Lesson 1 Introduction to Management Accounting

ACF311M1/M2 Module

Lecture Notes

B.Devlin

INTRODUCTION

TO

MANAGEMENT ACCOUNTING

Lesson 1 Introduction to Management Accounting

What is accounting?

Accounting is an information system. It exists to provide information for the end-user. It is possible to distinguish between two branches of accounting.

1 Financial accounting.

The purpose of financial accounting is to report the financial performance of the company. It’s main focus is on external reporting to a number of groups viz.

Owners (shareholders)

Loan creditors (banks)

Trade creditors (suppliers)

Sundry creditors (suppliers of services)

Government agencies (tax authorities)

Employees (trade unions)

A set of financial statements - a profit and loss account, a balance sheet and a cash flow statement are prepared and published.

2 Management accounting

The main purpose of management accounting is to provide information to the management team at all levels within the organisation for the following purposes:

(a) formulating the policies - strategic planning

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

(c) controlling the activities of the organisation

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

(e) performance appraisal at strategic and operational level

Definition: Management accounting is the application of professional knowledge and skill in the preparation and presentation of accounting information in such a way as to assist management in the formulation of policies and in planning and controlling the operations of the organisation.

Let us look at a simple financial statement.

Example Financial Accounts

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

Financial accounts indicate the results of a business over a period of time. They deal with historic or past costs and are concerned with stewardship accounting.

A management accounting/ cost statement provides information to allow managers to plan, control and organise the activities of the business. The purpose of a costing/maagement accounting information system is:

To provide information about product costing to be used in financial

Statements.

To provide information for planning, controlling and organising.

The information provided by the costing system should be:

Relevant

Reliable

Timely

Succinct

Presented in the desired format.

A cost system should be

Cost effective

Appropriate for the organisation

Encourage managerial action.

Example Management Accounts

		Products
	A	B	C	Total
Materials	£4,800	£3,700	£6,500	£15,000
Wages	1,500	2,500	3,000	7,000
Prod. overhead				2,000
	-------	-------	-------	-------
Prod. cost	6,800	6,800	10,400	24,000
Admin. costs				2,000
Selling costs				1,000
	-------	-------	-------	-------
Total cost	7,800	8,000	1,200	27,000
Sales	10,240	10,800	8,960	30,000
Profit	2,240	2,800	----	3,000
(Loss)	----	----	(2,240)	----
Net profit margin	24%	26%	----	10%
	-------	-------	-------	-------

This performance statement is of the same business as the previous example of

Financial accounts. However, it gives management much more information. It analyses the cost elements in respect to materials, labour and overheads allowing management to focus on costs which require investigation and control. It facilitates decision-making. E.g. should product C be discontinued?

Compared to the financial accounts the management accounting information which is much more comprehensive will allow management to better carry out their functions of planning, controlling organising and decision-making.

Cost classification

The management accountant will use cost information for two main reasons.

To ascertain the cost of a product. This information is used to value stock which is required for external reporting.

To assist management in the decision-making process.

Cost Objectives

(a) Product costing

It is essential for an organisation to ascertain the cost of manufacturing a product. The information is used for two purposes:

Also some businesses use a cost plus pricing strategy. The product cost is calculated and a mark up percentage is added to arrive at a selling price which gives a reasonable gross profit which in turn can cover the non-production overheads and leave a satisfactory net profit.

(b) Decision making - Cost behaviour

The classification of costs into variable, fixed and semi-fixed is important in terms of decision-making and cost control, activities that comprise the fundamentals of the management accounting function.

Variable costs are those costs which increase/decrease with the level of production and sales. In a manufacturing company the variable production costs change directly with the level of production.

Fixed costs can be either committed fixed costs or discretionary fixed costs. Fixed costs are termed fixed because they do not change in response to changes in the level of activity. It should be noted that they are not fixed because they do not change because cost items like rent is often subject to revision.

Semi-fixed/semi-variable costs are costs which move in the same direction but not at the same rate as the level of activity. The semi-fixed/semi-variable cost contains a fixed and a variable element. For example, the electricity bill contains a fixed or standing charge and and the variable aspect which depends on usage.

Cost ascertainment

It is important that the management accountant can determine the variable and fixed costs and there are a number of techniques to assist in separating the fixed and variable elements of semi-fixed or semi-variable costs.

Analysing costs by direct observation of the resources required to convert materials into a finished product and applying costs to these activities. Direct materials, direct labour and machine time can be established quite easily.

Example

Output 10000units £30000

15000units £40000

£40000 - £30000 = £10000/

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

The fixed costs therefore are £10000.

Costs

Output

On the scattergraph total costs are plotted against output at a number of different activity levels. Then a ‘line of best fit’ is drawn through some of the coordinates. Where this line coincides with the Y axis this represents the level of fixed costs. Once this is established it is simple to calculate the other costs which are not fixed ie. the variable costs. The assumption is that at zero output the business still has to meet the fixed costs- the periodic costs related to time.

MARGINAL COSTING

FOR

DECISION MAKING

Lesson 2

One of the main functions of management is decision-making. Many of the decisions are of a short-term nature. Only rarely is a manager faced with a decision which has a long term impact eg. buying a new machine, expanding the factory, take-over of another company. Since most of the decisions have a short-term impact it can be assumed that the capacity of the factory will not change. Therefore fixed or periodic costs are not affected by tactical short-run decisions. The only costs which are affected are variable costs ie. those costs which vary directly with the level of activity of the factory. These would include direct materials, direct labour and variable overheads.

Also all the decisions comprise a choice between alternative courses of action. Therefore, past costs can have no relevance for future decisions. Past costs can consist of sunk costs or committed costs.

In marginal costing all costs are classified according to how they behave. They are either variable or fixed. The fixed costs are treated as periodic ie. they are related to time. Examples of fixed costs would be rent, rates, insurance, depreciation etc. These costs stay constant in the short-term regardless of the decision that management takes. Therefore, in making decisions, in choosing between different alternative courses of action management identifies the variable costs and treats the fixed costs as irrelevant.

To summarize the technique of marginal costing:

· Costs are classified as either fixed or variable.

· In the short-run all fixed costs remain unchanged and therefore treated as irrelevant.

· The only relevant costs are variable costs ie. those costs which increase/decrease as output increases/decreases.

Definition: Marginal costing is a costing principle whereby variable costs are charged to cost units and the fixed costs attributable to the relevant period are written off in full against the contribution for that period. (ICMA)

Marginal cost = variable cost = direct materials

Direct labour

Direct expense

Variable overhead

Contribution = sales revenue - variable(marginal) costs

Contribution is the amount which helps to pay off the fixed costs and any excess represents profit. Contribution is not profit.

Marginal cost is the amount at any given volume of output by which total costs are changed if the volume of output is increased or decreased. It is the cost of making one extra unit of output. The definition stesses the manner in which costs behave in relation to the volume of activity. It concerns the identification of variable and fixed costs ie. the costs that increase or decrease as output increases or decreases. Only the variable costs both production and non-production change as the output changes.

Example:

A company manufacture units with avaiable cost per unit of £2 and fixed costs of £5,000.

Volume (costs)			1,000	10,000
	£	£	£	£
Variable costs	---		2,000	20,000
Fixed costs	5,000	5,000	5,000	5,000
	-------	-------	-------	-------
Total cost	5,000	5,002	7,000	25,000
	-------	-------	-------	-------

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

Extra contribution 6,000

----------

Profits can be increased by an additional £6,000 since fixed costs are already covered. However management must consider other relevant factors in arriving at the final decision.

How will existing customers react? They may wish to buy at £1.10 per unit. Could the spare capacity be used more profitably rather than accepting the special order?

Shut-down decisions

With product C making a loss management might consider discontinuing this product. However, using marginal costing principles, with fixed costs treated as irrelevant for short-run decision-making the income statement can be reformatted.

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

Since product C makes a contribution it may be inadvisable to close it down. If Product C is closed down the company will lose £1,000 contribution and the overall effect would be to reduce profits to £17,000.

Make or Buy

Limiting factor decisions

Often a company finds that there is a limiting factor or constraint which inhibits its capacity to meet the desired production level. The limiting factor may be any resource eg. materials, labour or machine hours. Management has to decide what is the best way to allocate the scarce resource among the product range in the most effective way so that profits are maximised.

Example:

Product	X	Y	Z
Desired production (units)	1,000	2,000
	£	£	£
Selling price per unit
Variable cost per unit
	-----	-----	-----
Contribution per unit

Desired production level

Product Z	500 units x 2 hrs.	1,000 hrs
Product Y	2,000 x 5 hrs	10,000 hrs
Product X	200 x 20	4,000 hrs

Product Z earns 500 units x £10 = £5,000 contribution

Product Y earns 2,000 units x £15 = £30,000 contribution

Product X earns 200 units x£20 = £4,000 contribution

---------

£39,000 contribution

----------

COST VOLUME PROFIT

ANALYSIS

Lesson 3

Cost Volume Profit Analysis

The CVP model makes the assumptions that costs can be simply divided into fixed and variable costs. It assumes that over a range of output levels - the relevant range - fixed costs remain constant and variable costs increase directly with output. The variable costs behave in a linear fashion. The fixed costs are periodic costs so that cost items such as rent, rates, insurance, depreciation etc. are constant at all levels of output. There is also an assumption that the sales revenue behave in a linear fashion ie. the selling price is constant per unit of output.

Economists take a more realistic view of cost behaviour. They contend that variable costs do not behave in a linear fashion but are effected by economies of scale. Companies can benefit from discounts for bulk purchases of materials and

The economies from the division of labour. The economists’ model represented in a curvilinear graph shows the total cost line rises steeply at low output levels, levels off within a range of output and finally rises steeply again as the benefits of economies of scale decline. The total revenue line rises steeply, levels off and then declines. This curvilinear total revenue line reflects the fact that to achieve more sales the company may have to reduce the selling price and does not increase proportionally with output.

As a compromise it is possible to accept the assumptions that the CVP model is based on within a certain range of output - the relevant range. Therefore, the CVP model can be used as a planning technique to:

(a) find the break-even point

(b) determine the margin of safety

(c) determine a target volume

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

(e) determine the operating gearing

Then

Sales - Variable costs = Contribution

Contribution is the excess of sales over variable costs and it represents the surplus available to meet the fixed costs. Once the fixed costs have been met any contribution left is profit.

Contribution per Unit

P/V or C/S ratio = Contribution X 100

Sales

The P/V ratio indicates the % of contribution to sales.

Formulae:

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

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

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

-----------------------------------

Contribution per unit

4 Profit volume ratio = Contribution x 100

----------------------------

Sales revenue

5 The Operating Gearing = Contribution / Profit

It is possible to present the profit volume relationship in a chart, a profit-volume chart. This chart dispenses with the need to draw cost and revenue lines and concentrates on the relationship between profit and output.

Revenues

and

Costs (£)

Output (units)

A break-even chart

Profit

Output (units)

Loss

Model.

Mix.

BUDGETING

The Planning Process

All organisations have their objectives. Some of the objectives may not be expressed in accounting terms for example objectives to improve the welfare of the staff or to improve the impact on the local environment. However, in this chapter the emphasis is on objectives usually expressed in quantitative terms eg. increase in market share, profit growth, increase in the asset value etc which they wish to achieve. There are three levels of planning - corporate long term planning, medium term planning and annual planning or budgeting. The annual budgets are steps along the way to achieve the long-range plan of the organisation.

Budgets are part of the planning and control process. They help to define the objectives of the organisation. Budgeting is probably the most important contribution that the accounting department makes to the role of management.

The accountant draws up a plan which integrates the various functional areas of the business. Control is exercised by firstly, delegating responsibility to departmental managers for the attainment of the budgets and then the regular comparison of the actual results with the planned outcomes.

The administration of the budget is the responsibility of the budget officer who is usually the accountant. The accountant works in conjunction with the budget committee comprised of the departmental management. Senior management

Outline the broad strategic objectives of the organisation and communicate these to the functional managers. The budget committee identifies the key budget factor which determines what acts as a constraint on the organisation’s activities. This key budget factor decides the key budget ie. the one which sets the objectives for the subordinate budget. The subordinate budgets are constructed by asking the questions - when are the goods to be sold, where are the goods to be sold and how are the goods to be produced.It may be the sales volume which drives the other subsidiary budgets. For instance, if the sales department forecasts the annual sales at 20,000 units then the production budget must be integrated with this figure. Alternatively, productive capacity may be the key budget factor. The company may have the capacity to produce only 18,000 units a year so this figure sets the objectives for the other budgets.

The accountant helps the managers to set the budgets by providing information as required. Sales forecasting may proceed by means of statistical methods which are based on economic indicators or by carrying out an internal forecast by canvassing the sales staff. The current sales level, past trends, market research can provide useful information.

On receipt of the various budgets the accountant notifies managers of revisions to their budget. Once the accountant and the committee agree the master budget which is a forecasted profit and loss account and balance sheet can be drawn up.

In terms of control the accountant is responsible for the regular monitoring of the budgets, for reporting back to the budget committee regularly(daily,weekly or monthly basis) through variance reports and for revising the budgets if necessary.

Preparing budgets

Example

The budgeted sales of Magee Engineering Lt. for 19x0 is as follows:

Product	Sales units	Unit selling price
Dag	20,000	£25
Mag	18,000	£20
Pag	15,000	£22

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

Dag increased by 20%

Mag increased by 50%

Pag increased by 20%

The purchasing director has requested that all components part stocks be reduced by 20% at the end of 19x0 because of improved delivery times from suppliers.

The product material specification and component cost for each of the products are as follows:

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

Sales Budget 19x0

Product	Units	Price	Total sales
Dag	20,000	£25	£500,000
Mag	18,000	£20	360,000
Pag	15,000	£22	330,000
	--------		------------
	53,000		£1,190,000
	--------		------------

Comment: the sales budget is computed from the sales information stated, the budget shows the the individual product sales units,sales value and total sales value. The budgeted sales for 19x0 are 53,000 units with a total sales value of £1,190,000.

Production budget 19x0

	Dag	Mag	Pag
Sales units (from the sales budget)	20,000	18,000	15,000
Add closing stock	3,600	4,500	2,400
	--------	--------	--------
	23,000	22,500	17,400
Less opening stock	3,000	3,000	3,000
	-------	--------	--------
Budgeted output	20,600	19,500	15,400
	--------	--------	--------

Comment: the production budget is the required production to meet sales budget requirements and changes in stocks, thus since closing stock requirements are greater than opening stocks then production must be increased to cope with required production for sales and increased closing stock requirements.

Comment: the material usage budget is the component usage. This is simply the production units from the production budget equated to the component specification in each production unit eg. material usage of compont A is the total usage of component A in Dag, Mag and Pag.

Comment: The material purchase budget gives the cost and quantity of each component that is needed to be purchased and the overall cost of all five components. This budget is based on the material usage budget adjusted for oppening and closing stocks.

Cash Budgets

Example

The London Toy Co. Ltd. commenced operations in December 19x0 with a capital of £600,000 which was raised through an issue of 600,000 ordinary shares of £1 each. The proceeds of the share issue were paid into the company bank account. During the course of December a number of transactions took place and these are summarized below.

Cash summary December 19x0

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

The profit and loss account is prepared on an accruals basis unlike the cash budget which is prepared on a receipts and payments basis. Also, depreciation appears as an expense in the profit and loss account.

Budgeted Balance Sheet

As at 30 June 19x1

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

Budgeted debtors, creditors and cash balance is obtained from the cash budget. Details of fixed assets can be obtained from the capital expenditure budget. Information about share capital, debentures etc. can also be obtained from the previous balance sheet.

Budgetary control is the establishment of departmental budgets relating the responsibilities of executives and the continuous comparison of actual with budgeted results, either to secure by individual action the objective of that policy or to provide a basis for its revision. The budget itself is merely a plan on paper which of itself will not be effective unless there is a system of control which can monitor the organisation’s progress to achieving the objectives.

By means of comparing actual results with the budgets and identifying any differences (variances) which occur management can take remedial action or revise the budget if necessary. The annual budgets are broken down into months so the comparison is performed regularly and results in a budget report ipresented to the departmental managers. To ensure that management are not overburdened with accounting data exception reports may be furnished. These reports identify only significant variances that require management’s attention and consequently are more user friendly and should encourage an appropriate managerial response.

Flexible Budgeting

Up to this point the budget has been fixed. This is quite appropriate for planning purposes but of little use for control purposes. The fixed budget does not respond to the actual level of activity. When organisations compile the master budget it is

based on a certain level of output and sales. In most instances, the company may find that this operating level is not set at the actual level of activity. Indeed most organisations find it difficult to forecast the actual level of activity eg. there may be a seasonal characteristic to the company’ trading. In such cases the business may find it more useful to prepare flexible budgets. A flexible budget is ‘designed to change in accordance with the level of activity attained’ (CIMA)

A fixed budget is not designed to change with different levels of activity. It does not allow for the pre-determination of costs and revenues at different levels of output which would facilitate comparison with actual costs and the identification of variances.

A flexible budget is designed to recognise cost behaviour at different levels of output so actual results can be compared with the expected results and the computation of variances and variance analysis is made possible.

Example:

A company produces garden furniture which experiences fluctuations in production levels because of its seasonal nature. The following costs for the budgeted level of activity of 20,000 units and the actual production costs fpr the period are given.

	Budget Costs (20,000 units)	Actual costs incurred (17,600 units)
	£	£
Materials - variable	21,000	20,000
Labour - variable	1,000
Maintenance - variable	3,000	2,680
Fixed production costs	10,000	10,000
Selling costs - fixed	5,000	6,000
	--------	--------
	40,000
	--------	--------

During the relevant period, the actual number of units produced was 17,600. You are required to prepare a budget flexed at the actual level of activity. In preparing the flexed budgets it is important to identify fixed and variable costs to forecast costs at different levels of activity.

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

The variance report highlights that in respect to actual materials, labour, maintenance and selling costs, these are higher than expected. Management can examine and analyse the variances and take appropriate action.

Many businesses prepare fixed budgets for departments where expenditure may be more predictable such as the administration department. Flexible budgets can be compiled for those departments whose expenditure is closely linked to the level of operations such as the production department.

So far the emphasis has been on the technical aspects of budgeting viz. the preparation and administration of budgets. However, the behavioural context deserves mention. One of the main components of budgeting is control which is all about altering the behaviour of the human resources in the organisation. Consequently, there may be some staff who regard budgets as a constraint on their freedom and may try to subvert the effectiveness of the budget. How can senior management ensure that the budgeting system can be most effective?

Research findings assert that managers prefer to work towards achieving objectives which motivate them. It appears that motivation is the glue which holds the budgeting and control systems together so creating this motivation is the key. There appear to be a number of factors involved.

Since budgets tend to be used as a management performance criteria there should be a reward system in place. Too often budgets are used as a mechanism to focus on poor performance so is it any wonder that the staff have negative feeling about them.

4 Overemphasis on performance/variance reports may encourage negative attitudes to budgeting. Hopwood referred to the ‘budget constrained’ style of management with performance in meeting the budget as the main criteria.

Research has indicated the role budgets have in motivating managers to achieve the company’s objectives. Good performance can lead to career advancement so the managers desire to be successful is linked to the success of the company.

INVESTMENT APPRAISAL

METHODS

Lesson 4

Most of the decisions management have to deal with are tactical and short-run but on occasion they may have to consider a decision that relates to a long period of time. Once the decision is taken the business has to live with it and may find it difficult to disinvest or reverse so a great deal of care has to be taken in these decisions.. In the planning process the company may have decided to persue a growth strategy so there may have to be investment in capital projects to sustain the growth in sales and productive capacity. Capital expenditure on new buildings, plant and machinery may be needed from time to time. Again the company may decide rather than grow organically a strategy of merger or takeover is best. Whatever the stategy the various investment projects have to be properly appraised. Capital projects have to chosen and decisions as to the financing of them has to be determined.

Definition:

Payback

This technique considers the length of time it takes to recover the initial invesment outlay and the project starts to pay for itself. If a company invests £100,000 on a capital project the question is how long does it take to get back £100,000 cash from the project. Cash flow does not include any non-cash items such as depreciation. Therefore, if the investment returns are given in profit after depreciation terms the annual depreciation is added back. Net cash flow is the difference between cash received and cash paid during a defined period of time.

Example:

A company is considering investing in a new machine which costs £100,000.

The following information is available:

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

Required:

The payback method has universal appeal because of its simplicity and the fact that it tends to favour less risky capital projects. Projects that take too long to pay for themselves are riskier and this method tends to reject these.

Accounting rate of return

Average annual profit

------------------------------- x 100

Average cost of investment

An average profit is calculated over the life of the project. The average cost of investment is calculated by adding the initial cost of the investment and the value at the end of its useful life divided by two.

Example:

A company has two alternative projects A and B, each involving an outlay of £500,000 and £600,000

Each project has an economic life of 5 years. Project A has a residual value of £50,000. Annual profits before depreciation is £200,000 before depreciation.

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

Net Present Value

A particular rate of interest is used to discount future flows of cash to present values. The discount rate used might reflect the cost of obtaining capital, or a target rate/cut-off rate,or a risk-adjusted rate. Once the future cash flows are discounted to present-day values they are totalled and compared with the cost of the project. If the discounted cash flows exceed the cost the difference is the net cash flow. In general, if the NPV is positive the project is worth considering.

Example:

A company wishes to evaluate a capital project based on the following information. The initial outlay is £100,000 and the project has an economic life of 5 years and realises £5,000 when it is sold at the end of year 5. The profits after depreciation have been estimated as year 1-3 £10,000 and £15,000 in the final two years. The rate of interest is 10%.

Year	Cash flow	Discount factor	Present value	Cumulative PV
	£		£	£
	(100,000)		(100,000)
	29,000	0.909	26,361	26,361
	29,000	0.826	23,954	50,315
	29,000	0.751	22,939	73,254
	34,000	0.683	23,222	94,476
	34,000	0.621	21,114	117,590
	5,000	0.564	2,820	120,410
			---------
			NPV =20,410
			--------

Since theNPV is +£20,410, the project is worthwhile.

Discounted payback

In the calculation of the NPV in the previous example a column records the cumulative present value of the cash flows. Since the payback method is criticised for ignoring the time value of money it is possible to remedy this shortcoming by using the discounted cash flows to ascertain the payback period.

In this example, the payback period is just over 4years. There is a shortfall of £5,524 which has to be generated in year 5.

£5,524 365 days

--------- x = 17 days

£117,590

Internal Rate of Return

Sometimes the company wishes to know the internal rate of return (IRR) ie. the yield of a capital project. The company may operate a cut-off point in respect to projects and should a project’s yield be below this target or threshold it will be rejected. The method is to discount cash flows using different discount rates until the NPV = 0. At that point the total present value of the cash flows is equal to the outlay on the project. The discount rate which produces a NPV = 0 is the internal rate of return of the project. In effect, the company could borrow money at a rate of interest equal to the internal rate of return to finance the project and the returns from the project would allow the company to break even. If the company’s target rate of return for capital projects is less than a project’s yield (IRR) the project is worth consideration.

Example:

Profitability Index

In the case where a company has a number of alternative projects and has limited resources it is useful to find a way of ranking these in relation to their potential profitability. The method is to divide the discounted cash flows by the initial cost of the project.

Profitability index for project X = £120410

----------- = 1.2

£100,000

For every £1 invested £1.2 worth of cash flow is generated.

THE COSTING

OF

OVERHEADS

Lesson 5 Absorption Costing

Definition: Overheads are expenses other than direct expenses. They include indirect materials, indirect labour and other indirect expenses. The prime costs - direct wages cost and the cost of materials consumed can be easily ascertained and charged to a job or process. However, many costs are incurred so that the business can operate eg. rent, rates, depreciation, heat and light etc. The technique for charging overheads to products, jobs or processes is called absorption costing. Absorption costing is concerned with the type and nature of costs rather than cost behaviour.

There are two main purposes of absorption costing:

(1) to ascertain the cost of a product, job or process.

(2) to assist business with their pricing - a cost plus approach.

It is relatively easy to ascertain the prime cost as they are closely identified with the final product. However it is more difficult to relate the indirect costs - the overheads to the product. Absorption costing is an attempt to achieve this so that overheas can be charged to products.

In apportioning costs a suitable basis is used eg. floor area is used to divide the rent of the factory between the two cost centres. The following bases of apportionment is useful in dealing with certain overhead cost items.

Overhead cost item	Basis
Rent & Rates, Light & Heating	Floor area of cost centre
Depreciation, insurance of machinery	Original cost or book value
Power costs	Horse power of machinery
Canteen expenses	Number of employees in cost centre
Maintenance costs for premises	Floor area

Once overheads are allocated and apportioned among a number of cost centre if there are any overheads located in non-production cost centres these have to be removed and re-apportioned to the production departments.

Example:

A company has the following distribution of overheads in two production departments A and B and two service departments, a stores and a maintenance department. Requisitions from the stores by Depts. A and B are £1,000 and £500 respectively. The maintenance personnel spend three-quarters of their time in Dept. A and the remainder in Dept. B.

Overhead	Dept. A	Dept. B	Stores	Canteen
	£	£	£	£
Allocated & Apportioned	10,000	5,000	3,000	4,000
Reapportion Stores costs	2,000		---
Reapportion Maintenance costs	3,000	1,000		---
	---------	--------	--------	-------
	15,000	7,000
	--------	-------	-------	-------

In the absorption stage an overhead recovery (absorption) rate (OAR) is calculated. The formula used is:

Suitable basis

Machine hrs.

Dept. B £7,000

OAR = ------------- = £0.20 per labour hr.

Labour hrs.

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

Product X Product Y

£ £

Direct materials 10 12

Direct labour 12 14

(Wage rate £2 per hr.)

Machine hours in

Dept. A 4 6

Product X Product Y

£ £

Prime cost 22.00 26.00

+ Production overheads

Dept. A (4 hrs. x 0.50) 2.00 (6 hrs. x 0.50) 3.00

Dept. B (6 hrs. x 0.20) 1.20 (7 hrs. x 0.20) 1.40

--------- ----------

23.20 30.40

--------- ---------

Traditional product costing measures accurately volume-related resources eg. direct costs but they fail to measure the way products consume non-volume related activities eg. support services like material handling, set-up costs, inspection costs. Resources are used up when these activities are triggered by production. It is the products which cause these activities to arise and ABC attempts to trace the consumption of these activities by the various products. Products which demand a lot of activities and resources are allocated an appropriate share of the overheads. For example, a new product will probably be low volume initially, requiring a lot of machine set-ups, quality testing etc. so it should bear the overheads it is causing to be created.

Example: Two products A and B are produced (5000 units of A and 45000 units of B). Each product requires the same number of machine/direct labour hours.

Number of set-ups: A = 10 B = 5

The cost of set-ups is £1.2m.

Absorption costing:

Product A = £120,000 (10% of £1.2m.) / 5000units = £24 per unit

Product B = £1.08m (90% of £1.2m.) / 45,000 units = £24 per unit

ABC system:

Product A = £800,000 (10/15 x £1.2m) / 5,000 units = £160 per unit

Product B = £400,000 (5/15 x £1.2m) / 45,000 units = £8.89 per unit

Since product A, the low volume product is responsible for the greater share of the set-up costs it is only right that it attracts most of this overhead. It is the number of set-ups that is the cost driver. The traditional costing system tends to overcost high volume products and undercost low-volume but complex products.

Definition: Activity based costing (ABC) is concerned with ‘cost attribution to cost units on the basis of benefit received from direct activities eg. ordering, set-up, assuring quality’.

ABC states that activities cause costs and products/cost units consume the activities. It is used by management to determine the most profitable products and to appreciate the cost implications of the operational activities within the business. It gets management to understand what causes costs. The technique uses cost drivers to attribute costs to activities and cost objects. Thus, overheads can be related to the activities which cause them.

ABC divides activities into four categories:

In absorption costing overheads are assigned to cost centres and charged to cost units by usually a volume-based measure such as machine or labour hours whereas ABC uses a two-fold approach by locating costs in cost pools and identifying cost drivers to facilitate assigning costs to cost units.

In product costing it is relatively easy to charge direct costs to cost units but the problem arises in relation to indirect costs(overheads). Overhead costs(resource costs) such as rent, rates, maintenance costs, cleaning materials etc. which can be identified with a particular cost pool are located there. Other overheads which cannot be identified with a cost pool are apportioned to the cost pools by means of cost drivers which are the main determinants of the cost of activities. These overheads are pre-determined in that they are part of the budgeting process. These cost drivers might include the number of production runs, the number of customer orders received, the number of quality control tests, etc.

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

When the overheads are located in the cost pools an average cost per transaction is calculated by dividing the total cost of an activity by the number of transactions performed. This average cost is then used to to charge each product with the amount of service demanded from each activity cost pool. Consequently, products are charged with a fairer share of the overheads they have helped to create. The result is more accurate product costing, better decision-making in respect to the product output mix and product pricing.

Example:

The ABC company produces two products X and Y and the following information is given:

	Product X	Product Y	Total
Production and Sales (units)	25,000	5,000	30,000
	--------	-------	--------
Unit cost (£)
Direct labour
Direct materials
Operating data
Machine hours
Labour rate per hour (£)
Number of set-ups
Number of inspections
Overheads
Production processing			£700,000