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F2 Course Notes PDF
F2 Course Notes PDF
F2 Course Notes PDF
Chapter 1
THE NATURE AND PURPOSE OF
MANAGEMENT ACCOUNTING
1.1 ACCA SYLLABUS GUIDE OUTCOME 1
Describe the purpose and role of cost and management accounting within an
organisation.
Cost accounting and management accounting are terms which are often used
interchangeably. It is not correct to do so.
2
1.2 ACCA SYLLABUS GUIDE OUTCOME 2:
Compare and contrast financial accounting with cost and management
accounting
Lecture Example 1
(ii) Cost accounting is that part of financial accounting which records the cash
received and payments made by an organisation.
3
1.3 ACCA SYLLABUS GUIDE OUTCOME 3:
Outline the managerial processes of planning, decision making and control.
1.3.1 Planning
Managers of all levels within an organisation take decisions. Decision making always
involves a choice between alternatives; e.g. decide on the selling price to charge for
a new product introduced on the market.
The first part of the decision-making process is planning. The second part is control.
1.3.3 Control
Managers use the information relating to actual results to take control measures and
to re-assess and amend their original budgets or plans. Actual performance of the
organisation is compared against detailed operational plans; e.g. check whether the
company is over or under spending on materials. Any deviations from the plans are
identified and corrective action is taken.
4
1.4 ACCA SYLLABUS GUIDE OUTCOME 4:
Explain the difference between strategic, tactical and operational planning.
LONG TERM
SHORT TERM
DAY-TO-DAY
5
1.4.1 Strategic Planning
Senior management formulate long-term (e.g. 5 to 10 years) objectives and plans for
an organization. Such plans include overall profitability, the profitability of different
segments of the business, capital equipment needs and so on.
Senior management make medium-term, more detailed plans for the next year, for
e.g. decide how the resources of the business should be employed, and to monitor
how they are being and have been employed. An example would be: - how many
people should be employed next year?
Lecture Example 2
Each manager must have a well-defined area of responsibility and the authority to
make decisions within that area. An area of responsibility may be structured as: -
6
1.5.1 Cost centre
A profit centre is a part of the business for which both costs and revenues are
identified; e.g. product division
Cost centres, revenue centres, profit centres and investment centres are also known
as responsibility centres.
Cost centre managers will want information regarding cost of material, labour,
expenses and overheads. The performance of the manager is judged on the extent
to which cost targets have been achieved.
Revenue centre managers will want information on markets and new products and
they will look closely at pricing and the sales performance of competitors – in
addition to monitoring revenue figures
7
1.6.3 Profit centres
Profit centre managers will want information regarding both revenues and costs.
They will be judged on the profit margin achieved by their division.
Investment centre managers will want the same information as the profit centre
manager and in addition they will require quite detailed appraisals of possible
investments and information regarding the results of investments already
undertaken.
Lecture Example 3
A. Costs only
B. Revenues only
C. Costs and revenues
D. Costs, revenues and investments
Data is the raw material for data processing. Data relate to numbers, letters,
symbols, raw facts, events and transactions which have been recorded but not yet
processed into a form suitable to make decisions. Data on its own is meaningless.
Information is data that has been processed so that it will be meaningful to the
person who receives it. It improves the quality of decision making.
8
While management accounting is mainly concerned with the provision of financial
information to aid planning, decision making and control, the management
accountant cannot ignore non-financial influences and should qualify the information
provided with non-financial matters as appropriate.
Lecture Example 4
Data is information that has been processed in such a way as to be meaningful to its
recipients.
A. True
B. False
Complete - An information user should have all the information he needs but it
should not be excessive.
Cost-effective - The benefits obtainable from the information must exceed the costs
of acquiring it. The value of information results from actions by decision makers who
use the information to improve profitability.
Understandable - Information must be clear to the user. If the user does not
understand it properly he cannot use it properly.
Relevant - Information must be relevant to the purpose for which a manager wants to
use it.
9
Timely - Information which is not available until after a decision is made will be useful
only for comparisons and longer-term control, and may serve no purpose even then.
Information prepared too frequently can be a serious disadvantage.
Easy to Use
Lecture Example 5
10
3. Non-financial information
Managers must not only look at quantitative information. They should also
consider qualitative, behavioural, motivational, even environmental factors,
when taking decisions.
4. External information
11
KEY NOTES
12
1. The purpose of cost and management accounting is to provide financial
information to managers that will help them to plan the activities, control the
activities for which they are responsible and see the financial implications of
any decisions they may take.
3.
Management Financial Accounting
Accounting
1. Users and decision- Internal use – External use –
makers management and shareholders, banks,
employees government
2. Purpose of information To aid in planning, To record the financial
decision-making and performance and position
control of the business
3. Legal requirements None Limited companies must
produce financial
statements
4. Formats Management decide the According to company
best way to present law
information
5. Nature of information Mostly monetary; but also Monetary information
nonmonetary information
6. Time period Historical and forward- Mainly historical
looking
5. Strategic Planning
Senior management formulate long-term (e.g. 5 to 10 years) objectives and
plans for an organization.
13
6. Tactical Planning
Senior management make medium-term, more detailed plans for the next
year
7. Operational Planning
All managers are involved in making day-to-day decisions. Operational
information is derived almost entirely from internal sources. It is prepared
frequently, is highly detailed and is mainly quantitative.
9.
10. Data is the raw material for data processing. Information is data that has been
processed in such a way as to be meaningful to the person who receives it.
Accurate
Complete
Cost-effective
Understandable
Relevant
14
Accessible
Timely
Easy to use
15
QUESTIONS
16
1. A strategy is the aim or goal of an organisation.
A. True
B. False
17
ANSWERS
18
1. B
2. C
3. D
4. A
5. D
6. C
19
Chapter 2
SOURCES OF INFORMATION
Different sources of information are available to organisations, including those
available within and outside the organisation. Such information will become the input
into an organisation’s decision making and management accounting systems.
Classification of data
1. Primary data are data collected especially for a specific purpose, e.g. raw
data.
Secondary data are data which have already been collected elsewhere, for
some other purpose but which can be used or adapted for the survey being
conducted, e.g. official statistics, data obtained from financial newspapers,
trade journals, etc.
2. Discrete data are data which can only take a finite or countable number of
values within a range, e.g. you cannot have 1.25 units but 1 unit, 2 units etc.
Continuous data are data which can take on any value. They are measured
rather than counted, e.g. a person can be 1.585m tall.
20
2.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Describe sources of information from within and outside the organisation
(including government statistics, financial press, professional or trade
associations, quotations and price list.
Explain the uses and limitations of published information/data (including
information from the internet).
The payroll system provides us with important information relating to our employees,
hours of work, output, employee turnover etc.
What information does this strategic planning system provide us with? It may
provide information about the company’s targets and objectives, its capital
investment programme and any long term plans it may have. Hence, this
information can be very sensitive and may not be available to all employees within
the company but only to top management.
Environmental scanning/monitoring: -
21
which would assist management in planning the organization's future course of
action1
1. Provide the company with useful information about the industry, e.g. the
tourism industry. This will help both the company and the industry to decide
on the future
2. Provide information for economic planning as most information deals with the
economy as a whole
22
2.1.2.3 Professional or trade associations
E.g. The Malta Chamber of Commerce provides a central, national organization for
the representation, promotion and protection of all members’ interests, as well as
acting as an authoritative medium of communication between members’ sectors,
Government, and the EU. The Malta Chamber also aims to establish and support
initiatives which lead to the establishment of new business ventures and employment
opportunities.2
In the UK, particular newspapers such as The Financial Times, the Guardian, The
Times and the Daily Telegraph provide statistics and financial reviews as well as
business economic news and commentary. In Malta, we have the Malta Business
Review and other journals which look into the local and foreign financial aspects.
Such information is now also widely available via electronic media and digital
television services (such as Bloomberg TV). There is also the internet as a widely
available source of up-to-date financial information. But the internet has its
limitations…
Lecture Example 1
i. Government statistics.
ii. The Financial Times.
iii. Data collected for a survey which was commissioned in order to determine
whether the company should launch a new product.
2 http://malta.usembassy.gov/com-link-trade.html
23
iv. Historical records of expenditure on light and heat in order to prepare current
forecasts.
A. i and ii only
B. i, ii and iii only
C. i, ii and iv only
D. i, ii, iii and iv
The economic environment affects firms at national and international level, both in
the general level of economic activity and in particular factors, e.g. inflation, interest
rates and exchange rates.
Even the state of the economy will influence the planning process of an organisation.
In times of boom, consumer demand and consumption increases. In times of
recession, the company has to focus on its survival through cost effectiveness and
competition.
2.3.1 Introduction
Sampling:
24
Definitions:
Population
the set of individuals, items, or data from which a statistical sample is taken
Sample
A group of items drawn from the population and used to estimate the characteristics
of the whole population.
http://tomhopper.me/2014/11/14/sample-size-matters/
1. Random
2. Systematic
3. Stratified random
4. Multi-stage
5. Cluster
Quota sampling is a non-probability sampling method, i.e. the samples are gathered
in a process that does not give all the individuals in the population equal chances of
being selected.
25
2.3.2.1 Random Sampling
Each item in the population has to be numbered. In random sampling, we find the
sampling frame. What is this? A list of the items or people forming a population from
which a sample is taken.
For e.g. if I want to use simple random sampling to choose 10 students from my F2
class, I can put each name on the attendance sheet on a piece of paper, put the
papers in a bag and blindly select the name of 10 students.
This method has limitations when the population is large or not known. It does not
guarantee a representative sample BUT eliminates selection bias.
Strictly speaking, systematic sampling is not 100% random as only the first item is
selected randomly.
In the following diagram, we have selected randomly the 2 nd person in the list, then
every 3, will be included in the sample.
http://www.snipview.com/q/Systematic_sampling
26
E.g. I would like to sample 8 houses from a long street which has 120 houses. This
means that every 15th house is chosen (120/8) after a random starting point is
chosen.
Limitations:
A systematic random sample can only be carried out if a complete list of the
population is available. Also there is the danger of bias.
We need to divide the entire population into different subgroups or strata, then
randomly select the final subjects proportionally from the different strata. How does it
work? We can divide our population into smokers and non-smokers. A random
sample is taken from each group. But the number in each sample must be
proportional to the size of that group in the population - probability proportional to
size. Hence, a representative cross-section of the strata in the population is
obtained.
https://sites.google.com/a/whps.org/mrs-murray-s-math-site/unit-1---intro-to-statistics
27
2.3.2.4 Cluster Sampling
1. He can divide the entire Maltese population into different clusters (cities).
2. Then he selects a number of clusters using simple or systematic random
sampling.
3. Then, from the selected clusters (randomly selected cities) the researcher will
interview all the students in that cluster.
Multi-stage sampling is similar to cluster sampling BUT a sample is taken from the
final group.
Advantages
28
For example, an interviewer may be told to sample 200 females and 300 males
between the age of 45 and 60. This means that individuals can put a demand on
who they want to sample (targeting ).3
Lecture Example 2
Under which sampling method does every member of the target population have an
equal chance of being in the sample?
A. Stratified sampling
B. Random sampling
C. Systematic sampling
D. Cluster sampling
Lecture Example 3
A. Systematic sampling
B. Stratified sampling
C. Quota sampling
D. Cluster sampling
3 https://en.wikipedia.org/wiki/Quota_sampling
29
Lecture Example 4
A. i and ii
B. ii and iii
C. iii only
D. ii only
30
KEY NOTES
31
1. Data may be primary (collected specifically for the purpose of a survey) or
secondary (collected for some other purpose). Discrete data can only take on
a countable number of values. Continuous data can take on any value.
Sample data arises as a result of investigating a sample. Population data
arises as a result of investigating the population.
a. Accounting system
b. Payroll system
c. Strategic planning system
a. Government sources
b. Business contacts - customers and suppliers
c. Trade associations and trade journals
d. The financial and business press and other media
6. The term population is used to mean all the items under consideration in a
particular enquiry.
32
11. Systematic Sampling (quasi-random)
Only the first item is selected randomly. Then, each nth item is chosen.
33
QUESTIONS
34
1. The population is divided into several groups and a sample is chosen to
represent the make-up of the population. A sample from each age group is
selected in the same proportion as the estimate of the population as a whole.
A. Systematic sampling
B. Stratified sampling
C. Quota sampling
D. Cluster sampling
2. The population is divided into smaller and smaller groups until small enough
to sample all of the people in the final group.
A. Systematic sampling
B. Stratified sampling
C. Quota sampling
D. Cluster sampling
35
ANSWERS
36
1. B
2. D
3. D
4. A
37
Chapter 3
COST CLASSIFICATION
3.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Explain and illustrate production and non-production costs
For the preparation of financial statements, costs are often classified as: - production
and non-production costs.
Production costs are costs identified with goods produced for resale. Production
costs are all the costs involved in the manufacture of goods, i.e. direct material,
direct labour, direct expenses, variable production overheads and fixed production
overheads.
3.2.1 Materials
3.2.2 Labour
38
3.2.3 Overheads
Overheads include all other costs which are not materials or labour. These include
rent, telephone, and depreciation of equipment.
Production Costs
These include all the costs involved in running the general administration department
of an organization.
Selling costs include all costs incurred in promoting sales and retaining customers.
39
3.3.3 Distribution costs
Distribution costs include all costs incurred in making the packed product ready for
dispatch and delivering it to the customer.
Finance costs include all the costs that are incurred in order to finance an
organization, for e.g. loan interest.
Non-Production Costs
Non-production costs are taken directly to the income statement as expenses in the
period in which they are incurred.
Lecture Example 1
40
Lecture Example 2
Direct costs: - these are costs which can be directly identified with a specific cost
unit or cost centre. There are 3 main types of direct cost: -
Direct materials: - materials used in making and selling a product (or even
providing a service); e.g. raw material, packing material.
Direct labour: - the specific costs of the workforce used to make a product or
provide a service.
Indirect costs: - these are costs which cannot be directly identified with a specific
cost unit or cost centre. These costs cannot be easily traced to a specific product.
41
Indirect labour: - all wages not charged directly to a product. These include
wages of non-productive personnel in the production department, example
supervisor.
Lecture Example 3
Identify whether the following costs are direct or indirect materials, labour or
expenses.
Lecture Example 4
Classification by Function
42
Please note that research costs are the costs of searching for new or improved
products. Development costs are the costs incurred between the decision to produce
a new or improved product and the commencement of full manufacture of the
product.
To use descriptions only of the items would lead to ambiguities and difficulties in
recording and processing the information. The items need to be logically coded. For
example, 5 cm brass plates may be coded as 05677 and no other class of item
should be coded the same.
43
3.5.1 Types of Code
1. Composite codes:
The CIMA terminology describes the use of composite symbols in codes. The first
three digits in the composite code might indicate the nature of the expense whereas
the last three digits might indicate the cost centre or the cost unit to be charged.
For example:
8 – labour
9 – semi-skilled
2 – grade 2
These codes are showing this was semi-skilled labour
1 – indirect cost
1 – Factory XYZ
3 – finishing department
This code shows us this labour expenditure is to be charged as indirect labour
to the finishing department in factory XYZ
A sequential code simply follows a sequence. Imagine we are drafting a register for
employees for salary purposes. We begin with the first employee being assigned
the number 00, the second employee is assigned the number 01 and so on. In this
code, we have allowed for there to be as many as 100 employees, since we have
allocated 2 digits to the code and can assign all of the numbers from 00 to 99, 100
numbers, to that number of employees:
Group classification (block) codes are very common in accounting circles in that they
commonly form the basis of charts of accounts, as depicted below:
44
1000 – Non-current assets
2000 - Current assets (excl. inventories)
3000 - Inventories
4000 – Non-current liabilities
5000 - Current liabilities
6000 - Equity
7000 - Revenues
8000 - Expenditures
The 1000 “Block” is allocated to non-current assets. This means that it is possible
to classify up to 1,000 different non-current assets using this block. Of course, there
may be sub blocks so that we can extend the range of non-current assets we can
have.
4. Faceted codes:
A faceted code is one that is broken down into a number of facets or fields, each of
which signifies a unit of information. We could use a chart of accounts, that is
commonly faceted; but let’s work through the faceted code of a furniture
manufacturer. We’ll consider a code that will deal with direct materials, direct
labour, and indirect costs.
Facet 1: 00 Preparation
01 Carpentry
02 Assembly
03 Finishing
04 Upholstery
45
Facets 1 and 2 should need little further explanation; but let’s expand Facet 3.
Let's use this code shown now to determine the code for grade 2 labour costs
incurred by the carpentry department. The code is:
01 01 0112;
and the code for buildings insurance for the upholstery department is:
04 03 0161.
These incorporate some digits which are part of the description of the item being
coded.
46
6. Hierarchical codes:
The coding systems used by libraries are examples of hierarchical codes. The
major advantage of such systems is that they are, in theory at least, infinitely
expandable: they can be extended for ever; but in a logical, structured, way.
If we assume that code 657 is the library classification number for accounting, then
we can develop the code hierarchically:
657 Accounting
and so on ...
The drawback of infinite expandability is that it would need an infinitely large storage
device to store an infinitely large code!
47
KEY NOTES
48
1. Production vs. Non-production costs
Production costs are costs identified with goods produced for resale. Non-
production costs are not directly associated with production of manufactured goods.
Administrative costs - all the costs involved in running the general administration
department of an organization.
Selling costs - all costs incurred in promoting sales and retaining customers.
Distribution costs - all costs incurred in making the packed product ready for dispatch
and delivering it to the customer.
Finance costs - all the costs that are incurred in order to finance an organization.
Direct costs – costs which can be directly identified with a specific cost unit or cost
centre. There are 3 main types of direct cost: - direct materials, direct labour and
direct expenses.
Indirect costs – costs which cannot be directly identified with a specific cost unit or
cost centre. These include indirect materials, indirect labour and indirect expenses.
49
QUESTIONS
50
1. In an organisation, manufacturing a number of different products in one large
factory, the rent of that factory is an example of a direct expense when costing
a product.
Is this statement true or false?
A. True
B. False
2. Specify whether the following expenses are production costs, selling and
distribution costs, administration costs and research and development costs.
51
ANSWERS
52
1. B – indirect expense
2. i. production cost
ii. selling cost
iii. research and development cost
iv. production cost
v. administration cost
53
Chapter 4
COST BEHAVIOUR
4.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Describe and illustrate, graphically, different types of cost behaviour.
Costs can be classified according to the way that they behave within different levels
of activity. Cost behaviour tends to classify costs as: -
Variable cost
Fixed cost
Stepped fixed cost
Semi-variable cost
A variable cost is a cost which tends to vary directly with the volume of output. As
total costs increase with activity levels, the variable cost per unit remains constant.
By their nature, direct costs will be variable costs. Examples of variable costs include
raw materials and direct labour.
54
Graph 2: - Variable cost per unit
A fixed cost is a cost which is incurred for an accounting period, and which, within
certain activity levels remains constant.
Examples of fixed costs include the salary of the managing director, the rent of a
building and straight line depreciation of machinery.
55
Graph 4: - Fixed cost per unit
The fixed cost per unit falls as the level of activity increases but never reaches zero.
A stepped fixed cost is only fixed within certain levels of activity. The depreciation of
a machine may be fixed if production remains below 1,000 units per month. If
production exceeds 1,000 units, a second machine may be required, and the cost of
depreciation (on two machines) would go up a step.
Other stepped fixed costs include rent of warehouse (more space required if activity
increases) and supervisors’ wages (more supervisors required if number of
employees increase).
Fixed costs increase in steps as activity level increases beyond a certain limit.
56
4.1.4 Semi-variable Costs (semi-fixed/mixed)
Semi-variable costs contain both fixed and variable components and are therefore
partly affected by changes in the level of activity.
57
Lecture Example 1
i. Electricity bill
ii. Raw materials
iii. Rent of factory
iv. Supervisors’ wages (more supervisors required as the number of
employees increases)
This graph represents a cost which is variable with output, subject to a minimum
(fixed) charge.
There are two main methods which analyse semi-variable costs into their fixed and
variable elements: -
High/low method
Least squares regression (covered in later chapters)
58
4.2.1 High-low method
Total cost at high activity level - total cost at low activity level
Total units at high activity level - total units at low activity level
Total cost at high activity level – (Total units at high activity level × Variable
cost per unit)
1. Easy to use
2. Easy to understand
1. It relies on historical cost data – predictions of future costs may not be reliable
2. It assumes that the activity level is the only factor affecting costs
3. It uses only two values to predict costs
4. Bulk discounts may be available at large quantities
Lecture Example 2
The total costs of a business for differing levels of output are as follows:
59
What are the fixed and variable elements of the total cost using the High-Low
method?
Lecture Example 3
MVP Steel has the following total costs at two activity levels:
Variable cost per unit is constant within this range of activity but there is a step up of
$5,000 in the total fixed costs when the activity exceeds 17,500 units.
A. $155,000
B. $158,000
C. $160,000
D. $163,000
60
The equation of a straight line is y = a + bx
Lecture Example 4
61
Lecture Example 5
Y = 5,000 + 6x
A cost object is any activity for which a separate measurement of cost is undertaken.
E.g. cost of a product, cost of a service, cost of a particular department.
A cost unit is a unit of product or service in relation to which costs are ascertained.
E.g. a hotel room, a course, one litre of paint.
Lecture Example 6
62
4.3.3.4 Cost Cards
A cost card lists out all the costs involved in making one unit of a product.
Cost Card: -
$
Direct Materials X
Direct Labour X
Direct Expenses X
Prime Cost XX
Variable Production Overheads X
Marginal Production Cost XX
Fixed Production Overheads X
Total Production Cost XX
Non-production overheads:
Administration X
Selling X
Distribution X
Total Cost XX
Profit X
Sales Price XXX
63
KEY NOTES
64
1. Different types of cost behaviour
Fixed cost – a cost which, within certain activity level, remains constant
Stepped fixed cost – a cost which is fixed up to a certain level of volume, and then it
increases to an even higher level of fixed cost to a certain level of volume
Semi-variable cost – it contains both a fixed and variable element and therefore is
partly affected by a change in the activity level
This method analyses semi-variable costs into their fixed and variable elements.
Always select the period with the highest activity level and the period with the lowest
activity level.
Total cost at high activity level - total cost at low activity level
Total units at high activity level - total units at low activity level
Total cost at high activity level – (Total units at high activity level × Variable
cost per unit)
y = a + bx
65
Cost Equation
y = a + bx
Cost unit - a unit of product or service in relation to which costs are ascertained. E.g.
a hotel room, a course, one litre of paint
Cost cards - lists out all the costs involved in making one unit of a product.
66
QUESTIONS
67
1. A semi-variable cost is one that, in the short term, remains the same over a
given range of activity but beyond that increases and then remains constant at
the higher level of activity.
A. True
B. False
2. A cost centre is
3. RCA has recorded the following costs over the last six months:
Using the high – low method what would be the total cost equation?
68
For output above 350 units, the variable cost per unit falls by 10%. This fall
applies to all units, not just the units above the 350 threshold.
5. Electricity costs for the first 6 months of the year are as follows:
Calculate the fixed and variable costs using the high-low method.
The fixed element of total cost increases by $8,000 at output levels in excess of
30,000 units.
69
ANSWERS
70
1. B - stepped fixed cost
2. C
3. B
4. $9050
Units $
300 8000
200 7000
100 1000
TC (300) = FC + VC
8000 = FC + (300 x 10)
FC = 5000
Units $
420 2400
300 2160
120 240
VC/unit = $240 = $2
120
TC = FC + VC
2400 = FC + (420 x 2)
FC = 1560
71
6. A
7. A
Units Cost
72
Chapter 5
PRESENTING INFORMATION
5.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Prepare written reports representing management information in suitable
formats according to purpose
When producing written reports, the management accountant needs to carry out four
steps: -
a. Prepare: determine the type of document required and establish
the user of the information
b. Plan: select the relevant date: summarise, analyse, illustrate to turn
the raw data into useful information
c. Write
d. Review what has been written
Title
At the top of your report show who the report is to, who it is from, the date and
a heading.
Introduction
Showing what information was requested, the work done and where results
and conclusions can be found.
Analysis
Conclusion
73
Appendices
Numbered headings and cross referencing between sections make reports easier to
follow (or navigate).
In this section, we will be looking at different ways how information can be presented
through the use of tables, charts and graphs. Scatter graphs will be described in
detail when discussing forecasting methods later on in the course notes.
5.2.1 Tables
b) Source: the source of the material used in drawing up the table should be stated
(usually by way of a footnote).
c) Units: the units of measurement that have been used must be stated.
d) Headings: all column and row headings should be clear and concise.
e) Totals: these should be shown where appropriate, and also any subtotals that
may be applicable to the calculations.
f) Percentages and ratios: these are sometimes called derived statistics and
should be shown, if meaningful, with an indication of how they were calculated.
74
g) Column layout: for ease of comparison columns containing related information
should be adjacent and derived figures should be adjacent to the column to
which they refer.
i) Layout: wherever possible ensure that the table is set up so that there is no
need to turn the page. This will affect the choice of columns and rows.
Illustration 1 – Tables
Dept A
2011 2010 % change
$ $ $
Raw Material 120,000 100,000 20%
Labour 56,000 50,000 12%
Overheads 24,000 20,000 20%
Bar charts
Line graphs
Pie charts
Scatter graphs
A bar chart is a widely used method of illustrating quantitative data. Quantities are
shown in the form of bars on a chart, the length of the bars being proportional to the
quantities.
75
1. Simple bar charts
A simple bar chart consists of one or more bars, in which the length of each bar
indicates the size of the corresponding information.
A component bar chart is used when each total figure in the data is made up of a
number of different components and it is important that these component elements
are shown as well as the total figure.
76
3. Percentage component bar chart
77
4. Compound (multiple) bar charts
Compound bar charts are sometimes termed multiple bar charts. A compound bar
chart is one where there is more than one bar for each sub-division of the chart. For
example if the sales per product for each year are given then for each year there
could be a separate bar for each product.
This has obvious similarities to a component bar chart where each component of the
total was shown as part of the total bar. However the difference here is that each
component has its own bar and is not stacked. It is a suitable format if the total of
each component of the bar chart has no significance.
400,000
300,000 A
200,000 B
100,000 C
0
2009 2010 2011
Years
C
Division
B 2011
2010
A
2009
0 100,000200,000300,000400,000500,000600,000700,000
$ Sales
78
5.2.2.2 Graphs
In many instances data can be more clearly and understandably presented in the
form of a line graph. The x axis would represent the independent variable whereas
the y axis represent the dependent variable.
Lecture Example 1
You may be required to plot more than one set of variables on the same graph.
If more than one line is to appear on a graph then they must also be drawn to the
same scale and the different line should be clearly indicated by use of a key (e.g.
continuous line, broken line, dotted line) or different colour.
79
The y axis must
be labelled - here
it represents the The subject of the graph
value of sales is explained in the title
The legend or
key identifies
each line
A pie chart is a circular chart divided into sectors, illustrating proportion. In a pie
chart, the arc length of each sector (and consequently its central angle and area),
is proportional to the quantity it represents. Together, the sectors create a full disk.
80
ABC Ltd
Divisional Sales 2011
26%
42% A
B
C
32%
81
Lecture Example 2
Last year, MV Quads made the following sales in each of its four stores which it has
in different areas of the country.
$
Store 1 30,000
Store 2 25,000
Store 3 70,000
Store 4 75,000
Total 200,000
Using a pie chart to represent the proportion of sales which each store has
made last year, what would be the angle of the section to represent the sales
from store 3? ___________________
Example: - Number of students and the marks they obtained in each class
Marks: f Cum f Cum %
90-99 0 50 100
80-89 2 50 100
70-79 6 48 96
60-69 9 42 84
50-59 12 33 66
40-49 10 21 42
30-39 7 11 22
20-29 3 4 8
10-19 1 1 2
0-9 0 0 0
82
83
KEY NOTES
84
1. When preparing reports, the management accountant should use the correct
structure including introduction, analysis, conclusion and any appendices.
2. Information can also be presented through the use of tables, charts and graphs.
4. A simple bar chart shows not only the actual amount of the data which can be
read off from the vertical axis but also the relationship between the data.
5. A component bar chart is used when each total figure in the data is made up of a
number of different components.
6. A percentage component bar chart is one where the percentage of the total for
each component is shown.
7. A compound bar chart is one where there is more than one bar for each sub-
division of the chart.
8. In many instances data can be more clearly and understandably presented in the
form of a line graph.
9. A pie chart is a circular chart divided into sectors, illustrating proportion. In a pie
chart, the arc length of each sector (and consequently its central angle and area),
is proportional to the quantity it represents.
85
QUESTIONS
86
1. Identify the correct formula for calculating the segment angles in a pie chart: -
Material W: $2,000
Material X: $1,000
Material Y: $4,000
Material Z: $2,000
If the material proportions were displayed on a pie chart, how many degrees
would Material Y represent? ____________
87
ANSWERS
88
1. C
2. D
3. B
4. A
89
Chapter 6
ORDERING AND ACCOUNTING FOR
INVENTORY
90
Department requires new Ordering and
materials Purchasing
Purchase requisition
Purchasing
department
Supplier
Goods with delivery note
Goods receiving
Receipt
department (stores)
Purchasing department
Proper records must be kept of the physical procedures for ordering and receiving a
consignment of materials to ensure that: -
Current inventories run down to the level where a reorder is required. The stores
department issues a purchase requisition which is sent to the purchasing
department, authorising the department to order further inventory.
91
6.1.2.2 Purchase order
The purchasing department draws up a purchase order which is sent to the supplier.
Copies of the purchase order must be sent to the accounts department and the
storekeeper (or goods receiving department).
6.1.2.3 Quotation
The supplier delivers the consignment of materials, and the storekeeper signs a
delivery note for the carrier. The packages must then be checked against the copy of
the purchase order, to ensure that the supplier has delivered the types and quantities
of materials which were ordered.
If the delivery is acceptable, the storekeeper prepares a goods received note (GRN).
A copy of the GRN is sent to the accounts department, where it is matched with the
copy of the purchase order. The supplier's invoice is checked against the purchase
order and GRN, and the necessary steps are taken to pay the supplier.
92
Lecture Example 1
Materials held in store are asset and are therefore recorded in the statement of
financial position of a company.
Lecture Example 2
The following represent the materials transactions for a company for a year: -
$’000
Material purchases 240
Issued to production 215
Materials written off 12
Returned to stores 6
Returned to suppliers 2
93
The material stock at 1 January 20x8 was $25,000.
__________.
Perpetual inventory is the recording as they occur of receipts, issues and the
resulting balances of individual items of inventory in both quantity and value. These
inventory records are updated using stores ledger cards and bin cards.
Bin Card
Commodity :
Package size
94
6.3.2 Stocktaking
The process of stocktaking involves checking the physical quantity of inventory held
on a certain data with the balance on the stores ledger cards or bin cards.
Periodic stocktaking involves checking the balance of every item in inventory at a set
point in time, usually at the end of an accounting year.
This involves counting and valuing selected items of inventory on a rotating basis.
Each item is checked at least once a year.
Inventory losses arising from theft, pilferage or damage must be written off against
profits as soon as they occur.
95
i. FIFO – materials are issued out of stock in the order in which they were delivered
into inventory, i.e. issues are priced at the cost of the earliest delivery remaining
in inventory. This is a logical pricing method but can be cumbersome to operate
since each batch of material has to be identified separately.
ii. LIFO – the last items of material received are the first items to be issued. LIFO is
not accepted for financial accounting purposes (IAS 2). The items remaining in
inventory are the first which were produced or purchased.
iii. Cumulative Weighted average cost – AVCO calculates a weighted average price
for all units in inventory. Issues are priced at this average cost, and the balance
of inventory remaining would have the same unit valuation.
Lecture Example 3
Calculate the value of material issued and closing inventory using FIFO, LIFO and
AVCO.
This method is only used if specifically mentioned in the exam question. Otherwise,
the cumulative weighted average method should be used.
96
Lecture Example 4
Using the information in lecture example 3, calculate the value of closing inventory at
the end of December using the periodic weighted average.
97
KEY NOTES
98
1. Procedures for ordering, purchasing and receiving materials
Purchasing
department
Supplier
Goods with delivery note
Goods receiving
Receipt
department (stores)
Purchasing department
i. Purchase requisition
iii. Quotation
99
3. Documents for issuing inventory
5. Perpetual Inventory
Perpetual inventory is the recording as they occur of receipts, issues and the
resulting balances of individual items of inventory in both quantity and value.
6. Stocktaking
i. Periodic stocktaking
Periodic stocktaking involves checking the balance of every item in inventory on the
same date, usually at the end of an accounting year.
This involves counting and valuing selected items of inventory on a rotating basis.
Each item is checked at least once a year.
100
7. Inventory Valuation Methods
i. FIFO – materials are issued out of stock in the order in which they were
delivered.
ii. LIFO – the last items of material received are the first items to be issued.
iii. Cumulative weighted average cost – AVCO values all items of inventory and
issues at an average price, which is calculated after each receipt of goods.
101
QUESTIONS
102
1. The following data represents the stores ledger control account for a
manufacturing company: -
$’000
Opening inventory 1.1.x8 18.5
Closing inventory 31.12.x8 16.1
Deliveries from suppliers 142.0
Returns to suppliers 2.3
Cost of indirect materials issued 25.2
How would the issue of direct materials be recorded in the cost accounts?
A. True
B. False
i. With LIFO, units are issued at a price close to the current market value
ii. With FIFO, inventory value will be very close to replacement cost
iii. Decision making can be difficult with both FIFO and LIFO because of the
variations in price
iv. A disadvantage of the weighted average method of inventory valuation is that
the resulting issue price is rarely an actual price that has been paid and it may
be calculated to several decimal places
A. i and ii only
B. i, ii and iii only
C. i and iii only
D. all of the above statements
103
ANSWERS
104
1. D
160.5 160.5
105
Chapter 7:
ORDER QUANTITIES AND REORDER
LEVELS
7.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Identify and explain the costs of ordering and holding inventory (including
buffer inventory)
A business holds inventory so that customer demands are met as soon as they
arise. Buffer (safety) inventory is the minimum inventory level required to prevent
stock-outs from occurring.
There are advantages and disadvantages of holding stock (of buying stock in large
or small quantities). The advantages include:
the need to meet customer demand
taking advantage of bulk discounts
reducing total annual re-ordering cost
Stock-out costs occur when the business runs out of inventory and these include:
i. Loss of sales
ii. Loss of customers
iii. Loss of reputation
iv. Reduced profits
106
Holding Cost =
Cost of holding 1 unit for 1 year x average inventory through the year
= Ch x Q
2
Ordering costs =
Cost per order x no of orders pa
= C0 x D
Q
Where: -
Q is the quantity per order.
Lecture Example 1
XYZ Ltd uses components at the rate of 10,000 units per annum, which are bought
in at $1.50 each. It orders 1,000 units each time it places an order. The average
inventory held is 500 units. It costs $50 each time to place an order, regardless of
the quantity ordered.
The total holding cost is 20% per annum of the average inventory held.
Required:-
Lecture Example 2
107
which is the economic order quantity. The company holds a buffer inventory of 500
components. The annual cost of holding one component in inventory is $2.
This is the quantity of inventory which is to be ordered when inventory reaches the
reorder level. If the re-order quantity is set so as to minimise the total costs
associated with holding and ordering inventory, then it is known as the economic
order quantity.
When determining how much to order at a time, an organisation will recognise that:
as order quantity rises, average stock rises and the total annual cost of holding
stock rises
as order quantity rises, the number of orders decreases and the total annual re-
order costs decrease.
The economic order quantity (EOQ) is the order quantity which minimises the total
costs associated with holding and ordering stock. At this quantity, holding costs are
equal to ordering costs.
108
7.2.2.1 EOQ formula
Q = EOQ =
Where:
Ch = cost of holding one unit of inventory for one time period
C0 = cost of ordering a consignment from a supplier
D = demand during the time period
Q = the reorder quantity (EOQ)
Total Annual Costs (TAC) = purchasing costs + holding costs + ordering costs
TAC =
DP + C0 D + Ch Q
Q 2
Where: -
D= demand during the time period
P = purchase price per unit
Ch = cost of holding one unit of inventory for one time period
C0 = cost of ordering a consignment from a supplier
Q = the reorder quantity (EOQ)
109
This formula is not given in the exam.
Lecture Example 3
The purchase price of a stock item is $25 per unit. In each three month period the
usage of the item is 20,000 units.
The annual holding costs associated with one unit equate to 6% of its purchase
price. The cost of placing an order for the item is $20.
What is the Economic Order Quantity (EOQ) for the stock item to the nearest
whole unit?
A. 730
B. 894
C. 1,461
D. 1,633
When bulk orders are placed, it is often possible to negotiate a quantity discount on
the purchase price. Although the purchase price and annual ordering cost will
decrease, the annual holding cost will increase.
7.3.1 Steps involved in calculating the EOQ when discounts are available
110
Example
Epsy Limited uses 15,000 units of its main raw material per month. The material
costs $10 per unit to buy, supplier’s delivery costs are $25 per order and internal
ordering costs are $5 per order. Total annual holding costs are $4 per unit. The,
supplier has offered a discount of 1% if 4,000 units of the material are bought at a
time.
Required:
1. EOQ = 2C0D
Ch
= 2(30)(180,000)
4
= 1,643 units
$
Purchase costs 180,000 units x $10 1,800,000
Holding costs $4 x 1,643/2 3,286
Ordering costs $30 x 180,000/1,643 ____3,286
1,806,572
111
2.
$
Purchase costs 180,000 units x $9.90 1,782,000
Holding costs $4 x 4,000/2 8,000
Ordering costs $30 x 180,000/4,000 ____1,350
1,791,350
Lecture Example 4
A company uses components at the rate of 500 units per month, which are bought in
at a cost of $1.20 each from the supplier. It costs $20 each time to place an order,
regardless of the quantity ordered.
The supplier offers a 5% discount on the purchase price for order quantities of 2,000
items or more. The current EOQ is 1,000 units. The total holding cost is 20% per
annum of the value of stock held.
112
EBQ =
Where: -
Lecture Example 5
A company has demand for 50,000 units p.a. They produce their own units at a cost
of $30 per unit, and are capable of producing at rate of 500,000 units p.a.
Machine set-up costs are $200 for each batch. Stock holding costs are 10% p.a. of
stock value.
When inventories reach the reorder level, an order should be placed to replenish
inventories. The reorder level is determined by consideration of the following.
113
• The maximum rate of consumption
• The maximum lead time
The maximum lead time is the time between placing an order with a supplier, and
that order arriving.
When the reorder level is reached, the quantity of inventory to be ordered is known
at the reorder quantity (EOQ).
This is a warning level to draw management’s attention to the fact that inventories
are approaching a dangerously low level and that stock outs are possible.
This also acts as a warning level to signal to management that inventories are
reaching a potentially wasteful level.
114
7.5.4 Average inventory
The average inventory formula assumes that inventory levels fluctuate evenly
between the minimum (or safety) inventory level and the highest possible inventory
level, i.e. the amount of inventory immediately after an order is received (safety
inventory + reorder quantity).
Lecture Example 6
A company stocks item AZX for which the following information is available: -
_____________
115
KEY NOTES
116
1. Holding Cost
Holding Cost =
Cost of holding 1 unit for 1 year x average inventory through the year
= Ch x Q
2
2. Ordering Cost
Ordering costs =
Cost per order x no of orders pa
= C0 x D
Q
3. The Economic Order Quantity
The economic order quantity (EOQ) is the order quantity which minimises the total
costs associated with holding and ordering stock. At this quantity, holding costs are
equal to ordering costs.
Q = EOQ =
EBQ =
117
5. Reorder Level
6. Minimum level
7. Maximum level
8. Average inventory
118
QUESTIONS
119
1. A manufacturing company uses 25,000 components at an even rate during a
year. Each order placed with the supplier of the components is for 2,000
components, which is the economic order quantity. The company holds a buffer
inventory of 500 components. The annual cost of holding one component in
inventory is $2.
A. $2,000
B. $2,500
C. $3,000
D. $4,000
2. The purchase price of a stock item is $25 per unit. In each three month period the
usage of the item is 20,000 units.
The annual holding costs associated with one unit equate to 6% of its purchase
price. The cost of placing an order for the item is $20.
What is the Economic Order Quantity (EOQ) for the stock item to the nearest
whole unit?
A. 730
B. 894
C. 1,461
D. 1,633
3. A company always determines its order quantity for a raw material by using the
Economic Order Quantity (EOQ) model.
What would be the effects on the EOQ and the total annual holding cost of a
decrease in the cost of ordering a batch of raw material?
120
4. Sky Limited wishes to minimise its stock costs. At the moment its reorder
quantity is 1,000 units. Order costs are $10 per order and holding costs are
$0.10 per unit per annum. Sky Limited estimates annual demand to be 15,000
units.
What is the optimal reorder quantity (to the nearest 100 units)?
A. 500 units
B. 1,000 units
C. 1,200 units
D. 1,700 units
5. A company uses 9,000 units of a component per annum. The component has a
purchase price of $40 per unit and the cost of placing an order is $160. The
annual holding cost of one component is equal to 8% of its purchase price.
What is the Economic Order Quantity (to the nearest unit) of the component?
A. 530
B. 671
C. 949
D. 1,342
6. A company determines its order quantity for a component using the Economic
Order Quantity (EOQ) model.
What would be the effects on the EOQ and the total annual ordering cost of an
increase in the annual cost of holding one unit of the component in stock?
7. The demand for a product is 12,500 units for a three month period. Each unit of
product has a purchase price of $15 and ordering costs are $20 per order placed.
The annual holding cost of one unit of product is 10% of its purchase price.
A. 577
B. 1,816
C. 1,866
D. 1,155
121
ANSWERS
122
1. C = $2 x (2000/2 +500)
2. C = 1,461 units
3. D – a fall in ordering costs reduce the EOQ and therefore the holding costs.
5. C
7. D
123
Chapter 8
ACCOUNTING FOR LABOUR
8.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Calculate direct and indirect costs of labour
Direct labour costs include the basic pay of direct workers. Direct workers are those
employees who are directly involved in making the products. Therefore, they are part
of the prime cost of a product.
Indirect labour costs include the basic pay of indirect workers, i.e. those employees
who are not directly involved in making the product, e.g. factory supervisor,
maintenance staff. These costs are part of the overhead cost.
NORMAL HOURS
124
8.1.3 Overtime and overtime premiums
When employees work overtime, they will receive a basic pay + an overtime
premium.
OVERTIME PREMIUM
Direct Indirect
Worker Worker
Shift allowances or shift premiums are similar to overtime premiums and are treated
as an indirect labour cost.
Lecture Example 1
A company employs 100 direct workers in the factory, who are paid a basic rate of
$5 per hour for a 35 hour week. In addition to working their normal hours last month,
each worker was asked to work an additional 5 hours overtime per week to meet
general production requirements. All overtime hours are paid at time and a half. As
a result of some faulty material, 150 hours of direct labour time were registered as
idle. Employee deductions total 30% of gross wages.
i. Gross wages
ii. Deductions
iii. Net wages
iv. Direct labour cost
v. Indirect labour cost
125
8.2 ACCA SYLLABUS GUIDE OUTCOME 2:
Explain the methods used to relate input labour costs to work done
Different methods can be used to determine the time spent doing jobs. These
include time sheets (activity time records), time cards (clock cards) and job sheets.
These methods are required to determine the costs to be charged to specific jobs.
The payroll department carries out functions that relate input labour costs to the work
done. It calculates the gross wages from time and activity records and makes the
required deductions, e.g. NI contributions and PAYE.
Labour A/c
Bank (gross paid) x WIP (direct labour) x
Production overheads:
Indirect labour x
Overtime premium x
Shift premium X
Sick pay x
Training x
Idle time x
x x
Therefore,
1. When gross wages are paid (gross = net pay + National Insurance + PAYE) to
employees, they are accounted for as
2. When labour is used within a particular production process, the direct labour
costs are transferred from the labour account using
126
3. Indirect labour costs are transferred from the labour account to be grouped with
other indirect costs using
Lecture Example 2
The idle time ratio shows the proportion of available hours which were lost as a
result of idle time
1. Time-based systems
2. Piecework systems
127
8.4.1 Time-based systems
Employees are paid a basic rate per hour, day, week or month.
1. Straight piecework systems – these are almost extinct. Today, it is normal for
pieceworkers to be offered a guaranteed minimum wage, so that they do not
suffer loss of earnings when production is low through no fault of their own.
2. Differential piecework systems – these systems involve different piece rates for
different levels of production. They offer an incentive to employees to increase
their output by paying higher rates for increased levels of production. For
example:
Incentive (bonus) schemes can also be in place which pay a basic time rate, plus a
portion of the time saved as compared to some agreed allowed time.
128
iii. Morale of employees is likely to improve since they are seen to receive extra
reward for extra effort.
2. Rowan – the proportion paid to the employee is based on the ratio of time
taken to time allowed
Lecture Example 3
Pride currently pays its direct production workers on a time basis, at a rate of $8.20
an hour. In an effort to improve productivity, Pride is introducing a bonus based on
(time taken /time allowed) x time saved x rate per hour.
The standard time allowed for a worker in the assembly department to perform this
particular operation once has been agreed at 45 minutes. In the first week of
operation, Paul worked for a total 45 hours and performed 99 operations.
The gross wages Paul should receive for this first week, to 2 decimal places is:
$__________
Lecture Example 4
In a manufacturing company,
If 350 units are made in one particular day, what will be the labour cost?
129
8.4.3 Individual vs. group bonus schemes
These incentive schemes exclude any bought-in costs and are affected only by costs
incurred internally such as labour.
For example, valued added should be treble the payroll costs and one third of any
excess earned would be paid as a bonus.
Labour turnover is the rate at which employees leave a company relative to the
average number of people employed. This rate should be kept as low as possible.
130
Labour turnover =
Number of leavers who require replacement x 100%
Average number of employees
Some employees will leave their job and go to work for another company or
organisation. Sometimes the reasons are unavoidable.
Illness or accidents
A family move away from the locality
Marriage, pregnancy or difficulties with child care provision
Retirement or death
Poor remuneration
Poor working conditions
Lack of promotion prospects
Bullying at the workplace
The costs of labour turnover can be large and management should attempt to keep
labour turnover as low as possible so as to minimise these costs.
Preventative costs
Replacement costs
Replacement costs
These are the costs incurred as a result of hiring new employees. These include: -
131
Preventative costs
These are costs incurred in order to prevent employees leaving and they include:
Lecture Example 5
The labour efficiency ratio measures the performance of the workforce by comparing
the actual time taken to do a job with the expected time.
132
8.6.2 Labour Capacity Ratio
The labour capacity ratio measures the number of hours spent actively working as a
percentage of the total hours available for work.
The labour production volume ratio compares the number of hours expected to be
worked to produce actual output with the total hours available for work.
Lecture Example 6
A company budgets to make 25,000 standard units of output in 100,000 hours (each
unit is budgeted to take four hours each).
Actual output during the period was 27,000 units which took 120,000 hours to make.
Required: -
Calculate the efficiency, capacity and production volume ratios.
133
KEY NOTES
134
1. Direct Labour Costs
Direct labour costs include the basic pay of direct workers. Direct workers are
those employees who are directly involved in making the products.
Indirect labour costs include the basic pay of indirect workers, i.e. those
employees who are not directly involved in making the product, e.g. factory
supervisor, maintenance staff.
NORMAL HOURS
OVERTIME PREMIUM
Direct Indirect
Worker Worker
135
4. The Labour Account
Labour A/c
Bank x WIP (direct labour) x
Production overheads:
Indirect labour x
Overtime premium x
Shift premium X
Sick pay x
Training x
Idle time x
x x
1. Time-based systems
2. Piecework systems
Time-based systems
Employees are paid a basic rate per hour, day, week or month.
Piecework systems
136
Incentive (bonus) schemes can also be in place, which pay a basic time rate,
plus a portion of the time saved as compared to some agreed allowed time.
7. Labour Turnover
Labour turnover is the rate at which employees leave a company relative to the
average number of people employed.
Labour turnover =
Number of leavers who require replacement
Average number of employees
137
QUESTIONS
138
1. Using the information given, complete the labour account.
2. In a manufacturing company, skilled workers are paid $10 per hour and unskilled
workers are paid $5 per hour.
In a particular week, the direct skilled workers have worked 20 hours overtime,
12 hours worked on specific orders whereas the other 8 hours worked on
general duties. Overtime is paid at a rate of time and a quarter.
The direct unskilled workers have worked 30 hours overtime. 20 hours were
spent on specific orders requested by a customer and the rest were spent on
general production overtime. Overtime is also paid at a rate of time and a
quarter.
What would be the total overtime pay which will be considered a direct cost?
_________
A. 11.11%
B. 10.96%
C. 13.89%
D. 11.27%
139
4. A company operates a differential piecework system and the following weekly
rates have been determined: -
5. Overtime premiums are treated as direct labour costs, if at the specific request of
a customer.
A. True
B. False
6. Employees who work night shifts may be entitled to a shift allowance or shift
premium. The extra amount paid above the basic rate is treated as an indirect
labour cost.
A. True
B. False
140
ANSWERS
141
1.
Labour A/c
Bank 89,140 WIP (direct labour) 44,700
Production overheads:
Indirect labour 27,430
Overtime premium 7,065
Shift allowance 5,295
Sick pay 1,450
Idle time 3,200
89,140 89,140
2. $405
3. B
b. $235
142
Simon 500 x 0.20 = 100
100 x 0.25 = 25
200 x 0.55 = 110
235
5. True
6. True
143
Chapter 9
ACCOUNTING FOR OVERHEADS
9.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Explain the different treatment of direct and indirect expenses
As we have seen in Chapter 3, direct expenses are expenses that can be directly
identified with a specific cost unit or cost centre, e.g. the hire of tools and equipment
used directly in producing a particular product. Direct expenses are part of the prime
cost of a product.
Overheads are indirect expenses which cannot be directly identified with a specific
cost unit or cost centre, e.g. factory rent, factory light and heat.
The total of these indirect costs is usually split into the following.
Production overhead
Administration overhead
Selling and distribution overhead
Lecture Example 1
Quad Ltd produces a particular product Quadro, which has the following cost card: -
$
Direct Materials 2 kg at $4/kg 8
Direct Labour 4 hrs at $10/hr 40
Direct Expenses 5
Prime Cost 53
144
Based on past experience, Quad’s monthly overheads are: -
Calculate: -
i. The overhead cost allocated to each unit of Quadro
ii. The cost per unit of Quadro
145
Lecture Example 2
STL Co has two production departments (Processing and Packing) and two service
departments (Maintenance and Canteen).
The following are budgeted production overhead costs for next period: -
$
Factory rent 20,000
Factory heat 5,000
Processing Dept – supervisor 15,000
Packing Dept – supervisor 10,000
Depreciation of equipment 7,000
Factory canteen expenses 18,000
Welfare costs of factory employees 5,000
80,000
Required: -
Allocate and apportion production overhead costs between the four departments
using a suitable basis.
Since service cost centres/departments are not directly involved in making the
products, the fixed production overheads of these service cost centres must be
shared out between the production departments. Examples of service cost centres
include: - stores, canteen, maintenance and payroll departments.
Two methods are used to reapportion service cost centre costs to production cost
centres: -
1. Basic method – when one service department does work of another service
department but not vice-versa
2. Reciprocal method – when both service departments do work for each other
146
Lecture Example 3
A suitable basis for sharing out the maintenance costs is the time spent servicing
equipment. The amount of time spent by the maintenance department servicing
equipment in both production departments was: -
Processing 60%
Packing 40%
Required: -
Reapportion the costs incurred by the two service cost centres to the two production
cost centres.
Many reapportionments are carried out until all of the service departments’
overheads have been reapportioned to the production departments – repeated
distribution method.
The results of the reciprocal method of apportionment may also be obtained using
algebra and simultaneous equations.
Regardless of the method used, the total overheads for production departments will
be the same.
147
Lecture Example 4
A suitable basis for sharing out the maintenance costs is the time spent servicing
equipment. The amount of time spent by the maintenance department servicing
equipment in both production and canteen departments was: -
Processing 50%
Packing 40%
Canteen 10%
Required: -
Reapportion the costs incurred by the two service cost centres to the two production
cost centres, using reciprocal reapportionment:-
a) repeated distribution
b) algebraic method
Having allocated and/or apportioned all overheads, the next stage in the costing
treatment of overheads is to absorb them into cost units using an overhead
absorption rate.
148
4. Absorb the overhead into the cost unit by applying the calculated absorption
rate.
Overheads can be absorbed into cost units using the following bases of absorption
(or 'overhead recovery rates'): -
This OAR is calculated for each department. Each product which passes through this
department will be charged this overhead rate.
149
Illustration 1
If budgeted output (activity) for the year was 1,000 units and budgeted fixed
production overhead is $10,000, what is the fixed production overhead absorption
rate (FOAR)?
If each unit takes two labour hours to be produced, what is the FOAR/ labour hour?
Lecture Example 5
Processing Packing
Labour hours 20,000 40,000
Machine hours 50,000 15,000
Calculate the OAR for each of the two production departments (to two decimal
figures).
150
Under– or over-recovery of overhead will occur in the following circumstances: -
Illustration 27
Assume a company budgeted to work 10,000 direct labour hours in the coming year.
If budgeted fixed production overhead was $50,000 the FOAR would be:
If in the year actual overhead was $60,000 and actual direct labour hours were 9,000
the following under absorption would occur:
Lecture Example 6
The following data relate to RCA Ltd for the year 20x8: -
Budget Actual
151
Lecture Example 7
A business absorbs its fixed overheads on the basis of direct labour hours. During
the month of January, there were the following figures: -
Lecture Example 8
Woody manufactures Woody Pecker, a product which has a production cost of $40
per unit. The company has budgeted production costs of $500,000 and budgeted
non-production overheads of $100,000 associated with the production of Product
Woody Pecker.
Required: -
Find the total cost of one unit of Woody Pecker if non-production overheads are
apportioned on the basis of a proportion of production costs incurred by the Woody
Pecker.
152
9.7 ACCA SYLLABUS GUIDE OUTCOME 7:
Prepare journal and ledger entries for manufacturing overheads incurred and
absorbed
The direct costs of production (materials, labour and expenses) are debited in the
work-in-progress (WIP) account.
Any over- or under- absorption should be transferred to the income statement at the
end of the accounting period.
x x
Under-absorption of overheads
Production overheads x Income statement x
x x
Lecture Example 9
Polar Co absorbs production overheads at the rate of $0.50 per direct labour hour.
Actual data for one month was as follows: -
153
Further Questions8
Question 1
A company’s overheads have been allocated and apportioned to its four cost centres
as shown below.
Cost centre A B
Use of C’s services 40% 60%
Use of D’s services 75% 25%
Use of E’s services 30% 70%
Required:
Reapportion the costs incurred by the service cost centres to the production
cost centres.
Question 2
A company’s overheads have been allocated and apportioned to its four cost centres
as shown below.
8 Article “Re-apportionment of service cost centre costs ” by Steve Jay, F2/FMA examiner, Student Accountant
August 2012, http://www.accaglobal.com/content/dam/acca/global/PDF-
students/2012s/sa_aug12_f2fma_reapportionment.pdf
154
Usage of service cost centres is as follows:
Cost centre A B C D E
Use of C’s services 40% 50% NIL 8% 2%
Use of D’s services 75% 20% NIL NIL 5%
Use of E’s services 30% 70% NIL NIL NIL
Required:
Reapportion the costs incurred by the service cost centres to the production
cost centres.
Question 3
A company’s overheads have been allocated and apportioned to its four cost centres
as shown below.
Cost centre A B C D E
Use of C’s services 40% 50% NIL 10% NIL
Use of D’s services 75% 20% 5% NIL NIL
Use of E’s services 30% 70% NIL NIL NIL
Required:
Reapportion the costs incurred by the service cost centres to the production
cost centres using the repeated distribution method.
155
Question 4
A company’s overheads have been allocated and apportioned to its four cost centres
as shown below.
Cost centre A B C D E
Use of C’s services 40% 50% NIL 10% NIL
Use of D’s services 75% 20% 5% NIL NIL
Use of E’s services 30% 70% NIL NIL NIL
Required:
Reapportion the costs incurred by the service cost centres to the production
cost centres using the algebraic method.
Question 5
A company has two production cost centres (V and W) and two service cost centres
(X and Y). The following overheads have been apportioned and allocated to the four
cost centres.
Cost centre V W X Y
Apportioned
and allocated 6,000 8,000 4,000 10,000
overheads ($)
The company has calculated the following usage of X and Y’s services:
Cost centre V W X Y
Use of X’s services 60% 30% NIL 10%
Use of Y’s services 80% 20% NIL NIL
156
Required:
How much would cost centre V’s total overhead cost be if the company used
the step-down approach to re-apportion service cost centre overhead?
A. $10,400
B. $10,720
C. $16,400
D. $16,720
157
KEY NOTES
158
1. Direct vs. Indirect Costs
Direct expenses are expenses that can be directly identified with a specific cost unit
or cost centre, e.g. the hire of tools and equipment used directly in producing a
particular product.
Overheads are indirect expenses which cannot be directly identified with a specific
cost unit or cost centre, e.g. factory rent, factory light and heat.
2. Absorption Costing
Overheads can be absorbed into cost units using different bases of absorption (or
'overhead recovery rates'), the most common are: -
159
6. Under- and Over- Absorption of Overheads
Method 1: Choose a basis for the overhead absorption rate which most closely
matches the non-production overhead such as direct labour hours, direct machine
hours.
The direct costs of production (materials, labour and expenses) are debited in the
work-in-progress (WIP) account.
160
Any over- or under- absorption should be transferred to the income statement at the
end of the accounting period.
x x
Under-absorption of overheads
Production overheads x Income statement x
x x
161
QUESTIONS
162
1. A factory consists of two production cost centres (A and B) and two service cost
centres (X and Y). The total allocated and apportioned overhead for each is as
follows:
A B X Y
$95,000 $82,000 $46,000 $30,000
It has been estimated that each service cost centre does work for other cost
centres in the following proportions:
A B X Y
Percentage of service cost centre X to 50 50 _ _
The reapportionment of service cost centre costs to other cost centers fully
reflects the above proportions.
After the reapportionment of service cost centre costs has been carried out, what
is the total overhead for production cost centre A?
A. $124,500
B. $126,100
C. $127,000
D. $128,500
3. A company manufacturers two products L and M in a factory divided into two cost
centres, X and Y. The following budgeted data are available:
Cost centre
X Y
Allocated and apportioned fixed
overhead costs $84000 $93000
163
Direct labour minutes per unit: -
Product L 36 25
Product M 30 40
Budgeted output is 9,000 units of L and 6,000 units of M. Fixed overhead costs
are absorbed on a direct labour hour basis.
What is the budgeted fixed overhead cost per unit for Product L?
A. $10
B. $11
C. $12
D. $13
A. $27,618
B. $28,171
C. $28,398
D. $28,453
164
5. Production Depts Service Centres
X Y Stores Maintenance
$ $ $ $
Allocated and apportioned 70,000 30,000 20,000 15,000
overheads
6. A company uses an overhead absorption rate of $3.50 per machine hour, based
on 32,000 budgeted machine hours for the period. During the same period the
actual total overhead expenditure amounted to $108,875 and 30,000 machine
hours were recorded on actual production.
By how much was the total overhead under or over absorbed for the period?
A. Under absorbed by $3,875
B. Under absorbed by $7,000
C. Over absorbed by $3,875
D. Over absorbed by $7,000
7. A company absorbs overheads based on labour hours. Data for the latest period
are as follows: -
165
ANSWERS
166
1. D
A X Y
2. B
3. B
X Y
$84,000 $93,000
Labour hours
L (9,000 x 36 /
60) 5,400 (9,000 x 25 / 60) 3,750
M (6,000 x 30 /
60) 3,000 (6,000 x 40 / 60) 4,000
84,000 7,750
= $84,000 = $93,000
8,400 7,750
= $10 / hr = $12 / hr
Production L = x36 / 60 = x 25 / 60
= $6 + = $5 = $11
167
4. C - $28,398
X Y Stores Maint
168
6. A
7. i) $17.50/labour hour
$148,750 = $17.50
8,500
169
Chapter 10
MARGINAL AND ABSORPTION
COSTING
10.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Explain the importance of, and apply, the concept of contribution
Fixed costs are treated as a period cost, and are charged in full to the income
statement of the accounting period in which they are incurred.
10.1.2 Contribution
170
Lecture Example 1
A company commenced business on 1 January making one product only, the cost
card of which is: -
$
Direct material 5
Direct labour 8
Variable production overhead 2
Fixed production overhead 5
Variable selling and distribution cost 3
The selling price of one unit is $35. Sales during the period were 5,000.
The fixed production overhead figure has been calculated on the basis of a budgeted
normal output of 3,600 units per annum. The actual fixed production overheads were
$15,000.
Calculate: -
i. The total contribution earned during the period
ii. The total profit or loss for the period
Inventory values using absorption costing are therefore greater than those calculated
using marginal costing.
Since inventory values are different, profits reported in the income statement will also
be different.
171
10.3 ACCA SYLLABUS GUIDE OUTCOME 3:
Calculate profit or loss under absorption and marginal costing
In marginal costing, fixed production costs are treated as period costs and are
written off as they are incurred.
In absorption costing, fixed production costs are absorbed into the cost of units and
are carried forward in inventory to be charged against sales for the next period.
In the long run, total profit for a company will be the same whether marginal costing
or absorption costing is used. Different accounting conventions merely affect the
profit of individual accounting periods.
$ $
Sales X
Less: Variable cost of sales:
Opening inventory X
Production Costs:
Variable costs X
X
Less : closing inventory (X)
(X)
X
Variable selling, distribution and
Less: administration costs (X)
CONTRIBUTION X
Less: Fixed costs (actually incurred): -
Production X
Selling & distribution X
Administration X
(X)
NET PROFIT X
172
Absorption costing Income Statement
$ $
Sales X
Less: Cost of Sales:
Opening inventory X
Production Costs:
Variable costs X
Fixed overhead absorbed X
X
Less : closing inventory (X) (X)
X
Fixed overhead (under)/over absorbed X/(X)
GROSS PROFIT X
Less : Selling & administration etc costs (non
production) (X)
NET PROFIT X
Lecture Example 2
Each desk is budgeted to require 4kg of wood at $3 per kg, 4 hours of labour at $2
per hour, and variable production overheads of $5 per unit. Fixed production
overheads are budgeted at $20,000 per month and average production is estimated
to be 10,000 units per month. Fixed production overheads incurred were $22,000 in
January and $18,000 in February.
173
There is also a variable selling cost of $1 per unit and fixed selling cost of $2,000 per
month.
During the first two months, X plc expects the following levels of activity:
January February
Production 11,000 units 9,500 units
Sales 9,000 units 11,500 units
Required:-
Reported profit figures using marginal costing or absorption costing will differ if there
is any change in the level of inventories in the period. If production is equal to sales,
there will be no difference in calculated profits using the costing methods.
If inventory levels increase between the beginning and end of a period, absorption
costing will report the higher profit. This is because some of the fixed production
overhead incurred during the period will be carried forward in closing inventory
(which reduces cost of sales) to be set against sales revenue in the following period
instead of being written off in full against profit in the period concerned.
If inventory levels decrease, absorption costing will report the lower profit because as
well as the fixed overhead incurred, fixed production overhead which had been
carried forward in opening inventory is released and is also included in cost of sales.
Therefore,
174
Profits generated using absorption & marginal costing can also be reconciled as
follows:
Lecture Example 3
January February
$ $
Absorption costing
Marginal costing
Difference
Lecture Example 4
Units $
Production 14,000 Fixed production costs 63,000
Sales 12,000 Fixed selling costs 12,000
Using absorption costing the profit for next period has been calculated as $36,000.
What would the profit for next period be using marginal costing?
A. $25,000
B. $27,000
C. $45,000
D. $47,000
175
10.5 ACCA SYLLABUS GUIDE OUTCOME 5:
Describe the advantages and disadvantages of absorption and marginal
costing
176
KEY NOTES
177
1. Marginal Costing
In marginal costing, only variable costs are charged as a cost of sale. Therefore, the
cost of a unit =
Fixed costs are treated as a period cost, and are charged in full to the income
statement of the accounting period in which they are incurred.
2. Contribution
3. Inventory Valuation
4. Profit Valuation
In marginal costing, fixed production costs are treated as period costs and are
written off as they are incurred.
In absorption costing, fixed production costs are absorbed into the cost of units and
are carried forward in inventory to be charged against sales for the next period.
In the long run, total profit for a company will be the same whether marginal costing
or absorption costing is used.
178
Marginal costing Absorption costing
Closing inventories are valued at Closing inventories are valued at full
marginal production cost production cost
Fixed costs are period costs Fixed costs are absorbed into unit costs
Cost of sales does not include a share Cost of sales does include a share of fixed
of fixed overheads overheads
5. Reconciliation of Profits/Losses
Profits generated using absorption and marginal costing can also be reconciled as
follows:
179
QUESTIONS
180
1. A company manufacturers and sells a single product. In two consecutive months
the following levels of production and sales (in units) occurred:
Month 1 Month 2
Sales 3,800 4,400
Production 3,900 4,200
The opening inventory for Month 1 was 400 units. Profits or losses have been
calculated for each month using both absorption and marginal costing principles.
Which of the following combination of profits and losses for the two months is
consistent with the above data?
2. Glossop Limited reported an annual profit of $47,500 for the year ended 31
March 2000. The company uses absorption costing. One product is
manufactured, the Rover, which has the following standard cost per unit.
$
Direct material (2kg at $5/kg) 10
Direct labour (4 hours at $6.50/hour) 26
Variable overheads (4 hours at $1/hour) 4
Fixed overheads (4 hours at $3/hour) 12
52
The normal level of activity is 10,000 units although actual production was
11,500 units. Fixed costs were as budgeted.
Inventory levels at 1 April 1999 were 400 units and at the end of the year were
600 units.
A. $44,300
B. $45,100
C. $49,900
D. $50,700
181
3. A company produces a single product for which cost and selling price details are
as follows.
Selling price 28
Direct material 10
Direct labour 4
Variable overhead 2
Fixed overhead 5
21
Profit per unit 7
Last period, 8,000 units were produced and 8,500 units were sold. The opening
inventory was 3,000 units and profits reported using marginal costing were
$60,000. The profits reported using an absorption costing system would be
A. $47,500
B. $57,500
C. $59,500
D. $62,500
4. A company made 17,500 units at a total cost of $16 each. Three quarters of the
costs were variable and one quarter fixed. 15,000 units were sold at $25 each.
There were no opening inventories.
By how much will the profit calculated using absorption costing principles differ
from the profit if marginal costing principles had been used?
182
ANSWERS
183
1. C
Month 1 Month 2
2. B
Inv ↑ , AC profit ↑
AC Profit 47,500
Diff in profits 2,400
MC profit 45,100
3. B
MC Profit 60,000
Diff in profits 2,500
MC profit 57,500
184
4. B
185
Chapter 11
JOB, BATCH AND PROCESS COSTING
11.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Describe the characteristics of job and batch costing
In job costing, production is usually carried out in accordance with the special
requirements of each customer. Therefore, it is usual for each job to differ in one or
more respects from another job.
The main aim of job costing is to identify the costs associated with completing the
order. Individual jobs are given a unique job number and the selling prices of jobs
are calculated by adding a certain amount of profit to the cost of the job.
Batch costing is similar to job costing in that each batch of similar articles is
separately identifiable. A batch is a group of similar articles which maintains its
identity during one or more stages of production and is treated as a cost unit.
The cost per unit manufactured in a batch is the total batch cost divided by the
number of units in the batch.
The selling prices of batches are calculated by adding a profit to the cost of the
batch, i.e. very similar to job costing.
186
Batch costing is used by manufacturing companies with manufacture products that
are too small to identify the cost per unit; for example, engineering component
industry, footwear and clothing manufacturing industries.
The usual method of fixing prices in a jobbing concern is cost plus pricing. Cost plus
pricing means that a desired profit margin is added to total costs to arrive at the
selling price.
Mark-up profit is calculated as a percentage of the total costs of the job, e.g. 20%
mark-up: -
%
Selling price 120
Total cost (100)
Profit 20
Margin profit is calculated as a percentage of the selling price of the job, e.g. 20%
margin: -
%
Selling price 100
Total cost (80)
Profit 20
187
Lecture Example 1
Country Ltd carried out the following job to meet a customer’s specific order: -
Department X Department Y
Direct materials used $5,000 $3,000
Direct labour hours 400 hours 200 hours
Direct labour rate per hour $4 $5
Production overhead per direct labour hour $4 $4
Administration overheads 20% of full production cost
Profit margin 25% of sales price
Lecture Example 2
Ringo Ltd manufactures iron rings to order. It has the following budgeted overheads
for the year: -
188
Calculate the cost of one batch of 500 rings if the following costs will also be
incurred: -
Materials $30,000
Labour 200 hours in Department X at $5 per hour
400 hours in Department Y at $10 per hour
Sometimes, jobs may not be 100% complete at year end. The value of work in
progress is simply the sum of the costs incurred on incomplete jobs.
Lecture Example 3
Three jobs were worked on during the month of July, the details of which are as
follows:
The overheads for the period were equal to budgeted overheads at $189,000.
Process costing is a costing method used where it is not possible to identify separate
units of production, or jobs, usually because of the continuous nature of the
production processes involved. All the products in the process are identical and
indistinguishable from each other.
The essence of process costing involves the averaging of the total costs of each
process over the total output of the process.
189
Average cost per unit = Costs of production
Expected or normal output
The output of one process forms the material input of the next process. Also, closing
work-in-progress (WIP) at the end of one period forms the opening WIP at the
beginning of the next period.
Oil refining
Paper
Foods and drinks
Chemicals
Process costing may also be associated with the continuous production of large
volumes of low-cost items, such as cans or tins.
190
11.6 ACCA SYLLABUS GUIDE OUTCOME 6:
Explain the concepts of normal and abnormal losses and abnormal gains
It is normal that the total of the input units may differ from the total of the output units.
This usually happens when there are losses or gains in the process.
Normal loss is the loss that is expected in a process and is often expressed as a
percentage of the materials input to the process.
If normal loss is sold as scrap, the revenue is used to reduce the input costs of the
process. If normal loss does not have a scrap value, it is valued in the process
account as $Nil.
Average cost per unit = Total cost of inputs – Scrap value of normal loss
Units input – Normal loss
Normal gain is the expected gain in a process. If the loss or the gain in a process is
different to what we are expecting, then we have an abnormal loss or an abnormal
gain in the process. If losses are greater than expected, the extra loss is abnormal
loss. If losses are less than expected, the difference is known as abnormal gain.
1. The costs of abnormal gains and losses are not absorbed into the cost of
good output but are shown as losses and gains in the process account
2. Abnormal loss and gain units are valued at the same cost as units of good
output.
Lecture Example 4
Materials $20,000
Labour $10,000
Overheads $ 8,000
191
11.7 ACCA SYLLABUS GUIDE OUTCOME 7:
Calculate the cost per unit of process outputs
The following steps should be followed when answering questions which include
normal loss, abnormal loss or abnormal gain: -
1. Draw the process account, and enter the inputs, i.e. units and values.
2. Enter the normal loss – units and scrap value if any.
3. Enter the good output – units only.
4. Balance the units. The balancing figure is either abnormal loss or gain.
5. Calculate the average cost per unit: -
Average cost per unit = Total cost of inputs – Scrap value of normal loss
Units input – Normal loss
6. Value the good output and abnormal loss or gain at this average cost per unit.
Process A/c
Units $ Units $
Input cost Raw Material x x Output x x
Labour x Normal Loss x x
Overheads x
Abnormal Gain x x Abnormal loss x x
x x x x
Scrap A/c
Units $ Units $
Normal loss x x Cash Received x x
Abnormal Loss x x Abnormal Gain x x
x x x x
If no scrap value is given, no scrap account can be drawn up and value of normal
loss in process account will be nil.
192
Abnormal Loss/Gain A/c
Units $ Units $
Process x x Scrap x x
Income Statement – Income Statement -
Gain x Loss x
x x x x
Lecture Example 5
A normal loss of 10% was expected. The actual output was 900kg.
Lecture Example 6
A normal loss of 10% was expected. The actual output was 2,700kg.
Losses have a scrap value of $5 per kg.
Calculate the cost per kg and prepare a Process Account and a Scrap
Account.
Lecture Example 7
193
A normal loss of 10% of input was expected.
Actual output was 850kg.
Losses are sold as scrap for $9 per kg.
Calculate the cost per kg and prepare a Process Account, a Scrap Account
and an Abnormal Loss/Gain Account.
Lecture Example 8
Calculate the cost per kg and prepare a Process Account, a Scrap Account
and an Abnormal Loss/Gain Account.
When units are partly completed at the end of a period (and hence there is closing
work in progress), it is necessary to calculate the equivalent units of production in
order to determine the cost of a completed unit. It would be unfair to allocate a full
unit cost to part-process units so we need to use the concept of equivalent units.
Equivalent units are notional whole units which represent incomplete work, and
which are used to apportion costs between work in process and completed output.
Closing work in progress units become opening work in progress units in the next
accounting period.
Since material is input at the start of the process, it is only the addition of labour and
overheads that will be incomplete at the end of the period. This means that material
194
cost should be spread over all units but conversion costs should be spread over the
equivalent units.
Lecture Example 9
During the month, 800 units were finished and transferred to the next process.
The remaining 200 units were WIP and were complete as follows:
Materials 100%
Labour 60%
Overheads 30%
Required: -
i. calculate the cost per unit
ii. value the finished output and the WIP;
iii. prepare a Process Account.
Work remaining in process (WIP) and fully-completed units can be valued using
either weighted average method or the FIFO method.
In the weighted average method, opening inventory values are added to current
costs to provide an overall average cost per unit. The cost of opening inventory is
added to the costs incurred during the period, and completed units of opening
inventory are each given a value of one full equivalent unit of production. Therefore,
no distinction is made between units in process at the start of a period and those
added during the period.
195
Lecture Example 10
At the beginning of July, there were 15,000 units of work in progress valued as
follows:
At the end of July, there were 5,000 units of work-in-progress. They were 100%
complete for materials and 50% complete for labour and overheads.
Required: -
The FIFO method of valuation deals with production on a first in, first out basis. The
assumption is that the first units completed in any period are the units of opening
inventory that were held at the beginning of the period.
This means that if opening WIP units are 60% complete with respect to materials
and 30% with respect to conversion costs (labour and overheads), only 40% more
work will need to be carried out with respect to materials and 70% with respect to
conversion costs.
Lecture Example 11
196
At the beginning of July, there were 15,000 units of work in progress valued as
follows:
At the end of July, there were 5,000 units of work-in-progress. They were 100%
complete for materials and 50% complete for labour and overheads.
Required: -
FIFO inventory valuation is more common than the weighted average method, and
should be used unless an indication is given to the contrary. You may find that you
are presented with limited information about the opening inventory, which forces you
to use either the FIFO or the weighted average method.
1. If you are told the degree of completion of each element in opening inventory,
but not the value of each cost element, then you must use the FIFO method.
2. If you are not given the degree of completion of each cost element in opening
inventory, but you are given the value of each cost element, then you must
use the weighted average method.
What happens if the losses do not occur at the end of the process (as we have seen
till now) but part way through a process? In this case, equivalent units must be used
to assess the extent to which costs were incurred at the time at which the loss was
identified.
Lecture Example 12
Prank manufactures chemicals and has a normal loss of 15% of material input.
Losses are identified when the process is 40% complete. Information for the month
of January is as follows: -
197
Material input 200 kg at $5 per kg
Conversion costs $4,100
Transfers to finished goods 160 kg
There is no opening or closing WIP
Required: -
Joint products are two or more products which are output from the same processing
operation, but which are indistinguishable from each other up to their point of
separation.
Joint products have a substantial sales value. Often they require further processing
before they are ready for sale. Joint products arise, for example, in the oil refining
industry where diesel fuel, petrol, paraffin and lubricants are all produced from the
same process.
11.12.2 By-Products
198
11.13 ACCA SYLLABUS GUIDE OUTCOME 13:
Value by-products and joint products at the point of separation
Joint process costs (pre-separation costs) occur before the split-off point. These
costs have to be apportioned between the joint products at the split-off point to
obtain the costs of each of the products in order to value closing inventory and cost
of sales.
The main methods of apportioning joint costs, each of which can produce
significantly different results are: -
Lecture Example 13
Two products W and X are created from a joint process. Both products can be sold
immediately after split-off. There are no opening inventories or work-in-progress. The
following information is available for the last period:
199
Product Production units Sales units Selling Price per unit
Using the sales value method of apportioning joint production costs, what was the
value of the closing inventory of product X for the last period?
A. $68,992
B. $70,560
C. $76,032
D. $77,616
Lecture Example 14
Joint production costs last month were $110,000 and these were apportioned to joint
products based on the number of units produced.
What were the joint production costs apportioned to product J for last month?
A. $63,800
B. $64,000
C. $66,000
D. $68,200
Lecture Example 15
200
The production from the process was as follows:
Kg
Product A 1,000 selling price $8.40 per kg
Product B 2,000 selling price $4.50 per kg
All the output of A and B incurred further processing at a cost of $4.80 per kg for A
and $2.20 per kg for B.
Calculate a cost per kg for A and B using the net realizable value approach.
When preparing process accounts, joint costs should be treated as ‘normal’ output
from a process. The treatment of by-products in process costing is similar to the
treatment of normal loss.
The by-product income is credited to the process account and debited to a by-
product account. To calculate equivalent units in a period, by-products (like normal
loss) are zero equivalent units.
201
Lecture Example 16
Sales revenue from the main product during December 2010 was $180,000.
A by-product is produced. Output has a net sales value of $2,500. Of this output,
$2000 was sold during the month and the remaining $500 was still in inventory at 31
December 2010.
Calculate the profit for December using the four methods of accounting for by-
products.
202
KEY NOTES
203
1. Job costing
2. Batch costing
A batch is a group of similar articles which maintains its identity during one or
more stages of production and is treated as a cost unit. The cost per unit
manufactured in a batch is the total batch cost divided by the number of units in
the batch.
Cost plus pricing means that a desired profit margin is added to total costs to
arrive at the selling price.
4. Process costing
204
The output of one process forms the material input of the next process. Also,
closing work-in-progress (WIP) at the end of one period forms the opening WIP
at the beginning of the next period.
o Oil refining
o Paper
o Foods and drinks
o Chemicals
5. Normal loss
Normal loss is the loss that is expected in a process and is often expressed as a
percentage of the materials input to the process.
If normal loss is sold as scrap, the revenue is used to reduce the input costs of
the process. If normal loss does not have a scrap value, it is valued in the
process account as $Nil.
Average cost per unit = Total cost of inputs – Scrap value of normal loss
Units input – Normal loss
6. Abnormal Loss/Gain
If the loss or the gain in a process is different to what we are expecting, then we
have an abnormal loss or an abnormal gain in the process. If losses are greater
than expected, the extra loss is abnormal loss. If losses are less than expected,
the difference is known as abnormal gain.
Abnormal loss and gain units are valued at the same cost as units of good output.
The following steps should be followed when answering questions which include
normal loss, abnormal loss or abnormal gain: -
a. Draw the process account, and enter the inputs, i.e. units and values.
b. Enter the normal loss – units and scrap value if any.
c. Enter the good output – units only.
d. Balance the units. The balancing figure is either abnormal loss or gain.
e. Calculate the average cost per unit: -
205
Average cost per unit = Total cost of inputs – Scrap value of normal loss
Units input – Normal loss
f. Value the good output and abnormal loss or gain at this average cost per unit.
7. Process Accounts
Process A/c
Units $ Units $
Input cost Raw Material x x Output x x
Labour x Normal Loss x x
Overheads x
Abnormal Gain x x Abnormal loss x x
x x x x
Scrap A/c
Units $ Units $
Normal loss x x Cash Received x x
Abnormal Loss x Abnormal Gain x x
x x x x
8. Equivalent Units
Equivalent units are notional whole units which represent incomplete work, and
which are used to apportion costs between work in process and completed
output.
Since material is input at the start of the process, it is only the addition of labour and
overheads that will be incomplete at the end of the period. This means that
206
material cost should be spread over all units but conversion costs should be
spread over the equivalent units.
Work remaining in process (WIP) and fully-completed units can be valued using
either weighted average method or the FIFO method.
In the weighted average method, opening inventory values are added to current
costs to provide an overall average cost per unit. The cost of opening inventory is
added to the costs incurred during the period, and completed units of opening
inventory are each given a value of one full equivalent unit of production.
Therefore, no distinction is made between units in process at the start of a period
and those added during the period.
The FIFO method of valuation deals with production on a first in, first out basis.
The assumption is that the first units completed in any period are the units of
opening inventory that were held at the beginning of the period.
Joint products are two or more products which are output from the same
processing operation, but which are indistinguishable from each other up to their
point of separation.
Joint products have a substantial sales value. Often they require further
processing before they are ready for sale.
207
13. By-Products
Joint process costs (pre-separation costs) occur before the split-off point. These
costs have to be apportioned between the joint products at the split-off point to
obtain the costs of each of the products in order to value closing inventory and
cost of sales.
The main methods of apportioning joint costs, each of which can produce
significantly different results are: -
208
QUESTIONS
209
1. The following statements refer to organisations using job costing:
(i) Work is done to customer specification.
(ii) Work is usually completed within a relatively short period of time.
(iii) Products manufactured tend to be all identical.
i. If profit is 25% of the job cost, the price to be charged for the job is
$_________.
ii. If profit is 25% margin, the price to be charged for the job is $_________.
Process X Process Y
210
The closing work-in-progress was complete to the same degree for all elements
of cost.
What was the total value of the 2,000 units transferred to the finished goods
warehouse last month?
A. $19,910
B. $20,000
C. $20,510
D. $21,710
211
10% of input. There were no opening or closing stocks and output for the period
was 2,900 units.
8. What is a by-product?
A. A product produced at the same time as other products which has no value
B. A product produced at the same time as other products which requires further
processing to put it in a saleable state
C. A product produced at the same time as other products which has a relatively
low volume compared with the other products
D. A product produced at the same time as other products which has a relatively
low value compared with the other products
10. Two products G and H are created from a joint process. G can be sold
immediately after split-off. H requires further processing into product HH before it
is in a saleable condition. There are no opening inventories and no work in
progress of products G, H or HH. The following data are available for last period:
$
Total joint production costs 350,000
Further processing costs of product H 66,000
212
Using the physical unit method for apportioning joint production costs, what was
the cost value of the closing inventory of product HH for last period?
A. $16,640
B. $18,625
C. $20,000
D. $21,600
213
ANSWERS
214
1. A
2. i. $125,000
ii. $133,333
3. C
Process X
Input 65,000 NL 5,200 (65000 x 8%)
Output 58,900
AL 900
65,000 65,000
Process Y
Input 37,500 NL 1,875
AG 75 Output 35,700
37,575 37,575
4. D
215
Finished Goods = $480,000
10,000
= $48
5. A
Total Costs
% EU
Opening WIP 300 40 120
Started &
Completed 1,700 100 1,700
2,000 1,820
6. D
7. D
Process A/c
Units $ Units $
Material 3,000 9,000 NL 300 450
Conv. 11,970
AG 200 FG 2,900 22,040
216
Finish Goods = 2,900 x $7.60
= $22,040
8. D
9. B
10. C
350,000
G H
420,000 330,000 = 750,000
= $350,000 x 330,000
750,000
= $154,000 +
66,000
220,000
330,000
= $20,000
217
Chapter 12
SERVICE AND OPERATIONS COSTING
12.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Identify situations where the use of service/operation costing is appropriate.
Service organisations do not make or sell tangible goods. In fact, the output of
service organisations/departments can be described as: -
1. A company operating in a service industry will cost its services, for which
sales revenue will be earned; examples are electricians, car hire services,
road, rail or air transport services, hairdressers, banks, colleges and hotels.
2. A company may wish to establish the cost of services carried out by some of
its departments, i.e. establishing a specific cost for an internal service. For
example costs of the vans or lorries used in distribution, the costs of the
computer department, or the staff canteen.
218
12.2 ACCA SYLLABUS GUIDE OUTCOME 2:
Illustrate suitable unit cost measures that may be used in different
service/operation situations.
The main problem with service costing is the difficulty in defining a realistic cost unit
that represents a suitable measure of the service provided.
Frequently, a composite cost unit may be deemed more appropriate. Therefore, two
variables will be considered. Hotels, for example, may use the 'occupied bed-night'
as an appropriate unit for cost ascertainment and control.
The total cost of providing a service will include labour, materials, direct expenses
and overheads. In service costing, labour may be the only direct cost involved in
providing a service. Overheads will make up the remaining total costs.
The cost per service unit is calculated by establishing the total costs involved in
providing the service and dividing this by the number of service units in providing the
service.
Lecture Example 1
The RCA Worldwide, with annual running costs of $5 million, has the following
students: -
Attendance
Number Weeks p.a. Hours/week
1st year students 2,700 30 28
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2nd year students 1,500 35 30
Required: -
Lecture Example 2
A. (i) only
B. (i) and (ii) only
C. (ii) only
D. (ii) and (iii) only
If organisations in the same industry use the same service cost units, then
comparisons between companies can be made easily.
Lecture Example 3
A transport business has 6 lorries in operation, 5 days a week for 50 weeks of the
year. Each vehicle is expected to make 4 journeys a day, delivering an average load
of 5 tonnes to each customer. The average customer is located 25 km from the
transport headquarters. Fuel and other variable running costs per kilometer traveled
(laden or unladen) are budgeted to be $0.50. Other fixed running costs amount to
$225,000 per annum.
220
KEY NOTES
221
1. Service/Operation Costing
i. A company operating in a service industry will cost its services, for which
sales revenue will be earned
ii. A company may wish to establish the cost of services carried out by some of
its departments
The main problem with service costing is the difficulty in defining a realistic cost
unit that represents a suitable measure of the service provided.
Frequently, a composite cost unit may be deemed more appropriate.
The cost per service unit is calculated by establishing the total costs involved in
providing the service and dividing this by the number of service units in providing
the service.
222
QUESTIONS
223
1. A company’s canteen has the following income and expenditure in a particular
month: -
$ $
Income 72,000
Food 18,000
Drink 4,000
Fuel costs 3,500
Maintenance of machinery 1,800
Repairs 1,250
Wages 5,650
During the month, the canteen served 1,200 meals for 30 days.
Calculate the average cost per meal served and the average income per meal
served.
A. Room occupancy
B. Cleaning cost per room
C. Meals served per guest
D. Average cost per occupied bed
A. True
B. False
224
Supervision $120 per week
Other general expenses (fixed) $200 per week
Required:
Calculate the expected average full cost per tonne/kilometre for the week.
225
ANSWERS
226
1. Average income per meal = $72,000
1,200 x 30
= $2
= $0.95
2. C
3. True
4.
3,680
227
Cost per tonne/kilometre $1,119 = $0.304
3,680
Note that the large element of fixed costs may distort this measure but that a variable
cost per tonne/kilometre of $279/3,680 = $0.076 may be useful for budgetary control.
228
Chapter 13
ALTERNATIVE COST ACCOUNTING
TECHNIQUES
After having looked into traditional costing techniques, in this chapter four alternative
cost management techniques will be introduced. These are: -
Differentiate ABC, target costing and life cycle costing from the tradition
costing techniques (note: calculations are not required)
229
In ABC, activities are the focus of, the costing process, e.g. equipment preparation,
order handling and quality control. Costs are traced from activities to products based
on the products demands for these activities during the production process
By grouping costs on the basis of cost drivers, we will be able to both manage costs
better (by managing the activity) and to calculate the cost of production.
230
13.1.1.3 The Advantages of ABC
2. It provides much better insights into what drives overhead costs. ABC recognises
that overhead costs are not all related to volume. It also identifies activities and
costs that do not add value.
3. ABC can be applied to all overhead costs, not just production overheads.
ABC may not be universally beneficial. There are four major issues to be considered:
1. Cost vs benefit
The need to analyse costs on a radically different basis will require resources,
which will lead to additional costs. Clearly the benefits which will be obtained
must exceed these costs.
While ABC is likely to provide better information for decision makers, it must
still be applied with care. ABC is not fully understood by many managers and
therefore is not fully accepted as a means of cost control.
ABC needs a new set of accounting records, this is often not immediately
available and therefore resistance to change is common. The setting up of
new cost pools is needed which is time-consuming.
231
Worked out example (no calculations required for exam)
The following example looks at the different activities within a company, their cost
and their cost driver. The cost per driver is found by dividing the total cost of the
activity by the quantity of the cost drivers. Overhead costs are then charged to
products or services on the basis of activities used for each product or service.
Lecture Example 1
A. Cost drivers
B. Cost centres
C. Cost pools
D. Cost benefit analysis
Lecture Example 2
232
Lecture Example 3
A. 1 only
B. 1 and 2 only
C. 2 and 3 only
D. 1 and 4 only
A target cost is a cost estimate derived by subtracting a desired profit margin from a
competitive market price.
Where a gap exists between the current estimated cost levels and the target cost, it
is essential that this gap be closed. Efforts to close a target cost gap are most likely
to be successful at the design stage. It is far easier to ‘design out’ cost during the
pre-production phase than to ‘control out’ cost during the production phase.
233
13.1.2.3 Ways to reduce a cost gap
2. Remove features that add to cost but do not significantly add value to the
product when viewed by the customer.
4. Review the whole supplier chain - each step in the supply chain should be
reviewed, possibly with the aid of staff questionnaires, to identify areas of
likely cost savings. For example, the questionnaire might ask ‘are there more
than five potential suppliers for this component?’ Clearly a ‘yes’ response to
this question will mean that there is the potential for tendering or price
competition.
5. Reduce waste or idle time that might exist. Where possible, standardised
components should be used in the design. Productivity gains may be possible
by changing working practices or by de-skilling the process. Automation is
increasingly common in assembly and manufacturing.
Lecture Example 4
D. Setting a selling price for the company to aim in the long run
234
13.1.3 Life-Cycle Costing
Life-cycle costing tracks and accumulates the actual costs and revenues attributable
to each product from inception to abandonment. It enables a product’s true
profitability to be determined at the end of the economic life.
Traditional cost accounting systems do not accumulate costs over a product’s entire
life but focus instead on (normally) twelve month accounting periods. As a result the
total profitability of a product over its entire life becomes difficult to determine.
3. Growth. The product gains a bigger market as demand builds up. Sales
revenues increase and the product begins to make a profit. Marketing and
promotion will continue through this stage. Unit costs tend to fall as fixed
costs are recovered over greater volumes. Competition also increases and
the company may need to reduce prices to remain competitive.
4. Maturity. Eventually, the growth in demand for the product will slow down and
it will enter a period of relative maturity. It will continue to be profitable.
However, price competition and product differentiation will start to erode
profitability. The product may be modified or improved, as a means of
sustaining its demand.
5. Decline. At some stage, the market will have bought enough of the product
and it will therefore reach 'saturation point'. Demand will start to fall and prices
will also fall. Eventually it will become a loss maker and this is the time when
the organisation should decide to stop selling the product or service. During
this stage, the costs involved would be environmental clean-up, disposal and
decommissioning. Meanwhile, a replacement product will need to have been
235
developed, incurring new levels of research and development and other setup
costs.
The level of sales and profits earned over a life cycle can be illustrated
diagrammatically as follows.
1. All costs (production and non production) will be traced to individual products
over their complete life cycles and hence individual product profitability can be
more accurately measured.
2. The product life cycle costing results in earlier actions to generate revenue or
to lower costs than otherwise might be considered.
3. Better decisions should follow from a more accurate and realistic assessment
of revenues and costs, at least within a particular life cycle stage.
236
6. Identifying the costs incurred during the different stages of a product’s life
cycle provides an insight into understanding and managing the total costs
incurred throughout its life cycle. Non production costs will become more
visible and the potential for their control is increased.
Lecture Example 5
A. (i) only
B. (i) and (ii) only
C. (i) and (iii) only
D. (i), (ii) and (iii)
13.1.4.1 Introduction
Total quality management (TQM) describes the situation where all business
functions are involved in a process of continuous quality improvement. It focuses on
delivering products or services of consistent high quality in a timely fashion. In the
past most companies considered quality to be an additional cost of manufacturing,
but recently they have begun to realize that quality saves money.
Costs of prevention (getting things right first time) are less than the costs of
correction.
Therefore companies should focus on getting things right first time (zero defect
philosophy) and then getting them better next time (continuous improvement). There
must be real commitment to continuous improvement in all processes by all
management.
237
In his article, Mark Lee Inman9 listed eight requirements of quality: -
A cost of quality report should be prepared to indicate the total cost to the
organisation of producing products or services that do not conform with quality
requirements. Four categories of costs should be reported:-
2. Appraisal Costs are the costs incurred to ensure that materials and products
meet quality conformance standards. They include the costs of inspecting
purchased parts, work in process and finished goods, quality audits and field
tests.
3. Internal Failure Costs are the costs associated with materials and products
that fail to meet quality standards. They include costs incurred before the
product is dispatched to the customer, such as the costs of scrap, repair,
downtime, and work stoppages caused by defects.
4. External Failure Costs are the costs incurred when products or services fail to
conform to requirements or satisfy customer needs after they have been
delivered. They include the costs of handling customer complaints, warranty
replacement, repairs of returned products and the costs arising from a
damaged company reputation. Costs within this category can have a dramatic
impact on future sales.
238
Prevention and appraisal costs are sometimes referred to as the costs of quality
conformance or compliance. Costs of compliance are incurred with the intention of
eliminating the costs of failure.
Internal and external failure costs are also known as the costs of non-conformance
or non-compliance. Costs of non-compliance are the result of production
imperfections and can only be reduced by increasing compliance expenditure.
Lecture Example 6
A customer returns a faulty product to a firm for repair under a warranty scheme.
Lecture Example 7
A company uses total quality management (TQM) and has recorded the following
costs of quality for a period.
$
Staff training 8,000
Inspection 12,000
Warranty claims 20,000
Rework of faulty items detected before delivery to customers 15,000
What would be the net benefit of spending an extra 10% on prevention cost to save
20% on external failure cost?
A. $2,000
B. $3,200
C. $5,000
D. $6,200
239
KEY NOTES
240
1. Activity Based Costing (ABC)
ABC links overhead costs to the products or services that cause them by
absorbing overhead costs on the basis of activities that ‘drive’ costs (cost
drivers).
2. Target Costing
Three steps: -
Take the selling price
Deduct the desired margin
The remainder will be the target cost. If the expected cost is higher
than the target cost, there is a cost gap.
3. Life-cycle Costing
Life-cycle costing tracks and accumulates the actual costs and revenues
attributable to each product from inception to abandonment. It enables a
product’s true profitability to be determined at the end of the economic life.
Costs of prevention (getting things right first time) are less than the costs of
correction.
241
iv. External Failure Costs - costs incurred when products or services fail to
conform to requirements or satisfy customer needs after they have
been delivered.
242
QUESTIONS
243
1. In which circumstance is activity based costing a more useful approach to
product costing: -
A. One product is produced
B. Overheads form a high proportion of total costs
C. Overhead expenditure is driven by the volume of output
D. It is very difficult to identify the relevant cost drivers
2. What is the name of the costing approach used where the product’s selling price
is identified and ways are established of meeting production costs and making
an acceptable profit?
3. Which of the following costs would be included to find the life-cycle cost of a
product?
244
5. In activity-based costing, overhead costs are allocated into:-
6. Kint Co manufactures shoes. The shoes are sold to large retailers who insist
upon the highest standard of quality. The shoes have to be manufactured to
precise dimensions and to be dyed to an exact colour shade. Below is a list of
expenses incurred in the last month:
$
Customer complaints department 3,456
Finished goods inspection 3,588
Shade matching 1,479
Quality control system development 5,110
Operative training 1,500
Rework 8,850
Machine maintenance 850
Goods inwards inspection 600
Compensation payments to customers for defective goods 4,600
Pre-despatch failure analysis 3,877
b. Categorise the expenses from the month into the four categorise of quality
cost given in (a).
245
7. Which of the following describes target costing?
B. A method of costing that sets a target price by adding a desired profit margin
to actual cost.
246
ANSWERS
247
1. B
2. B
3. D
4. A
5. D
6.
a. Costs of quality
Prevention costs: These represent the cost of any action taken to investigate,
prevent or reduce defects or failures.
Appraisal costs: These are the costs of assessing the quality achieved.
Internal failure costs: These are costs arising within the organization relating to a
failure to achieve the specified level of quality.
External failure costs: These are costs arising when the failure to achieve the
specified level of quality is detected outside the organization.
b. Analysis of costs
Prevention costs
Quality control devpt.
Operative training
Machine maintenance
Shade matching
Appraisal costs
Finished goods inspection
Goods inward inspection
248
Note: Rework could also be categorized ax external failure costs.
Quality control development could be categorized as an appraisal cost
Shade matching could be categorized as as appraisal cost.
Goods inward inspection could be categorized as a prevention cost.
7. A
249
250
Chapter 14
NATURE AND PURPOSE OF
BUDGETING
14.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Explain why organisations use budgeting
The budget is 'a quantitative statement for a defined period of time, which may
include planned revenues, expenses, assets, liabilities and cash flows. A budget
facilitates planning'.
251
14.2 ACCA SYLLABUS GUIDE OUTCOME 2:
Describe the planning and control cycle in an organization
The overall planning and control cycle is summarized in the diagram below: -
Set mission
Identify objectives
Long-term
planning process Gather data about alternatives
Budget
process Monitor actual results Control
process
252
Stage 1:- Set Mission
This involves establishing the broad overall aims and goals of the organization – its
mission may be both economic and social. Most organizations now prepare and
publish their mission in a mission statement.
This requires the company to specify objectives towards which it is working. The
objectives chosen must be quantified and have a timescale attached to them.
Objectives should be SMART: -
Specific
Measurable
Achievable
Relevant
Time limited
To formulate its strategies, the firm will consider the products it makes and the
markets it serves. E.g. of strategies are: -
Developing new markets for existing products
Developing new products for existing markets
Developing new products for new markets
253
Stage 5:- Select course of action
Having made decisions, long-term plans based on those decisions are created.
This stage shows the move from long-term planning to short-term plans – the annual
budget. The budget provides the link between the strategic plans and their
implementation in management decisions.
Detailed financial and other records of actual performance are compared with budget
targets (variance analysis)
This is the control process in budgeting, responding to divergences from plan either
through budget modifications or through identifying new courses of action
Lecture Example 1
a) Budget centres: Units responsible for the preparation of budgets. A budget centre
may encompass several cost centres.
254
b) Budget committee: This may consist of senior members of the organisation, e.g.
departmental heads and executives (with the managing director as chairman). Every
part of the organisation should be represented on the committee, so there should be
a representative from sales, production, marketing and so on. Functions of the
budget committee include:
i. liaising between the budget committee and managers responsible for budget
preparation
ii. dealing with budgetary control problems
iii. ensuring that deadlines are met
iv. educating people about budgetary control.
d) Budget manual:
Lecture Example 2
255
Lecture Example 3
A. The budget committee should set the budgets for cost centre managers.
B. Cost centre managers should prepare their own budgets.
C. Management accountants should prepare budgets for cost centre managers
D. Senior management should prepare cost centre budgets.
The long-term plan forms the framework within which the budget is prepared. It is
therefore necessary to communicate the implications of that plan to the people who
actually prepare the budget.
Generally there will be one factor which restricts performance for a given period.
Usually this will be sales, but it could be production capacity, or some special labour
skills.
On the assumption that sales is the principal budget factor, the next stage is to
prepare the sales budget. This budget is very much dependent on forecast sales
revenue.
256
Stage 5: Co-ordination and review of budgets
At this stage the various budgets are integrated into the complete budget system.
Any anomalies between the budgets must be resolved and the complete budget
package subject to review. At this stage the budget income statement, balance sheet
and cash flow must be prepared to ensure that the package produces an acceptable
result.
All of the budgets are summarized into a master budget, which is presented to top
management for final acceptance.
The budget process involves regular comparison of budget with actual, and
identifying causes for variances. This may result in modifications to the budget as the
period progresses.
257
KEY NOTES
258
1. A budget is a quantified plan of action for a forthcoming accounting period.
Set mission
Identify objectives
Long-term
planning process Gather data about alternatives
Budget
process Monitor actual results Control
process
a. Specific
b. Measurable
c. Achievable
d. Relevant
e. Time limited
259
4. Budget centres: units responsible for the preparation of budgets
7. Budget manual:
a. charts the organisation
b. details the budget procedures
c. contains account codes for items of expenditure and revenue
d. timetables the process
e. clearly defines the responsibility of persons involved in the budgeting
system.
260
QUESTIONS
261
1. The main purpose of budgeting are:
A. (i) only
B. (i) and (ii) only
C. (ii) only
D. (i), (ii) and (iii)
262
ANSWERS
263
1. B
2. B
3. D
264
Chapter 15
BUDGET PREPARATION
15.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Explain the importance of principal budget factor in constructing the budget.
Lecture Example 1
A. Demand
B. Labour hours
C. Materials
D. Cash
265
1. Sales budget
2. Production budget
3. Raw material usage budget
4. Raw material purchases budget
5. Labour budget
6. Overheads budget
Budgeted production =
Forecast sales + closing inventory of finished goods – opening inventory of
finished goods
Material usage = Budgeted production for each product x the quantity required
to produce one unit of the product
The overhead budget will be made up of variable costs and fixed costs
Lecture Example 2
The XYZ company produces three products, X, Y, and Z. For the coming accounting
period budgets are to be prepared using the following information:
266
Budgeted sales
M1 M2
(kg per unit) (litres per unit)
Product X 5 2
Product Y 3 2
Product Z 2 1
Standard cost of raw material $8 $4
Labour
X Y Z
Standard hours per unit 4 6 8
Labour is paid at the rate of $3 per labour hour
Variable overheads at $2 per labour hour
Fixed overheads at $1 per labour hour
267
SALES BUDGET
units/value
Cash budgets are vital to the management of cash. They show the expected inflows
and outflows of cash through the company. They help to show cash surpluses and
cash shortages.
268
Management can therefore use cash budgets to plan ahead to meet those
eventualities – arranging borrowing when a deficit is forecast, or buying short-term
securities during times of excess cash.
Lecture Example 3
The selling price of a book is $15, and sales are made on credit through a book club
and invoiced on the last day of the month.
Variable costs of production per book are materials ($5), labour ($4), and overhead
($2).
Nov Dec Jan Feb March April May June July Aug
No of 1000 1000 1000 1250 1500 2000 1900 2200 2200 2300
books
The company produces the books two months before they are sold and the creditors
for materials are paid two months after production.
Variable overheads are paid in the month following production; wages are paid in the
month of production.
The company is going through a restructuring and will sell one of its freehold
properties in May for $25,000, but it is also planning to buy a new printing press in
May for $10,000. Depreciation is currently $1,000 per month, and will rise to $1,500
after the purchase of the new machine.
The company’s corporation tax (of $10,000) is due for payment in March.
The company presently has a cash balance at bank on 31 December 2011, of
$1,500.
Required
a. Produce a cash budget for the six months from 1 January 2012 to 30 June
2012.
b. How can Maze finance the short-term deficits that will arise between January
and June 2012?
269
15.4 ACCA SYLLABUS GUIDE OUTCOME 4:
Prepare master budgets (income statement and statement of financial
position)
When all the functional budgets have been prepared, they are summarized and
consolidated into a master budget which consists of:
1. Budgeted income statement
2. Budgeted statement of financial position
3. Cash budget
‘What if’ analysis is a form of sensitivity analysis which allows the effects of changing
one or more data values to be quickly recalculated. It enables each of the input
values to be changed both individually and in combination to see the effects on the
final result.
Michelle Ltd is considering launching a new product which has the following details:
Sales volume will now be 800, i.e. 200 less. Total contribution will be lower by 200 x
$3 = $600. Hence profit will now be $1000 - $600 = $400, i.e. 60% lower
270
15.5.2 Scenario Planning
271
KEY NOTES
272
1. Principal Budget Factor
i. Sales Budget
Budgeted production =
Forecast sales + closing inventory of finished goods – opening
inventory of finished goods
v. Overhead Budget
The overhead budget will be made up of variable costs and fixed costs
273
3. Cash Budget
Cash budgets are vital to the management of cash. Management can use
cash budgets to plan ahead to arrange borrowing when a deficit is forecast, or
buy short-term securities during times of excess cash.
4. Master Budget
5. What If Analysis
‘What if’ analysis is a form of sensitivity analysis which allows the effects of
changing one or more data values to be quickly recalculated
6. Scenario Planning
274
QUESTIONS
275
1. A retailer forecasts the following data for the coming period;
Sales $500,000
Opening inventory $40,000
Closing inventory $50,000
Mark-up 25%
A. $365,000
B. $385,000
C. $390,000
D. $410,000
A. 2,080
B. 1,920 (400 + 2000 – 480)
C. 2,000 (no adjustment)
D. 2,400 (2000 + 400)
3. A company manufactures two products, exe and wye, from the same direct
material. In period three an equal number of each product will be produced. Each
unit of exe requires 2kg of material and each unit of wye requires 3kg of material.
The company always holds a closing inventory of raw material sufficient for 40%
of the next period’s production. The budgeted closing raw material inventory for
period two is 900kg.
A. 225 units
B. 450 units
C. 900 units
D. 1,125 units
276
4. Which of the following is part of a master budget?
A. Labour budget
B. Material purchases budget
C. Budgeted income statement
D. Production budget
Units
Sales 19,000
Opening inventory of finished goods 4,000
Closing inventory of finished goods 3,000
Kg
Opening inventory of raw materials 50,000
Closing inventory of raw materials 53,000
a. What is the budgeted raw material purchases for next period (in kg)?
_______
b. What is the budget cost for raw materials? _________
277
9. A hardware store has budgeted sales of $36,000 for its power tool department in
July. Management wants to have $7,000 in power tool inventory at the end of
July. Its beginning inventory of power tools is expected to be $6,000. What is the
amount of merchandise purchases in $?
A. $36,000
B. $43,000
C. $42,000
D. $37,000
10. A store has the following budgeted sales for the next five months.
May $210,000
June $186,000
July $180,000
August $220,000
September $240,000
Cash sales are 25% of total sales and all credit sales are expected to be
collected in the month following the sale. The total amount of cash expected to
be received from customers in September is _______________
11. A plan that shows the expected cash inflows and cash outflows during the
budget period, including receipts from loans needed to maintain a minimum cash
balance and repayments of such loans, is called:
A. An income statement.
B. A statement of financial position.
C. A cash budget.
D. An operating budget.
12. The following sales are predicted for a company’s next four months.
Each month’s ending inventory of finished goods should be 30% of the next
month’s sales. At September 1, the finished goods inventory is 140 units. The
budgeted production of units for October is
278
A. 572 units.
B. 560 units.
C. 548 units.
D. 600 units.
E. 180 units.
279
ANSWERS
280
1. D
Op Inv. 40,000
Purchases 410,000
45,000
Cl Inv. 50,000
400,000
2. A
Sales 2,000
Cl Inv 480 (20% x [2000 x 1,2])
2,480
Op Inv. (400) (20% x 2000)
2,080
3. B
281
4. C
5. C
6. C
7.
a. Production budget
Sales 19000
Cl Inv 3000
22000
Op Inv (4000)
Production 18000
x 8kg
Required 144,000
Required 144000
Cl Inv 53000
197000
Op inv (50000)
147,000
b. 147,000 x $5 = $735,000
8. 24,500 units
Sales 24000
Cl Inv 2500 (2000 x 1.25)
26500
Op Inv (2000)
Required 24,500
282
9. D
Sales 36000
Cl Inv 7000
43000
Op Inv (6000)
Required 37,000
10.
September
11. C
12. A
560 units + (0.3 x 600 units) – (0.3 x 560 units) = 572 units
283
Chapter 16
FLEXIBLE BUDGETS
16.1 Introduction
Budgetary control involves controlling costs by comparing the budget with the actual
results and investigating any significant differences between the two. Any differences
(variances) are made the responsibility of key individuals who can either exercise
control action or revise the original budgets.
If this control process is to be valid and effective, it is important that the variances
are calculated in a meaningful way. One of the major concerns is to ensure that the
budgeted and actual figures reflect the same activity level.
A fixed budget is a budget which is normally set prior to the start of an accounting
period, and which is not changed in response to changes in activity or
costs/revenues. It is produced for a single level of activity, i.e. based on estimated
production.
Comparison of a fixed budget with the actual results for a different level of activity is
of little use for budgetary control purposes. This is because we will not really be
comparing like with like.
A flexible budget is a budget that adjusts or flexes for changes in the volume of
activity. The flexible budget is more sophisticated and useful than a fixed budget,
which remains at one amount regardless of the volume of activity.
For example, a firm may have prepared a fixed budget at a sales level of $100,000.
Flexible budgets may be prepared at different activity levels e.g. anticipated activity
284
100% and also 90%, 95%, 105% and 110% activity. Flexible budgets can be useful
but time and effort is needed to prepare them.
A flexed budget is a budget prepared to show the revenues, costs and profits that
should have been expected from the actual level of production and sales.
If the flexed budget is compared with the actual results for a period, variances will be
much more meaningful.
The high-low method may have to be used in order to determine the fixed and
variable elements of semi-variable costs. However, please note that fixed costs
remain unchanged regardless of the level of activity and should not be flexed.
Lecture Example 1
A company has prepared the following fixed budget for the coming year.
$
Direct materials 50,000
Direct labour 25,000
Variable overheads 12,500
Fixed overheads 10,000
$97,500
At the end of the year, the following costs had been incurred for the actual
production of 12,000 units.
$
Direct materials 60,000
Direct labour 28,500
285
Variable overheads 15,000
Fixed overheads 11,000
$114,500
Required: -
Prepare a flexed budget for the actual activity for the year and calculate any
variances which have arisen.
Lecture Example 2
Each manager must have a well-defined area of responsibility and the authority to
make decisions within that area. This is known as a responsibility accounting unit.
As discussed in Chapter 1, an area of responsibility may be structured as: -
A common problem is that the responsibility for a particular cost or item is shared
between two (or more) managers. For e.g. the responsibility for material costs will be
shared between production and purchasing managers. It is important that the
reporting system should be designed so that the responsibility for performance
achievements is identified as that of a single manager.
286
16.5 ACCA SYLLABUS GUIDE OUTCOME 5:
Explain the concept of controllable and uncontrollable costs and revenues
The main problem with measuring performance is in deciding which costs are
controllable and which costs are traceable. The performance of a manager is
indicated by the controllable profit and the success of the division as a whole is
judged on the traceable profit.
Controllable costs and revenues are those costs and revenues which result from
decisions within the authority of a particular manager within the organization. These
should be used to assess the performance of the managers.
Most variable costs are controllable in the short term because managers can
influence the efficiency with which resources are used.
287
CONTROLLABLE PROFIT STATEMENT 10
$ $
(internal) XXX
XXX
The following control report will be presented only to the responsible manager. It will
include a number of recommendations how any variance will be controlled or
eliminated
288
Budget Actual Variance
Current Year Current Year Current Year
month to date month to date month to date
Managing Director
Factory A
Factory B
Administration costs
Selling costs
Distribution costs
R&D costs
Production director
Factory A
Machining department
Casting department
Assembly department
Inspection and quality
control
Factory manager’s office
Head of machining
department
Direct materials
Direct labour
Indirect labour
Power
Maintenance
Other
289
KEY NOTES
290
1. Budgetary Control
Budgetary control involves controlling costs by comparing the budget with the
actual results and investigating any significant differences between the two.
Any differences (variances) are made the responsibility of key individuals who
can either exercise control action or revise the original budgets.
2. Fixed Budgets
A fixed budget is a budget which is normally set prior to the start of an
accounting period, and which is not changed in response to changes in
activity or costs/revenues. It is produced for a single level of activity, i.e.
based on estimated production.
3. Flexible Budgets
A flexible budget is a budget that adjusts or flexes for changes in the volume
of activity. The flexible budget is more sophisticated and useful than a fixed
budget, which remains at one amount regardless of the volume of activity.
4. Flexed Budgets
A flexed budget is a budget prepared to show the revenues, costs and profits
that should have been expected from the actual level of production and sales.
If the flexed budget is compared with the actual results for a period, variances
will be much more meaningful.
5. Responsibility Accounting
Each manager must have a well-defined area of responsibility and the
authority to make decisions within that area.
a cost centre – the manager is responsible for cost control only
a revenue centre – the manager is responsible for revenues only
profit centre – the manager has control over costs and revenues
investment centre – the manager is empowered to take decisions
about capital investment for his department. Later on, we will be
discussing two measures of performance in investment centres: return
on investment and residual income
291
QUESTIONS
292
1. Which TWO of the following are true for flexible budgets?
Budgeted costs per month throughout 2007, at two different capacity levels are as
follows:
During May 2007 when demand was for 724,000 units and 36,250; labour hours
were worked; actual costs for each cost element were reported as:
Required:
Prepare a flexed budget statement of warehouse costs for May 2007 for an
activity level of 724,000 units.
293
ANSWERS
294
1. D
2. Flexed Budget
(Alternatively Standard rate $16.00 per hour ÷ standard rate of 20 units per hour =
$0.8 per unit
Stock picking cost at 724,000 units = 724,000 x $0.80 per unit = $579,200
At 200,000 units
$500,000 = Fixed cost + 200,000 x $2.0
Fixed cost = $100,000.
At 724,000 units total cost = $100,000 + (724,000 x $2.0) = $1,548,000
295
Chapter 17
STATISTICAL TECHNIQUES IN
BUDGETING
In this chapter, we will be looking at different statistical techniques which can be
used to arrive at budgeted figures. The main problem faced when forecasting costs
is that of trying to find how costs vary with the level of activity. Useful techniques in
cost estimation are: -
Sales forecasts may also make use of past sales data. Techniques which may be
useful here are: -
As described in chapter 3, the high low method is one of the methods used to
analyse semi-variable costs into their fixed and variable elements.
Total cost at high activity level - total cost at low activity level
Total units at high activity level - total units at low activity level
296
3. Find the fixed costs
Total cost at high activity level – (Total units at high activity level × Variable cost per
unit)
1. Easy to use
2. Easy to understand
3. Quick method
1. It relies on historical cost data – predictions of future costs may not be reliable
2. It assumes that the activity level is the only factor affecting costs
3. It uses only two values to predict costs – all data falling between the highest
and lowest values are ignored
4. Bulk discounts may be available at large quantities
Lecture Example 1
Calculate the variable cost per unit and the total fixed costs and use these to
forecast the cost expected if production is 6,500 units. Note that when
production is greater than 5000 units, an additional machine must be used and
depreciation increases by $500/month.
Information about two variables that are considered to be related in some way can
be represented on a form of graph known as a ‘scatter diagram’, each axis
representing one variable. For example, the level of advertising expenditure and
297
sales revenue of a product, or the level of electricity cost and the number of units
produced can be plotted against each other.
The values of the two variables are plotted together to show a number of points on
the graph. The way in which these are scattered or dispersed indicates if any
relationship is likely to exist between the variables.
For example; the following scatter graph shows the relationship between 2 variables;
the independent variable can be the units, the dependent variable can be production
cost.
The "best-fit" line (trend line) is the straight line which passes as near to as many of
the points as possible. By drawing such a line, we are attempting to minimise the
effects of random errors in the measurements.
298
The line of best fit would be drawn as follows: -
When we have our line of best fit drawn on the scatter diagram, we can use it to read
off values for the variables at any points on the axes.
In doing this, we have to assume that the line of best fit is accurately drawn and that
the relationship established, based on past data, will also apply in the future - this is
known as extrapolating the trend.
Using scatter diagrams with lines of best fit is useful as a forecasting technique and
has the advantage of relative simplicity.
299
17.3 ACCA SYLLABUS GUIDE OUTCOME 3:
Analysis of cost data.
i. Explain the concept of correlation coefficient and coefficient of
determination
ii. Calculate and interpret correlation coefficient and coefficient of
determination
iii. Establish a linear function using regression analysis and interpret the
results
Use linear regression coefficients to make forecasts of costs and revenues
Explain the advantages and disadvantages of linear regression analysis
Linear regression analysis is based on working out an equation for the line of best fit.
These formulae are given in the exam. Remember always start working ‘b’,
then move to ‘a’.
300
Lecture Example 2
The total costs of a business for differing levels of output are as follows:
Required: -
i. What are the fixed and variable elements of the total cost using linear
regression analysis?
ii. Estimate the total costs if output is: -
a) 400 units
b) 900 units
c) 1,200 units
17.3.1 Correlation
One way of measuring ‘how correlated’ two variables are, is by drawing the ‘line of
best fit’ on a scatter graph. When correlation is strong, the estimated line of best fit
should be more reliable.
301
17.3.2 Different degrees of correlation
No correlation
302
17.3.3 The correlation coefficient (r)
r = 0 indicates no correlation
Lecture Example 3
Using the details in Lecture Example 2, find the correlation coefficient and comment
on the result obtained.
94% of the variation in the dependent variable (y) is due to variations in the
independent variable (x). 6% of the variation is due to random fluctuations.
Therefore, there is high correlation between the two variables.
303
Lecture Example 4
Using the details in Lecture Example 2, find the coefficient of determination and
comment on the result obtained.
Lecture Example 5
Advantages
2. Unlike the high low method, which uses only two past observations,
regression analysis can build into the regression line a large number of
observations - this is likely to make the relationship derived more accurate.
Disadvantages
2. It still uses past data to forecast future values of the variables - if the
relationship which existed in the past is not valid for the future, the forecast
will be inaccurate.
304
Lecture Example 6
1 6 124
2 2 47
3 7 190
4 5 60
5 3 115
(i) Calculate the values of ‘a’ and ‘b’ using linear regression
(iii) Use your regression line to estimate the maintenance cost of a machine that
is 10 years old.
A time series is a series of figures or values recorded over time. The data often
conforms to a certain pattern over time. This pattern can be extrapolated into the
future and hence forecasts are possible. Time periods may be any measure of time
including days, weeks, months and quarters.
305
Example: -
Y = T+S+C+R
306
In the exam, it is unlikely that you will be expected to carry out any calculation of ‘C’.
Therefore, ‘C’ will be ignored.
Please note that when the number of time periods is an even number, we must
calculate a moving average of the moving average. This is because the average
would lie somewhere between two periods.
These seasonal variations can be estimated using the additive model or the
proportional (multiplicative) model.
This is based upon the idea that each actual result is made up of two influences.
The SV will be expressed in absolute terms. Please note that the total of the
average SV should add up to zero.
307
The multiplicative model
The SV will be expressed in proportional terms, e.g. if, in one particular period the
underlying trend was known to be $10,000 and the SV in this period was given as
+12%, then the actual result could be forecast as:
Please note that the total of the average SV should sum to 4.0, 1.0 for each quarter.
Lecture Example 7
The following sales figures are available for the last two years for Sauce Co. All of
the figures represent actual sales except for quarter 2 of 2012, which is an estimate.
The financial director is satisfied that this estimate can be relied upon.
The following centred moving averages have been calculated, using a base period of
four quarters:
The average seasonal variations for 2010 have already been made available to you
and are 0.908 for quarter 3 and 1.082 for quarter 4. The random component is
negligible and can therefore be ignored.
Required:
308
Lecture Example 8
Using the data from example 3 together with the trend already calculated; calculate
the average seasonal variation using the multiplicative model.
Lecture Example 9
The trend for train passengers at Bravo Train Centre is given by the relationship
y = 5.2 + 0.24x
Lecture Example 10
Matthews’ Western division anticipates steadily growing demand for its products,
subject to some seasonal variation.
Recently it has employed the services of a statistician to help forecast sales. The
following extracts from the statistician’s report are available.
Based on linear regression analysis the quarterly trend in sales units for the Western
division may be represented by the equation:
y = 1,500 + 60x
where
y = forecast sales trend in cases per quarter
x = the quarter number, where the first quarter of the year 2000 = 1, the second
quarter of the year 2000 = 2, etc.
The average seasonal variation in sales follows an additive model with the following
quarterly variations.
Quarter 1 2 3 4
Seasonal Variation (Cases) +50 –40 –60 +50
309
Use the information provided by the statistician to forecast sales in cases for
the last quarter of 2004 for the Western division.
Advantages
Disadvantages
1. it assumes that past trends will continue indefinitely and that extrapolating
data based on historic information will give valid conclusions. In reality, the
sales of products may be influenced by the actions of competitors, particularly
in relation to new products becoming available on the market.
The product life cycle concept suggests that all products pass through a number of
stages from development to decline. We have looked into this concept in Chapter 13.
If an organisation knows where a product is in its life cycle, they can use this
knowledge to plan the marketing of that product more effectively and, the
organisation may be able to derive an approximate forecast of its sales from a
knowledge of the current position of a product in its life cycle.
1. It is over-simplistic to assume that all products comply with a life cycle curve
that follows the standard model shown above.
310
17.6 ACCA SYLLABUS GUIDE OUTCOME 6:
Adjust historical and forecast data for price movements.
An aspect of budgeting which requires great care is the estimation of future costs
based on historical figures in an environment of rising prices. When using past
accounting data as the basis for forecasting future figures, old costs need to be
adjusted to show what they would be at current, or rather at next year’s, prices. The
Retail Price Index (RPI) is a government produced index used to measure the
general rate of price change in the economy.
Lecture Example 11
Units
Required:
Using this information, determine monthly fixed costs and unit variable cost.
11 https://en.wikipedia.org/wiki/Index_(economics)
311
For example, if a product costs $100 in 2015 but it cost $50 in 2010,
$50 = 100
$100 = 200
The year that is used as the initial year for comparison is known as the base year.
The base year should also be fairly recent on a regular basis.
1. Simple Indices
A simple index measures the changes in either price or quantity of a single item in
comparison to the base year.
A price index – this measures the change in the money value of a group of
items over time.
p0
q0
Lecture Example 12
Calculate the simple quantity index for 2012 using 2011 as base year.
312
Lecture Example 13
Calculate the simple price index (or price relative) for 2012 based on 2011.
A value in any specific time period is based on the value of the same entity in the
preceding period. Each index number is calculated using previous year as base.
Lecture Example 14
$
2008 1,000
2009 1,100
2010 1,210
2011 1,331
2012 1,464
3. Composite Indices
Composite indices are used when we have more than one item.
313
Worked out example
2010 2011
$ $
Product A 2.00 2.25
Product B 2.50 2.65
Product C 3.50 3.00
This index ignores the amounts of each product which was consumed. To overcome
these problems, we can use a weighting which is an indicator of the importance of
the component
4. Weighted Indices
Lecture Example 15
$ $
Product R 12 13
Product C 9 10
Product A 22 30
314
Weighting
Product A 4
Product B 5
Product C 1
Calculate a weighted price index for 2012 for these three products with 2011 as
the base year.
Lecture Example 16
a) Quantity weights
b) Value weights
Paasche index is a multi-item index using weights at the current date. Hence, the
weights are changed every time period.
Lecture Example 17
315
Required: -
Calculate
a) i) a Laspeyres price index (i.e. weighted by the quantities of each item at the
base date)
∑pnq0 x 100
∑p0q0
ii) a Paasche price index (i.e. weighted by the quantities of each item at the
current date)
∑pnqn x 100
∑p0qn
b) i) a Laspeyres quantity index (i.e. weighted by the prices of each item at the
base date)
∑p0qn x 100
∑p0q0
ii) a Paasche quantity index (i.e. weighted by the prices of each item at the
current date)
∑pnqn x 100
∑pnq0
Fisher’s ideal index is found by taking the geometric mean of the Laspeyres index
and the Paasche index.
Lecture Example 18
The Laspeyres index of retail prices for 2010 is 134.5. The corresponding Paasche
index is 137.5.
Required
Calculate Fisher’s ideal index.
316
17.8 Advantages and Disadvantages of Indices
Advantages
2. The use of indices makes comparison between items of data easier and more
meaningful- it is relatively easy to make comparisons and draw conclusions
from figures when you are starting from a base of 100.
Disadvantages
1. The Laspeyres and Paasche approaches give different results. This suggests
that there may be no single correct way of calculating an index, especially the
more sophisticated index numbers. The user of the information should bear in
mind the basis on which the index is calculated.
2. The overall result obtained from multi-item index numbers, such as Laspeyres
and Paasche are averages - they may hide quite significant variations in
changes involved in the component items.
4. Index numbers are relative values, not absolute figures and may not give the
whole picture. For example, Division A has achieved growth of 10% compared
to last year while Division B has only achieved 5%. At first glance it may
appear that Division A is performing better than Division B. The actual sales
figures for the period are $27,500 for Division A and $262,500 for Division B.
The absolute increase in sales revenue compared to last year is $2,500 for
Division A ($2,200/$25,000 x 100% = 10% increase) but $12,500 for Division
B ($12,500/$250,000 x 100%= 5 % increase)
317
KEY NOTES
318
1. High Low Method
The high low method is one of the methods used to analyse semi-variable
costs into their fixed and variable elements. To find the variable cost per unit:
Total cost at high activity level - total cost at low activity level
Total units at high activity level - total units at low activity level
Total cost at high activity level – (Total units at high activity level × Variable cost per
unit)
2. Scatter Diagram
Two variables that are considered to be related in some way can be
represented on a form of graph known as a ‘scatter diagram’.
These formulae are given in the exam. Remember always start working ‘b’,
then move to ‘a’.
5. Correlation
Correlation measures the strength of the relationship between two variables.
319
This formula is also given in the exam.
7. Time Series
A time series is a series of figures or values recorded over time. The data
often conforms to a certain pattern over time. This pattern can be extrapolated
into the future and hence forecasts are possible.
Y = T+S+C+R
320
An index number is a technique for comparing, over time, changes in some
feature of a group of items by expressing the property each year as a
percentage of some earlier year.
Fisher’s ideal index is found by taking the geometric mean of the Laspeyre
index and the Paasche index.
321
QUESTIONS
322
1. The following statements have been made about linear regression analysis:
(i) It provides more accurate estimates than the high low technique.
(ii) It can only be used to estimate variable cost
(iii) It assumes that cost behaviour is linear.
(iv) It only takes into account two observations of cost and output.
Which of the following statements about the use of linear regression analysis in
cost estimation are true?
(i) Trend
(ii) Seasonal variation
(iii) Cyclical variation
3. A time series model of sales volume has the following trend and additive
seasonal variation.
Trend
Y= 5,000 +4,000 X
Where Y= quarterly sales volume in units
X= the quarter number (Where the first quarter of 2009= quarter 17, the second
quarter of 2009= quarter 18 etc).
First +3,000
Second +1,000
Third -1,500
Fourth -2,500
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What would be the time series forecast of sales units for the third quarter of
2010?
A. 79,500
B. 95,500
C. 97,000
D. 98,500
4. A firm has used linear regression analysis to establish the relationship between
total cost and activity in units.
5. Which of the following could be included in a time series based sales forecast?
A. Trend
B. Seasonal variation
C. Cyclical variation
D. Random fluctuation
A. 1 only
B. only
C. 1, 2 and 3 only
D. 1, 2, 3 and 4
6. A company uses a multiplicative time series model to forecast sales. The trend in
sales is linear and is described by the following equation:
where T = 1 denotes the first quarter of 2010, T = 2 denotes the second quarter
of 2010 etc.
Quarter 1 2 3 4
% Variation -30 +40 +10 -20
324
A. 423 units
B. 480 units
C. 517 units
D. 3,157 units
7. Which of the following are feasible values for the correlation coefficient?
1. +1.40
2. +1.04
3. 0
4. -0.94
A. 1 and 2 only
B. 3 and 4 only
C. 1, 2 and 4 only
D. 1, 2, 3 and 4
8. The following statements relate to the advantages that linear regression analysis
has over the high low method in the analysis of cost behavior:
A. 1 only
B. 1 and 2 only
C. 2 and 3 only
D. 1, 2 and 3
9. The following table shows the number of units produced each month and the
total cost incurred:
Cost
Units ($ ‘000)
January 100 40
February 200 45
March 300 50
April 400 65
May 500 70
June 600 70
July 700 80
325
a. Calculate the regression line, y = a + bx.
b. Calculate the correlation coefficient.
10. Regression analysis is being used to find the line of best fit (y = a + bx) from five
pairs of data. The calculations have produced the following information:
What is the value of ‘b’ in the equation for the line of best fit (to 2 decimal
places)?
A. 0.01
B. -1.40
C. 0.89
D. 1.40
11. Which of the following is NOT a feasible value for the correlation coefficient?
A. +1.3
B. +0.8
C. 0
D. -0.8
12. If the correlation coefficient of a set of data is 0.8, what is the coefficient of
determination? ___________
13. Two years ago the price index appropriate to the cost of material X had a value
of 120. It now has a value of 160.
If material X costs $2,000 per kg today, what would its cost per kg have been
two years ago?
A. $1,500
B. $1,667
C. $2,667
D. $3,200
326
14. A company recorded the following prices and usage of materials over the last
two periods.
Period 1 Period 2
usage price per kg usage price per kg
kg $ kg $
What is the value of a Laspeyre price index (to the nearest whole number) of the
business’s material costs for period 2?
A. 71
B. 121
C. 123
D. 142
15. Four years ago material X cost $5 per kg and the price index most appropriate to
the cost of material X stood at 150. The same index now stands at 430.
What is the best estimate of the current cost of material X per kg?
A. $1.74 ($5 x 150 430)
B. $9.33 ($5 x (430 – 150) 150
C. $14.33 ($5 x 430 150)
D. $21.50 ($5 x 430 100)
16. The data in the table below has been extracted from a company’s cost
accounting records. It shows the total costs and the inflation index for the periods
in which the costs were incurred. Cost behaviour patterns are the same in both
periods.
The variable cost per unit, to the nearest $0.01, at an inflation index of 1.06 is:
A. $1.45
B. $1.59
C. $1.53
D. $1.50
327
17. The table below contains details of an airline’s expenditure on aviation fuel.
The following statements relate to the changes between 2008 and 2009.
A. 1 only
B. 2 only
C. 2 and 3 only
D. 2 and 4 only
328
ANSWERS
329
1. B
2. D
3. B {5,000 + (23 x 4,000) - 1,500 = 95,500} the 3rd quarter of 2010 is 23.
4. A
5. C
7. B
8. B
x y xy x² y²
= 1309000 - 1176000
9800000 - 7840000
= 133,000
1,960,000
= 0.067 x 1000
330
= 67.85
= 60,000 - 27140
= 32,860
10. C
= 419600 - 407700
305000 - 291600
= 11,900
13,400
= 0.89
14. C {(200 x 15) + (10 x 21)} / {(200 x 12) + (10 x 20)} x 100 = 123
15. C
16. B
331
Using the high-low method
332
Chapter 18
BEHAVIOURAL ASPECTS OF
BUDGETING
18.1 Introduction
(a) The managers who set the budget or standards are often not the managers who
are then made responsible for achieving budget targets.
(b) The goals of the organisation as a whole, as expressed in a budget, may not
coincide with the personal aspirations of individual managers. This is known as
dysfunctional behaviour.
(c) When setting the budget, there may be budgetary slack (or bias). Budget slack
is a deliberate over-estimation of expenditure and/or under-estimation of revenues in
the budgeting process. This results in a budget that is poor for control purposes and
meaningless variances.
Motivation is the drive or urge to achieve an end result. Hence, if employees and
managers are not motivated, they will lack the drive or urge to improve their
performance and to help the organization to achieve its goals and move forward.
The management accountant should therefore try to ensure that employees have
positive attitudes towards setting budgets, implementing budgets and feedback of
results.
333
Factors such as financial and non financial rewards, prestige and esteem, job
security and job satisfaction may all play a part to motivate management and
employees.
Management accounting planning and control systems can have a significant effect
on manager and employee motivation.
These include: -
The level at which budgets and performance targets are set
Manager and employee reward systems
The extent to which employees participate in the budget setting process
• if targets are very low, actual performance can be pulled down from where it might
naturally have been
• if targets are habitually very high, then employees might give up and, again,
performance can be reduced – if you know that no matter how hard you try you will
fail to meet the target, it’s easy to conclude that you might as well not try at all.
So, the aim is to set budgets which are perceived as being possible, but which entice
employees to try harder than they otherwise might have done. The concept of a
‘motivating budget’ is a powerful one, although the budget which is best for
motivating might not represent the results which are actually expected. Managers
can, and perhaps should, build in a margin for noble failure.
When the budget is very easy, actual performance is low. It has been pulled
down by the low demands made of employees.
334
When the budget is very difficult, actual performance is low. Why try when you
are doomed to failure?
When a budget is set at the level of the expectations (the best estimate of
what performance will actually be), employees are likely to perform as
expected.
If a more difficult aspirational budget is set, employees will try harder, and if
the budget is judged just right then their actual performance will be at its
maximum, though often falling short of the budget.
335
Lecture Example 1
aspirations; expectations
Managers may receive financial rewards (for e.g. bonuses) or non-financial rewards
(for e.g. promotion or greater responsibility) based on their ability to meet budget
targets.
336
These budgets will begin with upper level management establishing parameters
under which the budget is to be prepared. Lower-level personnel have very little
input in setting the overall goals of the organization as they are essentially reduced
to doing the basic budget calculations consistent with directives.
One disadvantage of the top-down approach is that lower-level managers may view
the budget as a dictatorial standard. They lack ownership of the budget and as
such, they will be reluctant to take responsibility for it. Further, such budgets can
sometimes provide ethical challenges, as lower-level managers may find themselves
put in a position of ever-reaching to attain unrealistic targets for their units.
However, it can be argued that this top down approach may be the only approach to
budgeting which is feasible if: -
the organisation is newly-formed
the business is very small
low level employees have no interest in participating in the process
they are not technically capable of participating in budget setting
only top level management have access to information which is necessary for
budgeting purposes
The budget holders have the opportunity to participate in setting their own budgets.
In fact, the lowest level organisational units are asked to submit their estimates of
expenditure for the next year. Senior management, meanwhile, has made a forecast
of the income it expects to receive. There may be a negative variance between the
forecast revenue and the sum of the departments’ budgets. The variance is resolved
by lengthy discussions or arbitrary decisions. This type of budget is also called
participative budget.
It is argued that bottom-up budgets improve employee morale and job satisfaction.
Furthermore, the budget is prepared by those who have the best knowledge of their
own specific areas of operation. This type of budget leads to better communication
and increases managers’ understanding and commitment.
On the negative side, a bottom-up approach is generally more time consuming and
expensive to develop and administer. Another potential shortcoming has to do with
the fact that some managers may try to "pad" their budget, giving them more room
for mistakes and inefficiency. As we have already discussed, this is known as
‘budgetary slack’.
337
18.6.3 Negotiated budget
Lecture Example 2
A. In centralized organisations
B. In well-established organisations
C. In very large businesses
D. During periods of economic affluence
Lecture Example 3
Goal congruence ensures that all members of the organisation pull in the same
direction towards helping the organisation to achieve its overall goals and objectives.
Lecture Example 4
Which TWO of the following are MOST likely to influence the motivation of budget
holders?
338
(3) The level of difficulty at which budgets are set
(4) The structure of the budget committee
A. 1 and 2
B. 2 and 3
C. 3 and 4
D. 1 and 4
339
KEY NOTES
340
1. Budgetary Control
The purpose of a budgetary control system is to assist management in
planning and controlling the resources of their organisation by providing
appropriate control information.
2. Dysfunctional Behaviour
The goals of the organisation as a whole, as expressed in a budget, may not
coincide with the personal aspirations of individual managers.
4. Motivation
Motivation is the drive or urge to achieve an end result. What affects
motivation?
The level at which budgets and performance targets are set
Manager and employee reward systems
The extent to which employees participate in the budget setting
process
7. Goal Congruence
Goal congruence ensures that all members of the organisation pull in the
same direction towards helping the organisation to achieve its overall goals
and objectives.
341
QUESTIONS
342
1. The following statements relate to the participation of junior management in
the budgeting setting process:
2. When the personal aspirations of individual managers do not concide with the
goals of the organisation as a whole, this is known as:
A. Goal congruence
B. Dysfunctional behavior
C. Budgetary slack
D. Participating budget
A. Goal congruence
B. Dysfunctional behavior
C. Budgetary slack
D. Participating budget
343
ANSWERS
344
1. C
2. B
3. C
345
Chapter 19
CAPITAL EXPENDITURE BUDGETING
AND DISCOUNTED CASH FLOWS
19.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Discuss the importance of capital investment planning and control
i. Growth
Without capital investment companies cannot grow and expand. The decisions
made affect the long term.
If the wrong capital investment decisions are done, then this can burden a
company unnecessarily. However a company must invest in order to maintain its
market share and hopefully grow.
ii. Risk
Capital investment is a long term investment. It requires long term funding. This
long term commitment brings with it risks; e.g. the risks of defaulting on the
financing. However, the potential gains made from the investment may fluctuate
more than the previous gains made by the business. Such fluctuations make the
company more risky.
iii. Funding
Capital investment is often a large amount - this means the company will need
to look for finance, both internally and externally. The choice of finance type is
crucial, as it needs to be appropriate for the investment type and the company at
the time
iv. Complexity
Investment decisions are often based on future estimates, often in many years
time. Estimates and variables are used which are often interrelated.
346
The estimates and variables will also change over time due to changes in the
environment in which the company operates (economic, political, social,
technological, environmental and legal).
All the costs incurred in self constructed assets (a business builds its own non-
current asset) should be included as a non-current asset in the statement of
financial position.
This expenditure is on day to day items, i.e. where the benefit is received short
term. This includes salaries, telephone costs or rent. It is incurred for the
purpose of trade, i.e. for expenditure classified as selling and distribution
expenses, administration expenses and fixed charges or to maintain the existing
earning capacity of non-current assets.
Capital income is the proceeds from the sale of non-current assets and non-
current asset investments.
Revenue income is derived from the sale of trading assets and from interest and
dividends received from investments held by the business.
347
Lecture Example 1
Very large proposals may require approval by the board of directors, while
smaller proposals may be approved at divisional level
348
Step 4: Implement, monitor and review investments
The time required to implement the investment proposal or project will depend
on its size and complexity. Following implementation, the investment project
must be monitored to ensure that the expected results are being achieved and
the performance is as expected: - this is known as post-completion audit. The
whole of the investment decision-making process should also be reviewed in
order to facilitate organisational learning and to improve future investment
decisions.
Example
You invest $100 for 3 years and you receive a simple interest rate of 10% a year
on the $100. This would be $10 each year. Simply $100 x 10% = $10.
The important thing to remember is that you get interest on top of the previous
interest. This is called compound interest.
Example
Suppose that a business has $100 to invest and wants to earn a return of 10%.
What is the future value at the end of each year using compound interest?
FV = PV (1+r)n
349
Where FV is the future value of the investment with interest
PV is the initial or ‘present’ value of the investment
r is the compound annual rate of return or rate of interest
expressed as a proportion
n is the number of years
The effective interest rate, on the other hand, can be compared with another
effective rate as it takes into account the compounding period automatically, and
expresses the percentage as an annual figure.
In fact, when interest is compounded annually the nominal interest rate equals
the effective interest rate.
To convert a nominal interest rate to an effective interest rate, you apply the
formula:
= (1 + i/m)mt – 1
Example
350
Example
What effective rate will a stated annual rate of 6% p.a. yield when compounded
semi-annually?
Effective Rate = (1 + (0.06/2)) 2 - 1 = 0.0609 = 6.09%
Lecture Example 2
19.5.1 Compounding
FV = PV (1+r)n
19.5.2 Discounting
A present value is the amount that would need to be invested now to earn the
future cash flow, if the money is invested at the ‘cost of capital’.
PV = FV
(1 + r) n
If the future value is in one year’s time, then you take this FV and multiply it by
1/interest rate (discount rate)
351
Example
A business is to receive $100 in one year’s time and the interest rate/discount
rate is 10%. What is the PV of that money?
PV = 100 /1.10
PV = $90.9
Example
A business is to receive $100 in two years’ time and the interest rate/discount
rate is 10%. What is the PV of that money?
PV = 100 /1.102
PV = $82.6
Example
$133 is received in 3 years time. Interest rate 10%. What is the PV?
Lecture Example 3
How much would you need to invest now (to the nearest $) to earn $5,000 after
5 years at a compound interest rate of 8% a year?
Lecture Example 4
What is the present value of $5,000 receivable at the end of year 3 at a cost of
capital of 7% per annum?
The present value can also be calculated using a discount factor (saving all the
dividing by 1.1 etc.)
352
1/1.13 = 0.751
There are also tables that give you a list of these ‘discount factors’ – a copy of
these tables is included at the end of these notes.
Hence, to calculate a present value for a future cash flow, you simply multiply
the future cash flow by the appropriate discount factor.
Let’s say you buy some goods for $100 and sell them for $200. However, $80 of
the receipt is on credit and you have not received it yet.
Profit looks solely at the income and costs. It matches these together,
regardless of timing of the actual cash payment or receipt.
Sales $200
Costs (100)
Profit 100
Cash flow, on the other hand, does not attempt to match the sale with the cost
but rather the actual cash paid and received.
Therefore, cash flows look at when the amounts actually come in and out: - the
money actually spent, saved and received. This is vital to capital investment
decision making - as the timing of inflows and outflows have a value too - the
time value of money.
Not only should the timing of the cash flows be taken into account when
planning on investments but also the type of cash flows to include. We call these
relevant costs.
353
19.7 ACCA SYLLABUS GUIDE OUTCOME 7:
Identify and evaluate relevant cash flows for individual investment
Relevant costs are those whose inclusion affects the investment decision.
The cash flows that should be included in a capital budgeting analysis are those
that will only occur if the project is accepted
You should always ask yourself “Will this cash flow change ONLY if we accept
the project?”
Hence, the only cash flows that should be taken into consideration in capital
investment appraisal are: -
Future (ignore past / sunk costs)
Incremental (A cost that would have been paid anyway can be ignored.
Examples of relevant incremental costs include repair costs arising from
use, hire charges and any fall in the resale value of owned assets which
results from their use)
Cash (Accounting items like depreciation ignore as they are not cash)
Lecture Example 5
Identify the cash flows that should be evaluated for this project.
Lecture Example 6
A machine was purchased for $20,000 and has an estimated life of five years. It is
not currently being used in the business.
354
A special order has now been received from a customer which would require the use
of the machine for five months. The current net realizable value of the machine is
$10,000. If it is used for the job, its value is expected to fall to $7,000. The machine
has a carrying value of $6,000.
Required
Determine the relevant cost of using the machine for the special order.
Discounted cash flow, or DCF, is an investment appraisal technique that takes into
account both the timing of cash flows and also the total cash flows over a project’s
life.
The NPV is the value obtained by discounting all the cash outflows and inflows for
the project capital at the cost of capital and adding them up. Hence, it is the sum of
the present value of all the cash inflows from a project minus the PV of all the cash
outflows.
NPV is positive – the cash inflows from a capital investment will yield a return in
excess of the cost of capital. The project is financially attractive
NPV is negative – the cash inflows from a capital investment will yield a return
below the cost of capital. From a financial perspective, the project is therefore
unattractive
NPV is exactly zero - the cash inflows from a capital investment will yield a return
exactly equal to the cost of capital. The project is therefore just about financially
attractive.
355
If a company has 2 projects under consideration it should choose the one with
the highest NPV.
Lecture Example 7
Year $
1 8,000
2 9,000
3 12,000
4 9,500
5 9,000
The firm currently has a return of 12% and this is considered to be its cost of capital.
Lecture Example 8
The equipment would have a resale value of $5,000 at the end of Year 4. The cost
of capital is 10%.
Calculate the NPV of the project. Recommend whether the project should be
undertaken.
356
19.8.2 Internal Rate of Return
The internal rate of return (IRR) is essentially the discount rate where the initial
cash out (the investment) is equal to the PV of the cash in. So, it is the
discount rate where the NPV = 0. If the IRR is higher than a target rate of
return, the project is financially worth undertaking.
Consequently, to work out the IRR we need to do trial and error NPV
calculations, using different discount rates, to try and find the discount rate
where the NPV = 0. This is known as the interpolation method.
Step 1: - Calculate two NPV for the project at two different costs of capital. It is
important to find two costs of capital for which the NPV is close to 0, because
the IRR will be a value close to them.
Step 2: - Having found two costs of capital where the NPV is close to 0, we can
then estimate the cost of capital at which the NPV is 0, i.e. the IRR. A formula
is used: -
L+ NPV L
NPV L - NPV H x (H - L)
Worked Example
If a project had an NPV of $50,000 when discounted at 10%, and -$10,000 when
discounted at 15%, what is the IRR?
Answer
10 + (50,000/60,000) x 5% = 14.17%
357
Lecture Example 9
Year $
0 (50,000)
1 18,000
2 25,000
3 20,000
4 10,000
Required: -
Both NPV and IRR use discounted cash flow techniques. NPV provides an absolute
measure of return, whereas IRR provides a relative measure. The rule for deciding
between mutually exclusive projects is to accept the project with the higher NPV.
Lecture Example 10
Year 0 1
Project A ($000) (200) 240
Project B ($000) (100) 125
Find the NPVs and IRRs of the two projects. Which project should be
chosen?
358
19.9 ACCA SYLLABUS GUIDE OUTCOME 9:
Calculate present value using annuity and perpetuity formulae(s)
19.9.1 Annuity
Example
$100 will be received at the end of every year for the next 3 years. If cost of
capital is 10%, what is the PV of these amounts together?
Yr 1 1/1.1 = 0.909
Yr 2 1/1.1/1.1 = 0.826
Yr 3 1/1.1/1.1/1.1 = 0.751
All added together 2.486 = Annuity factor (or get from annuity table)
Lecture Example 11
A payment of $4,000 is made for the next 3 years. The cost of capital is 8%.
What is the PV of this annuity?
359
Lecture Example 12
Find the present value of an annuity of $3,000 for five years, compound interest
at 4% pa, the first receipt being in one year’s time.
19.9.2 Perpetuity
Worked Example
What is the present value of an annual income of $50,000 for the foreseeable
future, given an interest rate of 5%?
Answer
50,000 / 0.05 = $1,000,000
Lecture Example 13
An investment will yield future cash flows of $3,000 for the foreseeable future.
What is the present value of this income at a discount rate of 20%?
Lecture Example 14
A project requires an initial outlay of $15,000 and will then generate $2,000
annually. Should the project be accepted at a discount rate of 16%?
The payback period is the length of time that it takes for a project to recoup its
initial cost out of the cash receipts that it generates. This period is sometimes
referred to as "the time that it takes for an investment to pay for itself."
360
The basic premise of the payback method is that the more quickly the cost of an
investment can be recovered, the more desirable is the investment. Hence, this
method focuses on liquidity.
The payback period is expressed in years. When the net annual cash inflow is
the same every year, the following formula can be used to calculate the payback
period.
Formula / Equation:
*If new equipment is replacing old equipment, this becomes incremental net
annual cash inflow.
Take the decimal (0.1429) and multiply it by 12 to get the months - in this case
1.7 months
Lecture Example 15
361
Example - Irregular Cash Flows
When the cash flows associated with an investment project change from year to
year, the simple payback formula that we outlined earlier cannot be used. To
understand this point, consider the following data:
When the cumulative cashflow becomes positive then this is when the initial
payment has been repaid and so is the payback period
So in the final year we need to make $10 more to recoup the initial 800. So,
that’s $10 out of $120. 10/120 x 12 (number of months) = 1.
The payback period incorporates the time value of money into the payback
method. All the cash flows are discounted at the company’s cost of capital. The
discounted payback period is therefore the time it will take before the project’s
cumulative NPV becomes positive.
362
Example
0 -1,700
1 500
2 500
3 600
4 900
5 500
NPV = $428,100
363
Lecture Example 16
XYZ plc is evaluating a possible investment project and uses a 10% discount rate to
determine its net present value.
Project A
$000
Initial cash outflow 400
Incremental cashflows
Year 1 100
Year 2 120
Year 3 140
Year 4 120
Year 5 100
364
KEY NOTES
365
A. Capital Expenditure
Capital expenditure includes expenditure on productive assets which are
intended for use on a continuing basis
B. Revenue Expenditure
Revenue expenditure is on day to day items, i.e. for the purpose of trade
D. Simple Interest
Simple interest is calculated on the original principal only
E. Compound Interest
FV = PV(1 + r)n
(1 + i/m)mt – 1
H. Discounting
PV = FV
(1 + r) n
366
IRR formula: -
L+ NPV L
NPV L - NPV H x (H - L)
M. Annuity
An annuity is a fixed periodic payment which continues either for a specified
time or until the occurrence of a specified event
N. Perpetuity
Perpetuity is a periodic payment or receipt continuing for a limitless period.
The PV of a perpetuity: -
Cash flow
Interest Rate
367
QUESTIONS
368
1. The net present value of a proposed project is $20,000 at a discount rate of 5%
and $(28,000) at 10%.
What is the internal rate of return of the project, to the nearest one decimal place?
A. 7.1%
B. 7.5%
C. 2.3%
D. 8.6%
A. $4,159
B. $10,780
C. $10,901
D. $14,000
A B C
$ $ $
Outlay 10,000 7,000 1,250
Expected returns (T1 – T4) 4,000 2,500 325
A. A only
B. A and B
C. A and C
D. A and B and C
4. The internal rate of return is the interest rate that equates the present value of
expected future net cash receipts to
369
5. A company has identified two mutually-exclusive projects which have an
equivalent effect on the risk profile of the company.
Project 1 Project 2
Discounted payback period 2.8 years 3.2 years
Net present value $17,200 $15,700
Internal rate of return 18% 22%
Average accounting rate of return 19% 21%
Cost of capital is 15%
Assuming that the directors wish to maximise shareholder wealth and no shortage
of capital is expected, which project should the company choose?
6. A project has a normal pattern of cash flows (i.e. an initial outflow followed by
several years of inflows).
What would be the effects on the internal rate of return (IRR) of the project and its
discounted payback period (DPP) of a decrease in the company’s cost of capital?
IRR DPP
A. Decrease Decrease
B. Decrease Increase
C. No change Decrease
D. No change Increase
7. A project has a normal pattern of cash flows (i.e. an initial outflow followed by
several years of inflows).
What would be the effects on the internal rate of return (IRR) of the project and its
payback period of an increase in the company’s cost of capital?
370
8. Consider the following graph.
NPV
Project X
Project Y
0 15% Discount
rate
A. 6 years
B. 5 years
C. 3 years
D. 2 years
371
10.
Net
present
value
0 Interest rate
5% 10% 15%
A. 1 and 2 only
B. 1 and 3 only
C. 2 and 3 only
D. 1, 2 and 3
11. Mr Manaton has recently won a competition where he has the choice between
receiving $5,000 now or an annual amount forever starting now (i.e. a level
perpetuity starting immediately). The interest rate is 8% per annum.
A. $370
B. $500
C. $400
D. $620
372
ANSWERS
373
1. A
2. A
3. B
Project A B C
NPV @ 10% $2,680 $925 $(220)
4. A
5. B
The NPV method is superior to all the other criteria for investment appraisal.
6. C
The IRR is independent of the cost of capital. If the cost of capital is reduced, later
cash flows will be discounted less dramatically and therefore the DPP will
decrease.
7. D
Both the internal rate of return and the payback period are independent of the cost
of capital.
8. A
True because the NPV profile of project Y crosses the discount rate axis beyond
that for project X.
B False – at discount rates less than 15% project X has a higher NPV
and is therefore preferred.
374
C and D False – at discount rates less than 15% project X is preferred,
whereas at rates greater than 15% project Y is preferred.
9. C
11. A
5000 = 4629.62
1.08
4629.62 = Cashflow
0.08
375
Chapter 20
STANDARD COSTING AND
BASIC VARIANCE ANALYSIS
20.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Explain the purpose and principles of standard costing
376
Lecture Example 1
Performance standards that have remained unchanged over a long period of time
are known as:
A. Ideal standards
B. Current standards
C. Basic standards
D. Long-term standards
Absorption costing systems focus on profit per unit, and the standard profit
per unit of product is the difference between its standard sales price and
standard full cost.
A standard cost card shows full details of the standard cost of each product.
377
Standard Cost Card – Product x
$ $
Direct Material x kgs @ $x x
x liters @ $x x
x
Direct labour x hrs @ $x x
x hrs @ $x x
x
Standard Direct Cost x
Variable production overheads x
Standard variable cost of (Marginal
production x Costing)
Fixed production overhead x
(Absorption
Standard full production cost x Costing)
Administration & marketing
overhead x
Standard cost of sale x
Standard profit x
Standard sales price X
A variance is the difference between a planned, budgeted, or standard cost and the
actual cost incurred. The same comparisons may be made for revenues.
The process by which the total difference between standard and actual results is
analysed is known as variance analysis.
When actual results are better than expected results, we have a favourable variance
(F). If, on the other hand, actual results are worse than expected results, we have an
adverse variance (A).
378
20.4 ACCA SYLLABUS GUIDE OUTCOME 4:
Calculate sales price and volume variance
The sales price variance shows the effect on profit of selling at a different price
from that expected.
The sales price variance = Actual units should have sold for $x
Actual units did sell $x
Sales Price Variance $ x (F/A)
379
The sales volume variance = Budgeted sales volume x units
(marginal costing) Actual sales volume x units
Sales Volume Variance in units x units (F/A)
x standard contribution per unit $x
Sales Volume Variance in $ $x (F/A)
Lecture Example 2
Hard Work Ltd has prepared the following standard cost card for its product HW: -
$ per unit
Materials (4kg at $4 per kg) 16
Labour (5 hrs at $6 per hr) 30
Variable overheads (5hrs at $2 per hr) 10
Fixed overheads (5 hrs at $3 per hr) 15
71
$
Materials (38,000 kg) 159,600
Labour (48,000 hrs) 310,000
Variable overheads 100,000
Fixed overheads 170,000
Required:
380
20.5 ACCA SYLLABUS GUIDE OUTCOME 5:
For given or calculated sales variances, interpret and explain possible causes,
including possible interrelationships between them
The selling price variance is a measure of the effect on expected profit of a different
selling price to standard selling price. It is calculated as the difference between what
the sales revenue should have been for the actual quantity sold, and what it was.
The sales volume profit variance is the difference between the actual units sold and
the budgeted (planned) quantity, valued at the standard profit (under absorption
costing) or at the standard contribution (under marginal costing) per unit. In other
words, it measures the increase or decrease in standard profit as a result of the
sales volume being higher or lower than budgeted (planned).
The direct material total variance can be subdivided into the direct material price
variance and the direct material usage variance.
381
Total Materials Variance
The direct material total variance is the difference between what the output actually
cost and what it should have cost, in terms of material.
382
The direct material price variance calculates the difference between the standard
cost and the actual cost for the actual quantity of material used or purchased. In
other words, it is the difference between what the material did cost and what it
should have cost.
The direct material usage variance is the difference between the standard quantity of
materials that should have been used for the number of units actually produced, and
the actual quantity of materials used, valued at the standard cost per unit of material.
In other words, it is the difference between how much material should have been
used and how much material was used, valued at standard cost.
The total labour variance can be subdivided between labour rate variance and labour
efficiency variance.
383
Total Labour Variance
The direct labour total variance = Actual units should have cost $x
Actual units did cost $x
Direct Labour Total Variance $ x (F/A)
The direct labour rate variance = Actual hrs should have cost $x
Actual hrs did cost $x
Direct Labour Rate Variance $ x (F/A)
The direct labour total variance is the difference between what the output should
have cost and what it did cost, in terms of labour.
The direct labour rate variance is the difference between the standard cost and the
actual cost for the actual number of hours paid for. In other words, it is the difference
between what the labour did cost and what it should have cost.
384
The direct labour efficiency variance is the difference between the hours that should
have been worked for the number of units actually produced, and the actual number
of hours worked, valued at the standard rate per hour. In other words, it is the
difference between how many hours should have been worked and how many hours
were worked, valued at the standard rate per hour.
The variable production overhead total variance can be subdivided into the variable
production overhead expenditure variance and the variable production overhead
efficiency variance (based on actual hours).
385
Total Variable Overhead Variance
Variable overhead efficiency variance Actual units should have taken X hrs
Actual units did take X hrs
Efficiency Variance in hrs X hrs (F/A)
x standard rate per hr $x
Efficiency Variance in $ $x (F/A)
The variable production overhead expenditure variance is the difference between the
amount of variable production overhead that should have been incurred in the actual
hours actively worked, and the actual amount of variable production overhead
incurred.
386
The variable production overhead efficiency variance is exactly the same in hours as
the direct labour efficiency variance, but priced at the variable production overhead
rate per hour.
The fixed production overhead total variance can be subdivided into an expenditure
variance and a volume variance. The fixed production overhead volume variance
can be further subdivided into an efficiency and capacity variance.
387
Total Fixed Overhead Variance
388
The volume efficiency variance is calculated in the same way as the labour efficiency
variance.
Fixed overhead vol efficiency variance actual units should have taken x hrs
Actual units did take x hrs
Vol Efficiency Variance in hrs x hrs (F/A)
x standard OAR rate per hr $x
Vol Efficiency Variance in $ $x (F/A)
The volume capacity variance is the difference between the budgeted hours of work and the
actual active hours of work (excluding any idle time).
Fixed overhead total variance is the difference between fixed overhead incurred and
fixed overhead absorbed. In other words, it is the under– or over-absorbed fixed
overhead.
Fixed overhead expenditure variance is the difference between the budgeted fixed
overhead expenditure and actual fixed overhead expenditure.
Fixed overhead volume variance is the difference between actual and budgeted
(planned) volume multiplied by the standard absorption rate per unit.
Fixed overhead efficiency variance is the difference between the number of hours
that actual production should have taken, and the number of hours actually taken
(that is, worked) multiplied by the standard absorption rate per hour.
389
Variance Favourable Adverse
Fixed overhead Savings in costs incurred Increase in cost of services used
Expenditure Changes in prices relating to fixed Excessive use of services
overhead expenditure Change in type of services used
Fixed overhead volume Labour force working more efficiently Labour force working less efficiently
Efficiency Lost production through strike
Fixed overhead volume Labour force working overtime Machine breakdown, strikes, labour
Capacity Shortages
390
20.15 ACCA SYLLABUS GUIDE OUTCOME 15:
Reconcile budgeted profit or contribution with actual profit or contribution
under standard marginal costing
The main differences between absorption and marginal costing operating statements
are: -
1. The marginal costing operating statement has a sales volume variance that is
calculated using the standard contribution per unit (rather than a standard
profit per unit as in absorption costing)
2. There is no fixed overhead volume variance
391
20.16 ACCA SYLLABUS GUIDE OUTCOME 16:
Calculate actual or standard figures where the variances are given
Variances can be used to derive actual data from standard cost details.
Rather than being given actual data and asked to calculate the variances, you may
be given the variances and required to calculate the actual data on which they were
based.
Lecture Example 3
A company operates a standard marginal costing system. Last month actual fixed
overhead expenditure was 2% below budget and the fixed overhead expenditure
variance was $1,250.
What was the actual fixed overhead expenditure for last month?
A. $61,250
B. $62,475
C. $62,500
D. $63,750
Lecture Example 4
In a period, 6,500 units were made. There was an adverse labour efficiency
variance of $26,000. Workers were paid at $8 per hour which was equal to the
standard labour rate. Total wages were $182,000.
Lecture Example 5
A company uses standard marginal costing. Last month the budgeted contribution
was $20,000 and the only variances that occurred were as follows:
$
Sales price 3,000 Adverse
Sales volume contribution 5,000 Favourable
Fixed overhead expenditure 1,000 Adverse
392
What was the actual contribution last month?
A $18,000
B $19,000
C $21,000
D $22,000
(ACCA Examiner’s report – F2 December 2010 Ex. 2)
2. Materiality. The size of the variance may indicate the scale of the problem and
the potential benefits arising from its correction.
4. The inherent variability of the cost or revenue. Some costs, by nature, are
quite volatile (oil prices, for example) and variances would therefore not be
surprising. Other costs, such as labour rates, are far more stable and even a
small variance may indicate a problem.
393
8. Costs and benefits of correction. If the cost of correcting the problem is likely
to be higher than the benefit, then there is little point in investigating further.
The control action which may be taken will depend on the reason why the variance
occurred.
The variance may be a result of a measurement error, e.g. wastage has been
unrecorded, scales have been misread or employees may adjust their records to
‘improve’ their performance. Control action is required to improve the accuracy of
the recording system so that measurement errors do not occur.
Spoilage and wastage will both negatively affect the efficiency of operations. It is
important to highlight the cause of the inefficiency that will lead to control action to
eliminate the efficiency being repeated.
Further Questions
Question 1
XYZ uses standard costing. The following data relates to labour grade II.
a. $4.96
b. $5.04
c. $4.95
d. $5.05
394
Question 2
The standard material content of one unit of product A is 10kg of material X which
should cost $10 per kilogram. In June 2009, 5750 units of product A were produced
and there was an adverse material usage variance of $1500.
Question 3
In January 2010, 6000 units of product X were produces. There was an adverse
material price variance of $5000. The standard price per kilogram is $10 and 5000kg
were used.
What was the actual material price per kilogram?
a. $11
b. $12
c. $10
d. $11.50
Question 4
The standard direct material cost for a product is $50 per unit (12.5kg at $4 per kg).
Last month the actual amount paid for 45,600kg of material purchased and use was
$173,280 and the direct material usage variance was $15,200 adverse.
a. $8800 adverse
b. $8800 favourable
c. $9120 favourable
d. $9120 adverse
a. 4160 units
b. 3520 units
c. 3344 units
d. 3952 units
395
Question 5
a. 2.01 hours
b. 2.00 hours
c. 1.99 hours
d. 2.02 hours
Question 6
In a period, 7000 units were made. There was an adverse labour efficiency variance
of $30,000. The standard labour rate is $10/hr but workers were paid $12/hr. Total
wages were $204,000.
a. 2.10 hours
b. 1.95 hours
c. 2 hours
d. 2.05 hours
396
Illustration 112
Its budgeted contribution for the last month was $20,000. The actual contribution for
the month was $15,000, and the following variances have been calculated:
A. $9,000 adverse
B. $9,000 favourable
C. $12,000 adverse
D. $12,000 favourable
The total variance between budgeted contribution and actual contribution is $5,000
adverse ($20,000 - $15,000). The sales volume and sales price variances sum to
$4,000 favourable (5,000 A – 9,000 F), so to balance, the variable cost variance
must be $9,000 adverse.
397
Illustration 213
A. $25,000
B. $26,000
C. $28,000
D. $29,000
Add back adverse variances and deduct favourable variances to actual profit to
arrive at budgeted profit.
Avoid double-counting: -
The fixed overhead volume variance ($3,000F is equal to the sum of the fixed
overhead capacity variance ($4,000 F) and the fixed overhead efficiency variance
($1,000 A), so it is important not to include all three and only to deduct $3,000 not
$6,000.
Hence,
Actual profit 27,000
Add Sales price variance 5,000
Less Fixed overhead volume variance 3,000
Budgeted profit 29,000
398
KEY NOTES
399
1. Standard Cost
i. Basic standards
ii. Ideal standards
iii. Attainable standards
iv. Current standards
2. Variance
When actual results are better than expected results, we have a favourable
variance (F). If, on the other hand, actual results are worse than expected results,
we have an adverse variance (A).
3. Sales Variances
The sales price variance = Actual units should have sold for $x
Actual units did sell $x
Sales Price Variance $ x (F/A)
400
The sales volume variance = Budgeted sales volume x units
(marginal costing) Actual sales volume x units
Sales Volume Variance in units x units (F/A)
x standard contribution per unit $x
Sales Volume Variance in $ $x (F/A)
4. Materials Variances
The direct material total variance = actual units should have cost $x
actual units did cost $x
Direct Material Total Variance $ x (F/A)
The direct material price variance = actual kgs should have cost $x
actual kgs did cost $x
Direct Material Price Variance $ x (F/A)
The direct material usage variance = Actual units should have used x kgs
Actual units did use x kgs
Usage Variance in kgs x kgs (F/A)
x standard cost per kg $x
Usage Variance in $ $x (F/A)
5. Labour Variances
The direct labour total variance = Actual units should have cost $x
Actual units did cost $x
Direct Labour Total Variance $ x (F/A)
The direct labour rate variance = Actual hrs should have cost $x
Actual hrs did cost $x
Direct Labour Rate Variance $ x (F/A)
401
The direct labour efficiency variance = Actual units should have taken x hrs
Actual units did take x hrs
Efficiency Variance in hrs x hrs (F/A)
x standard rate per hr $x
Efficiency Variance in $ $x (F/A)
Variable overhead efficiency variance = Actual units should have taken X hrs
Actual units did take X hrs
Efficiency Variance in hrs X hrs (F/A)
x standard rate per hr $x
Efficiency Variance in $ $x (F/A)
402
Fixed overhead volume variance = actual units produced x units
budgeted units produced x units
Volume Variance in units x units (F/A)
x standard rate per unit $x
Volume Variance in $ $x (F/A)
The volume efficiency variance is calculated in the same way as the labour efficiency
variance.
Fixed overhead vol efficiency variance = actual units should have taken x hrs
Actual units did take x hrs
Vol Efficiency Variance in hrs x hrs (F/A)
x standard OAR rate per hr $x
Vol Efficiency Variance in $ $x (F/A)
The volume capacity variance is the difference between the budgeted hours of work and the
actual active hours of work (excluding any idle time).
403
8. Operating Statement – Absorption Costing
The main differences between absorption and marginal costing operating statements
are: -
1. The marginal costing operating statement has a sales volume variance that is
calculated using the standard contribution per unit (rather than a standard
profit per unit as in absorption costing)
2. There is no fixed overhead volume variance
404
Operating Statement for the period ending …….(under Marginal Costing)
$
Budgeted contribution x
Sales Volume Variance x F
Sales Price Variance (x) A
x
Cost Variances $F $A
Materials Price x
Usage X
Labour Rate X
Idle x
Efficiency X
Variable Overheads Expenditure X
Efficiency X
X x (x) A
Actual Contribution x
Fixed Overheads
Budgeted Fixed Overhead x
Expenditure Variance x
Actual Fixed Overheads (x)
Actual Profit X
405
QUESTIONS
406
1. A company’s budgeted sales for last month were 10,000 units with a standard
selling price of $20 per unit and a standard contribution of $8 per unit. Last
month actual sales of 10,500 units at an average selling price of $19.50 per
unit were achieved.
What were the sales price and sales volume contribution variances for last
month?
A. True
B. False
3. A company operates a standard costing system. The variance analysis for last
month shows a favourable materials price variance and an adverse labour
efficiency variance.
The following four statements, which make comparisons with the standards,
have been made:
407
4. A company operates a standard absorption costing system. The standard
fixed production overhead rate is $15 per hour.
A. $7,500 Adverse
B. $7,500 Favourable
C. $10,500 Adverse
D. $10,500 Favourable
5. A company uses standard costing and the standard variable overhead cost
for a product is:
6 direct labour hours @ $10 per hour.
Last month when 3,900 units of the product were manufactured, the actual
expenditure on variable overheads was $235,000 and 24,000 hours were
actually worked.
i. What was the variable overhead expenditure variance for last month?
A. $5,000 Adverse
B. $5,000 Favourable
C. $6,000 Adverse
D. $6,000 Favourable
ii. What was the variable overhead efficiency variance for last month?
A. $5,000 Adverse
B. $5,000 Favourable
C. $6,000 Adverse
D. $6,000 Favourable
6. A company sold 20,000 units in a period when budgeted sales were 18,000
units.
On an absorption costing basis the sales volume profit variance for the period
had a value of $ 10,000. The standard fixed overhead absorption rate was
$4.00 per unit.
408
What would the sales volume contribution variance be on a marginal costing
basis?
A. $2,000 adverse
B. $2,000 favourable
C. $18,000 adverse
D. $18,000 favourable
409
ANSWERS
410
1. A
2. False
3. A
4. B
5. i. B
411
ii. C
6. D
7. C
412
Chapter 21
SPREADSHEETS
21.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Explain the role and features of a computer spreadsheet system
A spreadsheet is a computer package which is divided into rows and columns. The
intersection of a row and a column is known as a cell.
413
Cell contents
414
21.1.2 Formula bar
The formula bar allows you to see and edit the contents of the active cell. The bar
also shows the cell address of the active cell.
All Excel formulae start with the equals sign =, followed by the elements to be
calculated (the operands) and the calculation operators. Each operand can be a
value that does not change (a constant value), a cell or range reference, a label, a
name, or a worksheet function.
Formulae can be used to perform a variety of calculations. Here are some examples:
-
1. =C4*5. This formula multiplies the value in C4 by 5. The result will appear in the
cell holding the formula.
4. =C4*B10-D1. This multiplies the value in C4 by that in B10 and then subtracts
the value in D1 from the result.
Note that generally Excel will perform multiplication and division before addition or
subtraction
415
5. =C4*117.5%. This adds 17.5% to the value in C4, for example in sales tax.
6. = (C4+C5+C6)/3. Note that the brackets mean Excel would perform the addition
first.
Without the brackets, Excel would first divide the value in C6 by 3 and then add
the result to the total of the values in C4 and C5.
1. 2^2 gives you 2 to the power of 2, in other words 22. Likewise = 2^3 gives you 2
cubed and so on.
2. = 4^ (1/2) gives you the square root of 4. Likewise 27^(1/3) gives you the cube
root of 27 and so on.
In Excel, the standard toolbar has a button Σ that simplifies adding a column or row
of numbers. When you click the AutoSum button, Excel creates a sum function for
the column of numbers directly above or the row of numbers to the left. Excel pastes
the SUM( ) function and the range to sum into the formula bar.
416
21.2 ACCA SYLLABUS GUIDE OUTCOME 2:
Identify applications for computer spreadsheets and their use in cost and
management accounting
For example, the spreadsheet above has been set up to calculate the totals
automatically. If you changed your estimate of sales for one of the departments, the
totals will change automatically.
Spreadsheets can be used for a wide range of tasks due to its ability to manipulate a
large amount of data very quickly to answer ‘what-if’questions.. Some common
applications of spreadsheets are:
Management accounts
Cash flow analysis and forecasting
Reconciliations
417
Revenue analysis and comparison
Cost analysis and comparison
Budgets and forecasts
‘What if?’ analysis / sensitivity analysis
Lecture Example 1
1. since formulae are hidden, the underlying logic of a set of calculations may
not be obvious.
2. a high proportion of large models contain errors
3. a database may be more suitable to use with large volumes of data
Lecture Example 2
418
Lecture Example 3
Lecture Example 4
(1) A spreadsheet is the most suitable software for the storage of large volume of
data
(2) A spreadsheet could be used to produce a flexible budget
(3) Most spreadsheets contain a facility to display the data within them in a
graphical form
419
KEY NOTES
420
1. What is a spreadsheet?
2. Cell contents
3. Uses of spreadsheets
421
QUESTIONS
422
1. The following statements relate to spreadsheets. Which statement is false?
A B C D
1
2
3 January February March
4 Production budget
5 Sales (units) 5,000 6,000 8,000
6 Production
A. =5000-6000*0.3=5000*0.3
B. =1.3*C5-D5*0.3
C. =C5=C5*0.3-0.7*D5
D. =C5+ (D5-C5)*0.3
423
ANSWERS
424
1. A
2. D
425
Chapter 22
PERFORMANCE MEASUREMENT
22.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Discuss the purpose of mission statements and their role in performance
measurement
Discuss the purpose of strategic and operational and tactical objectives and
their role in performance measurement
A mission statement contains the overall goals and objectives of the organisation
which are not time specific and not quantified, i.e. what the organization should be
doing in the longer term and how it should go about doing it. Mission statements
often include the following information:
Strategic objectives are often the responsibility of the senior management and will be
measured by indicators that reflect the performance of the whole organisation, e.g.
ROI, net profit %.
Tactical objectives are often the responsibility of middle management and measures
may be used that summarise the performance of a department or division, e.g.
actual profit compared to budget produced monthly.
Operational objectives are often concerned with the day-to-day running of the
organisation and are often physical measures, e.g. quantity of rejects, number of
customer complaints produced daily.
426
Lecture Example 1
Corporate objectives concern the firm as a whole; e.g. profitability, market share,
customer satisfaction quality.
Unit objectives are specific to individual units of an organisation, e.g. increase the
number of customers by x%; reduce the number of rejects by x%, respond more
quickly to calls (especially in the case o hospital ambulance service, local police, and
firemen).
Some objectives are more important than others. Secondary objectives should
combine to ensure the achievement of the primary corporate goals.
427
22.2 ACCA SYLLABUS GUIDE OUTCOME 2:
Discuss the impact of economic and market conditions on performance
measurement
Explain the impact of government regulation on performance measurement
General economic conditions influence the demand and supply for a company’s
products. Government economic policy affects demand quite rapidly. Changes in
interest rates are determined largely by government policy and have a direct effect
on credit sales.
Market conditions
Government regulation
a. The government may raise the taxes on sales and profits and this will surely
affect demand
b. It may provide funds towards new investment and may offer tax incentives
c. It will influence business through the different legislation, e.g. companies act,
employment law, consumer protection rights
d. The government’s economic policy will affect business activity, e.g. interest
rates (mentioned above), inflation, economic growth.
A key aspect of performance measurement is ratio analysis. Ratios are of little use in
isolation. Firms can use ratio analysis to compare: -
428
1. budgets, for control purposes
2. last year’s figures to identify trends
3. competitors’ results and/or industry averages to assess performance
Capital employed is defined as total assets less current liabilities or share capital and
reserves plus non-current liabilities. It is important to exclude all assets of a non-
operational nature, e.g. trade investments and intangible assets such as goodwill.
Profit before interest and tax (operating profit) represents the profit available to pay
interest to debt investors and dividends to shareholders. If we wish to calculate
return on ordinary shareholders funds (the return to equity holders), we would use
profit after interest and tax divided by total equity14.
ROCE represents the percentage of profit being earned on the total capital
employed; and relates profit to capital invested in the business. Capital invested in a
corporate entity is only available at a cost – corporate bonds or loan stock finance
generate interest payments and finance from shareholders requires either immediate
payment of dividends or the expectation of higher dividends in the future.
ROCE rewards investors for the risks they are taking by investing in the company.
The higher the ROCE figure, the better it is for investors. It should be compared with
returns on offer to investors on alternative investments of a similar risk. 15
The primary ratio measuring overall return is analysed in more detail by using
secondary ratios:
support-resources/fundamentals-exams-study-resources/f2/technical-articles/ratio-analysis.html
429
Asset turnover
Return on sales
Good performance is often explained by costs not being controlled and selling
prices being high. It looks at profits after charging non-production overheads.
The trading activities of a business can be analysed using the gross profit margin.
When particular areas of weakness are found, subsidiary ratios are worked out: -
The asset turnover indicates how well the assets of a business are being used to
generate sales or how effectively management have utilised the total investment in
generating income.
The higher the asset turnover the better but do watch out for the problems caused by
overtrading, i.e. operating the business at a level not sustainable by its capital
employed.
430
Lecture Example 2
Below are the financial statements for RCA Ltd for the years ended 30 June 20X8
and 20X9:
Income statements
20X8 20X9
$000 $000
_______ _______
Net profit 37,900 45,800
240,000 330,500
_______ _______
431
Share capital 10,000 12,000
Share premium 4,000 5,000
Revaluation reserve - 30,000
Retained earnings 78,900 99,700
_______ _______
92,900 146,700
Non-current liabilities
Loan 125,000 150,000
Current liabilities
Trade payables 10,600 21,700
Overdraft - 9,100
Taxation 11,500 3,000
_______ _______
240,000 330,500
_______ _______
Required: -
For each of the two years, discuss and calculate the following ratios for RCA
Ltd:-
1. ROCE
2. Asset Turnover
3. Net Profit Margin
4. Gross Profit Margin
Liquidity is the ability of an organization to pay its debts when they fall due. There
are two main measures of liquidity: -
If current assets exceed current liabilities then the ratio will be greater than 1 and
indicates that a business has sufficient current assets to cover demands from
creditors.
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A very high current ratio could indicate that a company is too liquid. Hence this is
not necessarily good as cash is an ‘idle asset as it earns no return. The company
can make use of cheap short-term finance.
Inventory often takes a long time to convert into cash. Hence inventory often takes a
long time to convert into cash. If this ratio is 1:1 or more, then clearly the company is
unlikely to have liquidity problems. If the ratio is less than 1:1 we would need to
analyse the structure of current liabilities, to those falling due immediately and those
due at a later date.
In practice, a company’s current ratio and acid test should be taken into account with
the company’s operating cashflow. A healthy cashflow often compensates for weak
liquidity ratios.
This is an indicator of the effectiveness of the company’s credit control systems and
policy. The faster the money is collected, the better for liquidity purposes. Usually,
the longer customers are given to pay their dues, the higher the level of bad debts.
But, on the other hand, if customers are pressured to pay quickly, the company may
find it hard to generate sales.
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22.3.3.2 Accounts payable payment period
The creditor days is a measure of how much credit, on average, is taken from
suppliers. Long payment periods are good for the customer as they increase
liquidity. However, they may damage the relationship with suppliers.
It is expressed as:
Cost of sales
For how long does a company carry inventory before it is sold? This is expressed
as:
The shorter the period the better for liquidity purposes as less cash is tied up in
inventory. The holding period may increase because of: -
Too little inventory may result in stoppages in production and inability to satisfy
customers’ demand.
The working capital period identifies how long it takes to convert the purchase of
inventories into cash from sales.
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Lecture Example 3
1. Current ratio
2. Quick ratio
22.3.4.1 Gearing/leverage
If the firm has excessive debt, then the need to pay interest before dividends will
increase the risks faced by shareholders if profits fall. Remember that interest and
capital repayments are legal obligations and must be met if the company is to avoid
insolvency. The payment of equity dividend is a legal obligation. Despite its risks,
borrowed capital is attractive to companies as lenders accept a lower rate of return
than equity investors due to their secured positions. Also interest payments, unlike
equity dividends, are tax deductible.16
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22.3.4.2 Interest Cover / income gearing
This ratio represents the number of times that interest could be paid out of profit
before interest and tax. The higher the figure, the more likely a company is to be able
to meet is interest payments. If the ratio is more than 4, it is usually considered to be
safe.
Lecture Example 4
1. Gearing
2. Interest cover
On the other hand, non-financial indicators can provide managers with incentives to
improve long-term financial performance. For example, if customer satisfaction is
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low, this could imply that sales demand will fall in the future and this will have a
negative effect on profits.
In recent years, the trend in performance measurement has been towards a broader
view of performance, covering both financial and non-financial indicators. The most
well-known of these approaches is the balanced scorecard proposed by Kaplan
and Norton.
The scorecard contains four key groupings of performance measures. These four
groupings, called ‘perspectives’, were considered sufficient to track the key drivers of
both current and future financial performance of the firm. The perspectives focused
on the achievements of the firm in four areas: -
2. The customer perspective focuses on the question, what must the firm do to
satisfy its customers so as to achieve its financial objectives?
Outcome measures for the customer perspective generally include measures
of customer satisfaction, market share, customer retention and customer
profitability. These outcome measures can be sub-divided into driver
measures, such as measures relating to lead times, on-time delivery, product
quality and product cost.
3. The internal business perspective considers the question, what must the
firm do well internally in order to support the product/market strategy and to
achieve its financial objectives? Typical outcome measures include those
relating to innovation (product and process) and operations (cycle times,
defect rates).
4. In the learning and growth perspective, the measures focus on the question
what infrastructure must the firm build to create long-term growth and
improvement? In other words, what capabilities must be improved or acquired
to achieve the long-term targets for the customer and internal business
process perspectives? Outcome measures may include metrics on employee
satisfaction, training and retention.
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The balanced scorecard approach to performance measurement offers several
advantages:
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22.4.2 Critical Success Factors and Key Performance Indicators
specific
measurable (i.e. be capable of having a measure placed upon it, for example,
number of customer complaints rather than the 'level of customer satisfaction')
relevant, in that they measure achievement of a critical success factor.
The following table demonstrates critical success factors and key performance
indicators of a college training ACCA students.
The main difficulty with the balanced scorecard approach is setting standards for
each of the KPIs. This can prove difficult where the organisation has no previous
experience of performance measurement. Benchmarking with other organisations is
a possible solution to this problem.
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Lecture Example 5
To which perspective of the balanced scorecard could the measure ‘training day per
employee’ be most appropriately applied?
A. Customer
B. Internal
C. Growth
D. Financial
Lecture Example 6
Perry plc operates a chain of high class hotels throughout the United Kingdom. The
division’s mission statement is ‘To be the hotel of first choice for business users and
tourists’. Although the chain has generally been popular with tourists it is not proving
quite so popular with business users and conference organisers.
Competition in the top segment of the hotel market is fierce, with customers
expecting the highest standards of facilities, service and catering. Over the last two
years the division has invested a large amount of money in modernising its hotels
including the improvement of bedrooms and public rooms, installation of gymnasia
and swimming pools and the information technology features required by business
travellers. A large amount of money has also been spent on staff training to improve
service levels and on a television advertising campaign to promote the improved
hotels to business users.
Head office is concerned that the performance of the hotel chain appears to have
declined over the last few years despite this expenditure.
$million
2001 2002 2003
Capital employed 50 70 90
Operating profit 15 16 17
Required: -
Suggest for each of the following headings two critical success factors
suitable for the hotel chain:
(i) financial success;
(ii) customer satisfaction;
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(iii) process efficiency;
(iv) organisational learning and growth.
For each critical success factor suggest one key performance indicator
suitable for the hotel chain.
(CAT Paper T7 June 2004 Qs. 3 amended)
In view of the large scale of many contracting operations, cost control is very
important.
Effectively, the level of profit being earned on the contract can be checked as each
architect or quantity surveyor’s certificate is received.
Accounting standards only allow revenue and contract costs to be recognised when
the outcome of the contract can be predicted with reasonable certainty. This means
that it should be probable that the economic benefit attached to the contract will flow
to the entity.
441
If a loss is calculated, then the entire loss should be recognised immediately. If a
profit is estimated, then revenue and costs should be recognised according to the
stage that the project has completed.
2. Cost method
Illustration
$
Contract Price 1,000
Estimated total costs 800
Costs to date 600
Agreed value of work done 700
Progress billings invoiced 600
Stage of Completion
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Cost method
In addition, inventory levels and cost targets would be monitored as well as any
bottlenecks identified and removed.
In recent years, the service sector has grown in importance. Banks, accountancy
and consultancy firms, transport companies have all increased. We shall consider six
main aspects of performance in relation to service organisations: -
1. Financial performance
2. Competitive performance
3. Service quality
4. Flexibility
5. Resource utilization
6. innovation
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1. Financial Performance
Because it is difficult to trace many common costs to different units of output and
because of the high level of stepped fixed costs, detailed financial ratio analysis is of
limited use.
2. Competitive Performance
3. Service Quality
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4. Flexibility
5. Resource Utilization
6. Innovation
Innovation can be measured in terms of how much it costs to develop a new service,
how effective the process is and how quickly it can develop new services. Hence, we
can calculate the proportion of new services to the total services provided or the time
between identification of a new service and making it available.
a) Cost
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b) Quality
c) Time
d) Innovation
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22.7 ACCA SYLLABUS GUIDE OUTCOME 7:
Discuss the meaning of each of the efficiency, capacity and activity ratios
Calculate the efficiency, capacity and activity ratios in a specific situation
As mentioned in Section 8.6, the following are the three main control ratios for
measuring performance in manufacturing businesses: -
The efficiency ratio measures the performance of the workforce by comparing the
actual time taken to do a job with the expected time.
Efficiency Ratio =
Expected hours to produce output x 100%
Actual hours to produce output
The capacity ratio measures the number of hours spent actively working as a
percentage of the total hours available for work.
Capacity Ratio =
Number of hours actively spent working x 100%
Total hours available
The activity ratio compares the number of hours expected to be worked to produce
actual output with the total hours available for work.
Production volume/activity
Efficiency ratio x Capacity ratio = ratio
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Lecture Example 7
The personal performance of the manager is not the same as the overall
performance of the responsibility centre he/she manages due to external factors
which are outside of the control of the organization. Hence measures which reflect
the performance of the unit as a whole may not reflect the performance of the
manager.
1. use measures based on controllable costs and revenue e.g. variance analysis in
cost and revenue centres
2. set specific managerial objectives against which performance can be measured
at regular intervals
448
In investment centres, divisional performance is measured using: -
1. Internal benchmarks
Comparisons between different departments or functions within an organization
2. Competitive benchmarks
Comparisons with competitors in the business sector through techniques e.g.
reverse engineering (buying a competitor’s product and dismantling it to
understand its content and configuration)
4. Strategic benchmarks
A type of competitive benchmarking aimed at strategic action and organizational
change
449
22.9.2 The Benchmarking Process
450
Lecture Example 8
A. Internal benchmarking
B. Competitive benchmarking
C. Functional benchmarking
D. Strategic benchmarking
451
KEY NOTES
452
1. Mission Statement
2. Objectives
Strategic objectives are often the responsibility of the senior management and
will be measured by indicators that reflect the performance of the whole
organisation
Tactical objectives are often the responsibility of middle management and
measures may be used that summarise the performance of a department or
division
Operational objectives are often concerned with the day-to-day running of the
organisation and are often physical measures
Mission Statement
Strategic Objectives
3. Measuring Profitability
453
Gross Profit Margin = Gross Profit x 100
Turnover
4. Measuring Liquidity
5. Measuring Efficiency
6. Measuring Risk
7. Balanced Scorecard
454
The financial perspective concentrates on how the firm appears to its
shareholders and considers what the firm’s financial objectives are.
The customer perspective focuses on the question, what must the
firm do to satisfy its customers so as to achieve its financial objectives?
The internal business perspective considers the question, what must
the firm do well internally in order to support the product/market
strategy and to achieve its financial objectives?
In the learning and growth perspective, the measures focus on the
question what infrastructure must the firm build to create long-term
growth and improvement?
9. Contract Costing
Six dimensions: -
Financial performance
Competitive performance
Service quality
Flexibility
Resource utilization
Innovation
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12. Manufacturing Sector
Cost
Quality
Time
Innovation
Production volume/activity
Efficiency ratio x Capacity ratio = ratio
14. Benchmarking
1. Internal benchmarks
Comparisons between different departments or functions within an
organization
2. Competitive benchmarks
Comparisons with competitors in the business sector
3. Functional benchmarks
Comparisons with organisations with similar core activities and practices
4. Strategic benchmarks
A type of competitive benchmarking aimed at strategic action and
organizational change
456
QUESTIONS
457
1. Which of the following is the best definition of return on capital employed?
A. Profit before interest and tax Ordinary shareholders’ funds x 100
B. Profit before interest and tax (Ordinary shareholders’ funds + Non-
current liabilities) x 100
C. Profit after interest and tax Ordinary shareholders’ funds x 100
D. Profit after interest and tax (Ordinary shareholders’ funds + Non-
current liabilities) x 100
2. A firm with current assets of $40 million and current liabilities of $20 million buys
$5 million of inventory on credit which increases its inventory level to $10 million.
What will the effect be on its current ratio and quick (acid test) ratio?
A. Internal
B. Competitive
C. Functional
D. Strategic
Sales $100,000
Cost of sales ($20,000)
Gross profit $80,000
Expenses ($30,000)
Net profit $50,000
A. 50%
B. 80%
C. 62.5%
D. 200%
458
5. Which one of the following is not a perspective of the balanced scorecard?
6. An extract from a company’s trial balance at the end of its financial year is given
below:
$000
Sales revenue (85% on
credit) 2,600
Cost of sales 1,800
Purchases (90% on credit) 1,650
Inventory of finished goods 220
Trade receivables 350
Trade payables 260
Required:
7. The use of the balanced scorecard rather than a profit-based measure is likely to
help solve the following problems:
(1) Subjectivity
(2) Short-termism
459
8. The Eastland Postal Service is government owned. The government requires it to
provide a parcel delivery service to every home and business in Eastland at a low
price which is set by the government. Express Couriers Co is a privately owned
parcel delivery company that also operates in Eastland. It is not subject to
government regulation and most of its deliveries are to large businesses located
in Eastland’s capital city. You have been asked to assess the relative efficiency of
the management of the two organisations.
Which of the following factors should NOT be allowed for when comparing the
ROCE if the two organizations to assess the efficiency of their management?
460
ANSWERS
461
1. B
2. D
Old current ratio = 40:20 = 2:1
New current ratio = 45:25 = 1.8:1
Therefore a reduction of 10%
3. C
4. A (50/100)
5. B
6.
7. B
8. C
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Chapter 23
ECONOMY, EFFICIENCY AND
EFFECTIVENESS
A not-for-profit organisation is ‘… an organisation whose attainment of its prime goal
is not assessed by economic measures. However, in pursuit of that goal it may
undertake profit-making activities.’ (Bois); for example charities, statutory bodies
offering public transport or the provision of services such as leisure, health or public
utilities such as water or road maintenance.
In not for profit organisations, performance is judged in terms of inputs and outputs
and hence the value for money criteria of economy, efficiency and
effectiveness.
463
23.1.2 Indicators to assess overall performance
1. Effectiveness
Financial indicators
Non-financial indicators
a. Workplace morale
b. Staff attitude to dealing with the public
c. Client satisfaction in the service being provided
2. Efficiency
3. Economy
A-value-for-money (VFM) audit will look also at the economy of the use of resources,
for e.g. in the case of state education, it will look into the cost wages of school
teachers, the cost of books, equipment.
Lecture Example 1
A government body uses measures based upon the ‘three Es’ to the measure for
money generated by a publicity funded hospital. It considers the most important
performance measure to be ‘cost per successfully treated patient.
464
Which of the three Es best describes the above measure?
Lecture Example 2
(i) Economy;
(ii) Effectiveness;
(iii) Efficiency
465
KEY NOTES
466
1. Not-For-Profit Organisation
467
QUESTIONS
468
1. The performance of a publicly funded hospital is monitored using measures
based upon the ‘three Es’. The most important performance measure is
considered to be the achievement of hospital targets for the successful
treatment of patients.
469
ANSWERS
470
1. B
471
Chapter 24
RETURN ON INVESTMENT AND
RESIDUAL INCOME
Decentralisation is the delegation of decision-making responsibility. Decentralisation
is a necessary response to the increasing complexity of the environment that
organisations face and the increasing size of most organisations.
Illustration 1
In 2011 a division’s controllable return on investment was 25% and its controllable
profit was $80,000. The cost of capital was 18% per annum.
What was the division’s controllable residual income in the last year?
$80,000____ = 25%
Capital Employed
472
Capital Employed = 80,000 = $320,000
25%
Profit 80,000
Imputed Interest (320 x 18%) 57,600
Residual Income 22,400
Lecture Example 1
Division X is a division of XYZ plc. Its net assets are currently $10m and it earns a
profit of $2.2m per annum. Division X's cost of capital is 10% per annum. The
division is considering two proposals.
Proposal 1 involves investing a further $1m in fixed assets to earn an annual profit of
$0.15m.
Proposal 2 involves the disposal of assets at their net book value of $2.3m. This
would lead to a reduction in profits of $0.3m.
Proceeds from the disposal of assets would be credited to head office not Division X.
Required:
Calculate the current ROI and residual income for Division X and show how
they would change under each of the two proposals.
473
3. the measure may be distorted by inflation as historical cost accounts do not
reflect the current value of the assets
4. ROI may discourage investment and re-equipment in more technologically up to
date assets. Old assets, almost fully depreciated, will give a low asset base in
the ROI calculation, which will result in an increased figure for ROI and give the
impression of an improved level of performance
5. ROI may lead managers to take decisions which are to their advantage but
which do not benefit the organization as a whole - it leads to dysfunctional
behaviour
24.2.3 Advantages of RI
1. investment centre managers see the imputed interest charge – this makes them
aware of the financial implications of their investment decisions
2. RI should avoid dysfunctional decision making – it ensures decisions are taken
which benefit both the investment centre and the company or group as whole –
goal congruency
24.2.4 Disadvantages of RI
Lecture Example 2
A company has a capital employed of $200,000. It has a cost of capital of 12% per
year. Its residual income is $36,000.
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Lecture Example 3
A company wishes to evaluate a division which has the following extracts from
income statement and statement of financial position.
Income statement:
$’000
Sales 500
Gross profit 200
Net profit 120
$’000
Non-current assets 750
Current assets 350
Current liabilities (450)
Net assets 650
Lecture Example 4
475
KEY NOTES
476
1. Decentralisation
3. Residual income
477
QUESTIONS
478
1. In the last year a division’s controllable return on investment was 25% and its
controllable profit was $80,000. The cost of finance appropriate to the division
was 18% per annum.
What was the division’s controllable residual income in the last year?
A. 5.3%
B. 6.7%
C. 26.7%
D. 46.7%
What will be the effect on residual income and return on capital employed if
the division accepts the project?
What will be the residual income of the division after the project is
implemented? _____________
479
5. Which of the following are suitable measures of performance at the strategic
level?
A. 1 and 2
B. 2 only
C. 2 and 3
D. 1 and 3
Would the manager adopt the project if the performance measure was either
(i) Return on Investment (ROI) or (ii) Residual Income (RI)?
480
ANSWERS
481
1. B
25% = 80,000
investment
investment
25%
= $320,000
2. D
= 46.70%
3. B
Current
= 30%
482
After project is accepted
= 29.8%
4. B
6. A
483
Chapter 25
COST REDUCTIONS AND
VALUE ENHANCEMENT
25.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Compare cost control and cost reduction
Cost control essentially involves the setting of targets for cost centre managers and
then monitoring performance against those targets.
Cost reduction is the reduction in unit cost of goods or services without impairing
suitability for the use intended, i.e. without reducing value to the customer. Hence, it
looks at methods of improving profitability by reducing costs without necessarily
increasing prices.
This relates to a policy of reducing the variety ad range of materials and components
purchased by the manufacturer and of components produced.
Its advantages are: -
484
i. The manufacturer can buy or make large quantities, hence gaining the benefit
of reduced unit cost
ii. Having proved the efficiency of a material or component, the manufacturer
knows that the quality and content will not change
iii. Inventory control will be easier as there is a reduction in variety
iv. Better service can be provided to customers in the provision of spare parts
v. Less time will be needed to train operatives who handle the component
i. If there is only one supplier of the material or component, the manufacturer will
be at risk if supplies are interrupted
ii. There may be restriction on the design of a new model if the manufacturer
wishes to continue the policy for economic reasons
iii. For the same reason, a standard component may be used in one model when
it would be better technically if a special component was used.
2. Standardisation of product
This refers to the production of articles to the same standard, or a range of products
each of which is standardised, e.g. a particular model of a car may be available in
different colours but apart from this, the cars are identical.
i. The manufacturer derives the benefit of long runs of production with reduced
unit cost
ii. Tooling is simpler because it is geared to one method of production
iii. Mechanization can be extensive because of the uniformity of the production
method
iv. The consequent buying of large amounts of the same materials and parts
results in a reduction of unit cost
v. Production management is simpler, being confined to standard processes
vi. Less training of operatives is required because the processes do not change
vii. There are fewer demands on the design staff
viii. Inspection costs are low
ix. Customers know they are buying a proven product and that the quality will not
change
i. the manufacturer may feel safe in doing what he knows best and may become
complacent about the success of the product, so that when the product faces
new competition or the public becomes disloyal, he is too slow to recognise it
485
ii. if the product has to be altered, then equipment, technical knowledge and
managerial experience may be too fixed to adapt successfully
Method study is the systematic recording and critical examination of existing and
proposed ways of doing work in order to develop and apply easier and more
effective methods, and reduce costs.
Work measurement involves establishing the time for a qualified worker to carry out
a specified job at a specified level of performance.
A cost reduction team can be used to identify scope for achieving cost reductions but
it is important that costs saved do not outweigh the costs of the team itself.
A cost reduction scheme will also bring about changes. These changes may harm
morale and upset the proper working of departments. Hence, a cost reduction
scheme should have a definite start and finish and should incorporate well-defined
targets.
Lecture Example 1
A. budgetary control
B. value analysis
C. redesigning and simplifying a product
D. using standardised components
17Value engineering – design the best possible value at the lowest possible cost: focus is on the
design stage
486
25.3 ACCA SYLLABUS GUIDE OUTCOME 3:
Describe and evaluate value analysis
Value analysis is a form of cost reduction. Hence, it examines the factors affecting
the cost of a product or service, in order to devise means of achieving the specified
purpose most economically at the required standard of quality and reliability. Are
customers willing to pay for upholstery which is relatively expensive for the
manufacturer to buy? If customers would pay the same price for a car produced with
cheaper upholstery, the company will modify the specification.
Step 1: establish the precise requirements of the customer for a particular product or
service. Hence the manufacturer can establish whether each function incorporated
into the product contributes some value to it.
Step 2: Establish and evaluate alternative ways of achieving the requirements of the
customers. The least cost alternative should be selected.
Step 5: Evaluate feedback from new proposals to establish the benefits from the
change.
487
3. Economic and financial benefits arise from the elimination of unnecessary
complexity and the better use of resources.
Lecture Example 2
488
KEY NOTES
489
1. Cost Control
Cost control involves the setting of targets for cost centre managers and then
monitoring performance against those targets.
2. Cost Reduction
Cost reduction is the reduction in unit cost of goods or services without
impairing suitability for the use intended, i.e. without reducing value to the
customer.
4. Value Analysis
Value analysis is a form of cost reduction. Hence, it examines the factors
affecting the cost of a product or service, in order to devise means of
achieving the specified purpose most economically at the required standard of
quality and reliability.
490
QUESTIONS
491
1. Cost control is concerned with the monitoring of actual costs against planned
or budgeted costs with the aim of identifying variances and taking corrective
action where possible.
A. True
B. False
2. The term used for different methods which try to reduce unit costs without
impairing suitability for the use intended is known as _______
____________.
492
ANSWERS
493
1. True
2. Cost reduction
3. D
494