LECTURE 1

What is management accounting?

- drive successful businesses

- information used by management to plan, evaluate and control

- make better decisions

- improve the e ciency = input to output and e ectiveness = outcome

Main managerial activities: Planning - decision making - controlling

Decision making and control process: (2 main stage)

1. Planning process: identify objectives - search alternative action - select alternative action -
implement decision

2. Control process: compare actual and planned outcomes - respond to divergencies

1. Planning:

- General and speci c goals

- Strategic (long-term) and operational planning

- Identifying and selecting a course of action

- Preparing budgets

2. Decision-making:

- Implementation of objectives / course of action

- Directing and motivating

- Includes day-to-day managerial activities

3. Controlling:

- Ensuring that the plan is actually carried out and it is appropriately modi ed as circumstances
change

- Budget versus actual comparison

- Performance reporting

- Corrective actions and revising plans

The impact of changing business environment on management accounting

- Emergence of global competition

- Changing product life cycles

ffi
fi
ff
fi
 - Advances in manufacturing technologies

- The impact of information technology

- Environmental and sustainability issues

- Pressures to adopt higher standards of ethical behaviour

- Deregulation and privatization

- Focus on value creation

- Customer orientation

Financial Management of the corporation (CFO):

Tax accounting - nancial accounting (cost accounting) - managerial accounting (performance

evaluation, planning support)

Costing: the process of determining the cost of products, services, activities.

Cost object: can be anything to which cost information is ascertained.

Manufacturing costs = product costs

- Direct Material (materials used in the nished product that can be physically traced to it)

- Direct Labour (labour costs that can be directly traced to an individual product)

- Manufacturing Overheads (all costs of manufacturing except DM and DL) - Indirect - machine

Non-Manufacturing costs = period costs

- Marketing costs

- Distribution costs

- Administrative costs

Manufacturing costs:

- Direct costs: Expenditure which can be economically identi ed with, and speci cally measured
in respect to, a relevant cost object. Example: DM (raw materials need to produce a good), DL
(cost of machine operative, worker in a factory)

- Indirect costs: Cannot be speci cally and exclusively identi ed with a cost object, Example:
indirect wages, cost of heating&lighting; rent

Product costs: Identi ed with goods purchased or produced for resale, Importance in inventory
valuation, Recorded in I/S when the good is sold, Example:all manufacturing costs usually - Going
to the balance sheet and when goods are sold its going to the income statement

Period costs: Not attached to products in inventory valuation, Treated as expenses in the period in
which they are incurred, Example: non-manufacturing costs - Going to the income statement

Cost behavior:

- variable cost: Cost which varies directly with changes in the level of activity, over a de ned
period of time - it is a / line on the diagram.

- Fixed costs: Within a given time period they are xed within speci ed activity levels, but they
are eventually subject to step increases or decreases by a constant amount at various activity
levels. It can be a line or a decreasing L or an increasing J

- Semi variable costs: These include both a xed and a variable component. /

- Step xed costs: These include both a xed and a variable component. Steps increasing /

LECTURE 2 - cost assignment

Categories of cost in production:

- Direct costs: Can be accurately identi ed and traced to speci c products, Examples include:
Direct labour, Direct materials

- Indirect cost: Are common and relate to several products, Cannot be traced accurately to one
product, Examples include: Supervisory, Rent, Utilities, Maintenance

- Direct cost tracing: When consumption of resources (labour, material, etc.) is explicit to a
product, E.g.: The production of an o ce desk requires 3 men-hours to assemble and 12kg of
wood and 15kg of steel.

fi
fi
fi
fi
ffi
fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
- Indirect cost allocation: When the consumption of resources cannot be directly traced to a
single product, Because such resources (overheads) serve the production of multiple products,
E.g.: Plant supervisor. Screws and glue to assemble the o ce desk; and polish to complete.

Production cost allocation –2 methods:

- The basis used to allocate cost is called an allocation base or cost driver (an overhead rate, for
example), The principle behind the basis used depends on the signi cance to the determinants
of cost:

- Cause-and-e ect: Where allocation bases are signi cant determinants of the cost., E.g.: Glue
cost allocation based on material receipts

- Arbitrary: Where cost allocation base is used that is not signi cant determinants of its cost.,
E.g. Glue cost allocation based on direct labour hours

Direct costs: (directly attributable to product) and go to inventory

Indirect costs: production overhead which is (absorbed to product) and go to inventory / Non-
production overhead what is (period cost)

Cost assignment systems

- Direct (marginal or variable) costing: Assigns only direct costs to products

- Absorption costing: Assigns both direct and indirect costs to products:

- Traditional costing systems: Job order costing / process costing

- Activity based costing system

Plant-wide (or Blanket) overhead (OH) rate:

Total manufacturing overhead = 9Mill

Total number of direct labour hours = 600k hrs

Plant-wide O/H rate = 9 000 000 / 600 000 = 15dollar / hr - this is an average number, so it
doesn’t shows the numbers of the department.

The two stage allocation process:

- Solves the problem with plant-wide OH rate

- The two-stage allocation process is the approach to establish departmental rates.

- Management accounting sets Cost Centers to identify the locations of production(i.e.

departments)

- Stage one: Overheads are assigned to cost centers

- 1.Assigning all manufacturing overheads to production and service cost centers.

- 2.Reallocating the costs assigned to service cost centers to production cost centers.

- Stage two: Costs accumulated in the production cost centers (in Stage1) are allocated to
products using an allocation basis.

- 3.Computing separate overhead rates to each production cost centre.

- 4.Assign (absorb) cost centre overheads to products.

ff
fi
ffi
fi
fi
Summary of indirect cost assignment process:

- Identify the production departments responsible for creating the products (or services)

- Identify the supporting departments that provide services for the production departments

- (Step1) Assign all indirect (overhead) costs in the company to production and support
departments

- (Step2) Reallocate the support department costs to the production department

- (Step3 ) Calculate predetermined overhead rate for each production department

- (Step4) Allocate (absorb) the department overhead costs to the unit of the individual products
(or services) using the predetermined overhead rates.

Step 1 –Assigning all manufacturing overheads to production and service cost centres

•First,we assign all manufacturing overheads to production and service cost centres
(Departments).

•Indirect labour

•Indirect materials

•Other indirect expenses

•Apportioned across cost centres (departments) on a reasonable and relevant basis, in our
example: taxes - management - depreciation

Step 2 –Reallocating the costs assigned to service cost centres to production cost centres

•The method chosen should be related to the bene ts that the production centres derive from the
services rendered.

•In our example there are two service cost centres:

•Material procurement

•Basis: meterial issues

•General factory support, maintenance

•Basis: direct labour hours

Step 3 –Computing separate overhead rates to each production cost centre.

•At this point all overheads are allocated to production centres.

•The overall aim is to allocate overheads from production centres to products.

•Step 3 is necessary because the production centresmanufacture more than one product

•In step 3 we establish departmental overhead rates to prepare for the allocation (absorption) to
products in step 4.

•The amount of time products spend in each production centre is the most common basis for
allocation (e.g. machine hours, direct labour hours and direct wages)

- CALCULATION : cost centre overhead / Cost centre direct labour hours or machine hours =
overhead absorption rate

Inter-service department reallocations

•The two-stage cost assignment process, in the previous slides, described ascenario when
service departments directly supported production,without using services from each other.

•Very often service departments provide services to each other of which certain portions are
relevant to production.

•For example, thepower department provides heating forthe procurement department,that in turn,
supportsproduction.

Methods of reallocating inter-service costs: Repeated distribution (reciprocal) method

Budgeted overhead absorption rate

•So far, we used actual overhead cost to calculate overhead rates

•In real life budgeted overhead rate are used.

•Actual overhead rate is too late because product costs in this case can be calculated at the end
of the period only.

•Budgeted overhead rate allows for upfront monitoring of product costs to prevent uctuations in
cost cumulation from changes in activity levels:

fi
fl
 CALCULATION: budgeted prod. Overhead / budgeted activity level = bud. Overhead absorption
rate

Over-and under-absorption of overhead

•Note that as long as budgeted level of activity and the actual level of activity is not the same
there is always an Over or Under Absorption situation

•This is because overhead absorption rate is set at the start of the period based upon an
expected level of production and that during the period, the level of output and/or overheads will
be di erent from the planned overheads and or output.

Over-and under-absorption of overhead

•OVER-absorption occurs when the total overhead recovered or absorbed is GREATER than the
actual level of overheads for the period

•UNDER-absorption occurs when the total overheads recovered or absorbed is LESS than the
actual overheads incurred in the period.

CALCULATION: bud. Prod overhead / bud. Act. Overhead = bud. Overhead rate

Accounting for under and over absorption

•When overheads are under absorbed, the balance on the overhead account is Debit.

•When overheads are over absorbed, the balance on the overhead account is Credit.

•At the end of the period the overhead account must be cleared against COS and/ or unsold
inventory.

LECTURE 3 - Absorption and variable costing systems

Absorption and variable costing

•Absorption costing (also known as full costing) traces all manufacturing costs to products and
treats non-manufacturing overheads as a period cost.

•Treatment applied in job-order and process costing systems

ff
 •Variable costing (also known as direct or marginal costing) traces all variable costs to products
and treats xed manufacturing overheads and non-manufacturing overheads as a period cost.

•Therefore, variable and absorption costing di er in the treatment of xed manufacturing overhead
costs.

Cost behaviour

Variable overheads:

Variable costs:
•Relevant to the volumes produced

•Incremental cost to output.

•Fluctuate with the changes in volumes
•When volumes increase variable costs produced

increase
•Directly attibutableto unit of production

•When volumes decrease variable cost •No over/ under recovery

decrease
•Example:

•Direct costs behave as variable cost

•Production supplies

•Some overhead costs behave as variable •Utilities for the equipment Wages for handling
cost
and shipping of the product

•Maintenance of equipment (shifts, seasonal

Fixed costs:
patterns, etc.)

•Irrelevant to output and

•Most of overhead costs behave as xed cost

Fixed overheads:

•Not relevant to volumes produced

•Absorbed based on predetermined

absorption rate

•Over/under recovery incur

•Examples:

•Rents

•Utilities

•Supervisors

Behaviour of manufacturing overhead costs

Non-munfacturing overhead costs

•Cost that cannot be related to the manufacturing process

•Accounted for as period cost

•Examples:

•Administration cost

•Selling expenses

fi
fi
ff
fi
 •Bad debt expense

•Interest expense

Summary: absorption costing pro t variable costing pro t

If the production is higher than sales : higher lower

If the sales is higher than production lower higher

Arguments in support of variable costing

• Variable costing provides more useful information for decision-making.

• Variable costing removes from pro t the e ect of stock changes.

• Variable costing avoids xed overheads being capitalized in unsaleable stocks.

Arguments in support of absorption costing

•Absorption costing does not understate the importance of xed costs.

• Absorption costing avoids ctitious losses being reported (e.g stocks accumulated for seasonal
sales).

• Absorption costing is theoretically superior to variable costing.(Note cost obviation concept

favors variable costing, whereas revenue production concept favors absorption costing.)

Conclusion

•Choice depends on the circumstances.

•Volatile sales and changing stock levels favor variable costing for internal monthly or quarterly
pro t measurement.

•Seasonal sales where stocks are built up in advance favors absorption costing.

•Debate only applies to internal reporting –IAS 2 requires that absorption costing is used for
external reporting.

•Debate only applies when historical cost accounting is used.

Alternative denominator measures

•Theoretical maximum capacity –A measure of maximum operating capacity based on 100%

e ciency with no interruptions for maintenance or other factors.

•Practical capacity –Theoretical capacity less activity loss from unavoidable interruptions (normal
losses).

•Normal activity –A measure of capacity required to satisfy average customer demand over long
term considering seasonal uctuations.

•Budgeted activity –The activity level based on the capacity utilization required for the next budget
period.

LECTURE 4 - Cost volume-pro t analysis

CVP analysis examines the relationship between changes in activity(volume)and changes in total
sales revenue, costs and net pro t.(a short-run method)

Volume–units produces, machine hours worked, number of visitors, passenger mile.

LINEAR CVP RELATIONSHIPS

Constant variable cost and selling price is assumed.

Only one break-even point, and pro t increases as volume increases.

The diagram is not intended to provide an accurate representation for all levels of output. The
objective is to provide an accurate representation of cost and revenue behavior only within the
relevant range of output.

Linear relationship is a good representation only within the relevant range. RELEVANT RANGE–
REVENUE AND COST and RELEVANT RANGE–FIXED COSTS

Break-even point: is that quantity of output where total revenues equal total cost –that is, where
the operating pro t is zero.

Contribution per unit = selling price per unit –variable cost per unit

ffi
fi
fi
fi
fl
fi
fi
fi
fi
fi
ff
fi
fi
fi
 Contribution to sales ratio = contribution per unit / selling price per unit

Break-evenpoint(units)= xed costs/ contribution per unit

Break-evenpoint($) = xed costs/ contribution to sales ratio

Target pro t ($) = ( xed costs+ target pro t) / contribution to sales ratio

Margin of safety: amount of units by which sales can fall before the company starts to generate
loss.

Margin of safety(units)= budgeted sales –break-even sales

Margin of safety(%)= (budgeted sales –break-even sales) / budgeted sales

CVP analysis assumptions

1. All other variables remain constant

• e.g. sales mix, production e ciency, price levels, production methods.

2. Total costs and total revenues are linear functions of output.

3. Pro ts are calculated on a variable costing basis.

4. Single product or constant sales mix.

5. The analysis applies over the relevant range only.

6. Costs can be accurately divided into their xed and variable elements.

7. The analysis applies only to a short-time time horizon.

Changes in xed costs

At the planning stage the rm must decide on how much productive capacity should be provided
and, therefore, the level of xed costs.

If maximum sales levels are 0Q1, 0Q2 and 0Q3, then pro ts are maximized at output level 0Q2.

The rm will choose to provide capacity of 0Q2 and will operate on total cost line AB during the
next period.

Changes in selling price

At the planning stage prior to setting selling prices for the forthcoming period, the rm is
considering whether to reduce the selling price in order to increase demand.

The potential revenue functions are 0A and 0C.

If anticipated demand is 0Q2 at the lower selling price and 0Q1 at the higher selling price, then
the lower price will be selected and the rm will be committed to a revenue function of 0C during
the next period.

Operating leverage is used as a measure of the sensitivity of pro ts to changes in sales.

DOL (degree of operating leverage) = contribution margin / operating income

DOL = % chnsage in operating income / % change in sales

Interpretation of operating leverage:

LOWER OPERATING LEVERAGE:

- Lower xed costs and higher variable costs.

- Break-even point is lower

- Once the business breaks even all additional units will earn a pro t of theSP/u –VC/u. However,
the pro t earned on each unit is low as variable costs are high.

HIGHER OPERATING LEVERAGE:

- Lower variable costs and higher xed costs.

- Break-even point is higher.

- After the break-even is achieved, the company will earn a higher pro t one very product as the
variable cost per unit is very low.

HIGH OPERATING LEVERAGE–E.G. PHARMACEUTICAL COMPANIES

High upfront development costs.

High advertising and commercial costs.

Low direct material and labour costs in the production.

LOW OPERATING LEVERAGE–E.G. ONLINE WEB SHOPS

fi
fi
fi
fi
fi
fi
fi
fi
ffi
fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
 No or very low warehousing costs.

No or very little sales sta .

No site for operation.

LECTURE 5 - Job-order costing system

When job-order costing is relevant

•Where each unit of output of a product is unique

•The cost of each output is calculated separately

•‚Job’ refers to each unique output of product; i.e. represent separate assignments in their own.

•The costs associated with each job are, recorded under a separate job number, thus allocating
the costs to the unique product:

•Each job will incur material costs; labour costs; and overhead costs speci c to the job.

•Examples: custom design products (furniture, vehicles, equipment)

Inventories

•Inventories is the collective term for:

•Raw material

•Work in progress (WIP)

•Finished goods

•Merchandise

•In a brewery:

•Raw materials are barley, wheat, corn and hops

•WIP is the fermentation stage to produce ethanol and carbonation

•Finished goods are bottled or canned beer available for consumption

Factory(manufacturing) overheadcosts

•Depreciation on equipment used in the production process

•Property taxes on the production facility

•Rent on the factory building

•Salaries of maintenance personnel

•Salaries of manufacturing managers

•Salaries of the materials management sta

•Salaries of the quality control sta

•Supplies not directly associated with a unit of product (auxiliarymaterials)

•Utilities for the factory

•Wages of facility management sta

•Overtime and unproductive time

Non-manufacturing overhead costs

•Selling and administrative expenses:

•Bad debt allowance

•Commission charges

•Corporate salaries

•Professional service fees (audit, legal, accounting, etc.)

Accounting procedures for direct material costs

1.When materials received (purchased), materials are recorded as an asset, valued at cost –in the
balance sheet

2.When materials are used in production, materials are transferred to WIP, at cost –in the balance
sheet

3.When WIP is nished, WIP is transferred to nished goods –in the balance sheet

Accounting procedures for indirect material costs

1.When materials received (purchased), materials are recorded as an asset, valued at cost –in the
balance sheet

2.When materials are used in production, materials are transferred to factory overheads at cost –
in the pro t and loss account

3.Using estimated absorption rates, factory overheads are allocated to individual WIP,at cost –into
the balance sheet

fi
fi
ff
ff
ff
ff
fi
fi
 4.When WIP is nished, WIP is transferred to nished goods –in the balance sheet

Accounting procedures for direct labour costs

1.Payroll account for wages –in the pro t and loss account

2.Transfer direct wages to WIP –into the balance sheet

3.When WIP is nished, WIP is transferred to nished goods –in the balance sheet

Accounting procedures for indirect labour costs

1.Payroll account for wages –in the pro t and loss account

2.Transfer indirect labour to factory overhead account –in the pro t and loss account

3.Using estimated absorption rates, factory overheads are allocated to individual WIPat cost –into
the balance sheet

4.When WIP is nished, WIP is transferred to nished goods –in the balance sheet

Accounting procedures for manufacturing overheads –other than indirect materials and indirect
labour costs

1.Other indirect manufacturing costs(i.e. maintenance costs and depreciation) are transferred to
factory overhead account–in the pro t and loss account

2.Using estimated absorption rates, factory overheads are allocated to individual WIPat cost –into
the balance sheet

3.When WIP is nished, WIP is transferred to nished goods –in the balance sheet

Accounting procedures for non-manufacturing overheads

1.Various non-product related expenses (i.e. selling and administrative expenses) are recorded in
non-manufacturing overheads as incurred –in the pro t and loss account

2.Non-manufacturing overheads remain in the pro t and loss account

Accounting procedures for nished goods sold

•When nished goods are sold, the cost of nished goods are transferred to cost of goods sold
(COGS) –in the pro t and loss

•COGS is recorded on delivery, when revenues are earned.

Contract costing:

Scope and objectives

• Contract costing is a job costing system applied to large cost of units

that take more than one accounting period to complete.

• The purpose of contract costing is to allocate:

• Contracts (project) costs;

• Contract revenues; thus

• Pro ts from contracts to the proper accounting periods

Features

• Contracts are executed at contract site away from executor’s orcontractor’s premises.

• Each contract is treated as a separate unit of cost for the purpose of cost assignment.

• The contracts are performed as per the speci cations given by the contractee (the person
placing the order).

• Since the work is performed at the contract site, most of the items of cost to be incurred are
direct in nature.

• The contract is executed by the contractor for some agreed amount of consideration known as
Contract Price.

• The payments by the contractee are made to the contractor in installments on the basis of the
extent of the work already completed by him and certi ed as complete by contractee’s engineer
or architect.

Accounting convensions

• No pro ts recognised at early stage of contract (less than one third complete

• Losses are accrued as incurred and as expected (i.e. provision for onerous contracts)

• Within the 35–85% stage of completion, the following formula is recommended to determine
pro t to date:

CALCULATION: 2/3 x Notional pro t x cash received/value of work certi ed

fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
 (Notional pro t = value of work certi ed - cost of work certi ed)

•If the contract is near (over 85%) completion a proportion of

the pro t should be recognised based on the following

formula:

CALCULATION: (cash received to date / contract price ) x estimated pro t

(esimated pro t = Contract price – Estimated costs)

LECTURE 6 - Joint and by product costing

Whenjointand by-productcostingis relevant

•Where the processingof materialsresult in the production of multipleproducts.In joint production

processes products are not identi able untilla speci c point in the production process is reached,
known as the split-o point.

•Before the split-o point costs incurred are joint and cannot be related to individual items.

•After split-o joint and by-products emerge from the joint production process.

•The allocation of costs to joint and by-product is critical in order to measure inventory and pro ts
in accordance with accounting principles.

Joint products vs. By-products

•The criteria to distinguish joint and by product is based on the relative sales value

•Joint product: When a group of individual products are produced in parallel and each product
has a signi cant sales value.

•By-product: Secondary product resulting from production process that have insigni cant relative
sales value compared to the joint products

Accounting forby-products

The concept:

•By-products aresecondaryand have low sales values

•The joint conversion costs prior to split-o are not allocated to by products

•Only costs associated with further processing of by-products are allocated

•The ultimate objective is to produce joint products

•Sales revenues are not recognised –the gain on sales of by-productsreduce joint process costs

fi
fi
ff
fi
fi
ff
ff
fi
fi
ff
fi
fi
fi
fi
fi
 LECTURE 7 - Process costing

When process costing is relevant

•Similar units of output are produced (that are not unique in their own)

•Output is calculated at average cost per unit (total cost/ total units)

•Mass production with repetitive and routine procedures

•Products produces in the same way consuming same amount of direct costs and overhead

•Examples: pharmaceutical industry, food processing.

Process costing system

•‚Process’ refers to separate production phases performed in di erent departments: (A)Brewing –

(B)Fermentation –(C)Bottling

•No attempt is made to allocate cost to individual units of output

•Direct costs and factory overheads are allocated to process A, B and C

•Completed units are transferred to nished goods at average unit cost

Three scenarios

I.All output fully complete

II.Ending WIP exists, but no beginningWIP

III.Beginning and ending WIP exist

Scenario I. –Process costing when all output is complete

1)No losses within a process

2)Normal losses with no scrap value

3)Abnormal losses with no scrap value

4)Normal losses with scrap value

5)Abnormal losses with scrap value

6)Abnormal gains with scrap value

Normal loss vs. Abnormal loss

Normal loss:

•Inherent to a technology

•Unavoidable, uncontrollable

•Not ine cient –normal

•Component of nished goods

•Abnormal loss:

•Additional loss due to ine ciencies

•Controllable

•Not component of nished goods

•Recorded in P&L for the period

Scrap, spoiled goods, defective goods

•In scenarios 1), 2) and 3) it was assumed that materials were completely used up in the
production of nished goods.

•In normal course of operation some losses of material may take the form of scrap, spoiled or
defective goods.

•Scrap relates to normal and abnormal losses. It is part of the loss attributable to the product that
can be sold separately.

•If normal, do not recognize revenue, credit (reduce) WIP

•If abnormal, do not recognize revenue, credit (reduce) abnormal loss

•Important to capture scrap values(sales price of scrap) in order to „ ne tune” the unit cost of a
product.

Scenario II. –Process costing with ending WIP

•At the end of an accounting period there may be some units that have entered a production
process but the process has not been completed. These units are called closing work in progress
(or WIP)units.

ffi
fi
fi
fi
ffi
fi
ff
fi
•If we assume that there is no opening WIP, then the output at the end of a period will consist of
the following:

•fully-processed units

•part-processed units (closing WIP).

•Closing WIP units become the opening WIP units in the next accounting period.

•It would not be fair to allocate a full unit cost to part-processed units and so we need to use the
concept of equivalent units (EUs) which spreads out the process costs of a period fairly
between the fully-processed and part-processed units

The conceptof equivalentunits(EUs)

Process costs are allocated to units of production on the basis of EUs.

•The idea behind this concept is that a part-processed unit can be expressed as a proportion of a
fully-completed unit.

•In previous scenarios all products were completedand the total costs could be divided by the
units produced to calculate the average unit cost.

•In this case it is not fair to do so because WIP must be converted into completed equivalents

Scenario III. –Beginning and ending WIP

When opening WIP exists two alternative assumptions are possible:

1.Weighted average method –Opening WIP is merged with the units introduces in the current
period –cannot be identi ed separately.

2.FIFO method –Opening WIP is the rst group of units to be processed and completed in the
current period.

fi
fi
 LECTURE 8 - Short term decisions

Concepts Underlying Decision Analysis

Short-run decision analysis is the systematic examination of any decision whose e ects will be
felt over the course of the next year or less.

Incremental analysis: comparing alternatives by focusing on the di erences in their projected

revenues and costs. Incremental analysis helps managers choose the alternative that maximizes
net pro t.

Overview of short-term decisions

Relevant cost

- Future

- Cash ow

- Speci c to decisions

- Opportunity cost

Decisions

- Accept or reject

- Make or buy

- Outsourcing

- Shut down

- Product mix

- Minimum price

- Further processing

Concept of relevant cost

The relevant nancial inputs for decision-making are future cash ows that will di er between the
various alternatives being considered.

Relevant cost:

- Future

- Cash ow

- Incremental (speci c to decision)

Relevant costs may also be

Opportunity costs: the value of a bene t sacri ced when one course of action is chosen in
preference to an alternative. The opportunity cost is represented by the potential bene t forgone.

Avoidable costs: the speci c costs of an activity or sector of a business which would be avoided
if that activity or sector did not exist (associated with shut down decisions).

Irrelevant Costs and Revenues

The rst step in the incremental analysis is to eliminate any irrelevant revenues and costs.

Irrelevant revenues are those that will not di er between the altevrnatives.

Irrelevant costs include costs that will not di er between the alternatives and sunk costs.

Irrelevant Costs and Revenues

The followings are IRRELEVANT (NOT relevant) costs:

Sunk cost: costs that have already been incurred.

Committed costs: these might include the cost of materials under a long-term contract

Notional costs: Non-cash items such as depreciation or the apportionment of general overheads.

fi
fi
fl
fl
fi
fi
fi
fi
fi
ff
ff
fi
fl
ff
ff
ff
fi
Relevant cost of material

Relevant cost of labour

Accept or reject decisions – one-o contracts, (1) accept or reject

- For example, the opportunity to accept an export contract for a home-market product (possibly
with some modi cation) but at a reduced price.

- Determine whether the contract will produce a positive contribution. If so, recommend going
ahead with the contract. If not, reject the o er (If positive, at least xed costs are covered).

With capacity constraints - (2) product mix

- Scarce resource and choice of activities. This situation usually arises due to the scar city of a
raw material or type of skilled labour.

- Determine which activity has the greatest contribution per unit of scarce resource and
concentrate on this activity.

- This will maximize the amount of contribution(and pro t) from the activities able to be
performed before the scarce resource is used up.

The objective of a sales mix decision is to select the alternative that maximizes the contribution
margin per constrained resource.

The decision analysis consists of two steps:

Step 1: Calculate the contribution margin per unit for each product or service a ected by the
constrained resource.

Step 2: Calculate the contribution margin per unit of the constrained resource.

Main question: (3) make or buy

Make or buy problem: decision by an organization about whether it should make a product or
whether it should pay another organization to do so.

fi
ff
ff
fi
fi
ff
 Examples of make of buy decisions - (3) make or buy

- whether a company should manufacture its own components, or else buy the components
from an outside supplier;

- whether a construction company should do some work with its own employees, or whether it

should sub-contract the work to another company;

- whether a service should be carried out by an internal department or whether an external

organization should be employed

Limiting factors in make of buy decisions - (4) outsourcing decisions

- Outsourcing: is the use of external suppliers for nished products, components or services.
(also contract manufacturing or sub-contracting)

- Trend in outsourcing: 1990s: companies concentrate on their core activities and turn other
functions over to specialist contractors.

- Reasons for outsourcing: specialist contractors can o er superior quality and e ciency -
contracting out manufacturing frees up capital - contractors have the capacity and exibility.

- Outsourcing scenarios are very similar to make or buy decisions and therefore you should
approach them in exactly the same way.

- Advantages: cost savings - access to expertise - releases capital - frees up capacity

- Disadvantages: loss of control - impact on quality - how exible, reliable is supplier - potential
loss of con dential information - loss of in house skill - impact on employees morale.

Closure of a divison, a product, a department of a business that appears to be loss-making. - (5)

shut-down decision

- Shut down decisions should NOT be made on the basis of pro tability under absorption
costing as this fails to consider the relevance of xed overheads.

- Shutdown decisions should focus on:

- variablecosts,

- avoidable costs,

- directly attributable costs if the closure is made,

- timing.

fi
fi
fi
ff
fl
fi
ffi
fl
 Further processing decisions - (5) further processing decisions

- In some cases more than one product may be produced from a single process. These products
may sell in their current state or may need further, separate processing before they can be sold.

- A joint product should be processed further past the split o point if sales value minus post-
separation (further processing) costs are greater than sales value at split-o point.

- For example in the oil re ning industry where diesel fuel, petrol, para n, and lubricants are all
produced from the same process.

Cost accumulation of further process decisions - (5) further processing decisions

Costs of the process will need to be apportioned between the products created by the process in
order to:

- Value inventory

- Prepare nancial accounts.

These costs are NOT relevant in the decisions as:

- Sunk

- Arbitrary apportioned.

The total joint cost may be relevant for the decision regarding the viability of the process as a
whole.

Joint costs can be apportioned between products based on:

- Physical quantity

- Relative sales value

- Net realizable value

(6) - Minimum price decisions

- Minimum price scenarios are dealt with in the exactly the same way as the other examples we
have seen so far.

- The minimum price quoted must be the relevant cost. Never be tempted to add on amount of
general overheads that a question may tell you is allocated to each job or a pro t mark up.
These items are not relevant.

- If the company has no limiting factor that the job’s minimum price is its variable cost.

- If there are scarce resources (eg.machine hour) then the minimum price of a job is the variable
cost plus the opportunity cost.

- Opportunity cost is the forgone contribution generated by the products excluded from the
production plan.

fi
fi
ff
ffi
ff
fi
 Lecture 9 - Budgeting

The basis for planning and control

A budget is a comprehensive nancial plan for achieving the nancial and operational goals of an
organization

Planning: Developing objectives for acquisition and use of resources.

Control: Steps taken by management to ensure that objectives are attained.

Strategic, planning, budgeting and control process

Multiple functions of a budget

De nition of the budget: short term plan for the organization prepared for up to a year ahead
derived from long term plans

Bene ts:

- Enhanced management responsibility

- Performance evaluation

- Coordination of activities

- Assignment of decision making responsibilities

Purpose of the budgeting

▪ Quantify future plans

▪ Set performance objectives and targets

▪ Co-ordinate departmental activities

▪ Communicate plans and objectives

▪ Motivating managers

▪ Control and evaluate business performance

fi
fi
fi
fi
 The link between objectives and the budge (goals and objectives)

S.M.A.R.T.

– Speci c

– Measurable

– Attainable

– Relevant

– Time-bound

Budget is the translation of the organizational business objectives and nancial goals into actual
values.

- Corporate objectives

- Business objectives

- Operational objectives

- Individual objective

Stages in the budgeting process

1. Prepare and circulate timetable to involved persons

2. Identify the key commercial factors that will a ect the business

3. Prepare a set of guidelines stating the key budget factors and conditions

4. Prepare the draft budgets at departmental level including explanations where guidelines have
not been met in full

5. Review and revise draft budgets following discussion

6. Draft the consolidated master budget

The budget is usually prepared for 1 year and traditionally it is split into 12 periods (months).

The process of communication

▪ A budget committee should be constituted.

▪ Following points should be communicated:

▪ Statement of the objectives of budgetary planning and control and the procedures to be used to
ensure uniformity of approach

▪ A de nition of responsibilities for each person involved

▪ A timetable for the preparation of the budget

▪ The budget control periods

▪ The responsibility centre for the preparation of each budget

▪ The cost codes to be used for cost collection and classi cation

▪ The standardized report layouts to be used by each unit to assist in consolidation

fi
fi
ff
fi
fi
Components of the master budget (operating budget)

The budgetary control process

▪ The quality of budgeting process lies in the level of monitoring.

▪ The role of exible budget and exed budget

▪ The tool is called variance accounting (variance analysis).

▪ Determining variances

▪ Revealing the potential causes of variances

▪ Favourable variances

▪ Adverse variance

▪ Preparing the variance report

Budget and motivation

▪ Budgets are used to set targets and to raise individual performance.

▪ Researches say:

▪ Budgets have no motivational e ect unless they are accepted by the managers

▪ The more demanding the budget target is the better the results achieved

▪ Demanding budget: more relevant and di cult targets

▪ Good communication helps to accept the budget

Incremental budgeting

▪ The budget is based on the current year’s actual results plus an extra amount for estimated
growth and in ation.

▪ For certain cost types incremental budgeting may be appropriate in a stable environment.

▪ Advantage

▪ Easy

▪ Disadvantage

▪ Unnecessary spending

fl
fl
fl
ff
ffi
 ▪ Budgeting slack

▪ No business scrutiny

Rolling budget

▪ It is particularly useful when an organization is facing a period of uncertainty making it di cult to

prepare accurate forecasts.

▪ Rolling budgets are an attempt to prepare targets and plans which are more realistic and
certain.

▪ Instead of preparing a periodic budget annually for the full budget period, budgets would be
prepared for 12 months ahead. The budget is extended by an extra months as the current
month ends.

▪ Advantages:

▪ Reduce the element of uncertainty

▪ Managers have to regularly reassess the budget

▪ Planning and control is based on more realistic plans

▪ Disadvantage:

▪ E ort and expense required to update budget on an ongoing basis

▪ May demotivate managers

Zero based budgeting

- Principle: next year’s budget is zero > start from the drawing board

- Assumption: expenditures from the previous periods do not re ect e cient operations.

- ZBB is useful in controlling indirect o/h costs.

- For each unit the following will need to be documented:

- The unit’s objective

- The unit’s present activities

- Justi cation for continuation of the unit’s activities

- A list of alternative ways of carrying out the activities

- Selection of recommended alternatives

- Budget required

Criticism of budgeting

• Encourages rigid planning and incremental thinking;

• Very time-consuming;

• Produce inadequate variance reports leaving the ‘how’ and ‘why’ questions unanswered;

• Ignores key drivers of shareholder value by focusing too much attention on short-term nancial
numbers;

• Represents a yearly rigid ritual;

• Commits the company to a 12 month commitment, which can be risky if budgets are based on
uncertain forecasts;

• Often based on only the lowest targets rather than attempting to beat the targets;

• Encourages spending what is in the budget even if this is not necessary in order to guard
against next year’s budget being reduced;

• Focus on achieving the budget even if this results in undesirable actions.

ff
fi
fl
ffi
fi
ffi
Lecture 10 - Standard costing and variance analysis

Standard costs are predetermined costs for a unit; they are expected costs that should be
incurred under e cient operating conditions.

Purpose of standard costing

- Providing a prediction of future cost that can be used for decision-making purposes.

- Providing a challenging target which individuals are motivated to achieve.

- Assisting in setting budgets and evaluating managerial performance.

- Acting as a control device by highlighting activities that do not conform to plan.

- Simplifying the task of tracing costs to products for pro t measurement and inventory
valuation.

Use of standard costs in developing budgets

Are standards the same as budgets?

- A standard is the expected production cost for one unit.

- A budget is the expected cost for all units.

When can we apply standard costing?

• Input required to produce a unit can be speci ed.

• Relevant mostly in manufacturing companies but can also be applied in services where the
processes are standardizable.

• Can be applied to organizations producing many di erent products as long as production

consists of a series of common operations.

Standard costing is most suited to organizations whose activities consist of a series of common
or repetitive operations.

Standards can be used to develop the production budget.

Establishing and revising standard costs

Basic cost standards: represent constant standards that are left unchanged over long periods.

Ideal standards: represent perfect (100 %) performance.

Currently attainable standards: they are standards that are di cult but not impossible to
achieve.

Standard quantity is the quantity that should have been used for the actual good output.

Standard price is the amount that should have been paid for the resources acquired.
ffi
fi
ff
fi
ffi