AAT Level 4 Diploma in Professional Accounting - Applied Management Accounting (AMAC) Course Notes PDF

1 on AAT LEVEL 4 Diploma in Professional Accounting iti Applied Management Accounting (AMAC) tu COURSE NOTES In st Fir  2 Applied Management Accounting on...

1 on AAT LEVEL 4 Diploma in Professional Accounting iti Applied Management Accounting (AMAC) tu COURSE NOTES In st Fir  2 Applied Management Accounting on iti tu 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 the prior written permission of First Intuition Cambridge Ltd. In Any unauthorised reproduction or distribution in any form is strictly prohibited as breach of copyright and may be punishable by law. © First Intuition Cambridge Ltd, 2024 st Fir  Introduction 3 Contents Page Introduction 4 1 Management accounting – the basics 13 on 2 Introduction to budgeting 43 3 Identifying budget data 65 4 Preparing budgets 79 5 Forecasting – statistical techniques 151 iti 6 Budgetary control – Making comparisons 189 7 Variance analysis 219 8 Limiting factors 275 9 tu Costing methods 299 10 Life cycle costing 317 11 Decision making 333 In 12 Financial performance indicators 377 13 Non-financial performance indicators 401 14 Divisional performance 419 15 Technology 435 st Fir  4 Applied Management Accounting Using your resources This symbol signifies an online lecture is available in respect of this topic. These lectures are available if you have purchased our Online, Online Live or Classroom course. To find out more about upgrading to one of these courses, please go to www.firstintuition.co.uk/fihub/fi-online/ or email us at [email protected]. on Illustrations show you how to complete a task step by step. If you are studying by yourself, these will get you ready for attempting the Lecture ILLUSTRATION Examples. Lecture Examples give you the chance to apply your knowledge to a question. If you are watching the online lectures or studying in the iti LECTURE EXAMPLE classroom, your tutor will guide you through these. Detailed solutions can be found at the end of each chapter. At the end of each chapter, you will find a bank of Practice Example tu PRACTICE EXAMPLE questions to attempt by yourself. These are designed to test your understanding of the material you have just learned. Detailed solutions are then given to each question. The Revision Example questions in the Task Bank are designed to prepare you for your assessment. They have been written in the style In REVISION EXAMPLE and standard of the assessment, although question types will vary in the real assessment. st Fir  Introduction 5 Aim of this unit In today’s world, management accountants are not only required to interpret and analyse data to produce reports. They are also required to have the requisite skills to be able to relate their findings to the organisation and provide insightful feedback that will help the business to move forward and achieve its objectives. This unit focuses on the three fundamental areas of management accounting: planning, control and decision making. All organisations rely on the provision of accurate, business- focused information in order to make sound business judgements. This unit will allow students to understand how the budgetary process is undertaken. Students will on be able to construct budgets and then identify and report both on areas of success and on areas that should be of concern to key stakeholders. Students will also gain the skills required to critically evaluate organisational performance. Students will be equipped with the knowledge and skills across a range of systems that will help to enhance the control environment of the organisation. Appreciating that there are many methods and understanding how and when it is appropriate to use each of them, will allow students to advise iti a business in a range of situations. Students will also gain an appreciation of the methods used to deal with the issues surrounding both short-term and long-term decision making. It is vitally important to understand the different challenges and uncertainties between the two types of decision making. Only by appreciating and tu incorporating those differences into the analysis produced can a management accountant consider themselves to be an integral part of the decision-making process. This unit is mandatory in the Level 4 Diploma in Professional Accounting. The learning outcomes from this unit are: In Learning outcomes Weighting 1. Understand and implement the organisational planning process 25% 2. Use internal processes to enhance operational control 27% 3. Use techniques to aid short-term and long-term decision making 25% 4. Analyse and report on business performance 23% st Total 100% The assessment Fir This unit will be a 3 hour computer based assessment (CBA). Competency for this unit is set at 70%. More details on the assessment structure and CBA instructions are given in your Task Bank.  6 Applied Management Accounting Learning outcomes This section illustrates the depth and breadth of content to be delivered for this unit. 1. Understand and implement the organisational planning process 1.1 The budgetary process Learners need to understand: purposes of a budget the budget cycle types of budget on - operating - capital - fixed - flexed sources of data for budgeting the principal budget factor. 1.2 Budgetary responsibilities and accountabilities iti Learners need to understand: Learners need to be able to: the role of the budget committee classify and allocate direct costs to the duties and responsibilities of the budget appropriate responsibility centres accountant apply the principle of responsibility the budgetary accountabilities of senior accounting tu managers in organisations apply responsibility accounting to the participatory alternatives: controllable and uncontrollable costs. - top down - bottom up the appropriate managers to provide information required to prepare budgets In how to identify appropriate responsibility centres and recovery methods for all types of indirect cost. 1.3 Types of budgets and recommendations for their use Learners need to understand: Learners need to be able to: the features of the following prepare operating budgets incorporating budget types: the following types of cost: st - incremental - direct - zero-based - indirect - priority-based - fixed - activity-based - variable - rolling - semi-variable Fir - contingency - stepped the comparative advantages of each - capital method - revenue the circumstances in which each method prepare production budgets incorporating should be recommended. the following schedules: - production plan ▪ inventory ▪ sales - material usage - material purchases - labour costs  Introduction 7 - labour hours - plant utilisation prepare cash flow forecasts/budgets allowing for: - time lags - changes in receivables - changes in payables changes in inventory. 1.4 Budgeting where resource constraints exist Learners need to be able to: on identify budget limiting factors: - market share - access to finance - shortage of production resources - plant capacity - factory space calculate the maximum level of production iti where a constraint exists. 1.5 Impact of internal and external factors on forecasts Learners need to understand: Learners need to be able to: the stages and features of the product life advise on the reliability of forecasts. tu cycle and their impact on income forecasts market trends and competitive pressures the expected impact of promotional activity external events affecting the reliability of cost forecasts. 1.6 Uncertainty in the budget setting process Learners need to understand: In the methods of dealing with the uncertainty inherent in budgeting - planning models - regular re-forecasting - re-budgeting - rolling budgets. 1.7 Budget revision to reflect changing circumstances st Learners need to understand: Learners need to be able to: the key planning assumptions used in the calculate the impact of changes to budget planning assumptions and forecasts the potential threats to budget achievement recalculate budgets accordingly. when a budget revision is appropriate. Fir 2. Use internal processes to enhance operational control 2.1 Budgetary control Learners need to understand: Learners need to be able to: the purpose of budget flexing as part of the flex budgets, adjusting each element of control process the budget correctly according to the the limitations of budget flexing in the context original budget assumptions about of a given scenario revenue and cost behaviour. the concept of feedback and feedforward provide potential reasons for variances control. (either calculated or given).  8 Applied Management Accounting 2.2 Standard costing Learners need to understand: Learners need to be able to: different types of standards: calculate the value of items to be - ideal included in standard cost cards - target calculate variances for revenue and costs: - normal - total sales variance - basic - sales price the purpose of standard cost cards - sales volume why variances occur - total material variance courses of action to be taken to address - material price on divergences from standard - material usage the interaction of variances - total labour variance how different types of standards can impact - labour rate on both behaviour and the level of the - labour efficiency variance - labour idle time how the use of standard costing can - total variable overhead variance complement budgetary control. - variable overhead price iti - variable overhead efficiency - total fixed overhead variance - fixed overhead expenditure - fixed overhead volume provide potential reasons for variances either calculated or given tu incorporate standard costs into budgetary control calculations. 2.3 Activity based costing Learners need to understand: Learners need to be able to: the circumstances where activity based calculate product costs using activity In costing would be most appropriate based costing the benefits of activity based costing over compare product costs derived under traditional absorption costing activity based costing to those under issues surrounding the introduction of activity traditional absorption costing. based costing the potential implications for unit selling prices and profitability where activity based st costing leads to a different unit cost. 2.4 Target costing Learners need to understand: Learners need to be able to: principles underpinning target costing calculate: the concept of value analysis - target costs Fir the value engineering process. - any cost gap. actions to take to reduce cost gaps. 2.5 Life cycle costing Learners need to understand: Learners need to be able to: principles underpinning life cycle costing identify the components of the life cycle how life cycle costing contributes to cost of a product operational control calculate the discounted and non- the concepts of economies of scale, discounted life cycle cost of a product mechanisation and learning effect and how  Introduction 9 costs can switch between variable and fixed interpret the results of calculations of life through the life cycle. cycle costs. 2.6 Technology and its impact on operational control Learners need to understand: technologies that are changing the way business collects and uses data: - cloud accounting - artificial intelligence - data analytics - visualisation how these technologies can provide benefit to operational control processes on the challenges faced by business in adopting these technologies. 3. Use techniques to aid short term and long term decision making 3.1 Comparison of short and long term decisions Learners need to understand: the fundamental differences between short term and long term decision making: - time frame - capital investment iti - risk. 3.2 Relevant costing Learners need to understand: Learners need to be able to: how to identify relevant costs calculate relevant: the concept of opportunity costs. - costs tu factors to be considered when a business - revenues. decides to: - make or buy products - supply or buy-in services - continue or discontinue products - continue or discontinue services. In 3.3 Key factor analysis Learners need to understand: Learners need to be able to: the concept of scarce resources calculate the contribution per unit of the concept of contribution scarce resources when contribution should be used as part of calculate the optimum production plan in the decision-making criteria. situations where there is one scarce st resource calculate total profit or total contribution based on the optimum production plan. 3.4 Linear programming Learners need to understand: Learners need to be able to: Fir the assumptions behind linear programming. calculate the optimum production plan in situations where there are multiple scarce resources calculate the optimum production plan using: - graphical approach - simultaneous equations. 3.5 Discounted cash flows Learners need to understand: Learners need to be able to: the concept of the time value of money calculate discounted cash flows.  10 Applied Management Accounting the benefits of discounted cash flows over non-discounted cash flows. 3.6 Appraisal methods for long term decisions Learners need to understand: Learners need to be able to: long term investment appraisal techniques: calculate net present values - Net Present Value (NPV) use the IRR formula - Internal Rate of Return (IRR) calculate the ARR of projects - Accounting Rate of Return (ARR) calculate the payback period of projects - payback period compare NPV, IRR, ARR and payback ▪ non discounted on period to support decision making. ▪ discounted strengths and weaknesses of each method. 4. Analyse and report on business performance 4.1 Financial performance indicators Learners need to understand: Learners need to be able to: what the performance indicator means calculate key financial performance iti the impact on performance indicators due to: indicators - learning effect interpret financial performance ratios to - economies of scale evaluate organisational performance. how some performance indicators interrelate with each other how proposed actions may affect the indicator tu actions that could be taken to improve the indicator. Performance indicators: Profitability: In Gross profit margin = gross profit/revenue x 100 Operating profit margin = Operating profit/revenue x 100 Return on capital employed (ROCE)= operating profit/capital employed x 100 (Where Capital employed = total equity + non-current liabilities) st Efficiency: Trade receivables collection period (days) = trade receivables/revenue x 365 Fir Trade payables payment period (days) = trade payables/cost of sales x 365 Inventory holding period(days) = inventories/cost of sales x 365 Working capital cycle (days) = inventory days + receivable days – payable days Expense/revenue percentage = specified expense/revenue x 100 Asset turnover (net assets) = revenue/(total assets – current liabilities). (Answer equals X times)  Introduction 11 4.2 Non-financial performance indicators Learners need to understand: Learners need to be able to: costs of quality calculate non-financial performance - prevention indicators - appraisal interpret non-financial performance - internal failure costs ratios to evaluate organisational - external failure costs performance how the behaviour of managers aiming to evaluate results from a balanced achieve a target can be affected by: scorecard. - the ethical code of practice on - commercial considerations non-financial performance indicators covering: - profitability - efficiency - productivity - quality measures that could be taken to improve iti performance balanced scorecards. 4.3 Divisional performance Learners need to understand: Learners need to be able to: the differences between cost, profit and calculate: tu investment centres - return on investment the issues of using return on investment and - residual income. residual income as performance measures the options available to organisations when setting a transfer price and the potential issues that may arise. In 4.4 Calculate forecasts Learners need to understand: Learners need to be able to: elements of a time series calculate index numbers the simple regression equation. use moving averages to calculate the concept of expected values. seasonal variations and trend from a time series use the simple regression equation to st calculate total cost calculate forecasts of future performance based on historical data interpret statistical data calculated to Fir evaluate organisational performance make recommendations based on results of sensitivity analysis.  12 Applied Management Accounting on iti tu In st Fir  13 1 on Management accounting – the basics iti Introduction This unit continues your management accounting studies and relies heavily on your tu understanding of some basic costing concepts and terminology. This chapter will remind you of some ideas that you should have seen before including different ways of classifying costs. Although much of the content of this chapter should be familiar to you do not underestimate the importance of brushing up this knowledge so that we can build more complex concepts on these foundations as we progress through the syllabus. In st Topics covered:  Revision of costing Fir  Classifying costs  Classifying costs by nature  Classifying costs by function  Classifying costs by behaviour  Capital versus revenue expenditure  Cost units and cost centres  Other types of responsibility centres  14 Applied Management Accounting Revision of costing One of the most important things for any business to understand is how much it costs them to produce a unit of their product or service. A car manufacturer needs to know how much it costs them to make a single car, a sandwich shop needs to know how much it costs them to make a ham sandwich and a train company needs to know how much it costs them to transport a passenger between two stations. Once the costs of producing a unit are established the business can use this information for a variety of useful purposes: on  Setting selling prices. A business needs to ensure a profit is being made by charging a price greater than the costs incurred to produce each unit.  Valuing items of inventory. Any units held in stock at the end of the year will need to be recognised as an asset in the financial statements of the business. Inventory is often valued at the cost of producing each unit.  Identifying ways to reduce costs. The easiest way to see where the business can reduce costs iti is to examine where they are spending money. Larger items of cost tend to be easier to reduce than smaller ones so they would be the sensible ones to start with.  Setting cost targets for production staff and managers. It helps to motivate staff if they have targets to work towards and this can include the expected cost to be incurred in producing each unit.  tu Using the cost targets set to review and improve actual performance. Businesses can perform ‘variance analysis’ by seeing whether staff beat the cost targets that were set for them or whether they fell short of them. This can allow staff to be rewarded or trained as appropriate. In Classifying costs In order to identify the total cost of producing a unit there are a wide variety of costs that need to be considered, these include material, labour and expenses. A key step in the process of dealing with these various costs in a business is to classify them into different categories. Costs can be classified by: st  Their nature – costs can be described as ‘direct’ or ‘indirect’.  Their function – costs can relate to production or non-production activities.  Their behaviour– costs can be variable or fixed. Fir  Chapter 1: Management accounting – the basics 15 Classifying costs by nature A fundamental way of classifying costs is to look at the extent to which they relate to the production of individual units. Direct costs Some costs can be identified with the production of a single unit in our business. These are known as ‘direct’ costs and a good way to think of them is as traceable costs as they can be traced to the production of a single unit. The total of direct costs is the prime cost. on Examples of common direct costs are:  Direct material – if a particular quantity of material is required for the production of a single unit of a product then this cost can be traced to each unit. For instance, building a car requires four wheels so the cost of those four wheels can be traced to each individual car that is produced.  Direct labour – if production staff take a certain amount of time working on each unit then iti their wage for that period of time can be traced to the individual unit being made. For example, if a production worker takes two hours to fix the wheels onto each car then the cost of the wage paid over those two hours can be traced to specific units. Indirect costs (or ‘overheads’) tu Many costs cannot be traced to individual units being produced and these are referred to as ‘indirect’ costs. They can be thought of as being shared over many units being produced over a period of time. Examples of common indirect costs are: In  Factory rent – when a business receives their monthly rent bill it would be impossible to trace that cost to a single unit of production as many units will have been produced over the month. The monthly rent cost can therefore be thought of as being shared over all of the units produced during the month.  Electricity to run machinery – as with many utilities, electricity is normally charged on a quarterly basis. An invoice for a three-month period cannot be traced to a single unit of st production so will be shared over all of the production of that period.  Administration expenses – any costs that are not related to the production process will be indirect costs as they cannot be traced to individual units of production. This would include administration costs such as the salaries of secretaries. Fir We mentioned material and labour costs when we discussed direct costs above but you should be aware that some forms of material and labour costs are indirect costs:  Indirect material – sometimes businesses will purchase materials that cannot be traced to individual units of production such as lightbulbs for the factory or supplies of office stationery such as envelopes. These sorts of materials would be indirect costs.  Indirect labour – some staff will not work on individual units and their salaries would therefore be indirect costs. This would include supervisors in the factory (who do not deal with specific units but monitor the activities of the direct workers who do), secretaries in the administration department and security staff. Indirect costs are often referred to as ‘overheads’. Remember that these costs are shared over many units, hence the term overhead.  16 Applied Management Accounting Classifying costs by function When we think of the ‘function’ of a cost we tend to mean the area of the business in which it is incurred. You can imagine a business having several buildings in which activities occur, such as the factory where units are produced, the offices where administrative jobs are performed and the warehouse where units are stored until they are sold.  Production costs – these are the costs incurred in the process of producing units and would tend to be those costs incurred within the factory environment. This would include the direct materials used to make physical units of production, wages of production staff, factory rent on and electricity to run production machinery.  Non-production costs – these are the costs incurred in the business that are not specific to the production process in the factory. This would include selling and distribution costs, administration expenses and finance charges. The relationship between the ‘nature’ and the ‘function’ of costs iti Direct costs are always production costs - since direct costs can be traced to the production of individual units these are incurred in the factory so would be categorised as production costs. Indirect costs can be production costs - whilst indirect costs are not directly linked to the production of a single cost unit, they may still be incurred as part of the production process. For example, the wages of a factory supervisor cannot be directly linked to the production of an tu individual unit however they are employed in the factory and are part of the production process. These costs are allocated or apportioned (using a reasonable basis) to production cost centres. We will see more detail of this later in the syllabus. Indirect costs can be non-production costs - costs such as wages of the sales team will not be related to the production process and are therefore treated as an indirect non-production cost. In LECTURE EXAMPLE 1 – CLASSIFYING COSTS Smars Ltd manufactures chocolate bars. Identify if the costs below are direct or indirect costs, and whether they are production or non-production costs. You will need two ticks for each cost. Direct Indirect Production Non- production st Salary of the factory supervisor Raw materials such as cocoa butter Fir Salary of the management accountant Cost of television advertising Salary of machine operative in the factory Factory rent charge  Chapter 1: Management accounting – the basics 17 Classifying costs by behaviour In order to prepare an accurate forecast of future costs it is important to understand the behaviour of each cost. The ‘behaviour’ of a cost relates to how it is affected by changes in the volume of production. If we were to increase the volume of production, some costs would increase whereas others would not. Variable costs Variable costs are those that ‘vary’ with the volume of production, so if we increase the number of on units produced the total cost will increase. We tend to assume that variable costs are incurred at a constant rate per unit. For example, each extra unit produced may incur an additional £5 of direct material cost no matter how many are made. Direct costs are normally variable costs and the costs can be traced to each individual unit; if we increase the number of units produced we will see an increase in the total cost incurred. If we wanted to calculate the total budgeted variable cost we can do so as follows: iti Total variable cost = variable cost per unit x budgeted production volume So, using the £5 per unit for direct materials introduced above, when we produce 1,000 units the total variable cost would be £5,000. If production volume is increased to 1,500 units the total variable cost would rise to £7,500. The 50% increase in the volume of production has led to a 50% increase in the total variable cost so the cost has increased in line with volume. tu Variable costs can be shown on a graph as: £ Total cost In Examples – direct materials or direct labour st Production volume The line on the graph shows that the total cost incurred rises in direct proportion to the increase in Fir the volume of production. If we assume a consistent variable cost per unit (such as our £5 per unit for direct material above) then the total variable cost line will be straight (or ‘linear’). In some situations in the real-world the total variable cost line may not be straight as the variable cost per unit may change as volume increases. This may happen if we get bulk discounts on purchasing large volumes from our supplier. At the production volume where we achieve the discount the variable cost per unit would fall below £5 per unit.  18 Applied Management Accounting Fixed costs Fixed costs do not vary with the volume of production but stay the same regardless of how many units are produced. For example, the rent paid for a factory will stay the same no matter how many units are made in the factory. In fact, even if the business produces no units at all the same amount of rent will need to be paid to the landlord. It is important to note that just because a cost is fixed this does not mean that it can never change but rather means that it does not change in relation to the volume of production. Your landlord can put your rent up from year to year but this is nothing to do with how many units are produced. on Fixed costs can be shown on a graph as: £ Total cost iti tu Example – factory rent Production volume The line on the graph shows that no matter how many units are produced the total fixed cost stays exactly the same. In Stepped fixed costs (sometimes referred to as semi-fixed costs) Some costs will be fixed over certain levels of activity but will then increase once a certain point is reached. For example, if you consider salaries paid to factory supervisors, each supervisor might earn £20,000 and be able to manage up to ten production workers. At low levels of production with only three workers we would only need one supervisor costing us £20,000. If the volume of production increased and we now needed six workers we would still only require one supervisor st meaning that the total cost stayed the same at £20,000. We can see, therefore, that the total cost is fixed over small increases in activity. If production rose again and we now needed eleven workers this would require a second supervisor meaning that the total cost would ‘step’ up to £40,000. Fir  Chapter 1: Management accounting – the basics 19 Stepped fixed costs can be shown on a graph as: £ Total cost Example – supervisor salaries on Production volume iti The line on the graph shows that within certain levels of production the total cost stays the same, and then it ‘steps’ up when a certain volume is achieved. This sort of ‘stepping’ up could happen several times. For instance if we needed a third supervisor, then a fourth, and so on; as volumes of production rise the cost will continue to step up each time we need another supervisor. Stepped fixed costs are sometimes called semi-fixed costs (not to be confused with semi-variable tu costs which we will look at next). Semi-variable costs (sometimes referred to as ‘mixed’ costs) Some costs will have both fixed and variable elements i.e. they will display a ‘mix’ of behaviour. For example, telephone bills tend to include a fixed element for line rental (which is the same cost no In matter how much you use the telephone) and a variable element for the call charges (which will ‘vary’ as we make more calls). If we wanted to calculate the total semi-variable cost we could do so as follows: Total cost = fixed cost + (variable cost per unit x production volume) The fixed cost element has nothing to do with the production volume and will be the same no st matter how many units are produced. The variable element of the cost will be affected by the production volume and is calculated in the same way as the purely variable costs that we saw earlier. Fir  20 Applied Management Accounting Semi-variable costs can be shown on a graph as: £ Total cost Example – utility bills such as electricity Variable element on Fixed element Production volume The line shows that even if we produced no units we would still incur the fixed cost but if we then iti increase the volume of production the total cost rises as we start to incur an increasing variable cost. In contrast to purely variable costs, the total semi-variable costs will not rise exactly in line with the increase in production volume. If we increase production volume by 50%, the total cost will not rise by as much as 50%. tu Splitting a semi-variable (or mixed) cost - The ‘high-low’ method We can show the components of mixed cost using an equation: Total cost = Fixed cost + variable cost In or Total cost = Fixed cost + (variable cost per unit x volume of production) If we want to be able to forecast costs for the future we need to be able to separate the fixed and variable elements of a semi-variable cost. One method we can use to achieve this is the High-Low method, it is likely you will have already seen this in previous studies. The High-Low Method st Activity Total cost £ Month 1 850 1,025 Month 2 1,300 1,250 Month 3 2,000 1,600 Fir Step 1 Select the highest and lowest levels of activity (or output) e.g. the highest level of output is 2,000 units of production with an electricity expense of £1,600 and the lowest is a level of 850 units at a cost of £1,025 Step 2 Set up a working to identify the difference in cost between the two output levels. Activity Total cost £ HIGH 2,000 1,600 LOW 850 1,025 Difference 1,150 units £575  Chapter 1: Management accounting – the basics 21 Step 3 Calculate the variable cost per unit £575 1,150 units = £0.50 per unit Step 4 Calculate the fixed cost using the formula TC = FC + (VC/unit x volume of production) i.e. If we pick the low pair there is an output of 850 units with a total cost of £1,025 Total Cost £1,025 = FC + (VC/unit x volume of production) £1,025 = FC + (£0.50 x 850) £1,025 = FC + £425 £1,025 – £425 = FC on £600 = FC So the variable cost per unit is £0.50 and the fixed cost is £600. The approach can be summarised as: (a) From the data given, select the highest and lowest production volumes and related costs. (b) Find the difference between the two volume figures and the two cost figures. iti (c) Divide the difference in the costs by the difference in the volumes to establish the variable cost per unit. (d) Use the variable cost per unit to help establish the fixed cost. tu LECTURE EXAMPLE 2 – PRACTICING THE HIGH-LOW METHOD Consider the output levels and associated total costs over a 5 month period Output Total costs In (units) (£) 700 350,000 400 250,000 600 320,000 900 450,000 st 750 360,000 Using the above steps find the fixed cost and variable cost per unit Step 1 Fir Step 2 Step 3 Variable cost per unit =  22 Applied Management Accounting Step 4 Fixed costs = Dealing with semi-variable costs with stepped fixed costs on In the illustration above we assume that the level of the fixed costs stays the same at £600 no matter how many units are produced. In reality it is likely that at some point an increase in production volume would affect the fixed cost (we may need more premises for instance which would increase the rent cost). For example, we may face a situation where fixed costs increase by £2,000 when activity levels increase above 5,000 units of output (i.e. they ‘step up’). To calculate the fixed costs we first need to use the High-Low method to identify the variable costs and then apply this to the total cost formula for activity either side of the ‘step’. iti (note – the High-Low method must be applied to two activity levels on the same side of the ‘step’) LECTURE EXAMPLE 3 – APPLYING THE HIGH-LOW METHOD WITH STEPPED FIXED COSTS tu The total cost for a business has been identified at various levels of output. The cost is made up of a variable element and a fixed element which changes when the output units exceed 6,000 units. The variable costs per unit remain constant. Units Total cost £ In 4,500 12,200 5,700 14,600 6,300 17,000 (a) What is the variable cost per unit? (note - use the two lower levels of output as these are both below the ‘step’ of 6,000 units) st Fir (b) What are the total fixed costs at when activity is below 6,000 units of output? (c) What are the fixed costs when activity exceeds 6,000 units of output?  Chapter 1: Management accounting – the basics 23 Capital versus revenue expenditure When a business spends money it can be categorised as either capital expenditure or revenue expenditure: Capital expenditure (‘Capex’) is where the item being paid for will last for more than one year. An example would be the purchase of a machine that may be owned for five or six years. Capital expenditure creates a non-current asset on the statement of financial position (or balance sheet) of the business. This asset will be capitalised and depreciated over the expected useful life of the asset; a delivery vehicle may be depreciated over five years whereas a factory building may be on depreciated over fifty years. Revenue expenditure (‘Revex’) is where the item being paid for will last for less than one year. An example would be payment of salaries which will only relate to the current month, another payment will be paid for the next month salary. Revenue expenditure is charged to the income statement as an expense for the period. iti Cost units and cost centres Cost card – this is the summary of the costs involved in producing a unit of a product. It will show the various elements of direct and indirect costs involved and can include both production and non- tu production costs. The cost card of a product will be very important in helping the business to set the price of that product. Cost unit – a cost unit is a product or service for which costs are being allocated and gathered together in a cost card. It is important to note that a cost unit may not necessarily be a single physical unit of production. A manufacturer of screws is highly unlikely to be interested in the cost In of producing a single screw as they won’t sell screws individually but in some higher volume. They may for instance be more interested in drawing up a cost card for a volume of 1,000 screws. For more expensive items like cars you may well use a single physical unit as your cost unit. Cost centres Cost centres are collecting points for costs. This could be a location (such as a regional office of a st nation-wide business), a function (such as a department in the factory) or an item of machinery. It must be possible to ascertain the costs for the cost centre and relate them to the cost units being produced. The manager of a cost centre will be responsible for the costs incurred by that cost centre and is likely to help head office to set budgets for costs such as materials and labour. Part of the managers Fir pay may be linked to the performance of their cost centre eg. did it achieve the budget for the period. Usually the concept of cost centres will relate to factory cost centres for the collection of production costs. These will generally be departments within the factory such as the assembly and welding departments in a car factory.  24 Applied Management Accounting There are two types of factory cost centre; production cost centres and service cost centres: Factory cost centres Production cost Service cost centres centres Physical cost units do not on Physical cost units pass through these cost pass through these centres as they provide cost centres i.e. support services i.e. stores or canteen sawing and sanding departments in a furniture factory iti Other types of responsibility centres There are a number of other responsibility centres a company could be analysed into. The key difference between them is the different levels of authority (or control) that the manager of the tu department has over certain aspects of the departmental performance. Cost centres (as discussed above) are where the manager only has control over the costs incurred in their department. They have no control over revenue so their performance should only be judged by looking at costs incurred (perhaps comparing them with budget). Revenue centres are departments where the manager has control over revenue only, eg the sales In department. The manager of such a department would be judged purely on their performance with regards to revenue generation and meeting revenue targets. Profit centres are where the manager controls both costs and revenues. This means that the manager of a profit centre would be accountable for both cost control and revenue generation, with their performance being measured in terms of meeting overall profit targets. Investment centres are similar to profit centres but as well as being responsible for revenue and st costs the manager is also responsible for investment decisions, such as undertaking new projects or purchasing new machinery. The manager of an investment centre would be accountable for cost control, revenue generation and the return which the centre generates on any investment made. It is only fair to assess the performance of a budget holder by only looking at the elements that Fir they control.  Chapter 1: Management accounting – the basics 25 Here are some Practice Examples for you to try… PRACTICE EXAMPLE 1 – DIFFERENT TYPES OF COST BEHAVIOUR Match each description in the boxes on the left with the type of cost it relates to. A cost that is unaffected by changes in the volume Variable cost of production on A cost that contains both a fixed and a variable Fixed cost element of cost A cost that changes in line with changes in the Stepped fixed cost volume of production iti A cost that is fixed over a particular range of Semi variable cost volumes but increases once that range is exceeded tu PRACTICE EXAMPLE 2 – CATEGORISING COSTS BY BEHAVIOUR Complete the following table to show whether each cost would be a fixed or variable cost for a manufacturer of wooden tables. In Cost Fixed Variable   Factory rent Electricity to heat the offices Purchases of wood Wages of production workers st Electricity to run production machinery Salaries of finance staff Fir  26 Applied Management Accounting PRACTICE EXAMPLE 3 – PRACTICING THE HIGH-LOW METHOD Consider the output levels and associated total costs over a 5 month period: Output Total costs (units) (£) 600 13,000 700 13,500 800 14,000 on 900 14,500 1,000 15,000 Using the above data identify the total fixed cost and the variable cost per unit. Fixed costs £ iti tu Variable costs £ per unit PRACTICE EXAMPLE 4 – PRACTICING THE HIGH-LOW METHOD In Consider the output levels and associated total costs over a 4 month period: Output Total costs (units) (£) 450 1,975 st 420 1,900 510 2,125 490 2,075 Using the above data identify the total fixed cost and the variable cost per unit. Fir Fixed costs £ Variable costs £ per unit  Chapter 1: Management accounting – the basics 27 PRACTICE EXAMPLE 5 – THE HIGH-LOW METHOD WITH STEPPED FIXED COSTS The total cost for a business has been identified at various levels of output. The cost is made up of a variable element and a fixed element which changes when output exceeds 5,000 units. The variable costs per unit remain constant. Output Total costs (units) (£) 3,800 61,600 on 4,600 71,200 5,300 85,600 Using the above data identify the variable cost per unit and the total fixed costs both below and above a volume of 5,000 units. Volume iti Below 5,000 unit Fixed cost Variable cost per unit tu Above 5,000 units In st Fir  28 Applied Management Accounting PRACTICE EXAMPLE 6 – THE HIGH-LOW METHOD WITH STEPPED FIXED COSTS The total cost for a business has been identified at various levels of output. The cost is made up of a variable element and a fixed element which changes when output exceeds 12,000 units. The variable costs per unit remain constant. Output Total costs (units) (£) 11,500 10,825 on 12,800 12,700 10,400 10,000 Using the above data identify the variable cost per unit and the total fixed costs both below and above a volume of 12,000 units. iti Volume Fixed cost Variable cost per unit Below 12,000 unit Above 12,000 units tu PRACTICE EXAMPLE 7 – DISTINGUISHING BETWEEN CAPITAL EXPENDITURE AND REVENUE EXPENDITURE Link the terms in the boxes on the left with the appropriate description In Capital expenditure Expenditure where the item being paid for will last for more than one year Revenue expenditure Expenditure where the item being paid for will last for less than one year st PRACTICE EXAMPLE 8 – DISTINGUISHING BETWEEN CAPITAL EXPENDITURE AND REVENUE EXPENDITURE Fir Identify whether each of the costs on the following list would be treated as capital expenditure or revenue expenditure. Cost Capital expenditure Revenue expenditure   Machinery Wages of production workers Rent of offices Computer equipment  Chapter 1: Management accounting – the basics 29 PRACTICE EXAMPLE 9 – CATEGORISING COSTS BY FUNCTION Match the terms in the boxes on the left with the appropriate description Production costs Costs incurred in marketing the product and delivering it to customers Administration costs Costs incurred in the factory as part of the production process on Selling and distribution costs Costs incurred in the general running and administration of the business PRACTICE EXAMPLE 10 – CATEGORISING COSTS BY FUNCTION iti Complete the following table showing which category each cost would fall into for a business that bakes cakes: Cost Production Administration Selling and tu distribution    Rent of the bakery Salaries of the sales team Purchases of flour In Rates bill for the offices Wages of the bakers Fuel for the delivery trucks st PRACTICE EXAMPLE 11 – CATEGORISING COSTS BY NATURE Match the terms in the boxes on the left with the appropriate description Direct costs Costs that can be traced to individual Fir units of production Indirect costs Costs that are shared over many units of production  30 Applied Management Accounting PRACTICE EXAMPLE 12 – CATEGORISING COSTS BY BEHAVIOUR Match the terms in the boxes on the left with the appropriate description Fixed costs Costs that are unaffected by the volume of production Variable costs Costs that increase in line with the volume of production on PRACTICE EXAMPLE 13 – CATEGORISING COSTS BY NATURE Complete the following table showing which category each cost would fall into for a business that manufactures wooden tables: iti Cost Direct Indirect   Rent of the retail shops Wages of production staff tu Electricity for running office computers Advertising campaign Wood used to make tables In PRACTICE EXAMPLE 14 – CATEGORISING COSTS BY BEHAVIOUR Show whether each cost would be a fixed or variable cost for a manufacturer of suitcases. Cost Fixed Variable   st Purchases of food for the canteen Purchases of leather for making suitcases Wages of canteen staff Wages of staff who stitch the suitcases together Fir Rates for the warehouse Rates for the factory  Chapter 1: Management accounting – the basics 31 PRACTICE EXAMPLE 15 – UNDERSTANDING BASIC DEFINITIONS Link the terms in the boxes on the left with the appropriate description: A location in a business for which costs, Cost centre revenues and investments can be identified A location in a business for which both costs Profit centre and revenues can be identified on A location in a business for which costs can Investment centres be identified iti tu In st Fir  32 Applied Management Accounting on iti tu In st Fir  Chapter 1: Management accounting – the basics 33 Solutions to Lecture Examples Lecture Example 1 Direct Indirect Production Non- production Salary of the factory   supervisor Raw materials such as   on cocoa butter Salary of the management   accountant Cost of television   advertising Salary of a machine   operative in the factory iti Factory rent charge   Lecture Example 2 Step 1 tu Output Total Costs (£) High: 900 450,000 Low: 400 250,000 Step 2 Differences 500 units £200,000 In 200,000 Step 3 Variable cost per unit = 500 Variable cost per unit = £400 per unit Step 4 TC = FC + (VC/unit x volume of production) Using the low pair: £250,000 = FC + (£400 x 400) st £250,000 = FC +£ 160,000 £250,000 – £160,000 = FC So the fixed cost = £90,000 Fir Lecture Example 3 Using the data for 4,500 and 5,700 units (as at 6,300 units the fixed cost will have ‘stepped’ up): Step 1 Output Total Costs (£) High: 5,700 14,600 Low: 4,500 12,200 Step 2 Difference 1,200 units £2,400 2,400 Step 3 Variable cost per unit = 1,200  34 Applied Management Accounting So part (a) is Variable cost per unit = £2 per unit Step 4 TC = FC + (VC/unit x volume of production) Using the low pair: £12,200 = FC + (£2 x 4,500) £12,200 = FC + £9,000 £12,200 – £9,000 = FC So part (b) is Fixed Cost = £3,200 on (c) If we now consider the production level of 6,300: TC = FC + (VC/unit x volume of production) £17,000 = FC + (£2 X 6,300) £17,000 = FC + £12,600 £17,000 – £12,600 = FC iti So now the Fixed Cost =£ 4,400. At this level of production the fixed cost has ‘stepped’ up from £3,200 to £4,400. tu In st Fir  Chapter 1: Management accounting – the basics 35 Solutions to Practice Examples Practice example 1 A cost that is unaffected by changes in the volume Variable cost of production A cost that contains both a fixed and a variable Fixed cost element of cost on A cost that changes in line with changes in the Stepped fixed cost volume of production A cost that is fixed over a particular range of Semi variable cost iti volumes but increases once that range is exceeded or “mixed” cost Practice example 2 Cost Fixed Variable   tu Factory rent  Not affected by changes in volume Electricity to heat the offices  Not affected by changes in volume In Purchases of wood  Increasing production volume will require more wood Wages of production workers  Increasing production volume will require more labour hours Electricity to run production machinery  Increasing production volume will require more machine hours st Salaries of finance staff  Not affected by changes in volume Fir  36 Applied Management Accounting Practice example 3 Step 1 Output Total Costs (£) High: 1,000 15,000 Low: 600 13,000 Step 2 Difference 400 units £2,000 £2,000 Step 3 Variable cost per unit = 400 So the variable cost per unit = £5 per unit on Step 4 TC = FC + (VC per unit x volume of production) Using the low pair: £13,000 = FC + (£5 x 600) £13,000 = FC + £3,000 £13,000 – £3,000 = FC iti So the fixed cost = £10,000 Practice example 4 Step 1 Output Total Costs (£) tuHigh: Low: 510 420 2,125 1,900 Step 2 Difference 90 units £225 £225 Step 3 Variable cost per unit = 90 In So the variable cost per unit = £2.50 per unit Step 4 TC = FC + (VC per unit x volume of production) Using the low pair: £1,900 = FC + (£2.50 x 420) £1,900 = FC + £1,050 st £1,900 – £1,050 = FC So the fixed cost = £850 Fir  Chapter 1: Management accounting – the basics 37 Practice example 5 Start by using the data for 3,800 and 4,600 units (as at 5,300 units the fixed cost will have ‘stepped’ up): Step 1 Output Total Costs (£) High: 4,600 71,200 Low: 3,800 61,600 Step 2 Difference 800 units £9,600 £9,600 on Step 3 Variable cost per unit = 800 So the variable cost per unit = £12 per unit. This will be the same both below and above the step. Step 4 TC = FC + (VC per unit x volume of production) Using the low pair: £61,600 = FC + (£12 x 3,800) iti £61,600 = FC + £45,600 £61,600 – £45,600 = FC So the fixed cost below the step = £16,000 If we now consider the production level of 5,300: tu TC = FC + (VC per unit x volume of production) £85,600 = FC + (£12 X 5,300) £85,600 = FC + £63,600 £85,600 – £63,600 = FC In So the fixed cost above the step =£22,000. At this level of production the fixed cost has ‘stepped’ up from £16,000 to £22,000. st Fir  38 Applied Management Accounting Practice example 6 Start by using the data for 10,400 and 11,500 units (as at 12,800 units the fixed cost will have ‘stepped’ up): Step 1 Output Total Costs (£) High: 11,500 10,825 Low: 10,400 10,000 Step 2 Difference 1,100 units £825 £825 on Step 3 Variable cost per unit =1,100 So the variable cost per unit = £0.75 per unit. This will be the same both below and above the step. Step 4 TC = FC + (VC per unit x volume of production) Using the low pair: iti £10,000 = FC + (£0.75 x 10,400) £10,000 = FC + £7,800 £10,000 – £7,800 = FC So the fixed cost below the step = £2,200 tu If we now consider the production level of 12,800: TC = FC + (VC per unit x volume of production) £12,700 = FC + (£0.75 X 12,800) £12,700 = FC + £9,600 In £12,700 – £9,600 = FC So the fixed cost above the step = £3,100. At this level of production the fixed cost has ‘stepped’ up from £2,200 to £3,100. Practice example 7 st Capital expenditure Expenditure where the item being paid for will last for more than one year meaning that it is capitalised as an asset Fir Revenue expenditure Expenditure where the item being paid for will last for less than one year meaning that it is written off as an expense in the period  Chapter 1: Management accounting – the basics 39 Practice example 8 Cost Capital expenditure Revenue expenditure   Machinery  Will last for several years Wages of production workers  Will relate to a single month Rent of offices  on Will relate to a single month Computer equipment  Will last for several years Practice example 9 Production costs Costs incurred in marketing the product iti and delivering it to customers such as sales staff salaries, petrol for delivery lorries and advertising campaigns tu Administration costs Costs incurred in the factory as part of the production process such as raw materials, direct production workers and factory rent In Selling and distribution costs Costs incurred in the general running and administration of the business such as office consumables, salaries of secretaries and power for computers st Fir  40 Applied Management Accounting Practice example 10 Cost Production Administration Selling and distribution    Rent of the bakery  Part of the production process Salaries of the sales team  Part of selling the product on Purchases of flour  Part of the production process Rates bill for the offices  An administration expense Wages of the bakers  Part of the production process iti Fuel for the delivery trucks  Part of distributing the product Practice example 11 tu Direct costs Costs that can be traced to individual units of production Indirect costs Costs that are shared over many units of production In Practice example 12 Fixed costs Costs that are unaffected by the volume of production st Variable costs Costs that increase in line with the volume of production Fir  Chapter 1: Management accounting – the basics 41 Practice example 13 Cost Direct Indirect   Rent of the retail shops  Cannot be traced to individual units of production Wages of production staff  A certain number of labour hours could be traced to each unit Electricity for running office computers  on Cannot be traced to individual units of production Advertising campaign  Cannot be traced to individual units of production Wood used to make tables  A certain quantity of wood could be traced to each unit iti Practice example 14 Cost Fixed Variable   Purchases of food for the canteen  tu This will be unaffected by the volume of production Purchases of leather for making suitcases  Increasing production volume will require more leather Wages of canteen staff  This will be unaffected by the volume of production In Wages of staff who stitch the suitcases together  Increasing production volume will require more hours of direct production workers Rates for the warehouse  This will be unaffected by the volume of production Rates for the factory  st This will be unaffected by the volume of production Practice example 15 Cost centre A location in a business for which costs, Fir revenues and investments can be identified Profit centre A location in a business for which both costs and revenues can be identified A location in a business for which costs can Investment centres be identified  42 Applied Management Accounting on iti tu In st Fir  43 2 on Introduction to budgeting iti Introduction Although many of the tasks in this assessment will involve numerical calculations of tu figures for budgets you also need to be aware of some of the different types of budgets that organisations can use and the way that they can affect the behaviour of staff. This chapter is technically quite straight-forward but you will need to spend time getting to grips with the terminology. In st Topics covered:  Budgeting Fir  The budgeting process  The budget cycle  Impact of budgets  Participation in the budgetary process  Types of budgeting systems  44 Applied Management Accounting Budgeting A quantitative plan of action for the forthcoming period A budget is a financial (involving cost measured in pounds) and quantitative (involving other numbers such as units of sales, hours of labour or kg of material) plan of what an organisation intends to achieve for a forthcoming period. This period could be the next few weeks, months or even years. Although preparing budgets can involve huge amounts of time and effort for a business, the process of creating a budget forces the company to look forward and plan for the future and on this is a major benefit and justifies the investment of resource. It will allow the business to anticipate potential problems and make contingency plans to deal with them effectively. Budgeting brings a number of other benefits: Purposes of budgeting Use the mnemonic ‘PRIME’ to remember these reasons which set out why budgeting is worth all iti the investment of time and effort.  Planning – the process of budgeting forces managers to look at the future and to set out detailed plans that will allow them to achieve targets in each department. This will make it easier for the business as a whole to deliver targeted performance for shareholders and investors;  tu Responsibility – a budget will identify who is responsible for achieving the targets within the budget for each cost centre. The manager in charge of each area of the budget is often referred to as the ‘budget holder’. Delegating responsibility in this way means that Head Office will know who to contact if there are any problems in achieving targets, or to praise those who met or even surpassed their targets, in a department; In  Integration – a budget will ensure the activities of the different parts of the organisation are smoothly integrated. This will assist good communication and co-ordination between departments is happening and encourage the business to operate as efficiently as possible;  Motivation – a budget will help to motivate staff within the organisation by setting targets for them to achieve. This is particularly effective if the pay of staff is linked to achievement of the budgets. For budgets to prove a truly motivating target they must be challenging but st achievable. If a budget is seen by staff as being impossible to achieve they are unlikely to make any real effort to try to achieve it;  Evaluation and control – a budget will allow evaluation of the actual results of the business. We can compare the actual results of the business to the budgets to see if managers have beaten the targets or fallen short. This process is known as ‘control’ and will allow Fir management to improve the performance of the business in the future.  Chapter 2: Introduction to budgeting 45 The budgeting process The administrative procedures often used in the budgeting process are as follows: (a) Establish the budget period. This will often be an entire accounting year and may be split into twelve monthly periods; (b) Issue the budget manual to the staff who will be involved in setting the budgets. This lists the stages in the budgeting process and will include instructions on the budgetary process. For example it can contain: on (i) The objectives of the budget (perhaps the total revenue growth we wish to achieve in the business). (ii) Organisational structures of the departments that fall within the same budget area. (iii) Administrative details such as due dates and who to submit budgets to. (iv) Procedures such as standard spreadsheet templates to complete. (c) Appoint the budget committee, a group of managers and staff who will coordinate the iti process of preparation and administration of the budget. The budget committee may contain the managing director, the finance director and perhaps the managers in charge of each major area of the business. They will agree on the planning assumptions that each budget holder will use as they prepare their part of the overall budget; (d) tu Identify the budget coordinator, this is usually an accountant, to head up the process and ensure that everyone else completes their tasks on time. (e) Each budget holder will then draw up the budget for their department. It is important to remember that different managers are likely to be involved in establishing different aspects of each budget. For instance, when producing a labour budget: In (i) The labour hours required is likely to be the responsibility of the production manager as they are most likely to be able to estimate how long staff normally take to make each unit. (ii) The wage rates are likely to be set by the human resources manager as they will decide how much staff in different departments will be paid. The budget coordinator will have to deal with each of these individuals. st The budget accountant The budget accountant is responsible for the production and issue of the budget. This will usually include the budgets for operating costs, income, capital and project budgets. Fir They will monitor the actual amount spent compared to the budget on a regular basis and report to the Finance Director. The budget accountant will prepare reports and analysis to enable senior management to make decisions. Budgetary accountabilities Senior managers within the organisation will be responsible for preparing and providing information to enable the preparation of the organisations budgets. The manager of each department or division will be accountable for their performance and the achievement of their budget. Approval of the budget by the manager will mean the manager has accepted the budget and will now be held accountable for it.  46 Applied Management Accounting The budget cycle The budget cycle (sometimes known as the budgetary control system) uses the budget to assess the actual performance of the business and then takes appropriate actions to bring the actual performance in line with the budget. The cycle of planning and control (1) Objectives on (4) Comparison (2) Budgets (3) Operating iti (1) The business will set overall objectives in terms of the desired market share, revenue, profit and the return expected for shareholders. (2) Managers will prepare budgets in line with achieving the stated objectives. This process will be done at the start of the year and is the ‘planning’ stage. (3) The various departments and employees of the business will ‘operate’ during the year with tu staff working to achieve the targets that have been set for them in the budgets. (4) At the end of the year we compare actual results with budgets in a process called ‘control’. One key way of doing this is ‘variance analysis’ which we will see later in this syllabus. This process of control will allow problem areas to be identified and corrective action to be taken to improve performance in the following year. In In general terms ‘planning’