand each of them. In addition narrative questions often list a number of costs, which the student needs to assess as being relevant or not relevant.
5.2. Cost volume profit analysis (CVP) CVP is a systematic method used to examine the relationship between costs, revenues, profits and sales volumes.
Exam focus CVP analysis is a common area that appears in the exams. Typical issues that are examined include: 1.
Calculating the breakeven point mathematically.
2.
Calculating the margin of safety.
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3.
Calculating the breakeven point / calculating the level of profit at a given level of sales from a graph.
Cost behaviour assumptions CVP analysis assumes: •
Fixed capacity
•
Constant total fixed costs
•
Constant unit variable costs
•
Constant unit price
Breakeven analysis Key point The Breakeven Point (BEP) is the level of sales volume at which neither a profit nor a loss is made. The formulae associated with breakeven analysis will not be provided as part of the exam question.
BEP (units)
=
total fixed costs ÷ contribution per unit
Contribution per unit = sale price - unit variable cost Units needed for target profit = (fixed costs + target profit) contribution per unit The margin of safety is the percentage by which sales can fall before a loss is made. Margin of safety: (expressed as a % of sales level) Management Accounting
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expected sales - breakeven sales expected sales
x 100%
Selling price at a particular breakeven point Total fixed costs + (Breakeven point x Unit variable cost) Breakeven point Breakeven charts •
Shows the profits and losses at different output levels by plotting the total cost and total revenue functions.
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Profit/volume chart •
Shows the relationship between profit and volume with the BEP where neither a profit nor a loss is made.
Exam focus Students need to be familiar with interpreting both profit/volume and breakeven charts. Exam questions on graphical interpretation are quite common.
Two CVP models The accountants’ model assumes that: •
Costs and revenues are linear and proportional to activity levels.
•
There is one BEP assuming fixed costs remain fixed.
•
Fixed costs are fixed but recognise changes as they occur (stepped cost).
The economists’ model assumes that: •
Costs and revenues are curvilinear.
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•
There may be more than one BEP within a relevant range.
•
Fixed costs are fixed but an average fixed cost is taken if changes occur.
Exam focus The examiner may test your ability to explain the theory that underpins CVP analysis. For example being aware of the underlying assumptions or being able to distinguish between the two models above.
5.3.
Key factor analysis
In a situation of scarce resources the aim of the firm is to maximise the contribution earned from the use of resource. Method: 1
Find the contribution per unit of the products
2
Find the contribution per limiting factor (CLF) of each product
3
Rank the products in order of CLF
4
Allocate the scarce resource up to the maximum demand to the product with the highest CLF, then allocate to the product with the next highest CLF and continue until the resource is used up.
Exam focus This topic may well be tested by means of determining a production plan (e.g.: B then A then D...…) or by calculating how much of a particular product is likely to be produced.
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5.4.
Costing for production decisions
Customer profitability analysis CPA is a technique for assessing the value that different customer segments contribute to company profits. The aim is to identify: •
which customers are the most profitable
•
what it is about their behaviour that is responsible for their profitability
Definition The basic CPA calculation for each customer segment is: Customer revenues – traceable customer costs = customer contribution
Costs and revenues are assigned to each identifiable customer segment. Tracing indirect customer costs means •
Establishing cost drivers for each customer related activity (e.g. sales visits, order handling, degree of customisation, speeded deliveries etc.)
•
Apportioning relevant overheads using the cost drivers in the same way as ABC.
Using CPA Originally unprofitable customers would be shed (and become loss making for the competitors instead). A more modern approach suggests that if a customer is not contributing enough profit the organisation must manage the customer relationship better by •
encouraging lower cost behaviour e.g. incentives for placing fewer larger orders
•
charging for high cost activities
When considering their approach, the business must also take account its relationship with its customers. Some customers make modest contributions, but still add value Management Accounting
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(e.g. making referrals or playing a part in product development.) Lifetime Profitability Customer Analysis (LPCA) LPCA takes a broader view than basic CPA by considering how customers may alter their behaviour over the lifetime of their relationship with the organisation. Customers be expensive to service at first, but over many years repay that cost by demanding more high margin products. Target costing Target costing is a Japanese technique designed to manage costs from the very start and so prevent them being ‘designed in’ and where possible reduce planned expenditure significantly. Once the organisation has developed a product that satisfies the needs of potential customers, the steps are: 1
Agree a target price – based on how much the customer is willing to pay (based on the perceived value of the product and the current price charged by competitors).
2
Decide on desired profit
3
Derive a target cost by subtracting the desired operating profit from the target price.
4
Estimate the likely costs and compare with the target.
5
If estimated costs exceed target, use a range of cost and value engineering tools to reduce costs until target is reached.
The gap is closed by considering the whole value chain for the product using a multi-disciplinary approach.
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The theory of constraints This technique identifies, and attempts to deal with, the existence of bottlenecks in the provision of a product or service. Definition Bottlenecks: Critical points in a process where a constraint is limiting the amount of work that can be performed in a given period of time.
Five basic steps to dealing with bottlenecks in a process: 1
Identify the constraints or bottlenecks in the system
2
Decide how to exploit the bottlenecks –ensure that the best possible use can be made of the system at that point
3
Subordinate everything else to the decision in step 2 – run the whole process to support the smooth movement of the bottleneck process. Note this means slowing down before the bottleneck to avoid a backlog
4
Elevate the bottleneck – find a way to remove the constraint whether by providing additional resources or introducing new technology
5
If bottleneck has been broken go back to step 1 and reapply the steps to the next bottleneck identified.
TOC in manufacturing Originally devised for manufacturing, where a bottleneck emerged in a production process, aim was to: •
Increase throughput contribution – rate at which system makes money from sales
•
Decrease investment – spending on purchases to create sales (inventory, R&D, non-current assets etc.)
•
Decrease operational expenses –money spent on creating goods for sale
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0.
Using the TOC requires the application of throughput accounting (TA) Two calculations: 1
The throughput contribution per hour (the return per factor hour) of the bottleneck:
Sales price p/u - material cost p/u Hours unit spends in bottleneck resource 2
The cost per factory hour to run the process, calculated as:
Total factory cost Total time available on key resource These can be combined to identify productivity of the factory. The aim is to achieve the highest possible TA ratio where: TA ratio = Return per factory hour / Cost per factory hour As TOC process is put into place, TA ratio can be monitored to ensure improvement is made. TOC in the service sector The concepts underpinning TOC have now spread to service industries and the public sector. The bottleneck in a service industry could be the manual processing of a document, the visit of a consultant, or the unpacking of a delivery, but the same principles apply. Exam focus Questions requiring calculations are quite common for CPA, but questions in the other areas tend to be discursive in nature.
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