Managerial Accounting PDF

MANAGERIAL ACCOUNTING Definition of accounting The process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information. Users of accounting information can be divided into two categories: (i) External parties outside the o...

MANAGERIAL ACCOUNTING Definition of accounting The process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information. Users of accounting information can be divided into two categories: (i) External parties outside the organization (financial accounting). (ii) Internal parties within the organization (management accounting). DIFFERENCES BETWEEN FINANCIAL AND MANAGERIAL ACCOUNTING i. Statutory requirement for public companies to produce annual financial accounts, whereas there is no legal requirement for management accounting. ii. Financial accounting reports describe the whole of the organization, whereas management accounting focuses on reporting information for different parts of the business. iii. Financial accounting reports must be prepared in accordance with generally accepted accounting principles. iv. Financial accounting reports historical information, whereas management accounting places greater emphasis on reporting estimated future costs and revenues. v. Management accounting reports are produced at more frequent intervals THE CHANGING BUSINESS 1. Organizations have faced dramatic changes in their business environment. i. Move from protected markets to highly competitive global markets ii. Declining product life-cycles iii. Growth in service industry iv. Advances in manufacturing technology v. Environmental issues 2. To compete successfully in today’s environment companies are: i. Making customer satisfaction an overriding priority. ii. Adopting new management approaches. iii.Changing their manufacturing systems. iv. Investing in AMT ’s. 3. Above changes are having a significant impact on the MAS (Management Accounting Systems). Focus on customer satisfaction and new management approaches 1. Key success factors -Cost efficiency –increased emphasis on accurate product costs and cost management. -Quality –TQM, quality measures. -Time – reduced cycle time, focus on non-value-added activities. -Innovation – responsiveness in meeting customer requirements. -Feedback on customer satisfaction. 2. Continuous improvement -Static historical standards no longer appropriate. -Benchmarking. 3. Employee empowerment -Delegate more responsibility to people closest to operating processes and customers. 4. Social responsibility and corporate ethics INTERNATIONAL CONVERGENCE OF MANAGERIAL ACCOUNTING 1. Management accounting practices can be observed at the macro or micro levels: Macro refers to concepts and techniques Micro refers to the behavioural patterns of use. 2. Tendency towards globalization at the macro level 3. Drivers of convergence include: Global competition Information technology (e.g. ERP systems) Standardization by transnational companies Global consultancy Use of global textbooks 4. At the micro level accounting information may be used in different ways due to influence of different national and local cultures PRIMARY FUNCTIONS OF COST ACCOUNTING SYSTEM 1. Inventory valuation for internal and external profit measurement Allocate costs between products sold and fully and partly completed products that are unsold. 2. Provide relevant information to help managers make better decisions Profitability analysis Product pricing Make or buy (Outsourcing) Product mix and discontinuation 3. Provide information for planning, control and performance measurement Long-term and short-term planning (budgeting) Periodic performance reports for feedback control Performance reports also widely used to evaluate managerial performance Note that costs should be assembled in different ways to meet the above three requirements. Consider a situation where a company has produced three products (A,B and C) during the period. The total costs for the period are £40 000. Product A has been sold for £20 000, product B has been completed but is in finished goods stock (inventory),and product C is partly completed. Costs must be traced to products to value stocks and cost of goods sold. In theory cost information computed for stock valuation ought not to be used for decision-making. Example: Short-term decision A company is negotiating with a customer for the sale of XYZ. The cost per unit recorded for stock valuation purposes is: The maximum selling price that can be negotiated is £500 per unit for an order of 100 units over the next three months. Should the company accept the order? OPERATIONAL CONTROL AND PERFORMANCE MEASUREMENT The allocation of costs to products is not particularly useful for cost control purposes. Instead, costs should be traced to responsibility/cost centres to the person who is accountable for controlling the costs. Example Budgeted costs per unit: Comparison of actual with budgeted costs by products NOTES: 1. Performance reports analysed in far more detail for cost centre managers. 2. Should not be used as a punitive device (identify areas where managers need to focus their attention). 3. Non-financial critical success factors are also of vital importance and should be included on the performance reports COST OBJECTS A cost object is any activity for which a separate measurement of cost is required (e.g. cost of making a product or providing a service). A cost collection system normally accounts for costs in two broad stages: 1. Accumulates costs by classifying them into certain categories (e.g. labour, materials and overheads). 2. Assigns costs to cost objects. Direct costs can be specifically and exclusively identified with a given cost object. Indirect costs cannot be specifically and exclusively identified with a given cost object. Indirect costs (i.e. overheads) are assigned to cost objects on the basis of cost allocations. Cost allocations consist of the process of assigning costs to cost objects that involve the use of surrogate, rather than direct measures. The distinction between direct and indirect costs depends on what is identified as the cost object. Traditional cost systems accumulate product costs as follows: Product costs are those that are attached to the products and included in the stock (inventory valuation). Period costs are not attached to the product and included in the inventory valuation. Example Product costs = £100,000 Period costs = £80,000 50% of the output for the period is sold and there are no opening inventories. Cost of goods sold (50%) 50,000 Period costs (100%) 80,000 Total costs recorded as an expense for the period 130,000 (Closing) stock (50%) 50,000 Important to predict costs and revenues at different activity levels for many decisions. Variable costs vary in direct proportion with activity. Fixed costs remain constant over wide ranges of activity. Semi-fixed costs are fixed within specified activity levels, but they eventually increase or decrease by some constant amount at critical activity levels. Semi-variable costs include both a fixed and a variable component (e.g. telephone charges). Note that the classification of costs depends on the time period involved. In the short term some costs are fixed, but in the long term all costs are variable. Avoidable costs are those costs that can be saved by not adopting a given alternative, whereas unavoidable costs cannot be saved. Avoidable/unavoidable costs are alternative terms sometimes used to describe relevant/irrelevant costs. Relevant costs and revenues are those future costs and revenues that will be changed by a decision, whereas irrelevant costs and revenues will not be changed by a decision. Sunk costs are the costs of resources already acquired and are unaffected by the choice between the various alternatives (e.g. depreciation). Sunk costs are irrelevant for decision-making. A cost that measures the opportunity that is lost or sacrificed when the choice of one course of action requires that an alternative course of action be given up is an opportunity cost. Example To produce product X requires that an order that yields £1 000 contribution to profits is rejected. The lost contribution of £1 000 represents the opportunity cost of producing product X. Incremental costs and revenues are the additional costs/revenues from the production or sale of a group of additional units. Marginal cost/revenue represents the additional cost/revenue of one additional unit of output BUSINESS SEGMENTATION As enterprises grow and activities become more complex, segmentation of operations/responsibilities/results is needed SEGMENTS ARE USEFUL FOR Stating financial objectives Monitoring the economic performance Monitoring the strategic-competitive Management Accounting structure performance Resource allocation Planning and budgeting CRITERIA FOR DEFINING A BUSINESS DIRECTLY TRACEABLE = counted where they are Review problem 45 ALT A ALT B SALES 100 6.6 (0,55 * 12) COST COGS (50) - WAGES (12) - RENT (5) (5) DOWNPAYM (5) (5) à SUNK COST à NOT RELEVANT RATIO (13) - AUDIT (2) - = PROFIT =18 - 5 = 13 =1,6 - 5 = 3.4 18 – 1.6 = 16.4 à IF I DON’T CONSIDER THE UNRELEVANT COSTS ALT A IS BETTER COST VOLUME PROFIT (CVP) ANALYSIS 1. How many units must be sold (or how much sales revenues must be generated) in order to break even? 2. How many units must be sold to earn a target profit ? 3. Will total profits increase if the unit price is increased by x% and units sold decrease y% ? 4. What is the effect on total profit if advertising expenditures increase by x $ and sales increase from A to B units ? 5. What is the effect on total profit if the sales mix is changed? It is grounded on the cost behavior classification (VARIABLE/FIXED) + Revenues PROFIT = P per unit * q VC per unit * q q=? FC Benefits of CVP include assisting managers in: Establishing prices of products. Analyzing the impact that volume has on short-term profits. Focusing on the impact that changes in costs (variable and fixed) have on profits. Analyzing how the mix of products affects profits. CURVILINEAR COST-VOLUME GRAPH 1. Results in two break-even points. 2. Note the shape of the total cost function: Initial steep rise, levels off, followed by a further steep rise. 3. The total revenue line initially rises steeply, then levels off and declines. LINEAR CVP RELATIONSHIPS Relevant Range = Range small enough so that the linearity of the function can be assumed LINEAR COST-VOLUME.PROFIT MODEL 1. Constant variable cost and selling price per unit is assumed. 2. Only one break-even point, and profit increases as volume increases. 3. The diagram is not intended to provide an accurate representation for all levels of output. The objective is to provide an accurate representation of cost and revenue behaviour only within the relevant range of output. BREAK EVEN CHART MARGIN OF SAFETY CVP ANALYSIS ASSUMPTIONS (COST VOLUME PROFIT) 1. All other variables remain constant - sales mix - production efficiency - price levels - production methods 2. A single product or constant sales mix. 3. Total costs and total revenues are linear functions of output. 4. The analysis applies only to the relevant range. 5. The analysis applies only to a short-term horizon. EXAMPLE – MULTIPLE PRODUCT (IN UNITS) FC/CM per unit = break even units EXAMPLE – MULTIPLE PRODUCT (IN SALES) FC/CM ratio= break even $ EXAMPLE 3 – SALES OF TARGETED INCOME Unit Sales Price = € 10 Unit Variable Cost = € 6 Fixed expenses = € 40 000 Interest expense = € 10 000 Tax rate = 40% Q1 - What is the level of sales in units and € are needed to obtain a targeted EBIT of € 20 000 ? Q2 – What is the level of sales in € is needed to obtain a targeted EBIT equal to 20 percent of sales ? Q3 - What is the level of sales in units and € are needed to obtain a targeted NET PROFIT of € 24 000? Q1 Unit Contribution Margin = € 4 (10 - 6) Sales – Variable Costs – Fixed Costs = EBIT QTI = (Fixed Costs + EBIT) / Unit Contribution Margin QTI = (40 000 + 20 000) / 4 = 15 000 units STI = 15 000 * 10€ = 150 000 € Q2 Contribution Margin as % of Sales = € 4 / € 10 = 40% Sales – Variable Costs – Fixed Costs = EBIT EBIT = 20% Sales STI% = Fixed Costs / (Contribution Margin % - 20%) STI% = 40 000 / (40% - 20%) = 200 000 € Q3 NET PROFIT = NP PROFIT BEFORE TAXES = PBT NP = PBT * (1 – Tax rate) PBT (EBIT) = NP / (1 - Tax rate) Sales – Variable Costs – Fixed Costs – Interest Expense = PBT STI% = (Fixed Costs + Interest Expense + PBT) / Contribution Margin % STI% = (40.000 + 10.000 + 40.000) / 40% = 225.000 € CVP: MARGIN OF SAFETY and DEGREE OF OPERATING LEVERAGE Assume the following projected income statement: Sales €100 000 Less: Variable expenses € 60 000 = 60% Contribution margin € 40 000 = 40% Less: Fixed expenses € 30 000 Operating Profit € 10 000 Q1 – Which is the Margin of Safety ? Q2 – Which is the Degree of operating Leverage ? Q1 Contribution Margin as % of Sales = € 40 000 / € 100 000 = 40% Break-even point in € (Sales)= € 30 000 / 40% = € 75 000 Safety margin (€)= € 100 000 - € 75 000 = € 25 000 Safety margin (%) = (€ 100 000 – € 75 000) / € 100 000 = 25% Q2 DOL = Total contribution Margin / Profit = € 40 000 / € 10 000 = 4.0 Now suppose that sales are 25% higher than projected. What is the percentage change in profits? Percentage variance in profits = DOL x percentage variance in sales Percentage change in profits = 4.0 x 25% = 100% 10000 à 20000 10000 à 30000  1M/50K = 20 - 350K/50K = 7 - VARIABLE 200K/50K = 4 - 50K/50K = 1 - - FIXED - 10% x 24 x X RELEVANT COSTS AND REVENUES The relevant financial inputs for decision-making are future cash flows that will differ between the various alternatives being considered. Therefore only relevant (incremental/differential) cash flows should be considered (differential analysis). Relevant costs and revenues are required for special studies such as: 1. Special selling price decisions. 2. Product-mix decisions when capacity constraints exist. 3. Outsourcing (Make or buy) decisions. 4. Discontinuation decisions. Decisions should not be based only on items that can be expressed in quantitative terms — Qualitative factors must also be considered. EXAMPLE à EVALUATION OF THE ORDER Only variable costs, the extra selling costs and sales revenues differ between alternatives and are relevant costs/revenues. Two approaches to presenting relevant costs — Present only columns 1 and 2 or just column 3. Since relevant revenues exceed relevant costs the order is acceptable subject to the following assumptions: 1. Normal selling price of will not be affected. 2. No better opportunities will be available during the period. 3. The resources have no alternative uses. 4. The fixed costs are unavoidable for the period under consideration. Note that the identification of relevant costs depends on the circumstances.  Assume now spare capacity in the foreseeable future (Capacity = 50 000 units and demand = 35 000 units) and that an opportunity for a contract of 15 000 units additional at £25 unit price emerges involving £1 per unit special selling costs. No other opportunities exist so if the contract is not accepted direct labour will be reduced by 30%, manufacturing non-variable costs by £70 000 per month and marketing by £20 000. Unutilised facilities can be rented out at £25 000 per month. 70% x 420 10 x 35 Company will be better off by £31 000 per month if it reduces capacity (assuming there are no qualitative factors). You can present only columns 1 and 2 or just column 3 (note the opportunity cost shown in column 3). In the longer-term all of the above costs and revenues are relevant. EXAMPLE 2: PRODUCT MIX DECISIONS Limiting or scarce factors are factors that restrict output. The objective is to concentrate on those products/services that yield the largest contribution per limiting factor. Profits are maximized by allocating scarce capacity according to ranking per machine hour as follows: NOTE that qualitative factors should be taken into account. EXAMPLE 3: OUTSOURCING (make or buy decision) Involves obtaining goods or services from outside suppliers instead of from within the organization. Example A division currently manufactures 10 000 components per annum. The costs are as follows: A supplier has offered to supply 10 000 components per annum at a price of £30 per unit for a minimum of three years. If the components are outsourced the direct labour will be made redundant (e.g. direct labour is eliminable). Direct materials and variable overheads are avoidable and fixed manufacturing overhead would be reduced by £10 000 per annum but non-manufacturing costs would remain unchanged. The capacity has no alternative uses. Assuming there is no alternative use of the released internal capacity arising from outsourcing annual costs will be as follows: Columns 1 and 2 can be presented or just column 3 which shows that the relevant costs of making are £240 000 compared with £300 000 from outsourcing (buying). Where the released internal capacity arising from outsourcing can be used to generate rental income or a profit contribution the lost income or profit contribution represents an opportunity cost associated with making the components. Assume that the released capacity from outsourcing enables a profit contribution of £90 000 to be generated. The relevant costs of making will now be: EXAMPLE 4: DISCONTINUATION DECISIONS Routine periodic profitability analysis by cost objects provides attention-directing information that highlights those potential unprofitable activities that require more detailed (special studies). Assume the periodic profitability analysis of sales territories reports the following: Assume that special study indicates that £250 000 of Central fixed costs and all variable costs are avoidable and £108 000 fixed costs are unavoidable if the territory is discontinued. The relevant financial information is as follows: Columns 1 and 2 can be presented or just column 3 which shows that the relevant revenues arising from keeping the territory open are £900 000 and the relevant (incremental) costs are £848 000.Therefore Central provides a contribution of £52 000 towards fixed costs and profits. 400,000 x 0,75 100 80 40 = 25% of labour 650 – Fixed OH 650 – 300 = 350 11 – 1.5 180,000 180 x 3 -1/6 x 300,000 ???  40/10 40-4 100 x 10 30 +15 + 25 + 400 25 x 1000 25 x 470 25 + 20 – 4 - 5 40 x 1000 40 x 470 25 + 20 + 30 + 25 1,620 x (25 + 20 + 30 + 25) 660 x (25 + 20 + 30 + 25) Fixed OH/ CM per Acre  (374/80.000) x 1000 First 6 months , second 6 months (160/80,000x40,000)+( 160/80,000x40,000x1,05) 116 x 1,02 80,000 + (80,000 + 5%) 84 x 0,4 80,000 x 4.1/1000 80,000 / 500 22 / 160 80,000 / 400 137,5 x 200 164 + 40 + 27,5 231,5 / 8000 4,1 – 2,89 1.21 / 0.50 0.50 x 100,000 100,000 – 50,000 50,000 / 0,75 Contribution margin/segment margin Variable/Fixed costs devided ASSIGNMENT OF DIRECT AND INDIRECT COSTS Direct costs can be specifically and exclusively identified with a given cost object – hence they can be accurately traced to cost objects. Indirect costs cannot be directly traced to a cost object – therefore assigned to cost objects using cost allocations. Cost allocations = process of assigning costs to cost objects that involve the use of surrogate rather than direct measures. Surrogates known as allocation bases or cost drivers. For accurate cost assignment, allocation bases should be significant determinants of the costs (i.e. cause- and-effect allocations). Allocation bases that are not significant determinants of the costs are called arbitrary allocations (result in inaccurate cost assignment). Traditional costing systems use arbitrary allocations to a significant extent whereas more recent (ABC) systems rely mainly on cause-and-effect allocations. Manufacturing organizations assign costs to products for: 1. Inventory valuation and profit measurement. 2. Providing information for decision-making. 1. For inventory valuation and profit measurement the aim is to allocate costs between cost of goods sold (COGS) and inventories. Accurate individual product costs are not required – only an accurate allocation at the aggregate level between inventories and COGS. 2. For decision-making more accurate product costs are required. Different cost information is required for inventory valuation and decision making but most companies use a single database and extract different costs for different purposes. Companies can choose to maintain their database using costing systems that vary on a continuum from simplistic to sophisticated (the choice should be based on costs versus benefits criteria). TRADITIONAL TWO-STAGE ALLOCATION PROCESS BLANKET OVERHEAD RATE Some firms use a single overhead rate (i.e. blanket or plant-wide) for the organization as a whole (example Baldwin Bicycles) 15£/Machine Hour EXAMPLE Assume that the company has 3 separate departments and costs and hours are analysed as follows: Product Z requires 20 hours (all in department C) Separate departmental rates should be used since product Z only consumes overheads in department C. A blanket overhead rate can only be justified if all products consume departmental overheads in approximately the same proportions: Product X spends 1 hour in each department and product Y spends 5 hours in each department (Both blanket and departmental rates would allocate £45 (£ 15*3) to X and £225 (£ 15*15) to Y). If a diverse range of products are produced consuming departmental resources in different proportions (product differentiation exists) separate departmental (or cost centre) rates should be established. DEPT A 10 * 1H DEPT A 10 * 5H X DEPT B 30 * 1H = 45£ Y DEPT B 30 * 5H = 225£ DEPT C 5 * 1H DEPT C 5 * 5H TWO STAGE ALLOCATION Applying the two-stage allocation process requires the following 4 steps: 1. Assigning all manufacturing overheads to production and service cost centres. 2. Reallocating the costs assigned to service cost centres to production cost centres. 3. Computing separate overhead rates for each production cost centre. 4. Assigning cost centre overheads to products or other chosen cost objects. OVERHEAD Maint. Cantine Service Cost Center Cutting Assembling Finishing Production Cost Center Raw Material Direct labour UNIT EXAMPLE 1 The annual overhead costs for a company which has three production centres and two service centres (Materials procurement and General factory support) are as follows: The following information is also available à COST DRIVERS Lighting and heating 500.000£/50.000sqm = 10£/sqm The annual overhead costs for a company which has three production centres and two service centres (Materials procurement and General factory support) are as follows: PAG 186 N 7.18 point A The following information is also available BUDGETED OVERHEAD RATES Actual overhead rates are not used because of: 1. Delay in product costs if actual annual rates are used. 2. Fluctuating overhead rates that will occur if actual monthly rates are used. An estimated normal product cost based on average long-run activity is required rather than an actual product cost (which is affected by month-to- month fluctuations in activity). Therefore use estimates of overhead costs and activity over a long- run period (typically one year) to compute overhead rates (i.e. £10 per hour in the above example). UNDER AND OVER RECOVERY OF OVERHEADS If actual activity or overhead spending is different from that used to compute the estimated overhead rates there will be an under or over recovery of fixed overheads. (Production plan) Assume actual activity is 900 000 DLH ’s and actual overheads are £2 million: Manufacturing costs are higher than the applied costs Applied overhead Under applied Assume actual overheads are £1 950 000 and actual activity is 1 million DLH ’s: We applied more costs than we actually incurred External financial accounting principles (GAAP) require that under/over recoveries are treated as period costs. EXAMPLE ASSUME 1.000.000 OH ESTIMATED ASSUME 1.000.000 DLH ESTIMATED OH BUDGETED 1.000.000/1.000.000 = 1£/DLH ACTUAL DLH IN 4 QUARTERS ARE: Q1= 180.000 Q2= 200.000 650.000 APPLIED OH OF 650.000£ Q3= 150.000 assuming actual oh 1.000.000 à UNDER APPLIED 350.000£ Q4= 120.000 NON-MANUFACTURING OVERHEADS Financial accounting regulations specify that only manufacturing overheads should be allocated to products. Non-manufacturing costs should be assigned to products for decision-making (Particularly cost-plus pricing). Simplistic methods, such as using direct labour hours, or a percentage of total manufacturing cost, are frequently used as allocation bases with traditional systems. Simplistic methods do not provide a reliable measure of the non-manufacturing overheads consumed by products. ABC is advocated for providing a more accurate measure of resources consumed by products.  With the allocation based on DLC we à see that pumps have a Margin %