CA4012 Cost Accounting

CHAPTER 3: MANAGEMENT RESPONSIBILITY AND PERFORMANCE

MEASUREMENT

KEY LEARNING OBJECTIVES

• Distinguish between cost centres, profit centres, revenue centres and investment centres.
• Types and application of performance measures to cost, profit and investment centres

Responsibility accounting is a system of accounting that segregates revenue and costs into areas of
personal responsibility in order to monitor and assess the performance of each part of the organisation.

RESPONSIBILITY CENTRES

COST CENTRE REVENUE CENTRE PROFIT CENTRE INVESTMENT

CENTRE
• A production or service • A centre whose • A centre whose • A centre whose
department, function, manager is manager is manager is
activity or item of accountable for accountable for both accountable not
equipment for which sales generated costs incurred and only for both sales
costs are separately but not for costs revenues generated. and costs, but has
collected for further incurred by the • The manager of a responsibility and
analysis. department. profit centre is authority to make
• Costs of one cost centre • Revenue centre someone who is decisions
can be apportioned to managers can very senior and who regarding working
another cost centre. also be held is able to make policy capital and capital
• The cost centre accountable for decisions affecting investment.
manager is only selling expenses. both revenue and • The manager
accountable for costs costs. would be at the
under their control. highest level.
Examples: Examples: Examples: Examples:
• Stores department in a • A department • An individual • A subsidiary in a
printing factory. which obtains branch of a group of
• Factory departments like grants and hairdressing chain companies.
machining and assembly donations for a which would incur • A whole company.
are known as production charity. costs and generate • A large division in a
cost centres. • The Regional Sales revenue. large group of
• A finance or Office. • A restaurant in a companies.
administration hotel.
department.

Note: The cost accounting system collects costs and/or revenues for each responsibility centre. A profit
centre can be made up of many revenue and cost centres.
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COST CENTRE
Productivity
• Output in relation to
input.
• Units produced per hour
/ per employee/ per
tonne of material.
Cost per unit
= production costs
total units produced
Note: In order to assess managerial or organisational performance, performance measures are calculated for
the purpose of comparison against:
- previous periods
- other departments within the same organisation
- targets
- competitors
- similar organisations
Cost Accounting
PERFORMANCE MEASUREMENT
REVENUE PROFIT CENTRE INVESTMENT CENTRE
CENTRE
• Actual results Gross profit margin Return on capital
measured = gross profit x 100% employed (ROCE) or
against sales return on investment
revenue (ROI)
targets/ target Profit margin
market share. = operating profit x 100% = EBIT x 100%
sales Capital employed
• Customer
rejects/ Cost/ sales ratio ▪ Capital employed excludes
returns vs total • production cost: sales all assets of a non
sales • administration cost: operational nature like
sales trade investment and
goodwill.
• Customer • marketing costs: sales
satisfaction ▪ EBIT = earnings before
survey/ Note: All measures used for
interest and taxes
cost and revenue centres can
questionnaires
be used to measure
. performance for profit Residual income (RI)
centres.
• Deliveries late = Pre-tax profit less notional
vs deliveries on interest charge for
schedule invested capital (i.e.
x % X capital employed)
• Number of
people served Asset turnover
per time = Revenue (sales) times
period Capital employed
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Apple
Computer

Branch HQ Branch
Investment centre
(California) (Florida) (Los Angeles)

iPad iPhone iPod

Revenue Centre
Division Division Division

Sales & Production R&D Cost Centre

Marketing Dept Dept Dept

PERFORMANCE MEASURES FOR COST CENTRES

Measures of Productivity/Efficiency/Cost Control

Output v Input
An indicator of how efficiently resources are being used. Given a certain amount of resources, how
many units of output did the cost centre produce?
Example
Number of units per hour
Number of units per employee
Number of units per tonne of material

Comparison of actual costs v expected costs

Comparison with historical data (eg actual cost this period v actual cost for the same period last year)

Cost per unit

= production cost
number of units of output

Standard hour
Used to measure output when a number of dissimilar products are manufactured. The standard hour
is the quantity of work achievable at standard performance, expressed in terms of a standard unit of
work done in a standard period of time. Standard time is determined by time/motion studies under
normal manufacturing conditions. Use of standard hours enables the following control ratios to be
calculated:

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Example – The standard hour

ABC Ltd manufactures three types of electrical appliances – microwave ovens, oven toasters and
blenders. The following output was produced during the month of June:

Product Type Actual output Budgeted output

(units) (units)
Microwave oven 150 140
Toasters 355 300
Blenders 115 130
Total output 620 570

It is difficult to assess how well ABC Ltd has performed by merely adding up the total number of units
produced. In this case it would be meaningless to compare 620 vs 570 units of three very different
products. Even comparing the product mix would not give any information as to whether the company
is operating efficiently.

Where a numberof dissimilar products are manufactured, output should be compared using the standard
hour. If the standard amount of time allowed to produce one unit of each type of product is known, then
the following calculation would be more useful.

(A) (B) (C) (A) x(B) (A) x (C)

Product Type Standard Actual Budgeted Total Total
hours per output output standard budgeted
unit (units) (units) hours hours
Microwave oven 3 hours 150 140 450 420
Toasters 1 hour 355 300 355 300
Blenders 1.5 hours 115 130 172.5 195
Total 977.5 915

Comparing total standard hours and budgeted hours, it can be said more output was produced than
expected. In this situation, this could be explained by the fact that more units of the time-consuming
microwave ovens were produced than expected. The increase in time consumed more than offset the
decrease due to a lesser number of blenders being produced than expected.

If the “standard hours” used in this example were actually labour hours worked, then it could be said
that the workers would be expected work harder than originally planned.

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PERFORMANCE MEASURES FOR REVENUE CENTRES

• Quantitative as well as qualitative measures can be used.

• Traditional measures
(i) actual v target market share classified by country, region, product, sales person,etc
(ii) actual sales ($ or number of units) v sales targets

• Customer focused organisations now supplement their traditional measures with other performance
indicators. Commonly used qualitative measures of performance:
(i) Manufacturers
- late deliveries vs on-time deliveries
- time from approval to launch of new products
- customer rejects/returns vs total sales
(ii) Airlines
- flight delays v departures on schedule
- customer satisfaction surveys
- average length of flight delays
- check in time per passenger
- customer complaints v compliments
(iii) Banks/supermarkets
- length of time in queue per customer
- no. of customers served per hour per staff

PERFORMANCE MEASURES FOR PROFIT CENTRES

• Objective – improve profit margins by maximising selling price or reducing excessive costs.
• Same considerations as for revenue and cost centres.
• Revenue – Cost = Profit

Types of measures
(a) Financial measures
• Net profit margin (net profit ÷ sales)
• Gross profit margin (gross profit ÷ sales)
• Cost to sales ratios.

(b) Non-financial measures

Example:
- machine down time vs total machine hours (Measures how efficiently machines are being used)
- value added time vs production cycle time (Value added time means productive time when the
product is actually being made. Production cycle time usually means total working hours
which includes idle time, set up time and downtime. It is not possible to achieve ratio of
100%. A high ratio means non-value-added activities are being kept to a minimum)
- actual v expected cost/time – for materials, labour and variable overheads

(c) Qualitative measures - use of surveys and questionnaires and interviews to measure customer service
performance, communications skills and interpersonal skills.

(d) any other measures used for cost centres and revenue centres.
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Example – Gross Profit and Net Profit Margins

The following is the income statement for Hiyo Enterprises:

RM’000
Sales 5,000
Cost of Sales (3,800)
Gross Profit 1,200
Selling expenses (300)
Administrative expenses (200)
Net / Operating profit 700

Gross Profit Margin = 1200/5000 = 24%

Net Profit Margin = 700/5000 = 14%

Example – Cost/Sales ratio

From the figures in example above, calculate the relevant cost/sales ratios.

Cost of Sales to Sales ratio

= 3800/5000
= 76%

Selling expenses to Sales ratio

= 300/5000
= 6%

Administrative expenses to Sales ratio

= 200/5000
= 4%

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PERFORMANCE MEASURES FOR INVESTMENT CENTRES

Return on investment (ROI) or Return on Capital Employed (ROCE)

• measurement of profit as a percentage of money invested

= profit before interest and tax X 100%

capital employed

Different definitions of profit are usually used but the most widely used is profit before interest and
taxes .This is on the basis that managers should not be made responsible for interest rates and tax
rates which are beyond their control.

• Capital employed is the funds used by the business to generate profits. The formula for capital employed
is:
(i) Capital + Non-Current Liabilities; or
(ii)Total Assets – Current Liabilities.

• ROI/ROCE is shown as a percentage rate per annum.

Example – Calculating ROI or ROCE

A company has the following annual figures for 2013:
2013
(RM)
Sales 50,000
Cost of Sales (10,000)
Gross Profit 40,000
Expenses (including taxes of RM5,000) (15,000)
Net Profit 25,000

Assets 250,000
Liabilities (Current) 150,000

Capital Employed = 250,000 – 150,000 = 100,000

Profit before interest and taxes = 25,000 + 5,000 = 30,000
ROI/ROCE = 30,000/100,000 = 30%

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Residual Income (RI)

• Measures a centre’s profits after deducting a notional or imputed interest cost on capital
employed.

= Operating profit – (Notional interest rate x Capital employed)

• It is usually used in assessing a situation where the investment centre does not borrow directly from the
bank but is funded by Head Office. Therefore, Head Office would want the investment centre to earn a
minimum profit to cover at least the head office borrowing cost (or “notional interest”).

• Notional or estimated interest does not involve any cash payment to Head Office. It is merely an
accounting adjustment. It is expressed as a percentage which represents the estimated interest cost or
required rate of return or cost of capital on the amount invested by Head Office in the investment centre.

Example – Residual Income

A division with capital employed of RM450,000 currently earns a ROI of 20%. It is considering making
an additional investment of RM50,000 on a project with a 4 year life and no residual value. The average
net profit from this investment would be RM12,500 per annum. A notional interest charge amounting to
12% pa of the amount invested is to be charged to the division each year.

The residual income of the division before investment will be

= (450,000 x 20%) – (450,000 x 12%)
= 90,000 – 54,000
= RM36,000

The residual income of the division after investment will be

= [(450,000 x 20%) +12,500] – [(450,000 + 50,000) x 12%]
= 102,500 – 60,000
= RM42,500

Generally, if residual income is positive then there is an increase in wealth. The above calculation
shows that the new investment will add to the overall wealth of the business.

Asset Turnover
• Measures the organisation’s ability to generate sales from utilising existing assets.
• Indicates how efficiently the assets of an organisation are being used to generate sales. (c) It is
expressed as the number of times sales covers the net assets of the business.

= Revenue (Sales) = x times

Capital employed

• Generally, the higher the number, the better.