CHAPTER 1 THE SCOPE OF MANAGEMENT ACCOUNTING

Introduction This is Paper L2 of the ZICA Accountancy Programme. This chapter will give an introduction to management accounting. This chapter provides definitions and the link etween management accounting and financial accounting. The chapter will go further to e!plain various terminologies" which form the asis for the #anagement Accounting framework which are relevant in commerce and industry whether e it Pu lic $ector or Private $ector. Contents %. The need for #anagement Accounting systems. 2. &efinition of #anagement accounting. '. Comparison of (inancial accounting and management accounting. Learning outcomes After studying this chapter the student should e a le to) &efine #anagement Accounting Compare and contrast financial and management accounting. *utline the managerial process of planning" decision+making and control.

1.0

MANAGEMENT ACCOUNTING

#anagers need detailed information a out the working of the usiness to ena le them plan" control and make decisions. #anagement accounting systems provide financial information regarding the financial aspects of usiness performance needed y management. %.% Management accounting

#anagement accounting is the application of the principles of accounting and financial management to create" protect" preserve and increase value so as to deliver that value to the stakeholders of Profit and ,ot (or Profit enterprises oth pu lic and private. 2.2.% FINANCIAL ACCOUNTING AND MANAGEMENT ACCOUNTING (inancial accounting is the classification and recording of the monetary transactions of an entity in accordance with esta lished concepts" principles" accounting standards and legal re.uirements and their presentation y means of Profit and Loss Accounts" /alance $heet and Cash (low $tatements" during and at the end of an accounting period. #any usinesses have a financial accounting system with a nominal ledger" sales ledger and purchases ledger and ooks of prime entry for recording transaction that have occurred during a given period. Comparison o inancia! accounting and management accounting Financia! accounts Limited companies are re.uired prepare y law to financial Management accounts There is no

2.2

2.'

legal

re.uirement to prepare management accounts. #anagement accounting formats are entirely at the discretion management. #anagement incorporate accounts oth of

accounts. The law and financial reporting prescri e pu lished statements. #ost standards formats of financial financial

accounting information

is of a monetary nature. (inancial accounts

monetary

and

non+

monetary measures. #anagement accounts are oth historical record and future planning tool.

present an essentially historic picture of past operations.

C"A#TE$ %UMMA$& 0nder this Chapter has een covered) &efinition of #anagement Accounting &efinition of (inancial Accounting Comparison of #anagement Accounting with (inancial Accounting

%ELF $E'IE( )UE%TION% %ELF TE%T )UE%TION% %. &efine management accounting 2. 1ighlight key differences etween management accounting and financial accounting

'

CHAPTER 2 VARIANCE ANALYSIS

INT$ODUCTION 1aving introduced the concept of standard costing in the previous level" this stage will deal with the computation of cost and sales variances and e!planation of the possi le causes of variances. After demonstrating the computation of cost and revenue variances" they will e summari2ed in the operating statement as a asis for reconciling udgeted and actual profit. CONTENT% %. 2. '. 4. 5. 6. 7. 3ariance accounting. La our variances. #aterial variances. *verhead cost variances. $ales variance. *perating statement. Causes of variances. LEA$NING OUTCOME% After studying this chapter you will e a le to) 8now what is meant y variance and variance analysis. 0nderstand the relationship etween variances. Calculate revenue and cost variances. Prepare the operating statement. 9!plain the causes of variances.

1.0

'A$IANCE ANAL&%I%

A variance is defined as) The difference etween a planned" udgeted" or standard cost and the actual cost incurred. The same comparison may e made for revenues. %.% 3ariance analysis is defined as) The evaluation of performance y means of variances" whose timely reporting should ma!imi2e the opportunity for managerial action.
C h a r t o f c o m m o n v a r ia n c e s o p e r a t in g p r o f it v a r ia n c e T o t a l c o s t v a r ia n c e T y p e t it le h e r e T o t a l L a b o u r v a r ia n c e T o t a l M a t e r ia l V a r ia n c e T o t a l v a r ia b le o v e rh e d v a r ia n c e E x p e n d it u r e V a r ia n c e E f f ic ie n c y V a r ia n c e T o t a l ix e d ! v e rh e a d V a r ia n c e V lu m e V a r ia n c e C a p a c it y v a r ia n c e E x p e n d it u r e V a r ia n c e T o t a l s a le s m a r g in v a r ia n c e " a le s m a r g in p r ic e v a r ia n c e " a le s m a r g in # u a n t it y V a r ia n c e

R a te v a r ia n c e

E f f ic ie n c y V a r ia n c e

P r ic e V a r ia n c e

U sage V a r ia n c e

E f f ic ie n c y v a r ia n c e

:hen actual results are etter than e!pected results we have a favoura le variance and when the actual results are worse than the e!pected results" we have an adverse variance %.2 3ariances can e divided into three main groups 3aria le cost variance (i!ed production overhead variances $ales variance

1.*

+E& ILLU%T$ATION

The following e!ample will e used to illustrate the computation of all variances including the preparation of an operating statement. 8ipata #anufacturing Company produces a single product which is known as 8iwaya. The product re.uires a single operation and the standard cost for this operation is presented in the following standard costs card.

STANDARD COST CARD

&irect materials #aterial < -.5kgs = 84-"--->8g 8;--2-

&irect La our ?rade A

2 hours = 82-"--->1r 2 hours = 8'"--->1r 2 1rs = 8'7"--->hr

4-

3aria le Production overhead (i!ed Production overhead Total standard cost $tandard Profit %tandard #rice

74

%46,00

/udgeted output for @une was 5"%-- units. Actual results for @une were as follows) Production of 4"A5- units was sold for 8 %"-42.75 million. #aterials consumed in production amounted to 2"'-- kilos at a cost of 8BA.B million La our hours paid amounted to A"--- hours at a cost of 8%62 million Actual varia le overheads amounted to 826 million (i!ed over heads amounted to 842' million

$E)UI$ED This information will e used to define and calculate the following variances) 1.-0 TOTAL DI$ECT MATE$IAL CO%T 'A$IANCE% The direct material cost variance is the difference etween what the output actually cost and what it should have cost in terms of materials. Total direct material co t !aria"ce = (Standard material cost per unit # Actual units produced) (Actual cost of materials) 0sing the data a ove)

DIRECT MATERIAL VARIANCE CALCULATION

$tandard material cost per unit ,um er of units produced Actual cost C Total material variance C 82-"--4"A5- units 8BA"B--"--D4"A5- ! 82-"---E F DBA"B--"---E + 1./00. 000 0A1

1.-1

DI$ECT MATE$IAL #$ICE 'A$IANCE

This is the difference etween the standard cost and the actual cost of the actual .uantity of materials used or purchased. In other words it;s the difference etween what the material did cost and what it should have cost. $irect Material Price Varia"ce = (SP where: SP = Standard Price AQ = Actual Quantity QP = Quantity Purchased AP) x QP

0sing the data a ove)

DIRECT MATERIAL PRICE VARIANCE CALCULATION

$tandard material price per 8ilo Guantity of materials purchased Cost of materials purchased #aterial Price 3ariance C 82-"--4"A5- units 8BA"B--"--H4-"--- F DBA"B--"--->2'--EI ! 2"'-D4-"--- F 4'"---E ! 2"'-+2./00.000 0A1

1.-,

DI$ECT MATE$IAL U%AGE 'A$IANCE

This is the difference etween the standard .uantity of materials that should have een used for the num er of units actually produced and the actual .uantity of materials used valued at the standard cost per unit of material. $irect Material U a%e Varia"ce = (SU AU) x SP here: SU = Standard Usa!e = "um#er of units produced x standard usa!e per unit AU = Actual Usa!e SP = Standard Price

DIRECT MATERIAL USAGE VARIANCE CALCULATION

$tandard #aterial price per 8ilo 82-"---

Actual materials used $tandard material usage per unit ,um er of units produced #aterial 0sage 3ariance C

2"'-- kilos -.5 kg 4"A5HD4"A5- ! -.5E+ 2'--I ! 84-"--D2"425+ 2"'--E ! 4-"--- 3 +4.000.000 0F1

1.40

TOTAL DI$ECT LA5OU$ CO%T 'A$IANCE% The direct la our cost variance is the difference etween what the output actually cost and what it should have cost in terms of la our. Total direct la&o'r co t !aria"ce =
(Standard la#our cost per unit # Actual units produced) (Actual cost of la#our)

0sing the data a ove)

DIRECT LABOUR COST VARIANCE CALCULATION

$tandard La our cost per unit ,um er of units produced Actual cost C Total material variance C 1.41 84-"--4"A5- units 8%62"---"--D4"A5- ! 84-"---E F D%62"---"---E + *,.000. 000 0F1

DI$ECT LA5OU$ $ATE 'A$IANCE

This is the difference etween the standard cost and the actual cost of the actual num er of hours used. In other words it is the difference etween what the la our did cost and what it should have cost. $irect La&o'r Rate Varia"ce = (S$ - A$) x A% here: B

S$ = Standard $ate A% = Actual %ours A$ = Actual $ate 0sing the data a ove)

DIRECT LABOUR RATE VARIANCE CALCULATION

$tandard La our rate per hour La our hours used Actual La our cost La our Jate 3ariance C 82-"--A"--- hours 8%62"---"--HD82-"--- F D8%62"---"---"--->A"---EI ! A"--D2-"--- F 2-"25-E ! A--+,.000.0000A1

1.4,

DI$ECT LA5OU$ EFFICIENC& 'A$IANCE

This is the difference etween the standard of la our that should have een used for the num er of units actually produced and the actual num er la our hours used valued at the standard la our hour rate. $irect La&o'r E((icie"c) Varia"ce = (S% - A%) x S$ here: S% = Standard %ours for actual production = "um#er of units produced x standard usa!e per unit A% = Actual %ours ta&en to produce the output S$ = Standard $ate per hour

DIRECT LABOUR EFFICIENCY VARIANCE CALCULATION

$tandard La our 1ours per unit Actual La our hours used $tandard La our hours per unit ,um er of units produced #aterial 0sage 3ariance C 82-"--A"--- 1ours 2 1ours 4"A5HD4"A5- ! 2E+ A"---I ! 82-"--DB"7--+ A"---E ! 82-"--- C

%-

+*-.000.000 0F1 1.20 TOTAL 'A$IA5LE #$ODUCTION O'E$"EAD 'A$IANCE The difference etween what the output should have cost and what it did cost in terms of varia le production overheads. TOTAL 'A$IA5LE #$ODUCTION O'E$"EAD (Standard 'aria#le o(erhead cost per unit # Actual units produced) (Actual cost of 'aria#le production o(erheads) 0sing the data a ove)

TOTAL VARIABLE PRODUCTION OVERHEAD COST VARIANCE CALCULATION

$tandard 3*1 cost per unit ,um er of units produced Actual cost C Total 3*1 cost variance C 86"--4"A5- units 82"6--"--D4"A5- ! 86"---E F D826"---"---E + *.100. 000 0F1

1.21

'A$IA5LE O'E$"EAD E6#ENDITU$E 'A$IANCE

This is the difference etween the amount of varia le overheads that should have een incurred in the actual hours actually worked and the actual amount of varia le overheads incurred.. Varia&le *rod'ctio" o!er+ead e#*e"dit're Varia"ce = ()'*% x A%) A'*% %%

here: )'*% A% = A'*%

= )ud!eted 'aria#le *(erhead $ate Actual %ours = Actual 'aria#le *(erhead $ate

0sing the data a ove)

VARIABLE OVERHEAD EXPENDITURE VARIANCE CALCULATION

/udgeted 3aria le overhead rate per hour La our hours used Actual 3aria le overhead Cost 3aria le overhead e!penditure 3ariance C 8'"--A"--- hours 826"---"--D'"--- ! A---E F 826"---"--824"---"--- F 826"---"--+,.000.000 0A1

1.2,

'A$IA5LE O'E$"EAD EFFICIENC& 'A$IANCE

This is the difference etween the standard cost of the hours that should have een worked for the num er of units actually produced and the cost for the units actually produced. Varia&le O!er+ead E((icie"c) Varia"ce = (S% - A%) x )'*% here: S% = Standard %ours for actual production = "um#er of units produced x standard usa!e per unit A% = Actual %ours ta&en to produce the output )'*% = )ud!eted 'aria#le *(erhead $ate

VARIABLE OVERHEAD EFFICIENCY VARIANCE CALCULATION

/udgeted varia le overhead rate per hour Actual La our hours used $tandard La our hours per unit 8'"--A"--- 1ours 2 1ours

%2

,um er of units produced 3aria le overhead 9fficiency 3ariance C 1.70

4"A5HD4"A5- ! 2E+ A"---I ! 8'"--DB"7--+ A"---E ! 8'"--- C +4.100.000 0F1

TOTAL FI6ED O'E$"EAD 'A$IANCE%

The difference etween fi!ed overhead incurred and fi!ed production overhead a sor ed. In other words it is the under or over a sorption. TOTAL FI6ED #$ODUCTION O'E$"EAD, (Standard +ixed *(erhead ,ost per unit # Actual units produced) (Actual cost of +ixed Production *(erheads)

0sing the data a ove)

%'

TOTAL FIXED PRODUCTION OVERHEAD COST VARIANCE CALCULATION

$tandard (*1 cost per unit ,um er of units produced Actual cost C Total (*1 cost variance C 874"--4"A5- units 842'"---"--D4"A5- ! 874"---E F D842'"---"---E +2-.100. 000 0A1

1.71

FI6ED O'E$"EAD E6#ENDITU$E 'A$IANCE This is the difference etween the udgeted fi!ed overhead e!penditure and actual fi!ed overhead e!penditure. Fi#ed *rod'ctio" o!er+ead e#*e"dit're Varia"ce = ()+*% - A+*%) here: )+*% = )ud!eted +ixed *(erhead A+*% = Actual +ixed *(erhead 0sing the data a ove)

FIXED OVERHEAD EXPENDITURE VARIANCE CALCULATION

/udgeted (i!ed *verhead Actual (i!ed *verhead Cost 874"--- ! 5"%-8'77"4--"--842'"---"---

%4

(i!ed *verhead 9!penditure 3ariance C 1.7,

8'77"4--"--- F 842'"---"--+-4.200.000 0F1

FI6ED O'E$"EAD 'OLUME 'A$IANCE

(i!ed *verhead 3olume 3ariance is the difference etween actual and udgeted production>volume multiplied y udgeted fi!ed overhead a sorption rate per unit. Fi#ed *rod'ctio" o!er+ead Vol'me Varia"ce = ()' - A') x )+*% here: )' = )ud!eted 'olume A' = Actual 'olume )+*% = )ud!eted +ixed *(erhead per unit

FIXED OVERHEAD VOLUME VARIANCE CALCULATION

/udgeted 3olume Actual 3olume /udgeted (i!ed *verhead rate per unit (i!ed *verhead 3olume 3ariance C 5"%-- 0nits 4"A5- 0nits 874"--D4"A5- F 5"%-- E ! 74"--+18.400.000 0A1

1.7*

FI6ED O'E$"EAD 'OLUME EFFICIENC& 'A$IANCE

This is the difference etween the standard cost of the hours that should have een worked for the num er of units actually produced and the cost for the units actually produced. Fi#ed O!er+ead E((icie"c) Varia"ce = (S% - A%) x )+*% here: S% = Standard %ours for actual production = "um#er of units produced x standard usa!e per unit A% = Actual %ours ta&en to produce the output )+*% = )ud!eted +ixed *(erhead $ate

%5

FIXED OVERHEAD VOLUME EFFICIENCY VARIANCE CALCULATION

/udgeted (i!ed overhead rate per hour Actual La our hours used $tandard La our hours per unit ,um er of units produced (i!ed overhead 9fficiency 3ariance C 8'7"--A"--- 1ours 2 1ours 4"A5HD4"A5- ! 2E+ A"---I ! '7"--DB"7--+ A"---E ! '7"--- C +2,./00.000 0F1 1.7FI6ED O'E$"EAD 'OLUME CA#ACIT& 'A$IANCE

The difference etween udgeted hours of work and the actual hours worked multiplied y the standard a sorption rate. Fi#ed O!er+ead !ol'me ca*acit) Varia"ce = (A% - )%) x )+*% here: )% = A% = )+*% )ud!eted hours to produce #ud!eted (olume Actual %ours ta&en to produce the output = )ud!eted +ixed *(erhead $ate

FIXED OVERHEAD VOLUME CAPACITY VARIANCE CALCULATION

/udgeted Capacity Actual La our hours used /udgeted (*1 rate per 1our unit ,um er of units produced (i!ed overhead 5"%-- ! 2 %-"2-- 1ours A"--- 1ours 8'7"--4"A5DA"--- F %-"2--E ! 8'7"---

%6

9fficiency 3ariance C C +81.-00.000 0A1 1.80 1.81 %ALE% 'A$IANCE% %ELLING #$ICE 'A$IANCE

The effect on e!pected profit when the actual selling price is different from the udgeted selling price. It is calculated as actual selling price minus udgeted selling price multiplied y actual volume of sales units. Sale Price Varia"ce = (AP - )P) x A' here: A' = Actual 'olume of sales AP = Actual Price per unit )P = )ud!eted Price per unit

SELLING PRICE VARIANCE CALCULATION

Actual selling Price /udgeted $elling Price Actual sales volume $elling price 3ariance C 82%5 82-4"A5D82%5"--- F 82--"---E ! 4"A53 +7,.740.000 0F1 1.8, %ALE% 'OLUME 'A$IANCE

$ales volume variance measures the increase or decrease in e!pected profit as a result of the actual sales volume eing higher or lower than the udgeted volumes. Sale Vol'me Varia"ce = (A' - )') x )P here: )' = )ud!eted 'olume of sales A' = Actual 'olume of sales )P = )ud!eted Profit per unit

%7

SALES VOLUME VARIANCE CALCULATION

Actual sales volume /udgeted sales volume /udgeted Profit $ales volume price 3ariance C 4"A5- units 5"%-- units 86-"--D4"A5- F 5"%--E ! 86-"--3 +14.000.000 0A1

%A

!PER$T%&' "T$TEME&T avourable Materials Labour Variable !1 ixed !1 Price Usage Rate Efficiency Expenditure Efficiency Expenditure Capacity Efficiency Price Volume -*,,, .*,,, /0*,,, .*,,, -*2,, 0-*),, 32*0,, ).*+,, 4.*4-, 2-*,,, 24+*4-, 2-.*+,, .)*3-, $dverse )*+,, (ifference

"ales

Total 5udgeted Profit 6-*2,, x ),7 $ctual Profit 6see 8or9ing belo87 W1 $ctual Profit computation Material Labour V!1 !1 Total cost "ales Profit

/,)*,,,

332,850

:;,,, +3*+,, 2).*,,, .)*,,, 0./*,,, 4,+*+,, 2*,0.*4-, 332,850

,.0

'A$IANCE% IN A %TANDA$D MA$GINAL CO%TING %&%TEM

As you may recall in an earlier stage" we covered the a sorption and marginal costing techni.ues. In our study of standard costing" we have so far used the standard a sorption costing techni.ue where the standard unit cost of a product has also included fi!ed production overhead.

%B

2.%

It is possi le to use standard marginal costing and this will create two differences in the way variances are calculated) In marginal costing" fi!ed costs are not a sor ed into product costs and so there are no fi!ed cost variances to e!plain any under or over a sorption of overhead. There will e no fi!ed overhead volume variances. There will e a fi!ed overhead e!penditure variance which is calculated in the manner demonstrated a ove. The sales volume variance will e valued at standard contri ution margin Dsales price per unit minus varia le costs of sales per unitE" not standard profit margin.

*.0

DE$I'ING ACTUAL DATA F$OM %TANDA$D CO%T DETAIL% AND 'A$IANCE% 09or:ing ;ac: 9ards1 E<am ocus (rom time to time" section A has included .uestions which have needed the working ackward techni.ue to find missing cost details. This section deals with working ackwards using variances to get any missing cost details. The following e!amples will e used to demonstrate how to work out missing cost details given materials and la our variances.

*.1

DE$I'ING %TANDA$D MATE$IAL #$ICE <K Ltd purchased 6"A5- kgs of material at a total cost of 82%"B2-"---" the material price variance was 8%"'7-"--- favoura le. $e=uired 0sing the price variance formula" calculate the standard price per kg. *., %o!ution 2*/4,*,, , )3-, .,, 3,!00

6"P < :.2*+.,*,,,=)*3-,7 x )*3-, > )3-, "P < /*.,, SP =

2-

'.'

DE$I'ING %TANDA$D MATE$IAL U%AGE In a period 2'"A7- 8gs of material were used at a total standard cost of 8B-7"-6-. The material usage variance was 8247"--- favoura le. $e=uired (ind the total standard allowed weight of material for the period. *.- %o!ution M"#$%&"' U(")$ V"%&"*+$ = ,SU - AU. SP .04*,,, > 6"U < ./*34, 7 ? :+,4*,),=./*34, .04*,,, > 6"U < ./*34, 7 /3 )-,, > "U < ./*34, 30,3/0 0) = SU

'.5

DE$I'ING %TANDA$D LA5OU$ "OU$% In a period 6"5-- units were made and there was an adverse la our efficiency variance of 826 million. :orkers were paid 8A"--- per hour and total wages paid were 8%A2 million. There was a nil rate variance. $e=uired (ind the num er of standard la our hours per unit. *.2 %o!ution
Labour Efficiency Variance > "R 6"1 < $17 Let "1 stand for standard hours per unit <.)*,,,*,,, > :3*,,, 6$ x )*-,, < :23.*,,,*,,,=3*,,,7 :3*,,, 6"1 x )*-,, < <.)*,,,*,,, > :23.*,,,*,,,=3*,,,7 3*,,, 3*,,, </*.-, </*.-, @ ..*4-, 2+-,, 3 1%( > > > = )*-,,"1 < ..*4-, )*-,,"1 )*-,,"1 SH

2%

'.7

DE$I'ING ACTUAL "OU$% (O$+ED In a period 5"7B2 units were made with a standard allowance of 6.5 hours per unit at 85"--- per hour. Actual wages were 86"--- per hour and there was an adverse variance of 8'6 million. $e=uired (ind the num er of la our hours actually worked. *.8 %o!ution
Labour Rate Variance > $1 6"R < $R7 $1 6-*,,, < /)*,,,*,,, > )*,,,7 /)*,,,*,,, 2*,,, /)*,,, > > 2,,,$1 2,,, $1

-.0

T"E $EA%ON FO$ 'A$IANCE% There now follows a list of possi le causes of variances. This is not an e!haustive list and in an e!amination .uestion you should review the information given and use your imagination and common sense to suggest possi le reasons for variances.

'A$IANCE #aterial Price

#aterial 0sage

FA'OU$A5LE 0nforeseen discounts received ?reat care in purchasing Change in material standard #aterial used of higher .uality than standard #ore effective use made of material errors in allocating material to Lo s 0se of workers at a rate of pay lower than standard The idle time variance is always adverse

AD'E$%E Price increase Careless purchasing Change in material standard &efective material 9!cessive waste Theft $tricter .uality control 9rrors in allocating material to Lo s :age rate increase

La our Jate

Idle Time

#achine reakdown ,on+availa ility of material

22

Illness or inLury to worker La our 9fficiency *utput produced more .uickly than e!pected" ecause of work motivation" etter .uality of e.uipment or materials 9rrors in allocating time Lo s $aving in costs incurred #ore economical use of services Production or level of activity greater than udgeted 0nplanned price increase Additional demand Lost time in e!cess of standard allowed *utput lower than standard set ecause of lack of training" su +standard material etc. 9rrors in allocating time to Lo s Increase in cost of services 9!cessive use of services Change in type of services used Production or level of activity less than udgeted 0nplanned price reduction 0ne!pected fall in demand Production difficulties

*verhead 9!penditure

*verhead 3olume $elling Price $ales 3olume

C>apter summar? 3ariances measure the difference etween actual results and e!pected results. The &irect #aterial Total 3ariance can e su divided into the direct #aterial Price 3ariance and the &irect #aterial 0sage 3ariance. &irect #aterial Price 3ariance are e!tracted at the time of receipt of materials" not time of usage The &irect La our Total 3ariance can e su divided into &irect La our Jate 3ariance and &irect La our 9fficiency 3ariance.

2'

The 3aria le Production *verhead Total 3ariance can e su divided into 3aria le Production *verhead 9!penditure 3ariance and the 3aria le Production *verhead 9fficiency 3ariance The (i!ed Production *verhead Total 3ariance can e su divided into e!penditure variance and volume variance. The volume variance can e su divided into efficiency variance and capacity variance. The $elling Price 3ariance measures the effect on profit of a different selling price to standard selling price The 3olume 3ariance measures the effect on profit of actual sales volume eing different to udgeted sales volume. The operating statement shows how the com ination of variances reconcile udgeted profit and actual profit 3ariances can e used to derive actual data from standard cost details There are two main differences etween variances calculated in a sorption costing system and the variances calculated in a marginal costing system. o In a marginal costing system the only (i!ed *verhead 3ariance is an 9!penditure 3ariance o The $ales 3olume 3ariance is valued at standard contri ution margin " not standard profit margin.

%TUDENT@%ELF TE%TING %ELF $E'IE( )UE%TION% %. 2. '. 4. :hat is variance analysis M #ention the su components of fi!ed overhead variance. 1ow do variances under marginal costing differ from those under a sorption costingM mention some causes of variances

E6AMINATION T&#E )UE%TION% %. C Ltd uses a standard costing system. The standard cost card for one of its products shows that the product should uses 48gs of material / per finished unit and the standard price per 8g is 84"5--. (or the month of April" the udgeted production level was %"--- units and the actual units made were %-4- units. The actual material .uantity of material / used was 4"%-- 8gs. The cost of the material / which was purchased was 8%4.4 million. 24

$e=uired Calculate Total #aterial 3ariances and analyse it into Price and 0sage 3ariances 2. Z plc uses a standard costing system and has the following la our cost standard in relation to one of its products) 4 hours direct la our = 86" --- per hour C 824"--&uring *cto er 2-<5" '"'5- of these products were made which was %5- units less than udgeted. The la our cost incurred was 87B" AB'"--- and the num er of direct la our hours worked was %'"45-. $e=uired Calculate total La our 3ariances and analyse it into Jate and 9fficiency variances for the month of *cto er. '. A company udgets to produce %"--- units of product 9 during august. The e!pected time to produce a unit of 9 is five hours" and the udgeted fi!ed production overheads is 82- million. The standard fi!ed production overhead cost per unit of product 9 will therefore e 5 hours = 84"--- DC82-"---E. Actual fi!ed production overhead e!penditure in august turns out to e 82-"45-"---. The la our force manages to produce %"%-- units of product 9 in 5"4-- hours of work. $e=uired Calculate the following fi!ed production overhead variances aE Total 3ariance. E 9!penditure 3ariance. cE 3olume 3ariance. dE 3olume 9fficiency 3ariance. eE 3olume Capacity 3ariance.

25

C>apter *
RELEVANT COSTING AN$ $ECISION MA-ING
INT$ODUCTION *ne of the key management tasks is decision making. &ecision+making is concerned with the future and involves making a choice etween alternatives. #any factors oth .ualitative and .uantitative need to e considered and for many decisions" financial information is critical. The overriding re.uirement of the information that should e supplied y the cost accountant to aid decision+making" is that of relevance. This chapter starts off y looking at the decision making process and then rules for identifying relevant costs and revenues. CONTENT% %. 2. '. 4. 5. 6. &ecision making process. Jelevant costs. Irrelevant costs. Jelevant costs of materials. Jelevant costs of La our. Jelevant costs of e.uipment. LEA$NING OUTCOME% After reading this chapter you should e a le to) *utline the decision making process. &escri e the concept of relevant costing. &istinguish etween relevant and irrelevant costs. $tate the rule for identifying relevant costs for materials" la our and e.uipment.

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1.0

T>e decision@ma:ing process

The decision making process has the following steps ) Identify o Lectives. $earch for alternative courses of action. Collect data a out the alternative courses of action. $elect the appropriate course of action. Implement the decision. Jeview.

The a ove steps are descri ed in detail elow) 1.1 Identi ? o;AectiBes

The first step in decision+making is to define organi2ation o Lectives which provide a framework for assessing the appropriate courses of action to e taken y managers. (or most organi2ations the main o Lective is profit ma!imi2ation. 1., %earc> or a!ternatiBe

1aving esta lished the o Lectives" the second step is to identify a num er options that would ena le an organi2ation achieve its o Lectives. A profit making organi2ation may have the following options to ena le it increase profits) 1.* &evelopment of new products &evelopment of new markets Co!!ect data a;out t>e a!ternatiBe courses o action

The management accountant will need to collect data a out the environment in which the organi2ation operates and a out the organisation;s capa ility. If the decision is more concerned with the short+term future of the organi2ation" such data as the selling prices for competing products will have to e collected. 1.%e!ect t>e appropriate course o action

(ollowing the data collection e!ercise a ove" the course of action" which est satisfies the organi2ation should e selected. 1.4 Imp!ement t>e decision

The chosen decision should e implemented.

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1.2

$eBie9

This is the final stage in the decision making process where the actual and planned outcomes are compared and any needed corrective measures are taken. ,.0 $ELE'ANT CO%T%

A relevant cost is a future incremental cash flow" which arises as a direct result of a decision. The definition highlights several important features of a relevant cost. $e!eBant costs are uture costs A decision is a out the future and it cannot alter what has already een done. Costs that have een incurred in the past are irrelevant to the decision that is eing made now a out the future. $e!eBant costs are cas> !o9s *nly cash flow information is relevant to decision making. This means costs or charges which do reflect additional cash spending e.g depreciation and notional costs should e ignored for the purpose of decision making $e!eBant costs are incrementa! Costs A relevant cost is an incremental cost this means that as a direct conse.uence of the decision. 2.% *ther terms used to descri e relevant costs ABoida;!e costs Avoida le costs are defined as the specific costs of an activity or sector of a usiness which would e avoided if that activity or sector did not e!ist. Di erentia! cost or incrementa! costs Incremental or differential costs are defined as the difference in total costs etween alternatives calculated to assist in decision making. &ifferential costs are relevant costs which are simply the additional costs incurred as a conse.uence of a decision.

2A

Opportunit? costs Jelevant costs may involve incurring a cost or losing a revenue. The loss of revenue is known as opportunity cost. *pportunity cost is defined as the value of a enefit foregone or sacrificed when one course of action is chosen in preference to an alternative. ,., Irre!eBant costs

A num er of terms are used to descri e costs that are irrelevant for decision making ecause they are either not future cash flows or they are costs which will e incurred anyway" regardless of the decision taken. Non@re!eBant costs inc!ude $unk costs Committed costs ,otional costs 1istorical costs ,on cash flow costs

%un: costs These costs are cost of resources already ac.uired where the total will e unaffected y the choice etween various alternatives. These are costs that have een created y a decision made in the past and that cannot e changed y any decision that will e made in the future. An e!ample of a sunk cost is a market research. $uppose that a company has spent 8%- million in advertising a product and has discovered 4--- units can e sold at a price of 8%-" ---. In deciding whether to go ahead in producing the product the market research cost of 8%-m is a sunk cost and irrelevant to the decision. Committed costs A committed cost is a future cash outflow that will e incurred anyway" whatever decision is taken now a out alternative opportunities. Committed costs may e!ist ecause of contracts already entered into y the organi2ation which it cannot now avoid.

2B

Non@cas> c>arges Notiona! costs A notional cost is a cost used in product evaluation and performance appraisal to represent the cost of using resources which have no conventional costs. 9!amples of notional costs in cost accounting systems are) ,otional rent. ,otional interest on capital employed.

UnaBoida;!e costs If a cost is unavoida le" it cannot e relevant to a decision ecause it will e incurred anyway. ,.* T"E $ELE'ANCE OF 'A$IA5LE CO%T% AND FI6ED CO%T%

The general rule is that varia le costs are relevant to decision making while fi!ed costs are irrelevant. 1owever e!ceptions to this rule does e!ist as shown elow. ,.Non re!eBant Baria;!e costs

There might e occasions when a varia le cost is in fact a sunk cost. (or e!ample if a computer repair shop received a one+off re.uest from a customer which calls for replacing a component and this component is already in stock ought in the past for 82---. If such a component will not e replaced neither has it got scrap value" nor alternative value approached y a customer to carry out a one off. In deciding whether to take up this job or not, though the material cost element represent a variable cost element, it will not be relevant in this case ,.4 $e!eBant i<ed costs

Although fi!ed costs are generally irrelevant" there might e occasions when a fi!ed cost is relevant. Direct!? attri;uta;!e i<ed costs These are fi!ed costs which though fi!ed within a relevant range of activity are relevant for either of the following reasons) They would increase if certain activities were undertaken. (or e!ample if an e!tra supervisor was employed if a particular Lo was taken.

'-

Genera! i<ed oBer>ead ?eneral fi!ed overheads are those fi!ed overheads which will e unaffected y decisions to increase or decrease the scale of operations" perhaps ecause they are an apportioned share of the fi!ed costs of items which would e completely unaffected y the decision. $uch fi!ed costs are irrelevant. *.0 $ULE% FO$ IDENTIF&ING $ELE'ANT CO%T%

?eneral principles for identifying relevant costs of the following cost elements will now e covered elow) *.1 The relevant costs of materials Jelevant costs of la our Jelevant costs of machines T"E $ELE'ANT CO%T% OF MATE$IAL%

The relevant cost of raw materials is generally their current replacement costs" unless the materials have already een purchased and would not e replaced once used. In this case the relevant cost of using the materials is the higher of) The current resale valueN and The value they would o tain if they were put to alternative use.

If the materials have no resale value and no alternative use" the relevant cost of using the material for the opportunity under consideration is nil. *., E6AM#LE

A new contract re.uires the use of 5- kg of material <Z4%. This metal is used regularly on the firm;s proLects. There are %-- 8gs in stock at the moment" which were ought for 82-" --- per 8g. The current purchase price is 82%" --- per 8g and the material could e scrapped off for net scrap proceeds of 8%5" --- per 8g. Assess the relevant cost of materials for each of the cases elow) Case 1 /ased on the details given a ove" what would e the relevant cost of the materialsM As the company would have to replace the 5- 8gs of material <Z4%" the relevant cost is the replacement cost for the materials. i.e 5- kg ! 82%"--- C 8 %"-5-"---.

'%

Case , $uppose material <Z4% that is in stock has no other use" what is the relevant cost for the materialM The relevant cost is the opportunity of selling the material which is) 40+g C +14.000 3 +740.000 Case * $uppose there is no alternative use for material <Z4% and only 25 8gs of the material is in stock" what would e the relevant costM
Materials in stoc9 6.-:g A2-*,,,7 disposal value Materials to be bought 6.-A :.2*,,,7 R$'$2"*# +3(#( 43% 5"#$%&"'( :;,,, /4-.600

Case $uppose material <Z4% is in stock ut it has no alternative use and has no disposal value" what would e the relevant costsM T>e re!eBant cost 9ou!d ;e ni! in t>is case. *.* T"E $ELE'ANT CO%T% OF LA5OU$

In determining the relevant costs of la our" the key .uestion is whether spare capacity e!ists. The following guidelines can e used) If there is spare capacity" and employment terms are such that la our is a fi!ed cost" the relevant cost is nil. If there is no spare capacity" two possi ilities e!ist as follows) o If e!tra la our comes from hired la our" the hire charge ecomes the relevant cost. o If the e!tra la our is taken from another activity that earns a contri ution for the company" the relevant cost ecomes the paid la our cost and the lost contri ution from that other activity.

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*.-

E6AM#LE

Zacks Ltd is currently deciding whether to undertake a new contract that will re.uire %5 hours of la our time. The standard cost per each product is as follows)
(irect Materials 62, 9g A:.,,,7 (irect Labour 6- hrsA:),,,7 Variable cost LessB "elling Price Contribution :;,,, ., /, -, 2.. ..

$e=uired Assess the relevant costs in each of the following scenarios. Case 1 The company has no spare capacity and decides to hire la our from outside" what is the relevant cost for the new contractM The relevant cost for the new product is) 14 >rs C +2. 000 3 +/0.000 Case , Assuming the company has 5 hours spare capacity" what will e the relevant costsM
(irect Labour 62, hrs A:),,,7 !pportunity Cost 6-hrs A ,7 R$'$2"*# +3(#( 43% '"738% :;,,, ), ,, 90

Case * Assuming Zacks Ltd withdraws the re.uired la our hours from a current activity which earns a standard contri ution" what would e the relevant cost for la ourM
(irect Labour 62- hrs A:),,,7 !pportunity Cost 6..=- C 2-7 R$'$2"*# +3(#( 43% '"738% :;,,, +, )) 159

*.4

T"E $ELE'ANT CO%T% OF MAC"INE$&

''

*nly the following incremental costs of using machines should e considered) Jepair costs arising from use 1ire charges Any fall in resale value of owned assets which results from their use.

&epreciation is not a relevant cost. *.2 E6AM#LE

A machine which originally cost 8%2 million with an estimated economic life of ten years and is depreciated at a rate of 8%.2 million per year. It has een unused for sometime and there are no production orders. A special order has now een received which would re.uire the use of the machine for two months. The current net realisa le value of the machine is 8A million. If it is used for the Lo " its value is e!pected to fall to 87.5 million. The net ook of the machine is 8A.4 million. Joutine maintenance of the machine currently cost 84--" --- per month. :ith use" the cost of maintenance and repairs would increase to 86--" --$e=uired :hat is the relevant cost of using the machine for the orderM *.7 %o!ution
all in value of machine 6:3m<:4D-m7 Maintenance costs 6:),,*,,, < :0,,*,,,7 x . R$'$2"*# +3(# 34 8(&*) 5"+1&*$ :;,,, -,, 0,, 600

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C"A#TE$ %UMMA$& This chapter has introduced the topic of &ecision #aking and has e!plained in great details the concept of Jelevant Costing. $ome key points covered have een) &ecision making has si! steps which are) o o o o o o Identify o Lectives $earch for alternative courses of action Collect data a out the alternative courses of action $elect the appropriate course of action Implement the decision Jeview

Jelevant Costs are future" incremental cash flows. An *pportunity Cost is the enefit foregone y choosing one opportunity instead of the ne!t est. ,on+relevant Costs include $unk Costs" Committed Costs" ,otional Costs and 1istorical Costs. 0nless you are given an indication to the contrary" you should assume that varia le costs are relevant and that fi!ed costs are irrelevant for decision making The relevant cost of raw materials is generally their current replacement costs unless the material have already een purchased and will not e replaced" in which case the relevant cost of using them is the higher of their current resale value and the value they would o tain if put to an alternative use. 0sing machinery will involve some incremental costs including o Jepair costs arising from use o 1ire charges o Any fall in resale value of owned assets which results from use. The relevant costs of scarce resource is the sum of the contri ution forgone from ne!t est opportunity for using scarce resources and the varia le cost of the scarce resource.

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%TUDENT@%ELF TE%TING %ELF $E'IE( )UE%TION% %. 2. '. 4. 5. #ention the steps involved in &ecision #aking Process ?ive characteristics of Jelevant Costs ?ive e!amples of Irrelevant Costs :hen are la our and material costs irrelevant though varia leM :hen are fi!ed costs relevant in decision makingM

E6AMINATION T&#E )UE%TION% (rom the multiple choice .uestions elow" choose the letter which est suits your selected answer. %. A. /. C. &. The costs most relevant to e used in decision making are)

$unk costs Current costs 9stimated future costs ,otional and full costs

2. :hich of the following statements is ,*T trueM A. /. C. &. Jelevant costs change according to the decision Jelevant costs are always future costs (i!ed costs can never e relevant costs Jelevant costs are those specific to a decision

'. (or decision+making purposes" which of the following are relevant costsM A. /. C. &. Avoida le costs (uture costs *pportunity costs &ifferential costs

DiE" DiiE " DiiiE and DivE DiE and DivE DiE and DiiE DiiE and DiiiE

4. The la our re.uirements for a special contract are 25- skilled la our hours paid at

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8%-" --- per hour and 75- semi+skilled la our hours paid = 8A" --- per hour. At present skilled la our is in short supply" and all such la our used on this contract will e at the e!pense of other work which generates a contri ution of 8%2" --- per hour. There are %"2-- e!cess semi+skilled la our hours" ut the firm has a policy of redundancy. The relevant cost for la our for the special contract is) A. /. C. &. 5 8' million 85.5 million 8A.5 million 8%%.5 million.

In order to utili2e some spare capacity" Chola is preparing a .uotation for a special order which re.uires %"--- kilograms of material ?. Chola has 6-- 8g of material ? in stock Doriginal cost 85" --- per 8gE. #aterial ? is used in the company;s main product G. The resale value of material ? is 84" --- per 8g. The present replacement price of material # is 86" ---. #aterial ? is readily availa le on the market. The relevant cost of the %--- 8gs of material J to e included in the .uotation is ) A. /. C. &. 84 million 85 million 85.4 million 86 million

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CHAPTER . SHORT TERM $ECISIONS

INT$ODUCTION 1aving introduced the concept of relevant costing in the previous chapter" this chapter proceeds to apply the concept to short run decision situations such as scarce resources" make or uy" close down of usiness segments and minimum pricing for one+off or special orders. CONTENT% %. 2. '. 4. #ake or uy decisions. Limiting factors. Close down decisions. $pecial pricing situations. LEA$NING OUTCOME%

After studying this chapter you should e a le to) Identify the optimal production solution when there is one limiting factor. $olve #ake or /uy decisions when there is one limiting factor. Apply the concept of Jelevant Costing to usiness decisions. 0se relevant costing concept to solve $pecial *rder Pricing pro lem. 0se Jelevant Costing to decide on closure of usiness segment.

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LIMITING FACTO$ #$O5LEM%

Although sales demand is a factor that often stops a company from increasing its profits" there are sometimes situations in which some resources could e in short supply making it impossi le for a company to increase its profits. A scarce resource is an item in short supply. In the conte!t of decision making in usiness" it is a resource in short supply and as a conse.uence of which the organi2ation is limited in its a ility to provide and sell more products or services. $uch scarce resources are also called limiting factors. %.% 9!amples of scarce resources are) 1., A limit on the availa ility of a key item of raw materials or a key component. A limit on the availa ility of a key type of la our such as skilled or .ualified la our. A limit on availa le machine time. Decision pro;!em

:hen a usiness has a limiting factor" a decision must e taken a out how the availa le resources should e used. 1.* 1.Approac> Identify the scarce resources. Calculate contri ution per unit of product. Calculate the units of the scarce resources used y each product. Jank the products ased on contri ution per limiting factor. Allocate resources according to the ranking.

)UE%TION Z Ltd makes two products which oth use the same type of materials and grades of la our ut in different .uantities as shown elow) La our 1ours per unit #aterials F 8g per unit &emand $ales price per unit Product < 2 5 5-8'-"--Product / 4 2 258'6"---

'B

&uring each week the ma!imum num er of la our hours availa le is %"A-- and the .uantity of materials availa le is limited to '---8g.The la our rate is 85"--- per hour and materials cost 82"--- per 8g. $e=uired Advise Z Ltd on a profit ma!imi2ing production plan. 1.4 %OLUTION
"tep 2

Identification of limiting factor Product < K Total hrs re.uired Availa le %>ort a!!
(emand -,, .-, Labour 1ours . 0 Total 1ours 2*,,, 2*,,, .*,,, 2*3,, 200

Product < K Total Availa le

S13%#4"''

(emand -,, .-,

Materials -9g .9g

Total 9g .*-,, -,, /*,,, /*,,, N&'

The conclusion is that only direct la our hours are a limiting factor.

4-

S#$: 2

C3*#%&78#&3* C35:8#"#&3* Product ? :,,, /, 62,7 62,7 10 Product E :,,, /) 6.,7 607 12

"ales Price Labour Material C3*#%&78#&3*

S#$: 3

C3*#%&78#&3* :$% L&5&#&*) F"+#3%

Product C3*#%&78#&3* , ;000. Labour hours per unit Contribution per 1our 6:;,,,7

? 10 . -

E 12 0 /

S#$: ! S#$: 5

R"*0&*) O:#&5"' P%3<8+#&3* P'"*

2st

.nd

Product ? Product E A2"&'"7'$ H38%(

U*&#( 500 200

1ours per Unit . 0

Total 1ours 2,,, 3,, 1800

,.0

Ma:e or 5u? Decisions

A #ake or /uy decision involves a decision y an organi2ation a out whether it should make a product>carry out an activity with its own internal resources or whether it should pay another organi2ation to make the product>carry out the activity. 9!amples of #ake or /uy decisions would e as follows) :hether a company should manufacture its own components or uy components from an outside supplier. :hether a company should have its own service department such as a cleaning department or su contract the activity to an e!ternal cleaning company

There are two situations in which the #ake or /uy decisions may arise)

4%

A usiness currently manufactures its own products or components and an e!ternal supplier offers to make them instead. The choice is simply whether to make the item in house or whether to uy them e!ternally. Alternatively a company may e faced with a short fall in its own in+house capa ilities leading to a need to su contract some work to makeup for the shortfall. In such a situation" the usiness might have to decide not only whether it should uy some units e!ternally ut which items should e purchased as well in order to ma!imise profit.

2.%

/ickson Ltd makes four components A" /" Cand & for which the costs in the forthcoming period are as follows) Product 0nits 0nit marginal costs &irect materials &irect La our 3aria le production overheads Tota! Baria;!e costs A 5-8;--A %6 4 / %--8;--%%A 6 C 2--8;--4 A 2 & %5-8;--A %2 4

,8

*-

1-

,-

(i!ed costs per annum are as shown elow) (i!ed costs specific to production of A (i!ed costs specific to production of / (i!ed costs specific to production of C (i!ed costs specific to production of & ?eneral fi!ed costs Tota! 8;--2"--%-"--%2"--%6"--'-"--20.000

An e!ternal supplier has offered to supply units of A"/"C and & for 824"---"842"---" 82-"--- and 82A"--- respectively. $e=uired &ecide whether /ickson Ltd should make or uy the components. 42

,.,

%OLUTION AND DI%CU%%ION The relevant costs in this .uestion are the differential costs etween the making and uying options and they consist of differences in unit varia le costs plus differences in directly attri uta le fi!ed costs. The company would save 8A million y su contracting product A where the purchase costs would e less than the marginal costs per unit of making internally and the company would save 8 2 million in fi!ed costs.
SOLUTION Costs Unit variable cost of buying Unit variable cost of ma9ing Extra cost of buying Volume Total extra cost of buying "aving in fixed costs ,N$# ("2&*).=E>#%" +3(#( $ :;,,, .0 .3 607 .*,,, 63*,,,7 6.*,,,7 ,10,000. 5 :;,,, 0. /0 3 0*,,, /.*,,, 62,*,,,7 22,000 C :;,,, ., 20 ) 3*,,, 03*,,, 62.*,,,7 39,000 ( :;,,, .3 .0 0 )*,,, .0*,,, 62)*,,,7 8,000

Conc!usionD The company should make products /" C and & as they have a higher relevant cost of uying. It should make product A. ,.* OT"E$ CON%IDE$ATION% AFFECTING T"E DECI%ION #anagement would need to consider other factors efore reaching a make or uy decisions. $ome would e .uantifia le and others would e not) Continuit? and contro! o supp!? Can the outside company e relied upon to meet re.uirements in terms of .uantity" .uality" delivery dates and price sta ilityM A!ternatiBe use o resources Can the resources used to make this article e transferred to another activity which will save costs or increase revenueM %ocia!E!ega! :ill the decision affect contractual or ethical o ligations to employees or usiness connectionsM

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MA+E O$ 5U& (IT" LIMITING FACTO$

In cases where a company cannot meet orders ecause it has e!hausted all availa le capacity" it may have to su contract some of the work in order to meet the shortfall in the short term. The short+term decision faced y the company is to decide on which work should e su contracted and which one should e done in house. In the long term management may look to such alternatives as capital e!penditure. *.1 Decision ru!e

The decision would e made after ranking the products according to e!tra purchasing costs per unit of limiting factor. Products with higher e!tra costs of uying should e made in house. *., )UE%TION ?ogo Ltd manufactures three components <"K and Z used in its finished product. The component workshop is operating at full capacity and is not a le to meet the current demand for the component. An e!ternal supplier has offered to supply the components at a unit price of 82"5--" 86"--- and 8%'"--- respectively. The varia le costs per product and machine re.uirements are as follows) Component < 8'"--2 Component K 84"--2 Component Z 87"--4

3aria le costs #achine 1rs $e=uired

9sta lish the order in which products should e ought from the e!ternal supplier.

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%OLUTION

SOLUTION Compo nent

Component

Component

44

!utside Purchase Price Variable Cost of Production Extra cost of buying Machine 1ours E>#%" +3(# 34 78?&*) :$% 5"+1&*$ H38% ("2$< Ran9ing< order of buying

? :;,,, .*-,, /*,,, 6-,,7 . ,250. 1(#

E :;,,, )*,,, 0*,,, .*,,, . 1,000 2*<

F :;,,, 2/*,,, 4*,,, )*,,, 0 1,500 3%<

The rule is to buy the product with the lowest extra cost of buying. -.0 CLO%U$E OF 5U%INE%% %EGMENT

:here part of a usiness appears to e unprofita le" a company is faced with a decision whether to allow such a segment to continue or to shut it down. The segment may e a product" a department" or channel of distri ution. In evaluating the closure the cost accountant should evaluate the following) -.1 Loss of contri ution from the segment $avings in specific fi!ed costs Penalties e.g redundancy" compensation to customers Alternative uses of resources released E<amp!e

8anLom e stores comprises three department namely kitchenware" garden tools and plum ing e.uipment. The company is concerned a out the poor performance and is considering whether or not to close down the plum ing tools section. 9stimated results for the store are as follows)

:itchen8are :; million "ales (irect Cost of sales (epartmental costs 0,, .,, -,

'arden tools :; million ),, /), 2,,

Plumbing tools :; million .,, 2-, /,

Total :; million 2*.,, 42, 23,

45

$pportioned "tore Costs Total costs P%34&#=,L3((.

-, /,, 100

-, -2, 60

-, ./, ,30.

2-, 2*,0, 190

$e=uired Assuming that the company cannot raise prices advise whether the section should e closed down and comment on any other factors which should e considered in making this decision. -., %o!ution

As long as the section makes contri ution which is higher than the specific fi!ed costs" it is advisa le to continue running the section in the short run. If the section was shut down" overall profit would fall as shown elow)
Plumbing tools :; million

:itchen8are :; million

'arden tools :; million

Total : ;million

"ales (irect Cost of sales (epartmental costs $pportioned "tore Costs Total costs P%34&#=,L3((.

0,, .,, -, -, /,, 100

),, /), 2,, -, -2, 60

< < < -, -, ,50.

2*,,, -), 2-, 2-, 3), 1!0

As shown a ove closure of the plum ing section is not advisa le in the short run as it leads to a drop in the overall profit of 82- million due to loss in the contri ution" which the product was making to fi!ed costs.

Additiona! comments If the plum ing section were closed down what would the do with the resources released from the closureM

46

For e<amp!e. suppose the company could sell a new product" a computer accessory from that space which could generate 8'-- million per year with direct cost of sales of 8%A- million and departmental costs of 85- million" the revised results would as shown elow)
:itchen8are :; million "ales (irect Cost of sales (epartmental costs $pportioned "tore Costs Total costs P%34&#=,L3((. 0,, .,, -, -, /,, 100 'arden tools :; million ),, /), 2,, -, -2, 60 Computer $ccessories :; million /,, 23, -, -, .3, 20 Total :; million 2*/,, 40, .,, 2-, 2*,+, 210

In this scenario" the deletion of the plum ing tools department and the its replacement with the computer accessories department would e the recommended course of action. 4.0 ONE@OFF CONT$ACT

This is a decision making situation where a company which is operating at elow full capacity is approached y a customer who is offering a price lower than the normal. The relevant costs to consider in this case are the varia le manufacturing costs" and if the price eing offered covers the varia le costs the company should accept the contract. 4.1 E<amp!e // Ltd makes a single product which sells for 82-"--- it has a full cost of 8%5"--which is made up as follows)

&irect material &irect la our D2 hoursE 3aria le overhead

8;--4 6 2

47

?eneral overhead Tota!

' 14

The la our force is currently working at B-O of capacity and so there is capacity for 2"5-- units. A customer has approached the company with a re.uest for the manufacture of a special order of 2"--- units for which he is willing to pay 826 million. $e=uired Assess whether the order should e accepted. The relevant cost to consider is the varia le costs. (i!ed costs will e incurred regardless of whether the contract is accepted and so are irrelevant to the decision a ove. 4., %OLUTION
:;,,, 2. .*,,, 2!,000 .)*,,, 2,000

Variable costs per unit !rder siGe T3#"' 2"%&"7'$ +3(#( Value of order P%34&#

Conc!usion The order should e accepted ecause the proposed selling price covers the varia le cost. *ther factors to consider in the one+off decision include) The possi ility of other customers asking for similar lower prices There could e more profita le ways of using the spare capacity The possi ility that additional fi!ed costs could e incurred

%TUDENT@%ELF TE%TING %ELF $E'IE( )UE%TION% %. :hat is a limiting factorM 2. ?ive e!amples of limiting factors

4A

'. 4. 5. 6.

:hat is the decision rule in limiting factor pro lems :hat is the asis for choosing etween the make or uy optionM :hat other factors should e considered in #ake or /uy decisions *n what asis should the decision e made in the short run whether to close down a loss making operationM

E6AMINATION T&#E )UE%TION% 8alu o o Limited has 5"--- kgs of materials P in stock for which it paid 82 million. The material is no longer in use in the company and could e sold for 8%5- per 8g. 8alu o o Ltd is considering taking on a single special order which will re.uire A"--- kgs of material P. The current purchase price of material P is 85-- per 8g. In the assessment of the relevant costs of the decision to accept the special order" the cost of material P will e)+ A. /. C. &. A sunk cost of 82"---"--A sunk cost of 82"---"--- and an incremental cost of 8%"5--"--An opportunity cost of 875-"--- and an incremental cost of 8%"5--"--An incremental cost of 84--"---.

4B

C>apter 4
COST VOLUME PROFIT /CVP0 ANALYSIS
INT$ODUCTION This chapter looks at a decision+making techni.ue called cost volume profit analysis DC3PAE commonly known as /reakeven Analysis. This concept looks at the relationship etween costs and sales and volumes in usiness. The chapter defines and demonstrates the reakeven point computation in terms of sales volume and revenue. It further shows the computation of the volumes for desired levels of profit and how to prepare reakeven charts. CONTENT% %. 2. '. 4. 5. /reakeven calculation. #argin of safety. Target profit computation. /reakeven charts. Limitations of C3P analysis. LEA$NING OUTCOME% After studying this chapter you should e a le to) 9!plain the concept of /reakeven and #argin of $afety. Calculate /reakeven Point and #argin of $afety. 0se C3P analysis to calculate the sales re.uired to achieve a target profit. Construct a single product reakeven chart and profit volume charts. 9!plain the limitations of /reakeven Analysis concept.

5-

1.0 1.1

MaAor Assumptions ;e>ind C'#A All costs can e resolved into fi!ed and varia le elements. (i!ed costs will remain constant and varia le costs vary proportionately with activity. *ver the activity range eing considered costs and revenues ehave in linear fashion. The only factor affecting costs and revenues is volume. Technology" production methods and efficiency remain unchanged. There are no stock level changes. Uses o C'# ana!?sis

C3P analysis is used widely in preparing financial reports for management. It is a simple techni.ue that can e used to estimate profits and make decisions a out the est course of action to take. Application of C3P analysis include) 1., 9stimating future profits. Calculating the reakeven point for sales. Analy2ing the margin of safety in the udget. Calculating the volume of sales re.uired to achieve a target profit. &eciding on a selling price for a product. T>e ;rea:eBen point

/reakeven is the volume of sales at which the usiness makes neither a profit nor a loss. At reakeven point total revenue e.ual total costs. /reakeven shows the minimum operating levels elow which an organi2ation should not go in order to avoid making a loss. 1.* 5rea:eBen computation /reak even can e computed using three approaches which are ) Contri ution per unit Contri ution sales ratio ?raph method

Contri;ution per unit met>od

5rea9 Even Point in Units > ixed Costs Contribution per Unit

5%

Contri;ution sa!es ratio

5rea9 Even Point in sales revenue > ixed Costs Contribution sales ratio

1.-

I!!ustration The following details relate to a shop that currently sells 25"--- pairs of shoes annually) $elling price per pair Purchase cost per pair Total annual cost fi!ed costs $alaries Advertising *ther fi!ed e!penses $e=uired Calculate the reakeven point using) aE Contri ution per unit E Contri ution sales ratio cE ?raph method 8'2-"--82--"--8A--"---"--8'2-"---"--8A--"---"---

1.4

%OLUTION aE
:;,,, 5rea9 Even Point in Units 2*+.,*,,, 2., > 2)*,,, Pairs

E
:;,,, Unit Contribution "elling Price

Contribution "ales Ratio

>

5rea9 Even < "ales revenue

ixed Costs C" ratio

>

:2.,*,,, :/.,*,,, :;,,, 2*+.,*,,, /3H

> /3H

:;, -*,

52

5$EA+ E'EN C"A$T

cE

100 0 600 800 /00 900 500 !00 300 200 100

lR ta o TTotal Cost

en ev

ue

:I,,,

F&>$< C3(#

10 V3'85$

15 ,000 .

20

2 5

3 0

B%$"0$2$* P3&*# 2)*,,, units

,.0

MA$GIN OF %AFET&

The difference etween udgeted sales volume and reakeven sales is known as the #argin of $afety. It is simply a measurement of how far sales can fall short of the udget efore the usiness makes a loss. A large margin of safety indicates a low risk of making a loss where as a small margin of safety might indicate a fairly high risk of a loss. ,.1 E6AM#LE #argin of safety is usually e!pressed as a percentage of udgeted sales. In the last e!ample the margin of safety is as follows) /udgeted sales 25"--5'

/reakeven sales #argin of safety

%6"--D25"---+ %6"---E 0nits B"--- units or B--->25--- C '6O

,.,

Target #ro it

C3PA can e used to calculate the volume of sales that would e re.uired to achieve a target level of profit. To achieve a target profit" the usiness will have to earn enough contri ution to cover all fi!ed costs and then make the re.uired amount of profit. 3olume to make target profit D TPE is given y)
ixed Costs @ Target Profit Contribution per unit

,.*

E<amp!e

Zaks Ltd has capital employed of 8%-- million its target profit on capital employed is 2-O per annum. Zaks Ltd manufactures a standard product sigma with the following details) $elling Price 3aria le Cost Annual (i!ed cost $e=uired :hat volume of sales is re.uired to achieve target profitM ,.%o!ution 86-" --82-" --8%-- million

Target profit 2-O of 8%-- million C 82- million 3olume re.uired to make target profit DTPE is)
:2,,*,,,*,,,m @ :.,*,,,*,,, :0,*,,,

54

:2.,*,,, *,,, > :0,*,,,

3, 0 0 0 8 *& #(

,.4

%ensitiBit? Ana!?sis and C'# Ana!?sis

In the conte!t of C3P analysis sensitivity analysis answers such .uestions as :hat will operating profit e if the output level decreases y say 5OM :hat will operating profit e if the varia le costs increased say 5OM ,.2 LIMITATION% OF 5$EA+@E'EN ANAL&%I%

Though reak even analysis is a useful techni.ue for managers" the techni.ues has several limitations including the following) It can only apply to a single product or a single mi! of a group of products. A reakeven chart may e time consuming to prepare. It assumes fi!ed costs are constant at all levels of output. It assumes that varia le costs are the same per unit at all levels of output. It assumes that sales prices are constant at all levels of output. It assumes production and sales are the same. It ignores the uncertainty in the estimates of fi!ed costs and varia le cost per unit.

55

C>apter summar? Cost+3olume FProfit analysis is the study of the interrelationship etween costs" volume and profits at various levels of activity. /reakeven point is the is the point at which profit is 2ero" where total revenue is e.ual to total cost /reakeven point formula Contri ution per unit method
5rea9 Even Point in Units > ixed Costs Contribution per Unit

Contri ution sales ratio

5rea9 Even Point in "ales value > ixed Costs Contribution sales ratio

#argin of safety is the difference in units etween the udgeted sales volume and the reakeven sales volume. It is sometimes e!pressed as a percentage of the udgeted sales volume. A company;s target profit is achieved when the total contri ution is C (i!ed costs P re.uired profits The reakeven point can also e determined graphically using the simple reakeven chart or a contri ution reakeven chart. /reakeven analysis is a useful techni.ue for managers as it can provide simple and .uick estimates. /reakeven charts provide a graphical representation of reakeven arithmetic. /reakeven analysis does have a num er of limitations" which are ased on the assumptions made in the analysis

56

%TUDENT@%ELF TE%TING %ELF $E'IE( )UE%TION% %. 2. '. 4. 5. 6. :hat are the maLor assumptions ehind C3PA #ention some applications of C3PA &efine the reak even point $tate the formula for calculating /9PM :hat is margin of safetyM :hat are the limitations of C3PAM

E6AMINATION T&#E )UE%TION% T>e o!!o9ing in ormation re!ates to =uestions 1 and , A usiness sells a single product at a selling price of 84-" --- with a contri ution to sales ratio of '-O. The fi!ed cost for the period is 82%- million. %. The num er of units that must e sold to reak even is

2.

If the usiness wishes to make a profit of 86- million" the num er of units that must e sold is

T>e o!!o9ing in ormation re!ates to =uestion * and 8 Limited;s product has the following cost and selling price structure)
"elling Price Variable cost ixed Cost Profit :;,,, )0 /0 2, .,

/udgeted activity is %"-5- units per month

'.

The udgeted margin of safety as a percentage of udgeted sales each month is

57

4.

To achieve a profit of 824 million in a month" the num er of units that must e sold is

5.

A product has the following udgeted operating statement for the sale of %--- units.
"ales Variable costs Contribution ixed costs P%34&# 2,*,,, )*,,, 0*,,, .*-,, 1,500

Kou are re.uired to compute) aE E cE dE The C>$ ratio /reakeven sales and units #argin of safety The sales volume re.uired to make a target profit of 82 million

5A

CHAPTER 1 PRICING $ECISIONS

Introduction Pricing is a very important type of decision that normally faces managers in organisations. Accounting information is often an important input to pricing decisions. There are two approaches to arriving at a price namely cost ased and demand ased approach. The chapter will mainly focus on the cost asis as outlined in the sylla us. Contents %. 2. '. 4. (actors affecting pricing. (ull cost pricing approach. #arginal cost ased pricing. *ther pricing strategies. Learning outcomes After studying this chapter the student should e a le to) 9!plain other factors affecting the price of a product or service. Calculate prices using full cost and marginal cost. &iscuss advantages and disadvantages of these pricing ases. &iscuss suita le pricing strategies for specific usiness situations.

5B

1.0

FACTO$% INFLUENCING T"E #$ICE OF A #$ODUCT :e start y discussing factors that affect the price of products and services y looking at asic economic analysis of demand. 9ffective pricing decisions should following factors) e ased on a careful consideration of the

OrganiFation goa!s+ like any other decision making process" consideration of the organi2ations o Lectives is the first step in setting suita le prices. (or e!ample an organi2ation whose key o Lective is to ma!imi2e cash generation should set prices that reflect this goal. #roduct Mi<+ an organisation which produces and sells a range of products should set the prices for each product within the mi! in a manner that ma!imises cash flow generated from the whole mi!. #riceEdemand re!ations>ip+ for most products" at higher prices the demand for the product is low and as the price is reduced the .uantity demanded increases. It is thus important that a price setter should have the knowledge of price>demand relationship for his product. A :no9!edge o t>e price e!asticit? o demand+ price elasticity of demand refers to the responsiveness of changes in demand to changes in prices. The concept of price elasticity is important when an organisation intends to adLust the current price. They should know what the likely impact would e on demand. Competitors and mar:ets F when setting selling prices it is always important to consider the possi le reaction from the competitors. #roduct !i e c?c!e+ each product goes through a cycle which include" introduction" growth" maturity" saturation and decline phases. The price must e set with reference to the stage the product has reached in the cycle. Mar:eting strateg?+ selling prices should e set with reference to the overall marketing strategy. (or e!ample" a company whose marketing strategy emphasises heavy advertising can afford to charge higher prices. Costs F in the long run" all operating costs must e fully covered y the sales revenue.

(actors affecting demand in the market as a whole include) The price of the good

6-

 ,.0

The price of other goods The si2e and distri ution of household income 9!pectation * solescence Guality of the product Tastes and fashions FULL CO%T@#LU% #$ICING

(ull+cost plus pricing is a method of determining the sales price y calculating the full cost of the product and adding a percentage mark+up for profit. The full cost may e a fully a sor ed production cost only or it may include some a sor ed administration" selling and distri ution overhead. This pricing method is common in industries that carry out contract or Lo ing work for which .uotations are regularly prepared for individual Lo s or contracts. The percentage profit is predetermined y the organi2ation. 1owever" the profit markup should not e rigid and fi!ed" it should e varied to suit different circumstances. ,.1 E6AM#LE

Lenco Ltd has egun to produce a new product" called $igma for which the following cost estimates have een made)
(irect Materials (irect Labour 6- hrsA:),,,7 Variable production !verheads 6-hrs at :.*-,,7 Total variable cost :;,,, .4 /, .3.

Production fi!ed overheads are udgeted at 8'- million per month and udgeted direct la our hours are 25"--- per month. The a sorption rate will e ased on la our hours. The company wishes to make a profit of 2-O on full production cost from product $igma. $e=uired Ascertain the full cost+plus ased price.

6%

,.,

%OLUTION
(irect Materials (irect Labour 6- hrsA:),,,7 Variable production !verheads 6-hrs at :.*-,,7 ixed overheads 6:/,*,,,*,,,=.-*,,,x-7 Total cost Mar9 up 6.,H of :337 S$''&*) :%&+$ :;,,, .4D,, /,D,, .-D,, )D,, 33D,, 24D), 105@90

,.* ,. *.0

AdBantages o u!! cost@p!us pricing It is .uick" simple and cheap method of pricing. It gives a price which ensures that all costs are covered. DisadBantages o u!! cost@p!us pricing It causes pro lems of finding a suita le overhead a sorption asis. /udgeted output volume needs to e esta lished as it is a key factor in the deriving of overhead a sorption rate. It does not consider market and demand condition. It ignores the e!istence of a profit ma!imi2ing price. Margina! cost@p!us pricing

#arginal cost+plus pricing is a method of determining the sales price y adding a profit margin on to either marginal cost of production or marginal cost of sales. *.1 E<amp!e A product has the following costs)
(irect Materials (irect Labour Variable production !verheads T3#"' 2"%&"7'$ +3(# :;,,, / 4 15

(i!ed overheads are 8%- million per month. /udgeted sales are 4-- units to allow the product to reak even.

62

$e=uired &etermine the profit margin which needs to e added to marginal costs to allow the product to reak even. *., %OLUTION
$t brea9even point * fixed cost > Total contribution J :2,* ,,,*,,, > 0,, 6Price < 2-*,,,7 .-*,,, > Price < 2-*,,, P%&+$ = !0,000

*.* *.

AdBantages o margina! cost@p!us pricing It is a simple and easy method to use. It draws management attention to contri ution" a concept which is important to decision making. DisadBantages o margina! cost@p!us pricing It does not pay sufficient attention to demand conditions" competitors prices and profit ma!imi2ation. It ignores fi!ed overheads in the pricing decisions" ut pricing decisions must e sufficiently high to ensure that a profit is made after covering fi!ed costs. OT"E$ #$ICING #OLICIE% %pecia! orders

-.0 -.1

A special order is a one+off revenue earning opportunity. The asic approach in such a situation is to determine the price at which the company reaks even or the minimum price it would charge. This is the price at which the company covers the incremental costs of producing and selling the product and the opportunity costs of the resources consumed. -., Mar:et penetration pricing

#arket penetration pricing is a policy of low prices when the product is first launched in order to o tain sufficient penetration into the market. Penetration prices aim to secure a su stantial total market. Circumstances in which penetration policy may e appropriate include) :here a firm wishes to discourage new entrants into the market.

6'

 -.*

where there are significant economies of scale to e achieved from high volume of output. where demand is highly elastic and so would respond well to low prices. Mar:et s:imming pricing

#arket pricing involves charging high prices when a product is first launched and spending heavily on advertising and sales promotion to o tain sales. The aim of market skimming is to gain high unit profits early in the products life. 1igh unit prices make it more likely that competitors will enter the market than if lower prices were charged. Circumstances in which market skimming policy may e appropriate include) :here the product is new and different" so that customers are prepared to pay high prices. :here the strength of demand and the sensitivity of demand is unknown. :here the product has a shorter life cycle and so there is need to recover the development costs and make profit relatively .uickly.

64

C>apter summar? This chapter has considered the last topic in the decision+making area of the sylla us" namely" pricing. The following are some of the key points highlighted. $everal factors including the following should e considered in making pricing decisions) o o o o o o o Product life cycle. #arketing strategy. *rgani2ation goals. Product #i!. Price>demand relationship. 8nowledge of the price elasticity of demand. Competitors and markets.

In full cost plus pricing the sales price is determined y calculating the full cost of the product and then adding a percentage mark+up for profit. #arginal cost cost+plus pricing involves adding a profit margin to the marginal cost of production>sales The most important criticism of cost plus pricing is that it fails to recogni2e the relation etween price and demand. The asic approach to pricing special orders is to esta lish the relevant cost of the order and this ecomes the minimum price that can e charged. Three alternative pricing strategies for new products are market penetration pricing" market pricing and premium pricing.

%TUDENT@%ELF TE%TING %ELF $E'IE( )UE%TION% %. 2. '. 4. 5. #ention factors that should e considered in pricing decisionsM :hat is full cost+plus pricingM :hat are some disadvantages of full cost+plus pricingM :hat is market penetration :hat is market skimming pricing strategy M

65

CHAPTER 2 INTRO$UCTION TO 3U$GETING

Introduction *ne of the functions of the standard costing techni.ue is to assist in udgeting. :e now turn our attention to udgeting starting with this chapter that will introduce the concept and illustrate the preparation of functional udgets. As you progress through the chapters you will notice that udgeting is a very important tool used y accountants in the planning and control of a usiness. CONTENT% %. 2. '. 4. 5. 6. &efinition of a /udget. * Lectives of /udgeting. Jesponsi ility accounting. (eed ack. (eed forward. Preparation of (unctional /udgets. LEA$NING OUTCOME% After studying this chapter you should e a le to) &efine a /udget. 0nderstand the o Lectives of /udgeting. 0nderstand the /udget preparation process. 9!plain typical pro lems faced in /udgeting. Prepare (unctional /udgets.

66

1.0

DEFINITION

A udget is a .uantitative e!pression of a plan of action prepared in advance of the period to which it relates. A udget may e prepared for the usiness as a whole" for departments" for functions such as sales and production or for financial and resource items such as cash" capital e!penditure" manpower and purchases. 1.1 O5GECTI'E% OF 5UDGETING

The key o Lectives of a udgeting process are) Communication Control Coordination Planning #otivation Performance evaluation Jesource allocation

67

*/@9CTI39 Planning

C*##9,T Annual udgeting gives management an opportunity to prepare detailed plans which are re.uired to implement the corporate strategic plans. The udget serves as a vehicle through which actions of the different parts of an organi2ation are rought together and reconciled into a common plan. :ithout a udget managers may e making conflicting decisions. Through the udget" the top management communicates its e!pectations to lower level management" so that all mem ers of the organi2ation may understand these e!pectations. Additionally it is not Lust the udget itself that facilitates communicationN there is a lot of e!change of vital information during the planning process itself. The interest and commitment of employees can e retained via a system of feed ack of actual results which lets them know how well or adly they are performing. A udget is a yardstick against which actual performance is measured and assessed. Control is provided y comparing the actual with the udget after which corrective actions are taken to eliminate the variances. A manager;s performance is often evaluated y measuring his or her success in meeting the udget. The udget provides a useful means of informing managers of how well they are performing in meeting targets that they previously helped in setting. /udgets are used to allocate resources to various section of an organisation

Coordination

Communication

#otivation

Control

Performance evaluation

Jesource allocation ,.0 ,.1

"O( 5UDGET% A$E #$E#A$ED 5udget centre

A udget centre is a clearly defined part of an organisation for which a udget is prepared for udgetary control purposes. The selection of udget centre in an organisation is an important step in the udgeting system.

6A

,.,

5udget period

The udget period is the period for which a udget is prepared and used" which may then e su divided into shorter control periods. The length of the udget period is affected y the following factors) The nature of the usiness F power supply companies may have longer udget period of up to 2- years" while clothing industry would e etter off with shorter periods. The nature of the cost items F udget period for capital cost items is normally longer than that for revenue cost items. The asis of control F a company with a .uarterly reporting system is likely should have .uarterly udget period. 5udget committee

,.*

A typical udget committee comprises the chief e!ecutive" the management accountant who is the udget officer and functional heads. The functions of the committee are to) ,.Coordinate udget preparation. Issue timeta les for udget preparation. Allocate responsi ilities for the preparation of functional udgets. Provide information for the preparation of udgets. $uggest amendments to udgets. Approve udgets after amendments. Assess the udgeting and planning process. 5udget manua!

The udget manual is a collection of instructions governing the responsi ilities of persons and the procedures" forms and records relating to the preparation and use of udgetary data. The management accountant is responsi le for the preparation of the udget manual and the manual normally include the following) 9!planation of the o Lectives of the udgeting process. *rgani2ational structure highlighting udget holders. *utline principal udgets. Administrative details including details for udget time ta le for udget preparation. 6B

 ,.4

Procedural matters such as specimen forms" account codes and specimen reports. 5UDGET #$E#A$ATION #$OCE%%

The udget preparation process is as follows) ,.21 Communicating details of the udget policy and udget guidelines. &etermining the factor that restricts output. Preparation of the sales udget. Preparation of functional udgets. ,egotiation of udgets with superiors. Coordination and review of udgets. (inal acceptance of udgets. /udget review.

COMMUNICATING DETAIL% OF T"E 5UDGET #OLIC& AND 5UDGET GUIDELINE% $trategic details should e communicated to the managers responsi le for preparing udgets. #anagers should also e provided with important guidelines for wage rate increases" changes in productivity as well as information a out industry demand and output. ,.2, DETE$MINING T"E FACTO$ T"AT $E%T$ICT% OUT#UT

/efore any plans could e prepared" management should identify the limiting factor also known as principal udget factor. This is a factor that restricts or limits an organisation;s performance for a given period. (or many organi2ations sales demand happens to e the limiting factor. 1owever" the principal udget factor could also e machine capacity" distri ution and selling resources" the availa ility of key raw materials or cash. ,.2* #$E#A$ATION OF T"E %ALE% 5UDGET

As sales demand is a common limiting factor" the initial plan to e prepared is the sales udget. $ome factors that are considered in preparing a udget are) Past sales pattern The economic environment Jesults of market research Anticipated advertising 7-

Pricing policies and discounts.

In addition to the a ove factors" management may use forecasting techni.ues such as time series and linear regression to estimate future sales demand. ,.2#$E#A$ATION OF FUNCTIONAL 5UDGET%

/ased on the sales udget" the following functional udgets can e prepared) (inished goods stock udget Production udget #aterial usage udget #achine utilisation udget La our udget Jaw material purchases udget *verhead cost udget ,.24 NEGOTIATION OF 5UDGET% (IT" %U#E$IO$%

*nce managers have prepared their draft udgets" they present it to their superiors for discussion after which the superior consolidates their udgets. ,.22 COO$DINATION AND $E'IE( OF 5UDGET%

The whole udgeting process is fairly comple! and functional udgets may e reviewed several times efore final approval. $uch reviews may im alance one udget against another hence the need for the udget officer to coordinate the whole process. ,.27 FINAL ACCE#TANCE OF 5UDGET

:hen all functional udgets have een completed" they are summari2ed into a #aster /udget consisting of a /udgeted Profit and Loss account /udgeted /alance $heet and Cash /udget. ,.28 5UDGET $E'IE(

/udgeting process does not end for the current year once the udget period has egunN udgeting is a continuous process. &uring the udget period the actual results are compared with udget. Corrective measures are taken to eliminate negative variances. If variances have occurred due to unrealistic udgets" then the udgets are revised.

7%

C>apter summar? In introducing the concept of udgeting" the following have een covered) A udget is a .uantitative e!pression of a plan of action prepared in advance of the period to which it relates. T>e :e? O;AectiBes o a ;udgeting process are) o Communication o Control and o Coordination o Planning o #otivation o Performance evaluation o Jesource allocation A typical 5udget Committee comprises the chief e!ecutive" the management accountant who is the udget officer and functional heads. The 5udget Manua! is a collection of instructions governing the responsi ilities of persons and the procedures" forms and records relating to the preparation and use of udgetary data. The udget preparation process is as follows) o Communicating details of the udget policy and udget guidelines o &etermining the factor that restricts output o Preparation of the sales udget o Preparation of functional udgets o ,egotiation of udgets with superiors o Coordination and review of udgets o (inal acceptance of udgets o /udget review A /udget Centre is a clearly defined part of an organisation for which a udget is prepared for udgetary control purposes. The /udget Period is the period for which a udget is prepared and used" which may then e su divided into control periods.

72

%TUDENT@%ELF TE%TING %ELF $E'IE( )UE%TION% %. 2. '. 4. &efine the term /udget. :hat are the o Lectives of /udgetingM :hat are the functions of the /udget CommitteeM *utline the udget preparation process.

E6AMINATION T&#E )UE%TION% End o c>apter =uestions %. :hich of the following are aims of udgetingM DTick all that applyE
Planning Coordinating (elegating authority Maximising sales demand Controlling %ncreasing output Communication

2.

:hich of the following are functions of the /udget CommitteeM DTick all that applyE
Coordinate budget preparation $gree policy 8ith regard to budgets Prepare budgets for sales demand

7'

CHAPTER 4 PREPARATION OF FUNCTIONAL AN$ CASH 3U$GETS

Introduction 1aving introduced the concept of udgeting in the previous chapter" this chapter will demonstrate how to prepare functional udgets and the cash udget. This chapter covers a topic that has fre.uently een su Lect of the e!aminations. CONTENT% %. 2. '. 4. 5. 6. 7. A. B. /udget preparation. $ales udgets. Production udgets. Jaw material usage udget. La our udgets. *verheads udget. Purchases udget. #aster udget. Cash udgets. LEA$NING OUTCOME%

After studying this chapter you should e a le to) Prepare (unctional /udgets Prepare Cash /udgets Prepare a #aster /udget

74

T"E %TE#% IN 5UDGET #$E#E$ATION

"tep 2

"ales 5udget

"tep .

Production 5udget

"tep /

Ra8 material

Labour 5udget

actory overhead

Cost of goods budget

"tep 0

"elling and (istribution budget M$"TER 5U('ET

'enera and administration budget

"tep -

5udgeted profit and loss

"tep )

Cash budget

Capital expenditure budget

"tep 4

5udgeted balance sheet

75

1.,

#$E#A$ATION OF FUNCTIONAL 5UDGET%

(unctional udgets are the udgets for the various functions and department of an organisation. They therefore include Production /udgets" #arketing /udgets" $ales /udgets" Personnel /udgets" Purchasing /udgets and Jesearch and &evelopment /udget. 1.* E6AM#LE H FUNCTIONAL 5UDGET% The following e!ample will e used to illustrate the preparation of functional udgets) #etallurgical 9nterprise manufactures two products known as Alpha and $igma. Alpha is manufactured in department % and $igma in department 2. The following information is availa le for 2-<5. /alance sheet for the accounting year 2-<5
ixed assets Land 5uildings and E#uipment Less depreciation :;,,, )0)*,,, 2.4*-,, :;,,, 3-*,,, -23*-,, ),/*-,,

Current $ssets inished goods Ra8 materials (ebtors Cash 0+*-/3 +0*),, 200*-,, 24*,,, /,-*)/3

Less current liabilities Creditors &et Current assets &et assets "hare Capital and reserves !rdinary shares :2,,, each Reserves

2.0*0,, 232*./3 430*4/3

),,*,,, 230*4/3 430*4/3

76

%tandard costs per unit

$lpha : Material Material Labour Variable Production overhead ? E 2, 9gA:23, - 9gA:0,, 2, hrsA:/,, per 1r 2*3,, .*,,, /*,,, 3,, 2- hrsA:4, per 1r 2*,-, 3 9gA:23, + 9gA:0,, 2- hrsA:/,, per 1r "igma : 2*00, /*),, 0*-,,

(ept 2 2, hrsA:3, per 1r (ept .

Total variable cost

4*),,

2,*-+,

!ther relevant information for .,?) (epartment 2 5udgeted ixed !verhead :20* .3, (epartment . : 4*2),

"toc9s orecast "ales 6units7 "elling price Closing "toc9s 6units7 !pening stoc9s 6units7 $lpha 3*-,, :2,*,,, 2*34, 24,

inished goods "igma 2*),, :20*,,, +, 3-

Closing stoc9s 6:g7 !pening stoc9s 6:g7 !ther ixed costs

Ra8 materials Material ? Material E 3*-,, 3*,,, 2,*.,, 2*4,, :2/D3 million

$E)UI$ED Prepare the following udgets.

77

iE iiE iiiE ivE vE 1.*1

$ales udget. Production udget. Jaw materials. La our udget. *verhead udget. T>e %a!es ;udget
Product $lpha "igma T3#"' %$2$*8$ Volume 3*-,, 2*),, "elling price :2,*,,, :20*,,, Total 6:;,,,7 3-*,,, ..*0,, 10/,!00

1.*,

T>e #roduction 5udget

The production udget is usually e!pressed in .uantity and represents the sales eing adLusted for opening and closing stocks as shown elow)
Product "ales $dd closing "toc9 Less opening stoc9 Production "igm a 2*),, +, 63-7 1,905 $lpha 3*-,, 2*34, 624,7 10,200

1.**

T>e ra9 materia!s usage ;udget

Materials ? :g 2.*30, 2,.*,,, 220*30, Materials E 9g 20*00-2*,,, )-*00-

Product "igma $lpha Total

2*),- x 3:g 2,*.,, x 2,:g

2*),- x +:g 2,*.,, x -:g

1.*-

T>e ra9 materia!s #urc>ases ;udget

Material ? 220*30, 2,*.,, 63*-,,7 119,5!0 :23, 20,6//@2 Material E )-*002*4,, 63*,,,7 56,1!5 : 0,, 23,958

Production $dd closing "toc9 Less opening stoc9 Production Purchase Price Total Cost6:;,,,7

7A

1.*4

T>e La;our 5udget

1rs per unit 22, Total 1rs .0*,42,.*,,, 2.)*,4:/,, 3/,823

Product "igma $lpha Total hrs Rate per 1our Total Labour cost

Volume 2*),2,*.,,

1.*2

T>e actor? oBer>ead ;udget

(epartment 2 2,*.,,D,, : 3,D,, 32)D,, 20*.3,D,, 2-*,+)D,, (epartment 2 2*),-D,, : 4,D,, 22.D/4*2-+D3, 4*.4.D2-

Labour 1ours !verhead rate Total Variable !1 6:;,,,7 ixed production overhead Total overheads

1.*7

Master ;udget

:hen all the functional udgets have een prepared" they are summari2ed and consolidated into a #aster udget which consists of the udgeted profit and loss account" udgeted alance sheet and cash udget which provides the overall picture of the planned performance for the udget period.

7B

%TUDENT@%ELF TE%TING %ELF $E'IE( )UE%TION% %. 2. '. 4. &efine the term /udget. :hat are the o Lectives of /udgetingM :hat are the functions of the /udget CommitteeM *utline the /udget preparation process.

E6AMINATION T&#E )UE%TION% )UE%TION ONE Kou are presented with the following udgeted Cash (low data for your organisation for the period ,ovem er 2-<4 to @une 2-<5. It has een e!tracted from the functional udgets that have already een prepared.
&ov ?0 :;,,, "ales Purchases Lages !verheads (ividends Capital Expenditure 0,*,,, .,*,,, -*,,, -*,,, (ec ?0 :;,,, -,*,,, /,*,,, )*,,, -*,,, 2,*,,, Kan?:;,,, --*,,, 0,*,,, 3*,,, 4*-,, eb ?:;, ,, )-*, ,, 0-*, ,, 2,*, ,, 4*-, , Mar ?:;, ,, 4,* ,,, --* ,,, 2.* ,,, 4*,, $pr ?:;,,, 4-*,,, )-*,,, 20*,,, 2,*,,,

2-*,,,

.,*,,,

Kou are also told the following) DaE D E DcE DdE DeE DfE DgE $ales are 4-O cash and 6-O credit. Credit sales are paid two months after the month of sale Purchases are paid the month following the purchases 75O of wages are paid in the current month and 25O the following month *verheads are paid the month after they are incurred &ividends are paid three months after they are declared Capital e!penditure is paid two months after they are incurred The opening cash alance is 87.5 million.

$e=uired Prepare a cash udget for the si! month period @anuary to @une 2-<5

A-

)UE%TION T(O The following information is relevant to .uestions 2" ' and 4 A usiness is preparing its Production /udget" #aterial 0sage and #aterial Purchases /udget for the forth+coming period. 9ach unit of the product uses 6 8gs of material <. *ther known information is as follows) Jelevant details /udgeted $ales of $igma Current stock of finished goods Je.uired closing stock of finished goods Current stock of raw materials Je.uired closing stock of raw material

4"6-- units A-- units %"%-- units 2"4-- 8gs '"--- 8gs

$e=uired Calculate the following) aE /udgeted production for the period E /udgeted material usage cE /udgeted material purchases

A%

)UE%TION T"$EE GM engineering ?# engineering Ltd produces two product called A and / using two raw materials" < and K. The work is done in two departments" machining and assem ly. 9stimates collected for the forth coming period for the two products and the relevant resources are as shown elow. Product &emand for the company;s products $elling Price per unit 9nding Inventory /eginning inventory Jaw #aterials re.uirements #aterial < #aterial K A A"5-4"--%"A7%7%.5 kilos 2.- kilos #aterial < Jaw material stocks /eginning inventory Closing inventory Jaw material cost per kilo D8;---E &irect la our hours per unit La our rate per hour D8;---E Production overheads #achine 1ours 5-4B8%.5 6hrs 8%.6 #achining 45"--'"---hrs / %"6-5"6-BA5 -.5 kilos 4.- kilos #aterial K 5-4A8%.Bhrs 8%.6 Assem ly 2'"--2"'--hrs

$e=uired (rom the a ove information prepare the following functional udgets) aE $ales /udget E Production /udget cE #aterial 0sage dE Purchases /udget eE Plant utilisation /udget fE La our /udget gE Production *verhead /udget hE Total production cost /udget

A2

CHAPTER 5 3U$GETARY CONTROL AN$ 3EHAVIOURAL IMPLICATIONS OF 3U$GETING

INT$ODUCTION Kou should y now have a full grasp of the udgeting process and e a le to prepare functional udgets and consolidate them into a #aster /udget. This chapter looks at the use of udgets for control y using the (le!i le /udgeting techni.ue. The chapter further looks at the impact of udgets on staff motivation. CONTENT% %. 2. '. 4. /udgetary control. (i!ed udgets. (le!i le udgets. /ehavioural implications of udgeting.

LEA$NING OUTCOME% After studying this chapter" the student should e a le to) 9!plain the concept of /udgetary control. &efine fi!ed and (le!i le /udgets. Apply (le!i le /udgets for control. Assess the ehavioural implications of udget control and performance evaluation" including participation in udget setting.

A'

1.0

FI6ED 5UDGET A fi!ed udget is a udget which is designed to remain unchanged regardless of the volume of output or sales achieved. :hen the actual volumes of production are different from the udget in a control period" a fi!ed udget is not adLusted to the new levels of activity. The maLor purpose of a fi!ed udget is at the planning stage" when it is used to define the road o Lectives of the organi2ation.

1.1

FLE6I5LE 5UDGET% A udget which y recogni2ing different cost ehavior patterns" is designed to change as volume of output changes. (le!i le udgets may e used in two ways) At t>e p!anning stage+ :here an organi2ation e!pects a wide range of output and sales" the fle!i le udgeting techni.ue may e used to prepare contingency plans for the various possi le output levels. At t>e end o t>e period + In order to carry out effective udgetary control" fle!i le udgeting techni.ue can e used to adLust the original udget in line with the actual level of output.

1.,

5UDGETA$& CONT$OL &efinition /udgetary control involves drawing up udgets for the areas of responsi ility for individual mangers and of regularly comparing actual results against e!pected results. The difference etween actual results and e!pected results are called variances and these are used to provide guideline for control action y individual managers.

A4

1.*

It is 9rong to use i<ed ;udgets as a ;asis or contro! action 9it>in an organiFation as s>o9n ;e!o9D
5udget $ctual /,,, :;,,, /,,*,,, 3-*,,, 0-*,,, 20*,,, ..*,,, 2)*,,, -,*,,, ./.*,,, 98,000 Variance Comment on Variances

Production and sales units "ales (irect Materials (irect Labour Maintenance (epreciation Rent and rates !ther Costs Total cost P%34&#

.,,, :;,,, .,,*,,, ),*,,, 0,*,,, 2,*,,, .,*,,, 2-*,,, /)*,,, 232*,,, 16,000

:;,,, 2,,*,,, 6.-*,,,7 6-*,,,7 60*,,,7 6.*,,,7 62*,,,7 620*,,,7 6-2*,,,7 151,000

avourable $dverse $dverse $dverse $dverse $dverse $dverse $dverse F"238%"7'$

1.%.5

0sing the variances contained in the a ove statement for control purposes is meaningless. Costs were higher ecause the output volume was also higher. The correct approach to udgetary control is as follows) Identify fi!ed and varia le costs Produce a fle!i le udget using marginal costing techni.ue.

1.2

The following assumptions will e used to prepare a (le!i le /udget ase on the udget a ove) Cost &irect material" direct la our" maintenance &epreciation Jent and rates *ther costs Cost ehavior 3aria le (i!ed $emi+varia le (i!ed component C 8%6 million 3aria le C 8 %--- per unit

A5

%.7

Converting the original fi!ed udget into fle!i le udget

O%&)&*"' B8<)$# A<A8(#5$*# #3 4'$> 3%&)&*"' 78<)$# .,,,,,=.,,, x /,,, ),*,,,=.,,, x /,,, 0,*,,,=.,,, x /,,, 2,*,,,=.,,, x /,,, &o adMustment &o adMustment 2),,,@ /,,, x 2, F'$>$< 78<)$# /,,*,,, +,*,,, ),*,,, 2-*,,, .,*,,, 2-*,,, 0)*,,, 2!9,000

F'$>&*) ("'$( %$2$*8$ "ales F'$>&*) V"%&"7'$ +3(#( (irect Materials (irect Labour Maintenance F&>$< +3(#( (epreciation Rent and rates S$5& 2"%&"7'$ +3(#( !ther Costs T3#"' +3(#

.,,*,,, ),*,,, 0,*,,, 2,*,,, .,*,,, 2-*,,, /)*,,, 181,000

%.A

/udgetary control statement ased on fle!ed udget

B8<)$# P%3<8+#&3* "*< ("'$( 8*&#( 2000 :;,,, .,,*,,, ),*,,, 0,*,,, 2,*,,, .,*,,, 2-*,,, /)*,,, 232*,,, F'$>$< B8<)$# A+#8"' 3000 :;,,, /,,*,,, 3-*,,, 0-*,,, 20*,,, ..*,,, 2)*,,, -,*,,, ./.*,,, V"%&"*+$ C355$*# 3* V"%&"*+$(

:;,,, /,,*,,, +,*,,, ),*,,, 2-*,,, .,*,,, 2-*,,, 0)*,,, .0)*,,,

:;,,, 2,,*,,, -*,,, 2-*,,, 2*,,, 6.*,,,7 62*,,,7 60*,,,7 avourable avourable avourable avourable $dverse $dverse $dverse

"ales (irect Materials (irect Labour Maintena nce (epreciati on Rent and rates !ther Costs Total cost

20*,,, $dverse

P%34&#

16,000

5!,000

98,000

89,000

F"238%"7'$

T>e Bariances ;ased on t>e reBised ;udgets are more meaning u!. Management can ta:e correctiBe measures ;ased on t>e a;oBe ;udget.

A6

,.0

5E"A'IOU$AL IM#LICATION% OF 5UDGETING In designing and using udgets for planning and control" the management accountant should consider the impact of udgets on people;s ehaviour. In the past ehavioural scientists have complained that accountants have not given sufficient consideration to the impact of control systems such as udgetary control.

,.10

In particu!ar 9e s>a!! e<amine t>e o!!o9ing ;e>aBiora! aspects o ;udgeting. ?oal congruence The use of udgets as targets Communication #otivation /udget ias or slack varia le Participation 0sing udgets for performance evaluation

,.11

GOAL CONG$UENCE The ideal udgeting system is one which encourages goal congruence. This simply means that the goals of individuals and groups should coincide with the goals and o Lectives of the organi2ation as a whole. Although goal congruence is difficult to achieve" recognition must e given to the fact that organi2ations o Lective cannot e imposed through a udget with no regard to individual o Lectives.

,.1,

T"E U%E OF 5UDGET% A% TA$GET% Jesearch studies have provided su stantial evidence that e!istence of a defined .uantitative goal or target is likely to motivate higher levels of performance than would e achieved if no such targets were set. Ideally such targets should coincide with personal goals. A good udgeting system should ensure that targets are clearly defined agreed and accepted y individuals concerned.

,.1*

COMMUNICATION Communication etween and across layers in the organi2ation is an important factor in any planning and control system. Lack of communication is likely to lead to non acceptance y users of such systemsN they could even hamper the operation of such systems. Jesearch has shown that fre.uent up to date communication of udgetary planning and control information to a manager has a motivating effect.

A7

,.1-

5UDGETA$& %LAC+ /udgetary slack is the difference etween the minimum necessary costs and the costs uilt into the udget or actually incurred. In the process of preparing udgets managers might deli erately overestimate costs or under estimate revenue so that they will not e lamed in the future for overspending and poor results. In controlling operations managers must then ensure that their spending rises to meet their udgets otherwise they will e lamed for careless udgeting.

,.14

MOTI'ATION #otivation is what makes people ehave in the way they do. It comes from individual attitude" or groups attitudes. Individuals will e motivated y personal desires and interests. These may e in line with o Lectives of the organi2ation and some people live for their organi2ation. (or others they may consider their Lo as a chore and their motivation may e unrelated to the organi2ation o Lectives. It is therefore vital that the goals of management and employees harmonise with the goals of the organi2ation as a whole. This is known as goal congruence. Although goal congruence is a ehavioral issue" it is possi le to design and run a udgetary control system which will go some way towards ensuring that the goal congruence is achieved. #anagers and employees must e therefore must e favora ly disposed towards udgetary control system for it to operate efficiently.

,.,

#A$TICI#ATION In relation to participation there are three possi le styles namely Top down DimposedE /ottom up DparticipatoryE ,egotiated style

,.,1

TO# DO(N 0IM#O%ED1 In this approach to udgeting top management prepares a udget with little or no input from operating personnel which is then imposed upon employees who have to implement the udget. This style is good in the following circumstances) In newly formed organi2ations. In very small usinesses. &uring period of economic hardship. :hen operational managers lack udgeting skills. AA

2.22 ,.,*

Advantages and disadvantages of the imposed style are) AdBantages o Imposed Management %t?!e Time taken to finalise udgets is reduced. 1igh .uality udgets due to reduce input from ine!perienced people. /udgets are likely to include all strategic issues. Jealistic to the e!tent.

,.,-

DisadBantages o Imposed Management %t?!e &efensiveness and low morale amongst staff. &oes not support team spirit. Limited acceptance of organi2ation goals and o Lectives. Lower level management not given sufficient planning skills.

,.,4

#A$TICI#ATI'E %T&LE OF 5UDGETING In this udgeting approach udgets are developed y lower managers who then su mit the udgets to the superiors for review and consolidation" Participative udgets are suita le in the following circumstances) :ell esta lished organi2ation. Large organi2ations. :hen operational managers have udgeting skills. :hen the organi2ation different units enLoy a measure of autonomy.

2.26 ,.,7

Advantages and disadvantages of the a ove approach include) AdBantages o #articipatiBe Management %t?!e #orale and motivation is likely to e improved. They likely to e more realistic. They are ased on information from employees with relevant knowledge. Coordination etween units is improved.

,.,8

DisadBantages o #articipatiBe Management %t?!e They consume more time. $lack may e uilt in y managers. Changes made y senior managers may cause dissatisfaction. Low level managers may lack udgeting skills. AB

,.,/

NEGOTIATED %T&LE OF 5UDGETING The a ove two styles are two e!tremes. In practice different levels of management often agree udgets y a process of negotiation. The udgeting process is a argaining process and this process is vital to making the udget more effective. C>apter summar? $ome key concepts covered in the chapter have included the following) (i!ed udgets are udgets that have regardless of the level of activity. een designed to remain unchanged

(le!i le udgets are udgets that have een designed to vary with changes in the level of activity. /udgetary control involves the setting up of udgets and using them as a asis for taking control actions. The concept of fle!i le udgeting is useful to udgetary control. There are asically two ways in which a udget can e set from the top+ imposed style or from the ottom F participatory. 9ach system has its own advantages and disadvantages. 0sed correctly a udgetary control system can motivate" ut it can also produce undesira le negative reactions. (actors that affect people in the process of setting up" implementing and using udgets include the following) o o o o o o o The use of udgets as targets #otivation Participation ?oal congruence 0sing udgets for performance evaluation Communication /udget ias or slack varia le

B-

%TUDENT@%ELF TE%TING %ELF $E'IE( )UE%TION% %. 2. '. 4. 5. 6. :hat is a (i!ed /udgetM :hat is a (le!i le /udgetM :hat is /udgetary controlM *utline some ehavioural implications of udgeting. :hat is udgetary slackM :hat are the advantages of Top+down approach to udgetingM

E6AMINATION T&#E )UE%TION% % A (i!ed /udget is) A. /. C. &. 2. A udget for a single level of activity 0sed when the mi! of products is fi!ed in advance of the udget period A udget which ignores inflation 0sed only for fi!ed costs

The term udget slack refers to) A. 9!tended lead+time etween the preparation of the functional udgets and the master udget. /. &ifference etween the udgeted output and the reakeven output C. Additional capacity availa le which can e udgeted for &. &eli erate over+estimation of costs and under+estimation of revenues in a udget.

'.

?reen plc makes two products" the < and the K. The following e!tract is taken from the production cost udget of ?reen plc)
Product ? Product E 2,*,,, ),*,,, 3*,,, .,.*,,, 2-*,,, /44*,,,

Production 6units7 Production cost budget 6:;,,,7

0*,,, /,*,,,

$e=uired

Ca!cu!ateD

B%

aE /udget cost allowance for an activity level of 5--- units of < E /udget cost allowance for an activity level of %-"--- units of K

B2

CHAPTER 16 ALTERNATIVE 3U$GETING SYSTEMS

Introduction In this chapter" we e!amine various methods which can e used as a asis for the preparation of udgets either as principles on which all the udgets are ased or particularly for functional udgets such as Administration udget. The student will note that udgeting approaches covered in this chapter are very useful to functional departments within the organi2ation and ,on Profit #aking *rgani2ations as their operations are not sales demand driven. CONTENT% %. 2. '. 4. 5. Incremental udgeting. Zero /ase /udgeting. Jolling udgets. Activity ased udgeting. Program planning ased udgeting.

LEA$NING OUTCOME% After studying this chapter the student should e a le to) &escri e and evaluate Incremental /udgeting. &escri e and evaluate the main features of Zero /ased /udgeting. &escri e and evaluate periodic and continuous udgeting. 0nderstand the concept of planned program ased udgeting.

B'

%.-

The alternative udgeting approaches which an organi2ation can adopt include) Incremental udgeting Zero /ased /udgeting Jolling udgets Activity ased udgeting

1.1

INC$EMENTAL 5UDGETING Incremental udgeting is a traditional approach to udgeting" widely used in commercial organi2ations and the pu lic sector. Incremental udgeting means) Basing on next years budget on current years results plus extra amount for estimated growth or inflation. $pecific changes" such as planned e!pansion or reduction in activities would e allowed for.

1.1

#$ACTICAL E6AM#LE Guench Zam ia Ltd is a water ottling company. Transport cost for last year amounted to 8%2 million. Planned e!pansion is e!pected to result in 8%million additional transport costs Destimated at current pricesE. Inflation is e!pected at 'O The transport udget for ne!t year will e) C %-'O ! D8%2m P 8%mE Advantages of Incremental udgeting method are) It is an easy and straightforward approach to udgeting It is appropriate for such elements of costs as rent and salaries ecause they are increased ased on the previous year;s figures.

The maLor disadvantage to incremental udgeting is that) It tends to carry forward past inefficiencies into the future. It does not encourage improvement on the past performance.

B4

1.,

IE$O 5A%ED 5UDGETING 0I551 Zero /ased /udgeting is defined as) QA method of udgeting which re.uires each cost element to e specifically Lustified as though the activities to which the udget relates were eing undertaken for the first time. :ithout approval the udget allowance is 2ero; CIMA Official Terminology Z// thus reLects assumptions inherent in incremental udgeting that this year;s activities will continue at the same level or volume and that ne!t year;s udget can e ased on this year;s costs. Z// is a cost enefit approach where y it is assumed that the cost allowance for an item is 2ero" and will remain so until the manager responsi le Lustifies the e!istence of the cost item and the enefits the e!penditure rings

1.*

(>ere can I55 ;e app!iedJ Z// can e applied organi2ations. oth in profit seeking and non+profit seeking

In a manufacturing firm Z// is est applied to service and support functions including finance" administration production planning and so on. Z// can also organi2ations. e useful to service industries and a wide range of

1.-

%TAGE% IN IM#LEMENTING I55 The implementation of Z// involves a num er of steps ut of greater importance is the development of a .uestioning attitude where the following .uestions are asked to evaluate each activity) $hould the activity or function e performed at allM :hat would e the conse.uence if the activity were not carried outM At what level should it e performedM Is it eing performed in the optimum mannerM 1ow much will it costM

B5

%.5

The rest of the stages are stated elow De inition o pac:ages A decision package is a comprehensive description of a facet of the organisation;s activities or functions which can e individually evaluated. EBa!uation and ran:ing o pac:ages :hen the decision packages have een prepared" management will the rank all the packages on the asis of their enefits to the organi2ation. $esources a!!ocation :hen the overall udgeted e!penditure level is decided upon the package would e accepted in the ranked priority se.uence up to the agreed e!penditure level.

%.6

The advantages and limitations of implementing Z// AdBantages o I55 It is possi le to identify and remove inefficient operations. It forces employees to avoid wasteful e!penditure. It challenges the status .uo. It should result in more efficient allocation of resources. DisadBantages o I55 It increases volume of paper work. It may emphasise short+term enefits at the e!pense of long+term enefits. The ranking of packages may e difficult.

,.0

$OLLING O$ CONTINOU% 5UDGET% A rolling udget is a udget continuously updated y adding a further period say a month or a .uarter and deducting the earliest period.

,.1

("& $OLLING 5UDGETJ A Jolling /udget is an attempt to prepare targets and plans which are more realistic and certain particularly with regard to price levels y shortening the period etween preparing udgets.

B6

Actual conditions may differ from those anticipated when the udget was drawn up for a num er of reasons including the following)+ Change in organi2ation structure. Introduction of new technology. 9conomic changes such as inflation. Changes in the levels of activity.

Any of these changes may invalidate the original udgets and they would re.uire revision. ,., O#E$ATION OF A $OLLING 5UDGET %&%TEM A t>ree@mont> ro!!ing ;udget 9ou!d operate as o!!o9sD A udget is prepared for the coming year" say @anuary to &ecem er roken down into .uarters. The first .uarter udget that is @anuary to #arch will e prepared in greater detail and the remaining three .uarters in less detail. Towards the end of the first .uarter a much more detailed udget will e prepared for the second .uarter and in less detail for the remaining .uarters. In addition a new .uarterly udget" which is also in less detail covering the first .uarter of the su se.uent year" is added. 2.' Advantages of continuous udgeting) 2.4 /udgets are more realistic and achieva le. The annual disruption associated with the preparation of an annual udget is removed. The pressures placed on managers to achieve unrealistic udget targets are eased. 3ariance feed ack is more meaningful. They force managers to reassess udgets regularly.

&isadvantages of continuous udgeting) #anagers will e faced with greater workload and additional staff may e re.uired #anagers may devote insufficient attention to preparing udgets which they know will e shortly revised. The organi2ation may e re.uired to operate annual udgets as opposed to short term udgets

B7

*.0

#$OG$AMMING #LANNING 5A%ED 5UDGETING %&%TEM% 0##5%1 Traditional udgeting approach which is department ased is not very suita le for ,on+Profit #aking *rgani2ations such as ?overnment #inistries. A maLor criticism of the traditional approach is its lack of information on the activities actually eing performed y the ministries. Costs are analysed y their nature rather than purpose. PP/$ are intended to overcome such criticisms. The aim of PP/$ is to ena le the management of a ,on+Profit #aking *rgani2ation to make more informed decisions a out the allocation of resources to meet overall o Lectives of organisations.

'.%

$tages in the implementation of PP/$ Jeview of o Lectives of the activities undertaken y an organi2ation Identification of programmes which should e undertaken to achieve the organisations o Lectives Identification and evaluation of various methods of the o Lectives of the various programmes. $election of appropriate programmes on the asis of cost+ enefit principles

*.,

AdBantages o ##5% (orces management to identify activities or programmes to e provided" there y esta lishing the asis for evaluating their worthiness. Provides information that ena le management to assess the effectiveness of their plans. #ore efficient allocation of resources.

C1":#$% (855"%?
Incremental udgeting is the traditional approach to udgeting where ne!t year;s udgets are ased on the current year;s results plus an e!tra amount for estimated growth and inflation for ne!t year. It encourages slack and wasteful spending to creep into udgets. The principle ehind Zero /ase /udgeting is that the udget for each cost centre should e made from the scratch or 2ero. 9very item of e!penditure must e Lustified in its entirety in order to e included in the ne!t year;s udget There is a three+step approach to Z// o &efine decision units BA

o 9valuate and rank packages o Allocate resources Continuous udgets Drolling udgetsE are udgets which are continuously updated y adding a further period Dsay a month or .uarterE and deducting the earliest period.

BB

%TUDENT@%ELF TE%TING %ELF $E'IE( )UE%TION% %. 2. '. 4. 5. 9!plain the term Incremental /udgeting. 9!plain the term Zero /ased /udgeting. :hat .uestioning approach should e followed in the Z// approachM 9!plain the term Jolling /udgets. :hat is PP/$M

E6AMINATION T&#E )UE%TION% %. Incremental udgeting is) A. A method of setting udgets where each item of e!penditure must Lustify its inclusion /. The setting of a udget which is challenging ut attaina le C. The setting of a udget y adLusting the previous period;s udget for changes in activity and inflation &. A method of determining the principal udget factor. 2. :hat might e the ase package and incremental packages for a personnel department coverM /A$9 I,CJ9#9,TAL Training Jecruitment Pension administration Jecruitment

A. Jecruitment /. &ismissal C. Training &. Pension administration

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1 CHAPTER 11 FORECASTING TECHNI7UES IN 3U$GETING

Introduction This chapter involves the num er crunching aspect of udgeting. The preparation of a udget calls for preparation of forecasts of costs and revenues. This chapter aims to provide an understanding of various forecasting techni.ues though more attention will e given to Linear Jegression and Time $eries. Contents %. $catter diagram. 2. The high+low method. '. Jegression analysis. 4. Linear regression analysis. 5. Time series. Learning outcomes After studying this chapter" the student should e a le to) &raw a scatter diagram and use it for forecasting. 9stimate costs using the high+low method. &erive the linear regression e.uation. (orecast usiness varia les using the linear regression. &escri e the use of time series in forecasting. Perform computations using the time series model.

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CO%T #$EDICTION Three methods that can e used to forecast costs are) $catter diagram The high+low method Linear regression analysis

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%CATTE$ DIAG$AM This is a method of cost estimation where past costs at different activity levels are plotted on a graph. A line of est fit is then drawn. This line should e drawn through the middle of the plotted points as closely as possi le so that the distance of the points a ove the line are e.ual to distances elow the line. :here necessary costs should e adLusted to the same inde!ed price level to allow for inflation.

1.,

E<amp!e

The following ta le shows the num er of units of a good produced and the total costs incurred)
Units Produced 2,, .,, /,, 0,, -,, ),, 4,, Total Costs :;,,, 3, +, 2,, 2/, 20, 20, 2),

$e=uired aE &raw a scatter diagram including a line of est fit E (orecast total costs at 75- units
SCATTER DIAGRAM
TOTAL COSTS , ;000. .,, 2-, 2,, -, , , .,, 0,, UNITS ),, 3,,

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%OLUTION At 75- units total costs are estimated at 8%A-" ---

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"IG"@ LO( MET"OD This method involves the splitting of the total cost into its fi!ed and varia le components. The identified fi!ed and varia le components ecome the asis for forecasting. The specific steps involved are) $election of periods of highest and lowest activity levels and their costs. Identification of total varia le costs. Computation of varia le cost per unit. 9stimation of fi!ed cost. (orecasting total cost.

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E<amp!e #aintenance costs for the si! months to '%st &ecem er 2-<A are as follows
Total cost :I,,, .*.), .*2), .*/., .*0,, .*/,, .*.))

Month Kuly $ugust "eptember !ctober &ovember (ecember

Units /0, /,, /3, 0., 0,, /),

$e=uired aE 0se the high+level method to calculate the fi!ed costs per month and the varia le cost per unit. E (orecast total cost at 45- units.

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%o!ution
Units 0., /,, 2., .0,=2., > Cost O :I,,, .*0,, .*2), .0, :.*,,,

S#$: 1 S#$: 2 S#$: 3

1igh Lo8 Variable costs Variable cost=unit

ixed Costs > Total cost < variable cost S#$: ! ixed costs > .0,, < 6:.*,,, x 0.,7 1,590,000 orecast cost at 0-, units > :2*-),*,,, @ 6:.*,,, x 0-,7 = 2,!90,000

S#$: 5

,.,

LINEA$ $EG$E%%ION Linear Jegression Analysis also known as the Least $.uares techni.ue is a statistical method of estimating values of a usiness varia le such as production cost using historical data. In the udgeting process" Linear Jegression analysis is usually used to predict costs and in the rest of this section the techni.ue will e used to demonstrate how to predict costs. Linear regression is used to derive the formula for the line of est fit whose general form is) & 3 a K ;< 9>ere. y is the dependent varia le C total cost ! is the independent varia le C the level of activity a is the intercept of the line on the y+a!is C fi!ed costs is the gradient of the line C the varia le costs per unit of activity :here) C
a >

n ?E < 6 ?7 6 E7 n ? . < 6 ?7 .

RK
n

<

bN? n

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1istorical data is collected from the previous periods and adLusted to a common price level to remove inflationary differences. This provides a num er of readings for activity levels < and their associated costs K. Then y su stituting these readings into the formulae elow for Qa; and Q ;" estimates of the fi!ed costs and varia le cost per unit are provided. ,.,1 )UE%TION

Answer the .uestion in paragraph %.2 a ove using the Linear Jegression method. %OLUTION Notes to t>e ca!cu!ations %tep 1 Ta ulate the data and determine which varia le is the dependent varia le" y" and which is the independent varia le" !. %tep , Calculate R<" RK" R<S" and R<K %tep * $u stitute results of step 2 into the formulae elow to find order C
a>

and a in that

n ?E < 6 ?7 6 E7 n ? . < 6 ?7 .

n RK
n

<

b N? n

%tep - $u stitute in the regression e.uation. $teps % and 2

? 2 . / 0 ) 4 28 E 3, +, 2,, 2/, 20, 20, 2), 8!0 ?E 3, 23, /,, -., 4,, 30, 22., 3/!0 ?P 2 0 + 2) ./) 0+ 1!0

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%tep *
64 x /40, 7 < 6.3 x 30,7 4 x 20, O .3P

;3 a3
4 x /40, < .3C7 < 6.3 x 30,7 4 x 20, < .3 Q. .-*/4.

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TIME %E$IE% A time series is a name given to a set of o servations taken at e.ual intervals of time e.g daily" weekly" monthly" etc. The following are e!amples of Time $eries) &aily output at a factory for one month #onthly sales over a year Total annual e!ports

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Time series Grap> A graph of Time $eries is called a 1istorigram. E6AM#LED 1st quarte r B2 BB %-A %24 2nd quarte r B% %-%-2 %'% 3rd quarte r B5 BA %-6 %2A 4th quarte r B4 B6 %%%'-

2-<2 2-<' 2-<4 2-<5

The a ove time series will e plotted on a graph so that the overall picture of sales could e clearly o served. The hori2ontal a!is is always chosen to represent time" and the vertical a!is represents the values of the data recorded such as sales.

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H&(#3%&)%"5
20, 2., 2,, S"'$( 3, ), 0, ., , 2 . / 0 - ) 4 3 + 2, 22 2. 2/ 20 2- 2) T&5$- B8"%#$%( Time Variable

The a ove historigram shows an upward trend or growth in sales. ,.*, COM#ONENT% OF A TIME %E$IE% A time series has four components namely) ,.** Trend $easonal variation Cyclical variation Jesidual or random variation

Trend This is the way in which the graph of a time series appears to e moving over along interval of time when the short+term fluctuations have een smoothed out.

2.'4

* served trend pattern could e) &own ward" where the values are steadily declining. 0pward" where the values are steadily increasing over the o served time period. ,o clear movement" where the values are going neither up nor downward.

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%easona! Bariation $easonal variations are short term fluctuations in recorded values due to different circumstances which affect results at different times of the year" on different days of the week" at different times of day or any other time period.

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1ere are e!amples of seasonal variations) $ales of swimming costumes will e higher in summer than winter $ales of alcoholic everages may e higher over the weekend compared to the week days

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C?c!ica! Bariation This is the wavelike appearance of a Time series graph when taken over a num er of years. $uch fluctuations are caused y circumstances which repeat in cycles. In usiness" cyclical variations are associated with economic cycles i.e successive ooms and slumps.

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$esidua! or random Bariations This covers any other variations which cannot e associated with the trend" seasonal variation or cyclical variations dealt with a ove. These are events which happen randomly and are due to unpredicta le causes" e.g strikes" fires" sudden changes in ta!es.

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ANAL&%I% OF TIME %E$IE% In order to use a Time series as a asis for forecasting" it;s necessary to disentangle the various influences and measure each one separately.

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Additive and multiplicative model In order to separate the various components of a Time series its necessary to make an assumption a out how the four components are com ined to give the total effect. Two possi ilities are the additive model and multiplicative model. A T $ C J C C C C C Actual value for the period Trend component $easonal component Cyclical component Jesidual component

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AdditiBe mode! A3TKCK%K$ Mu!tip!icatiBe mode! A3T<C<%<$

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2.4'

(or the purpose of forecasting in the preparation of udgets" we shall ignore the random factor which is not easy to forecast. The cyclical factor will e assumed to e common to the figures under a forecast and so will e ignored. This leaves us with two varia les" trend and seasonal factors and we will egin y looking at how to find the trend in a time series. IDENTIF&ING T"E T$END Three methods could e used namely) ?raphical method Linear regression #oving averages

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*f the a ove methods we shall focus on how to use the #oving Averages in esta lishing the trend. ,.-4 MO'ING A'E$AGE% A #oving Average is an average of the results of a fi!ed num er of periods. $ince a moving average is an average of several time periods" it relates to the mid+point of the overall period. #oving averages of an odd num er of time periods results
Eear .,?! .,?2 .,?. .,?/ .,?0 .,?"ales /+, /3, 0), 0-, 04, 00,

$e=uired Compute a moving average of the annual sales over a three year period.

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%o!ution
Eear .,?, .,?2 .,?. .,?/ .,?0 .,?"ales /+, /3, 0), 0-, 04, 00, Moving Total of / year 2./,C 2.+,CC 2/3, 2/), 202, Moving $verages of / years "ales 02, 0/, 0), 0-/ 04,

L0*/0K*80K-201E* LL0*80K-20K-401E* There is an upward trend in sales which is more noticea le from the #oving Average than the original series of figures. ,.40 MO'ING A'E$AGE% OF E'EN NUM5E$ OF $E%ULT% :here the moving average is calculated for an even set of num ers e.g. values collected on a .uarterly asis a special pro lem arises in that the average does not relate to any specific time period as shown elow) 1st quarte r B2 BB %-5.75 %-A %24 This a erage is falling between 2!"3 and 2!"4the a erage needs to relate to a particular time period otherwise seasonal ariation cannot be calculated To overcome this difficulty" we take a moving average of the moving average as shown elow) The following is a Time $eries for sales collected over a four year time period for a company in the retail sector.
st

2-<2 2-<' 2-<4 2-<5

!uarte

"nd !uarte %%-

#rd !uarte

$th !uarte

2-<2 2-<' 2-<4 2-<5 $e=uired

r B2 BB %-A %24

r B% %-%-2 %'%

r B5 BA %-6 %2A

r B4 B6 %%%'-

&etermine the trend and the .uarterly seasonal factors ,.41 %OLUTION A moving average of four will e used" since the volume of sales would appear to depend on the season of the year and each year has four .uarterly results. The moving average of four does not relate to any specific period of time and as such a second moving average of two will e calculated on the first moving averages.

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Kear Ruarter ?. ?. ?. ?. ?/ ?/ ?/ ?/ ?0 ?0 ?0 ?0 ????% 2 ' 4 % 2 ' 4 % 2 ' 4 % 2 ' 4

"ale s 6,,,7 B2 B%

0 Ruarterly moving totals

0 Ruarterly moving average

Mid point of . moving average Trend

/4. B5 /4+ B4 /33 BB /+2 %-/+/ BA 0,. B6 0,0 %-A 02. %-2 0.) %-6 00. %%042 %24 0+/ %'% -2/ %2A %'-

+/ +0 ++) +4 +3 +3 +3 +3 2,, 2,2 2,2 2,2 2,. 2,/ 2,2,4 2,+ 222 220 223 2., 2./ 2.) 2.3

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Discussion o t>e so!ution /y taking a mid+point Da moving average of twoE of the original moving averages" we can relate the results to specific .uarters" e.g the first trend value of B4 relates to .uarter ' of 2-<2. The upward trend in the sales values is more visi le in the trend values compared to the original values.

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FINDING T"E %EA%ONAL 'A$IATION% *nce the trend has een found" we can now esta lish the .uarterly seasonal variations using either the Additive model or the #ultiplicative model. :e shall illustrate the calculation of seasonal variations using oth models.

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%EA%ONAL 'A$IATION% U%ING T"E ADDITI'E MODEL As earlier discussed" if we ignored the random factor DrE and the cyclical factor DcE the additive model can e stated as) &3TK% M re@arranging t>e ormu!a in terms o %D % 3 & H T Mt>is e<pression is no9 used ;e!o9 to esta;!is> t>e seasona! actor. %o!ution
Kear "ales 6,,,7 E Trend T

"easonal factor T > E<T

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.,?.R2 .,?.R. .,?.R/ .,?.R0 .,?/R2 .,?/R. .,?/R/ .,?/R0 .,?0R2 .,?0R. .,?0R/ .,?0R0 .,?-R2 .,?-R. .,?-R/ .,?-R0

B2 B% B5 B4 BB %-BA B6 %-A %-2 %-6 %%%24 %'% %2A %'-

+0 +) +4 +3 ++ 2,2 2,. 2,2,+ 220 2.2 2.)

2 <. . . <2 <) </ </ <0 / -

2.62

In order to find the .uarterly factors" the figures are summari2ed in a ta le elow)
R2 .,?. .,?/ .,?0 .,?Total $verage . ) / 22 /D)4 R. . </ 0 2D// R/ 2 <2 </ </ 62D,,7 R0 <. <<0 <22 6/D)47 Total <2 <. <0 3 2 ,D//

3ariations around the asic trend line should cancel each other out and add up to 2ero. Looking at the ta le a ove they do not cancel out as yet" they give a total of -.''. :e therefore spread the total variation e.ually to all .uarters as shown elow)
R2 Estimates of #uarterly variations $dMustment to reduce variation to Gero 6,D// = 07 inal estimates of #uarterly variations /D)4 <,D,3./D-3 R. 2D// <,D,3.2D.R/ 62D,,7 <,D,3.62D,37 R0 6/D)47 <,D,3.6/D4-7 Total ,D// <,D// ,D,,

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%EA%ONAL 'A$IATION% U%ING T"E MULTI#LICATION MODEL As earlier discussed" if we ignored the random factor D r E and the cyclical factor D c E the additive model can e stated as) &3T< %

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M re@arranging t>e ormu!a in terms o %D % 3 &E T Mt>is e<pression is no9 used ;e!o9 to esta;!is> t>e seasona! actor. Computation of the trend

Kear

.,?.R2 .,?.R. .,?.R/ .,?.R0 .,?/R2 .,?/R. .,?/R/ .,?/R0 .,?0R2 .,?0R. .,?0R/ .,?0R0 .,?-R2 .,?-R. .,?-R/ .,?-R0

"ales 6,,,7 E B2 B% B5 B4 BB %-BA B6 %-A %-2 %-6 %%%24 %'% %2A %'-

Trend T

"easonal factor T > E=T

+0 +) +4 +3 ++ 2,2 2,. 2,2,+ 220 2.2 2.)

2D,2,) ,D+4+. 2D,.,) 2D,.,0 ,D+3++ ,D+-,2D,-33 ,D+420 ,D+4.,D+)0+ 2D,.03 2D,/+4

2.64

Computation of seasonal variations In order to find the .uarterly factors" the figures are summari2ed in a ta le elow)

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R2 .,?. .,?/ .,?0 .,?Total $verage 2D,.,) 2D,-33 2D,.03 /D2,0. 2D,/04

R. 2D,.,0 ,D+420 2D,/+4 /D,/22D,2,-

R/ 2D,2,) ,D+3++ ,D+4..D+4/, ,D++2,

R0 ,D+4+. ,D+-,,D+)0+ .D3+0) ,D+)0+

Total 2D+3+3 /D+320 /D+)4) .D,)02.D,,// 0D,,22

:hilst under the Additive model" the average should come to 2ero" under the #ultiplication model the total should come to 4" % for each .uarter. The total is actually 4.--%% so -.---275 has to e deducted from each total as shown elow)

R2 Estimates of #uarterly variations $dMustment to reduce variation to Gero inal estimates of #uarterly Variations Rounded off values 2D,/04 <,D,,,.42D,/0-

R. 2D,2,<,D,,,.42D,2,.

R/ ,D++2, <,D,,,.4,D++,4

R0 ,D+)0+ <,D,,,.4,D+)0)

Total 0D,,22 <,D,,22 0D,,

2D,/

2D,2

,D++

,D+)

0D,,

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TIME %E$IE% ANAL&%I% AND FO$ECA%TING (orecast of future values are found y finding the trend using the graphical method" Linear Jegression or #oving Average and then making an adLustment for seasonal variation. E<amp!e

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0sing the seasonal factors calculated a ove and the following trend values for 2-<6 prepare the .uarters %" 2 '" and 4 of 2--6 forecasts using additive and multiplication model.
Eear .,,) Trend Values Ruarters 2 2/, . 2/) / 2// 0 2/-

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ADDITI'E MODEL FO$ECA%T

Eear .,,) Trend Values "easonal factor orecast Ruarters 2 2/,D,, /D-3 2//D-3 . 2/)D,, 2D.2/4D./ 2//D,, 62D,37 2/2D+. 0 2/-D,, 6/D4-7 2/2D.-

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MULTI#LICATI'E MODEL FO$ECA%T

Eear .,,) Trend Values "easonal factor orecast 2 2/,D,, 2D,/ 2/0D03 . 2/)D,, 2D,2 2/4D/+ Ruarters / 2//D,, ,D++ 2/2D44 0 2/-D,, ,D+) 2/,D..

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FINDING T$END 5& MAT"EMATICAL E6T$A#OLATION (uture Trend can also e found y e!trapolating past trend into the future as shown in the e!ample which follows) Trend values for sales y Zam 1ouse over the last three years have een as follows Kear % 2 ' %st Guarte r 7"4BA"'B5 B"-B6 2nd Guarte r 7"66% A"4BA B"2B7 'rd Guarte r 7"AAB A"7-B B"4B5 4th Guarter A"%24 A"AAB"7-6

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Average seasonal variations for the four .uarters have een) Guarter % 2 ' 4 %o!ution
$verage increase in trend > 6+*4,) < 4*0+,7=22 > .,2

%st Guarter P 5' P BB7 P %"2-' + 2"25'

uture trend for the next year Eear 0 Estimate of Trend values for year 0 +4,) @ .,2 +4,) @ 6. x .,27 +4,) @ 6/ x .,27 +4,) @ 60 x .,27 Trend +*+,4 2,*2,3 2,*/,+ 2,*-2, "easonal factors orecast +*+), 22*2,22*-2. 3*.-4

%st Guarter 2 Guarter ' Guarter 4th Guarter

rd nd

5' BB7 %"2-' +2"25'

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C"A#TE$ %UMMA$& This chapter has considered statistical techni.ues which an accountant can use to o tain information for inclusion in udgets. #ethods for forecasting costs include) o $catter diagram o The high+low method o Linear regression analysis $catter diagrams can e used to estimate the fi!ed and varia le components of costs" which can e used forecast total costs. The 1igh low #ethod is a relatively simple way of determining the fi!ed and varia le costs elements of varia le costs. The linear regression analysis model is used formulate the e.uation for the Line of /est (it which can e used to estimate values of a given varia le. A Time $eries is a series of figures or values recorded overtime. A Time $eries has 4 components ) o Trend o $easonal variation o Cyclical variation o Jandom factors The four components can e com ined using either a #ultiplicative or an Additive model. (orecasts can e made y calculating the trend line and adLusting these using the seasonal factors.

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%TUDENT@%ELF TE%TING %. #ention three methods used to predict costs. 2. :hat is a scatter diagramM '. #ention steps are involved in the 1igh+Low method. 4. $tate the formula for Linear Jegression Analysis. 5. :hat is meant y trendM 6. :hat is $easonal 3ariationM 7. :hat is Cyclical 3ariationM E6AMINATION T&#E )UE%TION% %. The total maintenance costs and machine hours for the past ten accounting years were as follows)
Eear 2 . / 0 ) 4 3 + 2, Machine 1ours 0,, .0, 3, 0,, /., .0, 2), 03, /., 2), Maintenance cost 6:7 +), 33, 03, 2.,, 3,, )0, -), 2.,, 33, 00,

$e=uired aE &erive the Jegression e.uation from the a ove data. E 9stimate the maintenance cost for the following year when 25- maintenance hours will e worked.

2.

:illiam owns a small corner shop and his sales over a three week period were as follows)
(ay Lee9 2 Lee9 . Lee9 /

%2-

Monday Tuesday Lednesday Thursday riday

-), 30, 4.3 )-3 0/0

-40 3444, )4+ 003

-33 +2, 32. 4,, 0).

:illiam has used Jegression Analysis to calculate a trend line for the sales of) y C 2.B4! P 64A.B $e=uired aE (ind the seasonal variation for each of the %5 days" and the average seasonal variation for the week using the following models)+ iE iiE The Additive model The #ultiplicative model

E (orecast sales using oth models a ove.

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CHAPTER 12 3U$GETING IN THE PU3LIC SECTOR

Introduction Like in the private sector" planning is an important management function in the pu lic sector. Control is e.ually important to ensure that plans are achieved. The udget provides the link etween the two activities. The udget e!presses what is to e undertaken in the ne!t year and authori2es the financial resources that will e needed. Two important udgets in the conte!t of pu lic sector udgeting process are capital and revenue e!penditure. Contents %. 2. '. 4. 5. &efinition of a udget * Lectives of udgeting Jevenue udgets Capital udgets /udgetary approaches Learning outcomes

After reading this chapter" the student should e a le to) &efine a /udget. *utline the o Lectives of Pu lic $ector /udgeting. &istinguish Jevenue /udgets from Capital /udgets. &escri e the key approaches to Pu lic $ector /udgeting.

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5UDGETING IN T"E #U5LIC %ECTO$

A udget plays a very important role in the managerial planning and control of pu lic sector organisations. Although Long+term and medium term plans are important in well run organisations" they are only an e!pression of intentions. It is only when these intentions are incorporated into annual udgets that they ecome firm commitments with funds eing allocated to ena le their achievement. The annual udget e!presses what is to e undertaken during the ne!t year and authori2es the financial resources that will e needed. /udgets are invaria ly e!pressed in financial terms" although other measures should ideally e incorporated. It is also important to make a clear distinction etween capital income>e!penditure and revenue income> e!penditure and to prepare separate annual revenue udgets and annual capital udgets. ,.0 T"E O5GECTI'E% OF ANNUAL 5UDGET #$E#A$ATION

The o Lectives of the annual udgetary process within the pu lic sector are discussed elow. ,.1 T>e esta;!is>ment o t>e re=uired income !eBe!s. The income in the pu lic sector comes from ta!ation" fees and charges levied y the ?overnment. /udgeted income for the forth coming year is arrived at y e!amining the current levels of income and y looking at the levels of e!penditure planned for the coming year. The desire to minimi2e ta! increases" while increasing .uality and .uantity of services" provide the dynamics and stresses of the udgetary process. ,., #!anning serBice e<penditure !eBe!s

*ne of the most important o Lectives of Pu lic $ector /udgeting is to assist in the planning of service e!penditure levels and the levels of service provision. The total of service e!penditure has to e accommodated within the total income raisedN ut within this total" choices have to e made etween e!penditure on various items. ,.* Aut>oriFation o e<penditure

The udget authori2es the e!penditure of pu lic funds on those services and to the total of those service e!penditure levels which are agreed in the udget. #oney should e spent on what has een authorised in the annual udgetN and one guideline for su se.uent decisions is to en.uire whether an item of e!penditure is included under a udget e!penditure head

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T>e contro! o e<penditure

The udget provides a asis for control of e!penditure. At its crudest total annual e!penditure should not e e!ceed the udget. This philosophy can e applied throughout the organisation" to the e!penditure of services and within services" to e!penditure on su services and to detailed heads. ,.4 A communication deBice

The udget is an e!cellent communication deviceN service managers are informed through out the udget not Lust of the annual e!penditure allocation ut also of service level proposed. ,.2 Focus attention

The udget process focuses attention on the futureN it thus forces a consideration y managers of the o Lectives" methods and costs of service delivery. ,.7 MotiBation o managers

Though the link etween udgeting and motivation is comple! it is possi le that managers are well motivated and form an attachment to the udget" when they have played a role in helping to formulate it. *.0 5UDGET% #$E#A$ED IN T"E #U5LIC %ECTO$ Jevenue income udget Jevenue e!penditure udget Capital income udget Capital e!penditure udget

(or most pu lic sector odies income and e!penditure of a revenue nature is usually much greater than the capital income and e!penditure in any given year. *.1 $E'ENUE 5UDGET%

Annual udgets have een developed as attempt y the Parliament to e!ercise control over the activities of the Central ?overnment. It is an esta lished practice that the total ?overnment and the appropriations of e!penditure for particular purposes have to e approved for each financial year y Parliament. The most compelling reason for a revenue udget is to determine the levels of income and e!penditure. (or ta! funded services this would ena le the ?overnment fi! levels of ta!ation and for the charges funded services" the ?overnment would e a le to set the level of charges.

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Line@Item 5udget

Line udgets are udgets which place considera le emphasis on the nature of the income and e!penditure e.g income from grants" fees" sales or e!penditure on salaries" materials traveling etc. At its most e!treme" a line udget would appear as shown elow) *.* E<amp!e o summarised !ine item ;udget
L3+"' A8#13%&#? B8<)$# 43% Y$"% E*<$< 31 M"%+1

E>:$*($(
Employees Premises costs Transport costs "upplies and services "upport services Capital financing costs Total Costs I*+35$ 'overnment grants "ales ees and charges Rent %nterest Miscellaneous income Total %ncome 5alance to be met from council tax ??? ??? ??? ??? ??? ???

:;,,,

???

??? ??? ??? ??? ??? ??? ??? ???

The main disadvantage with the a ove approach is that the statement cannot identify the amount allocated to each individual service and would therefore fail to reflect the planned level of activity for each service.

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#$OG$AMME 5UDGET %T$UCTU$E

This is a udget approach which places emphasis on the purpose of the e!penditure such as crime prevention" mental health care" refuse disposal etc. It is argued that the programme udgeting approach as illustrated elow should lead to etter managerial planning and control ecause resources could e allocated more precisely to specific activities and actual achievements could e monitored more effectively. *.4 An e<amp!e o a programme ;udget or a po!ice aut>orit?
P3'&+$ A8#13%&#? B8<)$# Crime control and detection Crime prevention advice Traffic control Cro8d control Police training court 8or9 Prison duties Rehabilitation of offenders $dministration Research and planning Total :;,,, ??? ??? ??? ??? ??? ??? ??? ??? ??? ??? ????

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CA#ITAL 5UDGETING

If a pu lic sector organisation is to e successful in achieving its fundamental aims and o Lectives it is necessary to give careful consideration to the planning of capital e!penditure re.uirements. -.1 T"E FO$M OF CA#ITAL 5UDGETING

Although capital udgets may e prepared for one year only" the long term nature of capital schemes suggest that udgets for several years a head will usually e more appropriate. A useful approach to the pro lem of planning and controlling capital e!penditure is to develop capital programmes which e!press the overall plan of short" medium and long term capital schemes" and reveal the allocation of priorities etween different parts of the organisation.

%26

-., 4.0

INFO$MATION IN A CA#ITAL #$OG$AMME Title of capital scheme The committee" department and officer responsi le A description of the scheme The priority rating The schemes in progress+ cost to+date Plus estimated future costs A##$OAC"E% TO T"E 5UDGETA$& #$OCE%%

:e now consider different models of the udgetary process within the pu lic sector. :e shall particularly consider four models that may e regarded as paradigms that any pu lic sector organisation can choose from. 4.1 Incrementa!E departmenta!

0nder this approach" the udget for each year takes as the starting point the udget for the previous year and adds or su tracts marginally from the ase. $uch systems tend to emphasi2e the o Lectives of the individual services and departments. 4., $ationa!E corporate

These approaches are less concerned with the udget ase and the past ut are more concerned with using resources to meet currently esta lished o Lectives. In addition these approaches foster a corporate view" taking into account inter service aspects and the o Lectives of the whole organisation. :e now move on to consider two models within the incremental model and two models within the rational model. 4.* T>e ;id s?stem %tage 1@ separate estimate preparation $eparate departments or services prepare ne!t years estimates in isolation adopting as a starting point the current years e!penditure and service levels Dthe ase udgetE. %tage , @ Aggregation and comparison The separate estimates" or ids Dsimilar to an auctionE are then aggregated and the total is compared with what can e raised via ta!ation and charges. #ore often than not total estimated e!penditure e!ceeds total estimated income.

%27

%tage * @ reductions in estimated e<penditure !eBe!s At this stage proposals are made to marginally increase the income from ta!es" fees and charges in order to reduce the gap etween income and e!penditure. 1owever the gap is reduced mainly y reducing the proposed e!penditure y a given percentage. %tage - H detai!ed estimate reduction (aced y the prospects to make su stantial cuts in proposed e!penditure" the following guidelines are often used) Proposed Capital e!penditure is dealt with first where measures taken may include) Cutting out new proLects &elaying progress on part completed proLects Postpone start of proLects Jevenue e!penditure is reduced y) 4.4.-1 ,ew services are cut efore e!isting services ,ew services are delayed Level of service reduced $ervice deferred to following year

C$ITICI%M OF T"E 5ID %&%TEM Litt!e reBie9 o t>e ;ase ;udget :ithin the id system there is little review of the ase udget. This is not desira le ecause any pu lic sector organisation is faced with a comple! network of changing needs and pro lems which should e incorporated in the udgeting process.

4.-,

A departmenta! orientation The system views the departmental estimates and allocations as the focus of the udgetary process. The pro lem created y this approach is that the interest of a group" say old people may not e thoroughly addressed y a single department.

4.-*

Outcomes are ignored The system places more emphasis on the financial control of inputs with little attempt to relate these to the outputs that emanate from the e!penditure.

4.--

%ing!e ?ear emp>asis The system emphasises the annual udget yet one year is too short for effective planning. %2A

2.0

FINANCIAL #LANNING %&%TEM%

(eatures which distinguish financial planning systems from the id systems include) Their multi+ year nature The issue of e!penditure guideline The Loint consideration of capital and revenue udgets A more helpful specification and classification in the udget document. 2.1 MULTI@ &EA$ NATU$E

0nder this system in addition to the annual udgets are considered" medium term plans say 2+' years commitments and forecasts are considered. The annual udget is seen as the first year of a rolling udget in which each year" one additional year is added on as the past year is dropped off. 2., E6#ENDITU$E GUIDELINE

An e!penditure guideline" a target growth percentage or even an e!penditure limit is esta lished for each service prior to the preparation of detailed estimates for a department. 2.* GOINT CON%IDE$ATION OF CA#ITAL AND $E'ENUE 5UDGET%

There is a simultaneous consideration of capital and revenue estimates due to the fact that estimates are considered for several periods. 2.DETAILED %#ECIFICATION AND CLA%%IFICATION

#uch greater specificity is introduced into the udget process. In place of a id system;s ase e!penditure plus incremental we now have) /ase e!penditure P Inflation F Jeductions P committed growth P new growth 2.7 2.8 (EA+NE%%E% OF T"E FINANCIAL #LANNING %&%TEM%

,o Lustification of the ase udget 9mphasis placed not on o Lectives ut department 9mphasis is on input and not output #LANNING #$OG$AMMING 5UDGETING %&%TEM% 0##5%1 PP/$ was introduced into the (ederal ?overnment of the 0nited $tates of America y president @onson in %B65.

%2B

The goals of the PP/$ are) The careful identification and e!amination of goals and o Lectives in each area of government activity Analysis of the output of a given programme in terms of its o Lectives #easurement of the total cost of specific programmes not Lust for one year ut for several years into the future. The formation of o Lectives and programmes e!tending eyond one year to relate a annual udgets to long term o Lectives. Analysis of alternatives to find the most efficient ways of reaching programme o Lectives for least cost The o Lectives of analytical procedures to serve as a systematic part of the udget reviews process 2./ #rogramme de ined A programme is a set of activities which encompasses all organisational efforts to achieve a specific o Lective. A programme such as care for the elderly would have cross departmental oundaries. 2.10 Limitations o ##5% approac>

The attraction of the PP/$ has faded due to) 2.,0 Comple!ity of programme structures+ technical pro lems are encountered in constructing programme structures. The enefits of incremental policy making+ PP/$ completely ignores incremental approach which is key to reducing conflict+ the ase or stating point is o Lective. Pressure on participants in the process. Participants should need to have knowledge of several speciali2ed areas and this tends to create pressure on them.

IE$O 5A%ED 5UDGETING 0I551 Z// is a techni.ue where y the total cost of every item included in a proposed udget must e Lustified and approved. ,o are or minimum e!penditure level should

%'-

e accepted for any activity. The approach is to re.uire to a re+evaluation of all e!penditure and of all activityN activities start from 2ero ase. In reality many ?overnment organisations may retain functions or goals which have lost their usefulness as the environment has changed. Z// seeks to e!pose such e!penditure. 6.2% Although Z// is an appealing concept" it is difficult to appraise all activities due to) 6.22 Time factor $ome e!penditure are politically motivated $ome e!penditure are as a result of past commitments which are supported y some legislation. #ay generate too much information which decision makers cannot comforta ly handle.

&espite these draw acks it is clear that there is need to e!pose pu lic sector e!penditure to systematic review. This can e achieved y) Ad hoc efficiency studies The use of virement policy *ption udgets

2.,*

AD "OC EFFICIENC& and e ectiBeness %TUDIE% $uch studies which scrutini2es the effectiveness of current operations may e motivated y internal reviews or the may e sparked y the activities of e!ternal review agents such as the auditors.

2.,-

T"E U%E OF 'I$EMENT #OLIC& 3irement is a policy which allows discretionary savings to e switched y service y service managers to e!penditure heads according to the department;s priorities. This system is attractive as it is an inducement to those for those closest to the service delivery who are most likely to e a le to deliver efficiency savings to search out those savings. :here savings are lost there may e little incentive to search for them.

2.,4

O#TION 5UDGET% 0nder this system the priorities of a department are evaluated y testing the effect on a department when the udget allocation is increased e.g what is the effect on the service if) %-O cut in e!penditureM 5O cut in e!penditureM %O cut in e!penditureM

%'%

$uch options force a service to consider policies and operating procedures.

C+a*ter S'mmar)
This chapter dealt with the following topics)+ * Lectives of Annual /udget preparation Types of /udgets prepared in the Pu lic $ector Jevenue /udgets Programme /udget structure Capital /udgeting Approaches to /udgeting Process Criticism of the /id $ystem (inancial Planning $ystems Planning Programming /udgeting $ystems DPP/$E Zero /ased /udgeting The 3irement Policy

%'2

CHAPTER 18 3U$GET PREPARATION IN THE PU3LIC SECTOR

Introduction 1aving discussed the various approaches and types of udgets in the pu lic sector" this chapter will proceed to demonstrate the preparation of a udget under the Pu lic $ector.. Contents %. 9stimated out+turn 2. ,e!t years estimate Learning out come After studying this chapter" he student should e a le to) Prepare forecast for the remainder of the current year Prepare a udget for the forth+coming year

%''

1.0

T(O %TE#% IN 5UDGET #$E#A$ATION The preparation of a udget in the pu lic sector involves the following two stages) 1.1 9stimated out+turn for the current year 9stimate for the ne!t year #$O5A5LE O$ E%TIMATED OUT@TU$N

The first step involves forecasting the out turn for the current year which forms the udgetary ase for the construction of the udget for ne!t year. 1., E%TIMATE FO$ NE6T &EA$

The ne!t step is to proLect the e!penditure and income for the forth coming year ased on the pro a le or estimated out+turn. ,.0 DETE$MINING T"E #$O5A5LE OUT@TU$N FO$ T"E CU$$ENT FINANCIAL &EA$. The process involved in calculating the pro a le out+turn for the current year is as follows)+ 9sta lishing the actual to date. Adding estimated e!penditure for the remainder of the current year. ,.1 In estimating the e!penditure for the remainder of the year" the following should e considered) The proportion of the year remaining. The anticipated inflation for the remainder of the year. Impact of pay awards on staff costs. Cost of new products to e commenced in the current year.

E6AM#LED #$E#E$ATION OF OUT@TU$N FO$ T"E &EA$ The following information relates to costs of a government funded Prisoners; Jeha ilitation Centre for a nine month period ending '%st &ecem er 2--4.

%'4

F3%5$% P%&(3*$%( R$1"7&'&#"#&3* C$*#%$ :I,,, I*+35$ 6!,500 Employees Running expenses $sset rents and capital charges T3#"' E>:$*<&#8%$ N$# E>:$*<&#8%$ +2*3,, .4.*-,, /4*-,, !01,800 30/,300

The following assumptions is the asis for preparing estimated out+turns Income ,o changes are e!pected in the pattern of income in the ne!t three months Emp!o?ees 9mployees will receive an increment of 4O in the ne!t .uarter $unning e<penses 25O of the running cost is e!pected to e fi!ed while and the varia le component is e!pected to rise y 6O. Asset rents and capita! c>arges Asset rents and capital charges is the actual payments made to '-th $eptem er 2--5 $e=uired Prepare a statement of the estimated out+turn as at '%st march 2--5.

%'5

,.,1

%o!ution
Estimated out< turn :;,,, 2.)*,,, 2./*).0 /)4*0.2 4-*,,, 599,0!5 !!0,0!5 Estimated out<turn .4.*-,, )3*2..,0*/4+,*3// .4)*-33 39/,!21

P%&(3*$%( R$1"7&'&#"#&3* C$*#%$ I*+35$ Employees Running expenses $sset rents and capital charges T3#"' E>:$*<&#8%$ N$# E>:$*<&#8%$ :;,,, 6!,500 +2*3,, .4.*-,, /4*-,, !01,800 30/,300 Lor9ings +0-,,=/x0 +23,,@ 6+23,,=/x2D,07 see 8or9ing belo8 /4-,,=.x0

Lor9ing R8**&*) +3(# ixed .-H Variable 4-H

,.*

DETE$MINING T"E E%TIMATE FO$ T"E NE6T &EA$

Preparing e!penditure for the coming year involves the following) Take the pro a le e!penditure prepared in step D2.2 a oveE one a ove Add t>e o!!o9ingD iE The full+year effect of any e!penditure" nota ly employee costs" where a part+year effect in the current year is to e converted into a full year effect for ne!t yearN for e!ample the pay increase for step one a ove would now e for the whole year. The part year effect of ne!t years estimated pay award. 9stimated price inflation for consuma les" energy" transport" etc Any committed growth for ne!t yearN whether this e due to salary increments" the full year effect of completed schemes and so on. (inally" add in new or discretionary growth.

iiE iiiE ivE

Deduct t>e o!!o9ingD

%'6

iE iiE

Any non+recurring e!penditure in the current year which will not e repeated ne!t year. Any savings which are estimated to accrue ne!t in the ne!t year

Additional re.uirements for the .uestion a ove C>arges iE Emp!o?ees iiE Charges to residents are e!pected to increase y %-O with effect from %st April 2--5 It is e!pected that a wage award of 6O will e made with effect from %st *cto er 2--5

$unning e<penses iiiE The fi!ed costs are e!pected to increase y %-O p.a with e!ception of 5-ivE 3aria le costs are e!pected to increase y 7.5O with effect from %st #arch 2--5

Asset rents and capita! c>arges vE The e!pected amount for the whole year is 8%2 million $e=uired 0sing this information prepare a udget for the ne!t year. %o!ution
P%&(3*$%( R$1"7&'&#"#&3* C$*#%$ B8<)$# 43% 31(# M"%+1 2009 :;,,, %ncome 2/3*),, Employees Running expenses $sset rents and capital charges Total Expenditure &et Expenditure 2//*)/) /+4*.03 2.,*,,, )-,*33-2.*.3-

W3%0&*)( :I,,,

%'7

%ncome Employee Total Running expenses ixed costs Variable Total

2.),,,x2D2 +23,,=/x2D,)x. )034.x2D,)

138,900 )0*34. )3*4)0 133,939 ++*+2) .+4*//. 36/,2!8

2D2x+,3// 2D,4- x .4)-33

%'A

End o c>apter =uestions The following information relates to a police authority for the si! months to '- $eptem er %B<B)
M"'8 P%32&*+$ C%&5&*"' R$+3%<( 344&+$ Employees Premises "upplies and services Transport Central department and technical support Miscellaneous expenses $sset rents and capital charges Total :;,,, ./-*-,, 03*,,, .+*4-, 4*),, /-*/,, .4*-,, 2-*,,, /+3*)-,

Note) aE 9mployees received a pay award of 5O during the first half of the year and paya le with effect from '- @une %B<B E 1alf of premises costs for the first half+year comprises space heating costsN space heating costs in the last 4 months of the year are e!pected to e.ual total costs for the first A months of the year. cE Asset rents and capital charges are paya le on '- $eptem er and '%st #arch. dE &ue to increase in the price of fuel" transport costs will e 2.5O higher in the second half of the year. eE $upplies and services includes a non+recurring payment of 85 million made in @une %B<B $e=uired Prepare a statement giving the estimated out+turn for the year ended '%st #arch %B<-

%'B

%OLUTION (O$+ING% (1 Emp!o?ees < P %.-5! C 2'5 5-2.-5! C 2'5 5-< C %%4 A7A Pay in .uarter 2 C %.-5 ! %%4 A7A C 1,0 2,, #remises ,on space heating costs C %>2 ! 4A --$i! months ,e!t ' months C 24 --->6 ! 2 9stimate for the A months 9stimate for the ne!t 4 months Total space heating cost Tota! #remises costs %upp!ies and %erBices Jecurring C D2B75-+5--E>6!%2 ,on recurring Tota! (Transport $i! months ,e!t si! months %.-25 ! 76-Tota! Centra! department and tec>nica! support $i! months to '-th $eptem er $i! months to '%st #arch Tota! Asset and Capita! C>arges $i! months to '-th $eptem er $i! months to '%st #arch Out Turn Misce!!aneous E<penses 27 5-->6 ! %2 24 --24 --A --'2 --'2 --64 --AA --5A 5-5-4/ 000 7 6-7 7B14 */0 '5 '-'5 '-70 200 (2 %5 --%5 --*0 000 44 000

(,

(*

(4

(7

%4-

Mal' Pro!i"ce Crimi"al Record o((ice

8;--9mployees Premises $upplies and $ervices Transport Central department and technical support #iscellaneous 9!penses Asset rents and capital charges 9stimated out+turn %2- 622 AA --5B --%5 'B'5 '-55 --'- ---0* *1,

C+a*ter S'mmar)
0nder this chapter" the following have een covered) $teps in /udget preparation process Pro a le or 9stimated out+Turn 9stimates for the ,e!t Kear

%4%

CHAPTER 1.
MO$ERN MANAGEMENT ACCOUNTING TECHNI7UES TTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTT
Learning Outcomes After studying this chapter students should e a le to)+ Appreciate the various developments in the modern manufacturing scenario &emonstrate strong knowledge of throughput accounting &iscuss Target costing To show understanding of Life Cycle Costing TTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTT T Throughput Accounting Introduction The CI#A *fficial Terminology defines QThroughput; as) QThe rate of production of a defined process over a stated period of time. Jates may e e!pressed in terms of units of products" atches produced" turnover" or other meaningful measurements DCA#+IE;. The term QThroughput; is defined y ?oldratt and Co! D%BABE y means of the following e.uation) Throughput C sales revenue less direct material cost. The aim of Throughput Accounting is to ma!imise this measure of throughput. The direct material cost referred to in the a ove definition relates to all material purchased during a particular period" and not simply to material used. The principle ehind throughput accounting is that all costs other than material are effectively fi!edN even those costs which are seen as varia le in the traditional sense" or costs which would normally e split into fi!ed and varia le elements" are treated as entirely fi!ed.

%42

The focus of throughput% As the e.uation shows" throughput is dependent on four elements) %E 2E 'E 4E 0nit selling price N $ales volumeN Purchase of usage of direct material. 0sage of direct materials

A focus on throughput necessarily focuses management attention on these four areas. There are strong interrelationship etween the a ove four items" particularly etween %" 2and 4. If a company were to reduce its selling price" if faced with a downward sloping demand curve" it would e!pect to see an increase in its sales volume" and might also see an increase in the speed of use of raw materials" particularly when the new sales are satisfied from stock. The throughput approach is therefore in sympathy with the @IT approach. #aterial held in raw material" work+in+progress or finished goods increases direct material cost" ut does not increase throughput. Throughput is only increased when finished goods are sold" and the value of the sales feeds through into sales revenue in the throughput e.uation. 1owever" the throughput approach does not go as far as the @IT philosophy in its attitude to stock. In throughput accounting" it is recogni2ed that it may sometimes e necessary to maintain stock" in order to alleviate a resource constraint and therefore increase the speed of throughput. Constraints on t>roug>put The idea of Qconstraint; is central to the throughput approach. It asks) Qwhat are the factors F market" organisational and production F which are preventing the company from e!panding at the present timeM; These factors might include) DiE DiiE DiiiE DivE DvE DviE Inade.uately trained sales forceN Poor reputation for meeting delivery datesN Poor physical distri ution systemN 0nrelia ility of material suppliers" delivery and>or .ualityN Inade.uate production resourcesN Inappropriate management accounting system.

*nce the constraints have een identified" management attention and action can e focused on alleviating them. $ome of the constraints may e interrelated) a poor reputation for meeting delivery dates could e associated with inade.uate production resources" which in turn may e related to the signals generated y the management accounting system. (or e!ample" if a company operates a traditional standard costing system" interrupting the production schedule of a particular work station" so that goods can e completed to satisfy a customer;s rush order" will result in an adverse direct la our efficiency variance eing

%4'

reported" if the interruption in work re.uires the machine to e stopped and reset to meet this rush demand. A stoppage of this kind is not necessarily undesira le" despite the signal sent out from the accounting system" ut it needs to e noted that such a stoppage would always e discouraged if efficiency variances were ased on keeping %-- per cent utili2ation of particular resources" a philosophy which traditional accounting systems have tended to encourage.

5ott!enec: $esources Throughput accounting is most associated with the management of production resources. The ultimate aim of many modern manufacturing approaches F CI#" @IT etc. F is to ena le production to take place in a complete alanced manner" so that productive resources are an e!act match for the demand placed upon them. This means that there are no constraints F known as ottleneck resources F within a factory. 1owever" the throughput approach recogni2es that this will rarely e the case when there is a healthy demand for the changes in demand y the consumer. The throughput approach is dedicated to the identification and su se.uent elimination of ottleneck resources. :here elimination is not possi le" it seeks to ensure that ottleneck resources are utili2ed for %-- per cent of their availa ility. A reassessment of the measures traditionally employed to record the efficiency of surrounding resources may sometimes e re.uired. (or e!ample" if the output of machine A ecomes the input to machine /" and machine / is a ottleneck resource" it would make more sense in terms of the overall efficiency of the facility if machine A were to limit its production to the capacity of machine /" in order to avoid the output of machine A simply ecoming work+in+progress" which would increase neither the throughput of the organisation nor its profit. As noted a ove" once a ottleneck has een identified" it is the aim of the throughput approach to eliminate it. This can sometimes e done with e!isting resources) it may e possi le" for e!ample" to modify other machinery in such a way that it can perform the operations of the ottleneck resource" and there y eliminate the pro lem. 1owever" the almost invaria le result of this is simply to move the ottlenecks to some other part of the plant" and management;s attention would then have to focus on the elimination of this second constraint. If reorgani2ation of e!isting resources cannot get rid of a ottleneck" and alternatives such as uying in particular components are not availa le or are reLected" a company must consider investing in new e.uipment in order to alleviate it. The throughput may thus lead to a etter allocation of capital investment funds than would e possi le under traditional system. The throughput approach should therefore e viewed as a search for continuous improvement" rather than another techni.ue which simply reports on the status .uo.

%44

T>roug>put measures The role of the accountant in a throughput environment is to devise measures which willN help production staff to achieve greater throughput volume. Attention should e drawn to the financial effects of ottlenecks. (or e!ample" if a particular machine which is a ottleneck resource fails to operate for one single hour as a whole" it will readily e appreciated that dividing this figure y total production time availa le results in a rate per throughput hour dramatically in e!cess of the cost of operating the ottleneck machine as measured y traditional accounting methods" thus highlighting the pro lem. Consistency etween Throughput as so far defined and traditional financial reporting are helpful in analy2ing performance. The reader will have noted that Qdirect material cost; in the definition of Qthroughput; given earlier related to the cost of material purchased in a period" rather than the cost of the material actually used. The ehavioural impact of this definition is to encourage managers to minimi2e stockholdings" an aim fre.uently found in modern manufacturing environments. 1owever" if an attempt is eing made to integrate throughput measure with traditional accounting systems" the measure of throughput would o viously need to e modified to reflect the more traditional approach. 1owever" the authors wish to point out that a de ate as to which is the right measure of throughput is sterile. As noted earlier" throughput is an approach to managing a usiness and management should select the measure which is most appropriate to the particular circumstances. A throughput report that deals with direct material in a manner which is consistent with traditional accounting measures is shown elow) Throughput report $ales &irect material cost of sales Throughput &irect la our Production overhead Administration costs $elling e!penses *perating profit ! D!E ! D!E D!E D!E D!E D!E !

DThe reader will note that the Qthroughput; in this report is an a solute measure in financial terms. This may e surprising as the 9nglish word Qthroughput; contains connotations of movement or flow. 1owever" Qthroughput; emphasises flow in the management of the production process" and as reiterated a ove" it is process management rather than accounting which reflects the true focus of the throughput approach.

%45

In this second Qversion; of throughput accounting" direct materials are treated in precisely the same way as in traditional accounting systems" i.e. direct material costs are associated with raw materials" work+in+progress" finished goods and cost of sales. 1owever" oth Qversions; of throughput accounting differ from conventional accounting in their treatment of direct la our costs and production overheads. In throughput accounting" these are regarded as period costs" to e e!pensed in the period in which they are incurred and are thus treated in e!actly the same way as selling" distri ution and administrative costs Dwhich" of course" will receive the same treatment under oth throughput accounting and traditional systemsE. Clearly" these results in all stocks in a throughput accounting system eing held at raw materials cost only. &orngren et al D%BB7E refer to throughput accounting as an e!ample of Qsuper+ varia le costing;. T>roug>put and contri;ution :hen making short Fterm Ludgments as to the relative profita ility of particular product lines" it has een conventional to look at the contri ution F selling price less direct costs and varia les production overheads F and to give priority to producing those items which show the highest contri ution per unit. Certainly" this measure is often used as the asis for encouraging salesmen to push particular products. In a throughput environment" the attractiveness of particular products is related to their consumption of ottleneck resources. The production scheduling process would result in priority eing given to those products which were est a le to generate throughput. (or e!ample" product A" with a unit contri ution of : 3, ,,, ut a re.uirement of two minutes of a ottleneck resource" would e preferred to product /" with a unit contri ution of 8 %6---" ut a re.uirement for five minutes of the ottleneck resource. In this respect" we should note" the throughput approach is simply employing the common short term decision Fmaking techni.ue of ma!imi2ing contri ution per limiting factor. It must e stressed that such product ranking are relevant for short+term production scheduling only" and their use should not e e!trapolated to determine longer term sales effort. :hen adopting a throughput approach" it would e e!pected that ottlenecks will e alleviated" so that the ranking can e e!pected to change Fpossi ly very .uickly F over period of time. Indeed" as indicated a ove" any change in the mi! of products demanded y customers can have the effect of immediately switching the ottleneck resource within a production capacity" and hence altering the relative attractiveness of particular products. The relationship etween the traditional accounting techni.ue of ma!imising contri ution per unit of scare resource and throughput accounting The relationship etween the traditional accounting techni.ue of ma!imising contri ution per unit of scare resource and the throughput approach is illustrated y the simple e!ample given elow.

%46

#xample A company produces two products" A and /" the production costs of which are shown elow) A / 8 8 &irect material cost %%&irect la our material cost 5 B 3aria le overhead 5 B (i!ed overhead 5 B Total production cost 25 '7 (i!ed overhead is a sor ed on the asis of direct la our cost. The products pass through two processes" K and Z" with associated la our costs of 84- --per direct la our hour in each. The direct la our associated with the two products during these processes is shown elow) Process K Z Time Taken Product A Product / %- mins. 2- mins. 'B mins. %5 mins.

$elling prices are set y the market" the current market price for A eing 865 and that for / 825. At these prices" the market will a sor as many units of A and / as the company can produce. The a ility of the company to produce A and / is limited y the capacity to process the products in K and Z. The company operates a two+shift system" giving %6 working hours per day. Process Z is a singleFprocess line" and for technical reasons this line can only e operated for a ma!imum of %2 hours per day. Process K is a dual process line" and thus two units can e processed simultaneously" although this dou les the re.uirement for la our. Process K operates for the full %6 working hours each day. $uestion /ased on the a ove information" what production plan should the company follow in order to ma!imise profitsM %olution In order to find the profit+ma!imising solution in any pro lem" the constraints which prevent the profit from eing infinite must e identifiedN the greater the num er of constraints the more difficult the pro lem is to solve. In the most simple case" where there is only one inding constraint" the profit ma!imising solution is found y ma!imising the contri ution per unit of the scare recourse" i.e. the inding constraint.

%47

Linear programming may e used to solve the pro lem where more than one constraint is inding for some" ut not all" feasi le solutions. :here the num er of products is limited to two" and such constraints are relatively few in num er" the pro lem can easily e e!pressed graphically to reveal the profit Fma!imising solution" and>or the pro lem can e e!pressed in the form of a set of simultaneous e.uations. As the num er of potentially inding constraints increase" the use of a computer ecomes the only feasi le way to solve the necessary num er of simultaneous e.uations. #a!imum process time K C 2 ! %6 ! 6- C%"B2- minutes #a!imum process time Z C %2 ! 6- C72- minutes $o the ma!imum num er which could e produced of each of the two products is) Products A #a! units K Z %"B2- C %B2 %722C '6 Product / #a! units %"B2- C 4B.2' 'B 72- C 4A %5

In the case of oth products" the ma!imum num er of units which can e produced in process K e!ceeds the num er which can e produced in process Z" and thus the capacity of process K is not a inding constraintN the pro lem" therefore ecomes one of deciding how to allocate the scare production capacity of process Z in such a way as to ma!imise profit. Traditional approach ' ma(imi)ing the contribution per minute in process * Contri ution of A C865 Dselling priceE less 82- Dvaria le costE C 845 Contri ution of / C852 Dselling priceE less 82A Dvaria le costE C 824 Contri ution of A per minute in process Z C 845 C 82.25 2Contri ution of / per minute in process Z C 824 C 8%.6%5 The profitFma!imising solution is therefore to produce the ma!imum possi le num er of units of A" '6 giving a contri ution of 845 ! '6 C8%"62-. &rofit maximi'ation It is clear" given their different solutions that the two approaches cannot oth lead to profit ma!imi2ation. A comparison of the two F the Qtraditional; approach and the Qthroughput; approach F shows that the former indicates that profits will e ma!imised y producing A only" while the latter indicates that product / alone should e produced.

%4A

This dichotomy of prescription arises solely ecause the traditional method holds that in addition to materials" some other costs are also varia le" whereas the throughput approach treats all costs" other than materials" as fi!ed. If these Qother; costs that are identified as varia le under the traditional approach really are varia le in the short term" the profits will e ma!imi2ed y producing A only" and the throughput solution is su +optimal. The calculation elow shows this) Traditional method C '6 units of A" with a contri ution of 8%" 628%" 62- F fi!ed costs C profit Throughput method C 4A units of / yielding 82" -%6 82" -%6 F Dvaria le la our cost P overheadE F fi!ed cost C profit 82" -%6 F 4A D8B P 8BE F fi!ed cost C profit 82" -%6E F fi!ed cost C profit The fi!ed cost is common to oth cases. Thus the throughput solution is su +optimal where there are costs" other than material" which are varia le F and identifia le with particular products F in the short run. The throughput approach is" in fact" a special case of the Qtraditional; method of ma!imising contri ution per unit of scarce resource in shortFterm decision making. It is a special case in as much as contri ution is measured after material cost only. /ut" as has een pointed out" if this is an accurate representation of reality" the contri ution should e measured in this way. If all costs other than material are" in fact" fi!ed" the traditional approach could e reworked to recogni2e this fact. The traditional approach would then e identical to the throughput approach" and the profit+ma!imising output would e recogni2ed as the production of / only. #roBision o additiona! resources to ;ott!enec: The aim of throughput management is to focus attention on ottleneck resources" with the immediate aim of ensuring that such resources are utili2ed for %-- per cent of their capacity" and the further aim of alleviating the constraint. In this e!ample" Z is the ottleneck resource. If management is a le to find a way to ena le this machine to work for one e!tra hour" the ma!imum num er which could e produced of the two products ecomes) Products A #a! units K Z %"B2- C %B2 %7A2C 'B Product / #a! units %"B2- C 4B.2' 'B 72- C 52 %5

%4B

:hether a particular constraint is inding now depends on the production plan. The capacity of K limits production of /" whilst the capacity of Z limits production of A. Adoption of a linear programming approach reveals that the profit ma!imising output" if la our and varia le overhead are truly varia le" is to produce units of A onlyN if the only varia le cost is material" the profit ma!imising output is to produce 4A.57 units of / and 2.57 units of A. Thus" if one e!tra hour is provided to relieve the ottleneck at Z" the a ove analysis suggests that" where no costs other than material are varia le Di.e. as assumed in the throughput approachE" the effect is to alter the optimal production plan so that oth A and / would e produced" rather than / alone. 1owever" K and Z oth ecome ottlenecks in this case" as they are oth utili2ed to %-- per cent of their capacity. K) H4A.57 ! 'BI P 2.57 C %AB6.A Z) H4A.57 ! %5I P H2.57 ! 2-I C 72A.6 P 5%.4 C 7A-mins If costs other than material are varia le Di.e. as assumed in the traditional approachE" the provision of one e!tra hour at Z does alter the optimal production plan" e!cept insofar as additional units of A can now e produced. Z remains a ottleneck" eing used to %-- per cent of its capacity" whilst spare capacity continues to e!ist in K. The .uality of the decision regarding the appropriate production schedule to follow is thus crucially dependant upon the .uality of the assumption on which the decision is ased. T>roug>put accounting as a tec>ni=ue o production management The e!ample a ove focused on the choice of product to product. It was shown that this choice is dependent on the assumptions that are made a out the ehaviour of costs. The actual profits which a company makes are clearly dependent on the accuracy of the data on which decisions are ased. The throughput approach has een shown to e a specific application of the Qcontri ution per unit of limiting resource; approach. It can therefore e argued that throughput accounting does not add anything to the accountant;s e!isting set of techni.ues. 1owever" the e!ample a ove is trivial in many respects. It relates to a company producing only two standard products" re.uiring only two production processes" and with a sta le demand for the products is largely unpredicta le. The contri ution of the throughput accounting approach may lie in the insights it can offer in such chaotic" ut realistic" production conditions. A glo al measure of throughput at the factory level may give a clear signal as to the efficacy of factory management. :ith a given level of resources" premises" machinery" employees etc." an increase in the throughput of the manufacturing unit period y period would give a simple measure improvement in the flow of goods through the factory and to the customer. /y drawing attention to impediments to that flow+ the ottleneck resources F management will focus on alleviating pro lems which are inhi iting the profita ility of the factory as a whole" rather than su +units or particular product lines. #anaging the throughput of a factory reflects the philosophy of Qmanagement y walking a out;" i.e. ottleneck machines or processes are generally much more easily identified y direct o servation than y relying on the output of conventional accounting

%5-

reports. Traditional variance reporting may encourage the attainment of high levels of local efficiency at the e!pense of overall efficiency. Criticisms o T>roug>put Accounting Throughput accounting has een criticised as not representing a profitFma!imising approach. The classical approach is illustrated elow. (or single+product firms as we have" a company has a range of products produced from common facilities. Advocates of throughput accounting would suggest that" y operating under the aegis of traditional techni.ues" which have as their o Lective profit ma!imi2ation" it is impossi le to realise that o Lective ecause output is invaria ly lower than the level which can e achieved using the throughput approach if we assume that output will generally not e!ceed B- per cent of the profit+ma!imising output" owing to the pro lems associated with production scheduling" it can readily e imagined that the throughput approach will actually lead to the profit+ma!imising output eing achieved in many cases" whereas adoption of the profit+ma!imising approach would result in lower level of profit. (urthermore" it has often een pointed out that ma!imisation of profit is a largely theoretical concept" and does not detract from the attractions of the throughput approach" which has een shown in a num er of organisations to result in increasing profit from period to period. The philosophy underpinning throughput accounting is that the goal of manufacturing is to make money. Critics suggest that the approach is e!cessively short+term" in that all costs other than direct material are regarded as fi!ed. A further criticism suggests that the approach is e!cessively short+term in that all costs other than direct material are regarded as fi!ed. This approach may not e realistic" even in the short term. A further criticism is that" in concentrating only on direct material" it says nothing a out why other costs are incurred" and therefore can do nothing to help their control. ,evertheless" it is an approach which focuses very clearly on measures designed to ensure that the production facility is responsive to the needs of the marketplace" and therefore fits in well with modern manufacturing creeds. In focusing on direct materials costs" the throughput approach could e argued to e either the direct opposite of" or the perfect complement to" the Activity /ased Costing approach with the latter;s focus la our and overhead costs. Target (osting %OME 'IE(% OF TA$GET CO%TING The CI#A Terminology defines Qtarget cost; as follows) QA product cost estimate derived from a competitive market price. 0sed to reduce costs through continuous improvement and replacement of technologies and processes;. The term Qtarget cost; is not included in the terminology" and may e regarded as a misnomer. It is not a costing system as such" ut rather refers to an activity whose aim"

%5%

consistent with the Terminology definition of target cost" is that of reducing cost. The most widely held view of target costing can e summarised as follows) )iew 1 An activity whose aim is that of reducing the life cycle cost of new products" through the e!amination of all ideas for cost reduction of the product at the pre+production stage. The aim is to meet customer re.uirements" such as .uality and relia ility" at the minimum possi le cost. This interpretation of target costing emphasis an important point made that is" namely that the a ility to influence cost is greater at the product planning" research and development stage" rather than the production stage itself. 3iew % sees target costing as moving the focus of cost+reduction efforts from the production phase of the life cycle to earlier phases in the cycle" where the opportunities for cost reduction efforts are greatest. 1owever" it has een argued that this view of target costing is too restrictive and an alternative interpretation may e e!pressed as follows) )iew 2 Target cost is an approach to cost reduction which can e applied to the production phase of the life cycle for oth new and e!isting products. These different interpretations are in no way contradictory and could e applied in tandem. The reason for making the distinction etween them is to clarify what may or may not e included in a particular discussion of target costing. Agreed target costs are finalN they are never e!pected to change" other things eing e.ual. 1owever" different targets may e set for different phases of the development process" as the figure elow shows)+ FigureD Target Costing Target cost o

$tepped strategy

o $ingle+target strategy
Concept &esign Testing Process Prod;n planning

%52

Although target costing is most commonly applied to product costs" it can also e applied to other areas. Calculating Target Costs There are three ways of arriving at a target cost" and these are listed elow in order of increasing sophistication) %E The Additional method" which is ased on e!isting technology and cost data" and uses the current of e!isting or similar components or products to set a target cost for the new product. 2E The Integrated method" which is a mi!ture of the addition method F and thus derives some parts of the target cost from e!isting cost data+ and the deductive>su traction method Dsee elowE 'E The &eductive>su traction method" which is ased on the price of competitor;s products" and works ackwards from the market price to derive the target cost. :e shall limit our discussion to the last of these" which is the method most fre.uently encountered. The deductive >su traction method is Fcalled ecause the target cost is simply the residual figure arrived at y deducting the target profit from the e!pected sales price" as follows) 9!pected sales price F target profit C target cost Dallowa le costE The starting point in this method will o viously e the esta lishment of an e!pected selling price. Establishing an Expected Sales Price ,ew rands of e!isting product types" or minor varieties of e!isting products" will enter esta lished market with knowledge of the relevant e!isting product market" and the place of the new good within it" should ena le a competitive price to e set. 1owever" in the case of a totally new product" y definition there will e no esta lished market for it and therefore no e!isting market price that can e used as a guide. (or companies" which are first to market" esta lishing an appropriate selling price is much harder than for those that follow. 1owever" the potential profits are much greater for the former than the latter. To help with the pricing decision in such situations" many @apanese companies employ functional analysis and employ Qpricing y function;. As we saw earlier" this approach views any product as a collection of individual functions" with the consumer eing willing to pay a price for each of them. /y decomposing the new product into its separate functions+ appearance" relia ility" ease of operation and maintenance etc. F and placing a value on each of this particular collection of functions can e esta lished. This information can then e used in conLunction with the company;s strategic plan for the

%5'

product in terms of desired sales volume and market position" to esta lish an e!pected selling price. Establishing a Target Profit It is at this point that target costing provides a mechanism where y the company;s product planning can e fully integrated into the strategic plans of the organisation. The strategy of a usiness in the short" medium or long term will e reflected in its short+medium and longF term profit plans" and the target profit for any individual product will e a function of its place within those plans. The Residual: Target Cost The deduction of the target profit from the e!pected selling price will give the target cost. As the process descri ed a ove makes clear" this cost will have een determined primarily y looking outward to the market. ,o estimate of the actual cost which will e incurred in the manufacture of the product will have een made up to this stage" and this must now e done. The costing should e ased on the most cost+effective design" materials" and production processes" irrespective of whether the company currently has the capacity to put into practice the plans on which the costing is ased. In the case of a modification of an e!isting product" management will o viously have the enefit of Qon+going; cost data in uilding up the target cost. This cost will always e greater than the target profit" as opportunities for cost reduction will usually have een identified during the life of the e!isting product. As we noted earlier" once production has commenced" it is rarely possi le to implement all the potentially enefited changes that come to management;s attention" ut companies should e a le to calculate the cost that would reflect the position if the changes where incorporated in the design and production process. 9ven when this is done" the initial estimate will almost invaria le e higher that the target post" the difference etween the two representing the so+called Qcost gap;" which must e ridged without sacrificing any of the ructions that were included in setting the e!pected selling price. 3alue analysis and functional analysis can fruitfully e employed to assist this estimating process. In the case of the totally new product" y definition the costing will e ased on internal information relating to previously e!perience costs" and the historic costing records are thus limited in use in supplying the re.uired data. In @apan" these data" and indeed data to support modified versions of the e!isting products" are often provided y Qcost ta les;. Cost Tables $ato D%B65E defines a Qcost ta le; as follows) Q...a measurement to decide cost and to e a le to evaluate the cost of not only e!isting products ut also the future products at the very eginning of the design processes. The purpose of cost ta les is implicitly in the definition)

%54

i. ii.

To help reduce cost To minimise the cost of new products.

Their use is thus consistent with the general principle of cost reduction" and a specific re.uirement to achieve a target cost. The Qmeasurement; of the definition is derived from a comprehensive data ase of detailed cost information on alternative materials" la our" e.uipment and production costs" including those not currently used or e!perienced y the company. This data ase ena les companies to esta lish QstateFof+the+art; costs for new or e!isting products" even though these costs are not necessarily attaina le with current facilities. Cost ta les are very widely used in @apanese industry" and autonomous agencies e!ist to provide the relevant data for various industrial sectors" in the a sence of sufficient in+ house information. They can e assumed to play no small part in the a ility of @apanese companies to estimate the final unit cost of a product at the planning stage to an accuracy of P %2 per cent. The integration of cost ta les with a company;s CA& system and the incorporation of functional analysis into the manipulation of the data ase" ensure that the cost implications of changes in asic design and functions can e readily determined at the earliest stages of a product;s life. Cost ta les thus allow @apanese companies to perform a vast num er of Qwhat ifM Calculations on all aspects of a product efore it enters the production stage. This greatly enhances the likelihood of its accepta ility to the consumer and its efficient manufacture+ and hence its profita ility. The dictates of world+class manufacturing mean that cost ta les continue to e used throughout the life of an individual product" to test the validity of design modifications" whether internally or e!ternally driven. Service Costing $ervice costing is cost accounting for specific services or functions e.g. canteens" maintenance" personnel" departments or functions. Therefore the services provided may e for sale e.g. pu lic transport" hotel accommodation" restaurants" power generation etc or they may e provided within the organi2ation e.g. maintenance" li rary and stores. A particular difficulty is to define a realistic cost unit that represents a suita le measure of the service provided. (re.uently a composite cost unit is deemed the more relevant" for e!ample" the hotel industry may use the Qoccupied ed per night; as an appropriate unit for cost.

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A%CE$TAINMENT AND CO%T CONT$OL Typical cost units used in service costing are shown elow) , %erBice #ossi;!e Cost Units Tonne per kilometer" Passenger per kilometer Patient per day" ,um er of *perations. 8ilowatt per hour *ccupied ed per night #eals served (ull time e.uivalent student

Transport 1ospitals 9lectricity 1otels Jestaurants Colleges

9ach organi2ation will have to determine what cost is most appropriate for use according to the nature of the usiness. :hatever cost unit is decided upon" the calculation of the cost per unit is done in a similar fashion to output costing i.e. Cost per serBice Unit 3 Tota! cost per period Num;er o serBice units supp!ied in t>e period

It will e reali2ed that the calculations shown a ove are similar to the calculation of cost driver rates using activity ased costing. $ervice costing using homogenous service centres or function and cost units that are a good measure of the service provided is a form of Activity /ased Costing. E<amp!e Information has een collected a out two hospitals over the last year) H&''#3: H3(:&#"' ,um er of eds ,um er of in+ patients Average stay ,um er of out patients visits 7A2'"472 7 U days 2%6"5-H3(:&#"' 5-A"%65 V 6'"B2C3:5$

V,ot recorded ut ed occupation percentage was A5O. %56

CO%T 5$EA+DO(N "i!!top "ospita! In+ patients +N000 Direct #atient Care $upplies" drugs #edical stores $upport services %"A2%"52A"72B"%-2"2%-"5-6B'"6-'"'-A"B52"56'"7-%"72%"A-A"2AA"-5%"55%"'56"A'2"7-%"A45"'A%"B'7"4%%2"%66"A42A5"45%"B75"-5%"5B%"626'5"6-4"4A7"72*ut+patients +N000 Copmed "ospita! In+patients +N000 *utpatients +N000

Indirect Costs ?eneral services '"524"47%6"2A5"5B$e=uiredD

Calculate) DaE Average length of stay in Copmed hospital D E /ed occupation percentage in 1illtop hospital DcE Cost per in patient day for oth hospitals DdE Cost per out+ patient attendance for oth hospitals and comment on the results.

%57

%o!utionsD DaE Average stay in Copmed hospital. Potential in+ patient days in a yearN 5-- eds ! '65days C %A2"5--. ThereforeN A5O occupancy C %A2"5-- ! -.A5 C %55"%25 in+ patient days Therefore" average stay C %55"%25 A"%65 C %B days. D E /ed occupation percentage in hilltopN C Actual in+ patient days ! %--O Potential in+ patient days C 2'"472 ! 7.5 ! %--O 7A- ! '65 C %76"-42A4"7-C 62O

DcE Costs per in+ patient day "i!!top "ospita! 8%6"2A5"5B-"--2'"472 ! 7.5 C 8B2"5%-

Costs for in+ patients ,ovem er of in+ patient days Copmed "ospita! 8%2"%66"A4-"--A"%65 ! %B C 87A"4'-

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DdE Cost per out+ patient attendance C Costs for out+ patients ,um er of out patient attendances "i!!top "ospita! C8 A"2AA"-52%6"5-C 8'A"2ACopmed "ospita! 84"4A7"726'"B287-"2%-

It will e seen that a composite cost unit Di.e. in patient daysE is used to calculate the costs. *se of *nit (osts +n The &ublic %ector The pu lic sector organi2ations cover an enormous range. 9!amples include primary and secondary state education" local authorities" the national health services" police and so on. Costs are collected" related to some measure of throughput or output and a unit cost calculated as descri ed a ove. These unit costs have three main uses. They serve as) DaE As indicators of relative fre.uency e.g. cost per pupil in different education authorities. + Cost per patient per day at various hospitals. + Cost per night in police cells. D E As measures of efficiency over time. These can help to indicate whether efficiency is increasing or decreasing over time. DcE As an aid to cost control. The regular production of unit costs and comparison with the costs of other esta lishments in the same field helps to control costs and engenders a more cost conscious attitude.

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Limitations of The Cost Units DaE Guality of performance is usually ignored. D E Throughputs are used rather than outcomes. Throughputs are numeric indicators where as outcomes are the impact which the activity has on the recipient of the service. DcE The throughput mi! is likely to differ. (or instance" the local authority;s costs to cater for the children;s home catering services for distur ed and disa led children will differ greatly to those homes catering for normal children. Like must e compared with like for the comparison to e fair. Life C cle Costing T"E NATU$E AND #U$#O%E OF LIFE C&CLE CO%TING In the section on pricing" the reader will find a description of the product life" where y products or services entering a market go through four stages) introduction" growth" maturity and decline. (rom the suppliers point of view" the life cycle will o viously egin efore the product is introduced to the marketing and distri ution efore the first unit of product is sold or the first service is delivered. The initial e!penditure will invaria ly e lower in a solute terms than the manufacturing costs to produce and support the product" and thus the a solute level of cost incurred on a product will rise over its life" with a tendency for costs to follow the sales pattern+ as sales increase" costs will increase" eing largely the manufacturing and support costs mentioned a ove. The aim of any usiness must e to ensure that these costs rise at a rate which is less than proportionate to the actual increase in sales revenue. The interactions of the revenue curve and the cost curve measures the profita ility of the product over its life. Although a relative decline in cost per unit may e e!pected from economics of scale and the e!perience curve once production commences. The actual profit associated with any individual product will have een largely determined efore it is introduced to the market. :e make no apology for reiterating that as much as B- per cent of the future cost that will e incurred throughout the remaining life of the product is actually dictated y the fundamental decisions taken at the pre+introduction stage regarding functions" materials" components and the method of manufacture. Life cycle costing has much with value analysis and target costing "in that it recognises Dal eit indirectlyE the importance of understanding cost throughout the whole life of a product" and emphasises" as do the other techni.ues" the importance of early decisions in determining what these costs will e. Indeed" as was the case with value analysis" life cycle costing was taken up in the early %B6-s y the American &epartment of &efence as part of a drive to increase the effectiveness of government procurement. %6-

1owever" as students of accounting are well aware" the mere recording of financial information does not of itself impact on the transactions which are undertaken" and it can only influence cost if it results into action. This reported association with increased effectiveness clearly indicates that Life Cycle Costing is a process which goes eyond the simple recording of information. The Terminology definition of Qlife cycle costing; creates some confusion in this conte!t" y defining it as) QThe practice of o taining" over their lifetimes" the est use of physical assets at the lowest total cost to the entity DterotechnologyE;. It is not clear how a costing method can itself e a practice that results in something eing o tained" ut clarification is fortunately provided in an e!planatory sentence that appears after the definition" via) QThis is achieved through a com ination of management" financial" engineering and other disciplines;. This indicates to the authors that Life Cycle Costing of itself does not result in the reduction of cost" ut when used in com ination with other techni.ues" such as 3alue Analysis" its recognition of the changing cost structure of products over time provides a valua le toolN for management in gaining control over the firm;s activities. &orngren et al D%BB4E state that) QLife cycle costing tracks and accumulates the actual costs attri uta le to each product from its initial research and development to its final customer servicing and support in the market place;. :hen used in this sense" it can e seen that Life Cycle Costing supplies the means where y a company can esta lish whether the lower costs which were e!pected through the application of cost reduction techni.ues" oth prior to and following a product;s introduction" have actually een delivered. The e!pected costs against which the actual costs are compared reflect the careful analysis and planning which should take place efore the production stage of a product and the cost reductions e!pected during the production phase through the application of the firm;s decision F making and control structure of these e!pected product cost changes throughout the product;s life is achieved y the process known as QLife Cycle /udgeting;. As life cycle udget relates specifically to products or services" it can e appreciated that a life cycle udget cost for a product has much in common with a target cost" particularly in companies where different targets are esta lished for different phases of the product;s life cycle. As costing terms have no legal validity" they do not necessarily re.uire the precision of terms relating to financial Di.e. statutoryE accounting" and no offence is committed if two companies follow e!actly the same set of procedures and attach a different title to their common activitiesN a semantic de ate as to the e!act oundaries" if any" of life cycle costing"

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life cycle udgeting" not only will the production cost of a product e forecast" ut those costs attri uta le to the product in respect of non+production overheads" such as marketing" distri ution and customer service" will also e considered. Life C cle !udgeting and Resource Allocation The reakdown of the production costs predicted to occur over the life of a product will form the asis for the udgeted production cost of each period. 1owever" a life cycle approach can also help managers in allocating resources to non+production activities) for e!ample" a mature product re.uires less marketing support than a product in the introductory phase" and support may e withdrawn almost entirely from a product in the introductory phase" and support re.uired y a product" ased on an understanding of its individual life cycle" can lead to a more effective allocation of resources" and represents an improvement of the traditional incremental approach to udgeting. Indeed" it could e used in support of decision packages in 2ero+ ase udgeting. The life cycle costing> udgeting approach can thus e seen to allow the integration and e!pression within the traditional accounting system of a num er of approaches to" and techni.ues for cost reduction" such as the learning curve and value analysis. 1owever" life cycle costing reports re.uire the tracking of costs and revenues throughout the entire life of a product" which represents a significant change to traditional accounting reporting" such in terms of focus and timing. (or e!ample" in traditional systems" many overhead costs are udgeted" recorded and reported y function F customer service" research and development etc. F and no attempt is made to attri ute these costs particular products. In contrast" with life cycle costing" this identification of costs with particular products forms the whole asis of the system F it is only y tracking these costs throughout the life of a product that the overall product profita ility can e ascertained. Life cycle cost reports will thus normally e an addition to" rather than a su stitute for" traditional accounting reports and practice. Jeports produced in this way can e seen to have four clear enefits) %E The costs of pre+production activities e.g. research" development and design and post production activities e.g. distri ution" marketing and customer service are highlighted on a productFline asis" a useful format which is not seen in traditional systems. 2E An understanding of the cost commitment>cost incurrence relationship is gained for different products. 'E The relationship etween different cost areas>categories is highlighted. (or e!ample" reducing cost at the customer service stage. This may have een known implicitly" ut life cycle costing makes the knowledge e!plicit. 4E The e!istence of life cycle reports facilities the conduct of post+completion product audits" along the same lines as capital e!penditure post+completion audits. The knowledge gained from such audit reports can e fed into the company;s decision making processes to improve future product decisions.

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#ost companies are operating in a manufacturing environment are finding that a out B-O of a product;s life cycle cost is determined y decisions made early in the cycle. #anagement accounting systems should therefore e developed that aid the planning and control of product life cycle costs and monitor spending at the early stages of the life cycle. E<ercise $e=uiredD aE 9!plain the nature of the Product Life Cycle concept and its impact on usinesses operating in an advanced manufacturing environment. E 9!plain life cycle costing and state what distinguishes it from more traditional management accounting practices. cE Compare and contrast life cycle udgeting with Activity+/ased #anagement identify and comment on any themes that two practices have in common. %o!utionsD DaEThe product life cycle DPLCE is shown in the diagram elow) :hen a product is first successfully introduced for the market" suggested y an e!pensive advertising campaign it will only achieve a relatively low sales volume. In an Advance #anufacturing Technology DA#TE environment" a very large amount of fi!ed costs will already have een incurred in designing the product and uilding or re+e.uipping the production line. In the growth stage sales increase and unit costs fall as the high fi!ed costs per unit decrease although new entrants may start to complete at this stage. This is the most profita le stage of the product life cycle.

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#roduct Li e C?!ce

Illustration of product life cycle

$ales revenue

Introduction

growth

maturity

decline

sales

,o of Kears The product is said to e mature when sales demand levels off. In a static market price competition will reduce the profita ility of each firm. (irms seek to differentiate their product at this stage. 9ventually" the product will ecome o solete and falling sales will ensure. This is the decline phase of the Plc. (irms will egin to pull out of the market will have developed a replacement product" there y incurring further large fined costs for JW&" design and new production facilities. In Advanced #anufacturing Techni.ues environments the time period for the product life cycle is decreasing. D ELife Cycle Costing DLCCE involves collecting cost data for each product from inception through its useful life and including any end cost. These data are compared with the life cycle udgeted cost for the product. This comparison will show if the e!pected savings from using new technology or production methods etc. The recognition of the total support re.uired over the life of the product whereas traditional costing y function e.g. Jesearch W &evelopment" production" marketing and so on. This for manufacturers LCC makes e!plicit the relationship etween design choice and production and marketing costs. The insights gained from company udgeted and actual life cycle costs may e used to refine future decisions. Consumers as well as producers may use LCC. A recent analysis has shown that the life cycle cost of purchasing a personal computer DPCE is around si! times the purchase cost.

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$taff the training and e!tra software will cost three times the cost of the PC and maintenance will cost twice the purchase cost over the life of the PC. It has een recogni2ed in Advanced #anufacturing Techni.ues environment that up to B-O of the costs incurred throughout a product life cycle will e determined efore the product reaches the market. Thus the early decisions regarding product design and production method are paramount and LCC attempts to recogni2e this situation. The high fi!ed costs of introducing a new product compared with reduced life cycle periods is a maLor challenge to profita ility in A#T environments. LCC is used to improve management decision making in reach conditions. DcEActivity /ased #anagement DA/#E uses the understanding of cash drivers found fromAactivity /ased Costing DA/CE to make more informed decisions. In particular" this approach yields a etter understanding of overhead costs in A#T environments compared to traditional a sorption methods. A/# aims to improve performance y) D E 9liminating waste DcE #inimi2ing cost drivers DdE 9mulating est practice DeE Considering how the use of resources supports oth operational and strategic decisions. This A/# seeks to consider all activities performed y the organisation in order to serve a customer or produce a product. Jesults of A/# in an A#T environment include) DiE DiiE DiiiE DivE Increased production efficiency Jeduced production costs Increase throughput Increased .uality assurance

These gains may e reali2ed y) i. ii. iii. $implified product designs #ore use of common su F assem ly Jeduced set+up times

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iv. v.

Jeduced material handling /etter use of the workforce e.g.. #ulti F skilling

Their A/# is very similar to LCC in some respects. ,or examplei. /oth attempt to increase management understanding of overhead costs ii./oth consider how the use of resources supports strategic decisions" that is" oth look at how resources inputs are used to o tain the re.uired organi2ational outputs. In an A#T environment oth methods focus management attention on the need to produce simplified products using common components and common su +assem lies and to ma!imi2e the output from e!pensive capital instruments. E<ercise Target costing ,sonsi Ltd is a company that manufactures mo ile phones. This market is e!tremely volatile and competitive and achieving ade.uate product profita ility is e!tremely important. ,sunsi is a mature company that has een producing electric e.uipment for many years and has all the costing system in place that one would e!pect of such a company. These include a comprehensive overhead a sorption system" annual udgets and monthly variance respects and the alanced scorecard for performance measurements. The company is considering introducing. dE Target costing) and eE Life cycle costing systems. :hat are the enefits of introducing the Costing $ystemsM %o!ution The modern usiness encouragement terms to e an instant one and is rapidly changing in terms of customer re.uirement" economic factors" technology and so on. ,sunsi is in a particularly versatile usiness ecause technology is changing rapidly as digital telephones take over and tent messaging develops. /oth target costing and life cycle costing are systems" which should help the company" lope with this. These systems help ,sunsy to

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complete in terms of cost to product development in the competitive telecommunicating market. Their specific advantages are as follows) %.Target costing Target costing may replace and is often compared with traditional standard costing>variance analysis" which has long een in place in the historical world. ,uns may wish to replace standard costing>variance analysis with target costing for cost control and reduction for the following reasons) aE It puts pressure on cost it can e used as a cost reduction technical unlike standard costing and can incorporate a leaving effect. This is likely to e important in the manufacture of phones. E Traditional standards may e too rigid for cost control in reduction purpose for a company such as ,sunsy as they usually need to e set for a year at a time. Target costing is more fle!i le and target can charge>reduce from years to months. cE It considers the market to price customers are prepaid to pay so it forces an originating to e outward rather than inward looking. ,sunsi needs to consider the final customer as well as the system supplier. dE It should motivate staff if used contently and help. /reak down any artificial functional arriers as it involves staff at all levels and in most functions and forces them to communicate. eE It leads towards the use of other techni.ues" such as value analysis and value engineering" which should supply production methods and reduce costs. This is particularly important in an industry with shunt produce life cycles. 2.Li e c?c!e costing aE The life cycle of ,sunsu;s products are likely to e shunt ecause of charging technology" therefore" it is vital that the product egin to generate profits .uickly. E 9stimating life cycle costs and revenue will highlight this cE Jesearch and development costs are likely to e .uite high and must e recovered in a short period. dE #any of ,sunsi;s costs are likely to e Xlooked inY during the design stage" say B4O" so it is important to control cash initially in order to ma!imi2e the profit over the product;s life. eE It focuses on the time as well as money. Time to the market is often a key as money factor is generally profited. It is more important to measure time than money>cost it may e vital for ,sunsi to ring new products to market .uickly and on time in order to achieve a product. fE #onitoring a costs and enefits over the life cycle helps to stop a proLect early if events have changed or not turned out as planned. gE It presents a different perspective that could e advantageous to ,suni as it is not tied to period reporting.

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/ecause of the a ove it would e advantage for the company to adopt oth of these techni.ues. In ormation tec>no!og? &uring %BB- a printing company defined and installed a management system that met the usiness news of a commercial environment which was characteri2ed at that time y) DiE DiiE DiiiE To unitary structure with one profit center. Central education from senior managers. %--O internal resoucing of ancihary seniors.

#anagement information system Bac.flush /ccounting In traditional accounting systems" the physical flow of materials and conversion costs is e!actly mirrored in the costing system) the product flow eings with raw materials and other prime manufacturing costs" proceeds through work+in+progress to finished goods and finally ends with costs F indeed" the traditional system has een referred to as one of se.uential tracking. $uch a system has two main enefits) i. %toc: Ba!uation. Companies may have stocks of raw materials" work+in+progress and finished costs through these accounts" a valuation period. /y tracking material and conversion costs through these accounts" a valuation can easily e placed on each for financial accounting purposes. This facility is important) although the disposition of the costs etween the first two of these stock categories is of little conse.uence" financial accounting is concerned to draw a clear distinction etween goods that have een sold in an accounting period" and the finished goods still remaining in stock at the end of the period. The reason for this concern is o vious) the latter will simply remain in the alance sheet. Contro! o costs. &etailed tracking of costs allow a considera le level of control to e e!ercised" not only over costs in total" ut also over the costs incurred y individual products or Lo s. This enefit applies most o viously to situations in which Lo costing" rather than atch or process costing is the norm.

ii.

1owever" the traditional system is time+consuming and e!pensive to operate as it re.uires large volumes of documentation" such as material re.uisitions and time tickets" to support it. (urthermore" the enefits associated with it are less o vious in the modern manufacturing environment" in which low stock levels are ecoming the general rule. In such a situation" all ut an insignificant amount of any one period;s costs of production will end up in cost of sales on the income statement" and thus the need to distinguish etween the goods sold during a period and those on hand at the period end ecomes largely redundant. /ackflush

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costing is a system that has een developed in response to these concomitants of the traditional method and the change in the environment. The primary enefit offered y ackflush costing is the considera le reduction in the clerical effort re.uired to maintain it" oth in terms of the num er and fre.uency of entries to the accounting system" and the level of supporting data and documentation. It must e stressed from the start that it is not a more accurate system of costing than those traditionally employed. Indeed" it can e critici2ed as eing less accurate. 1owever" against the general ackground of low stock levels mentioned a ove" this reduction in accuracy is regarded y the system;s advocates as relatively unimportant" and more than outweighed y the cost savings to e gained from its operation. A further point must e stressed) as ackflush costing does not attach conversion costs to products until they are completed" or even sold" it follows that the system cannot e successfully operated in situations in which work+in+progress is significant and> or fluctuates from period to period. In such situations Dand" as we shall see" when the same situation applies to raw materials and finished goods in some variantsE" the use of ackflush costing would lead to different results than would have een o tained under the traditional tracking systems" and would e inconsistent with the reporting re.uirements of financial accounting. Distinguis>ing eatures o ;ac: !us> costing The Terminology defines ackflush costing as follows) QA method of costing associated with a @IT production system" which applies cost to the output of a process. Costs do not mirror the flow of products through the production process" ut are attached to output produced Dfinished goods" stock and cost of salesE" on the assumption that such ackflushed costs are a realistic measure of the actual costs incurred;. The recognition of the costs to e associated with products in the ackflush system and thus their point of entry into the cost accounts is triggered y certain events. &ifferent Qtriggers; or Qtrigger points; can e employed in ackflush accounting and therefore a num er of variants of the system e!ist. 1owever" the feature which distinguishes it from other systems" whatever variant is eing considered" is that its focus is on output) costs are associated with output" and then Qflushed ack; through the system to attach to particular products. Although the treatment of material costs in ackflush accounting differs from variant to variant" a further common feature" noted therefore" the identification of conversion costs with particular products cannot e used as an effective control mechanism during production. It follows from this that another prere.uisite for successful introduction of ackflush system is that management control of the production process is capa le of eing carried out effectively in the a sence of costing information.

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In a modern manufacturing environment" it can e argued that effective operational control could e maintained through computer monitoring of the process" y the use of non+financial measures e!pressed in physical .uantity terms and y direct o servation of the operations themselves Dfor e!ample" in the @IT environment in which ackflush costing is most likely to e employed" a lack of raw materials would cause the production line to come to a standstill" and thus pro lems would e immediately evident to all concerned and solutions rapidly soughtE. Accounting entries in ;ac: !us> costing &orngren et al D%BB7E descri e three variants of a ackflush costing system. The variant which differs least from traditional se.uential accounting Dmethod %E has the following two trigger point+ the purchase of raw materials or components and the completion of good finished units of product. The purchase of materials triggers a de it to the initial stock account and a credit to creditors for the cost of the materials purchased. The authors call this initial stock account Qraw and in process;" rather than Qraw material;" as it com ines oth the traditional raw material and work+in+progress accounts. The ne!t trigger point is the production of finished goods) a de it is made to the finished goods account e.ual to the standard cost of the produced" and credits are made to the raw and in+process and conversion costs accounts" showing respectively the standard material value and conversion costs of the completed goods. The a ove te!t and &rury D%BB6E have .ualified e!amples of this and the following variant. The simplest and most e!treme version Dmethod 2E has only one trigger point) the completion of finished goods for the actual produced and conversion costs. This variant not only e!cludes from costing record any raw materials purchased ut not yet used to produce a finished good" ut also fails to record a creditor for material until the production process has een completed. It is not clear how this latter point can e reconciled with the financial account re.uirement to recogni2e lia ilities. Presuma ly" it would e feasi le only where the throughput time of the manufacturing process is so fast that stocks of raw materials and work+in+process are non+e!istent F a highly impro a le situation. (urther" when the lia ility is eventually recogni2ed" it appears to e recorded at standard rather than actual cost" and the mechanics for recording actual costs and calculating variances are also unclear. The third variant Dmethod 'E again has a similar initial trigger point to the first Di.e. the purchase of raw materials or componentsE" ut takes as its second trigger point the sale" rather than the manufacture" of finished units and e!penses all conversion costs immediately on sale. There is only one stock account F merely called Qinventory;+ which contains only the outstanding material costs of raw materials" work+in+progress and finished goods. /y charging all conversion costs to the income statements" this variant is intended to focus management attention on selling the products" as profit can no longer e olstered y simply producing for stock. The analogy with throughput accounting should e o vious.

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E<amp!e o accounting or ;ac: !us> costing 0met>od 11 As '% &ecem er a widget manufacturer has no stocks. The standard cost of a widget is) 8 #aterials) 2kg at 8%- per kg 2La our) %-minutes at 824 per hour 4 *verheads) 86 per kg of material %2 Total cost '6 /udgeted monthly production is %"--- units. &uring @anuary) #aterials purchased and used) 2"%--kg La our) %75 hours *verheads incurred (inished goods produced (inished goods sold 2-"5A4"4%%%"5-%"-5- units %"--- units

The triggers for entry into the cost accounting ledgers are the purchase of materials and the completion of finished goods. The entries to record these transactions are as follows. :hen materials are purchased) &9/IT Jaw and in process account CJ9&IT Creditors or cash with the actual cost of the materials. :hen the goods are completed) &9/IT (inished goods account with the standard cost of finished goods. CJ9&IT Jaw and in process account with the standard cost of material CJ9&IT Conversion cost account with the standard cost of la our and overheads. &9/IT Conversion cost account with the actual cost of la our and overheads. CJ9&IT Creditors or cash :ith the actual cost of la our and overheads. :hen the goods are sold) &9/IT Cost of sales account CJ9&IT finished goods account with the standard cost of goods sold.

The alance on the accounts are then) Cost variances written off to the Profit and Loss AccountN

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The value of closing stock at standard cost Dpermitted y the International Accounting $tandardsE. Jaw and in process account 8 8 D%E Creditors>cash 2-"5AD2E $tandard cost of materials D5E Profit W loss A>C 42D%"-5 ! Z2-E 2%"--2%"--2%"---

(inished goods account 8 D2E $tandard cost of D4E Cost of sales production D%"--- ! 8'6E D%"-5-!8'6E '7"A-D5E Profit W loss account 42$tock c>d '7"A-D6E $tock >d %"A--

8 '6"--%"A-'7"A--

Conversion account 8 8 D'E Creditors> cash %5"B%D2E $tandard cost of la our D5E Profit and loss account and overheads D%"-5-! D4 [%2EE AB%6"A-%6"A-%6"A--

Cost of sales account 8 D4E (inished goods D%"--- ! '6E '6"---

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Criticism o 5ac: !us> As the introductory remarks to part of the appendi! made clear" the virtue of ackflush accounting is its sheer simplicity. 1owever" it is a!iomatic that simple systems provide rather less information than more comple! systems. $everal criticisms of ackflush costing have een made passim" ut a detailed criti.ue can e found in Calvasina et al D%BABE. QIn a true @IT manufacturing system with a @IT purchasing system" material also goes directly into the production process and there is no need for a separate raw material inventory account. :hile this goal is achieva le theoretically" raw material inventories never actually reach 2ero. Typically" the company at a minimum will receive items in a cost Feffective delivery si2e. (or e!ample" it will receive a truckload or a railcar load. Thus" a small ut very real raw material inventory e!ists in an ideal situation. The name JIP is at est a cosmetic change. If there is no raw material inventory on hand" e!cept what is needed to complete the work in progress" it would seem that the new situation is identical to the old situation when the appropriate title was work+in+process;. They o Lect to the late appearance of entries in the accounting system when ackflush costing is used" and conclude their criticisms with the following remarks) Q/ecause of no reports from accounting on inventory" managers have to take a physical count. A Lo that contradicts one of the asic o Lectives of the @IT philosophy F the elimination of wasteful" non+value+ adding functions. The physical inventory counts not only increase overhead costs directly ut also disrupt production that reduces efficient use of plant resources. The ackflush system looks very similar to what used to e called a periodic system. In this system" accountants waited until the end of the fiscal period to take a physical count of the inventory. At that time" the appropriate num ers were derived from the ending inventory count. :hile the @IT presents management with less accounting and less information on which to ase its decisions;. *ne might e forgiven for a measure of pu22lement and confusion at all this. After all" traditional accounting has always Q ackflushed; costs from work+in+progress to finished goods when products are completed. *n the other hand" traditional systems re.uire the identification of products at different stages of completion in work+in+progress" which would involve considera ly more physical stock counting then the envisaged in a ackflush system. :hile ackflush costing will reduce the documentation flow+most o viously from raw materials to work+in+progress F the com ination of raw materials and work+in+progress in ackflush;s Qraw and in+ process; account does not allow the important distinction to e made etween raw materials that are still availa le for use and those that have already een uilt into unsold products. 1owever" if the manufacturing circumstances are such that high levels of stock are unavoida le" ackflush costing ecomes an impossi ility anyway.

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The reader looking for prescriptive advice on the use and usefulness of ackflush costing will e disappointed) the present authors must fall ack on the truism that the circumstances of the particular operation under consideration will determine ACTI'IT& 5A%ED CO%TING 0A5C1 Activity ased costing DA/CE can e defined asQan approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Jesources are assigned to activities and activities to cost o Lects ased on consumption estimates. The latter utilise cost drivers to attach activity costs to outputs;. (rom the a ove terminology it is clear that A/C looks at activities as the causes of costs Dcost driversE. Cost drivers are activities which give rise to costs. These may include" num er of orders made Dfor ordering costsE" num er of production runs Dfor material handling costsE. In addition A/C acknowledges the fact that y producing products" demand is created for the activities. Costs should therefore e allocated to products ased on the activities that the products have consumed. Need or A5C The development of A/C was due to the limitations in the traditional product costing systems. The traditional product costing systems were esta lished at a time when a num er of firms were producing a narrow range of products. In addition the main cost elements were made up of direct materials and direct la our" as compared to overhead costs. Therefore distortions arising from overhead allocations were not as significan In contrast" firms today produce a range of products which do not need significant la our. Instead overhead costs are considera le. This means that the traditional approach of overhead allocation using direct la our asis does not reflect a true picture. Therefore a more accurate cost allocation system ecomes necessary and this was made possi le with advancements in the cost information systems which reduced the cost of operating a more comple! system. Esta;!is>ing an ActiBit?@5ased@Costing %?stem There are asically (*0J steps involved) %. 2. '. 4. Identifying the maLor activities that take place in an organi2ationN &etermining the cost driver for each maLor activityN Create a cost pool for each activityN Assigning the cost of activities to products according to the products demand for activities.

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Traditiona! 's A5C %?stems In a typical traditional cost system there will e the usual two+stage cost allocation process. In the first stage the system allocates overheads to production and service departments and then reallocates service department costs to the production departments. In an A/C system overhead costs are assigned to each maLor activity instead of departments. A num er of activity+ ased cost centres Dcost poolsE will therefore need to e esta lished. Activities in an A/C system will e made up of a num er of tasks. $uch activities may include" set+up machines" materials purchasing" product inspections and production scheduling. 9ven though activity cost centres may e identical to traditional cost centres" A/C systems tend to have more activity cost centres. In a traditional cost system overheads are traced to products using a limited num er of allocation ases which vary in direct proportion with production volume. The common ases used are direct la our hours and machine hours. (or A/C systems" a num er of cost drivers which will include non+production volume related are used. These will include" num er of purchase orders and num er of production runs. In addition traditional systems normally allocate service>support costs to production centres. These costs are added to the production cost centres . 1owever" in A/C systems separate cost driver rates for support centres are esta lished and support activities costs re assigned to cost o Lects without any reallocation to production centres. It is therefore evident from the a ove that y having a num er of cost centres and cost drivers" A/C systems can more accurately measure the resources consumed y cost o Lects. In contrast traditional cost systems tend to produce less accurate costs as most allocation ases used are not related to the cost o Lects. Ot>er Considerations The cost> enefit of implementing an A/C system should e analysed. It is .uite o vious that the more comple! the A/C system is the more eneficial it will e in the organi2ation. It is however a fact that" such a detailed and comple! system will e more costly to a traditional costing system. Costs associated with an A/C system will include software and staff training which may e prohi itive. Consideration must e given to the poor decisions that will e made as a result of having an inaccurate traditional costing system. Poor decisions may relate to having to having unprofita le products and dropping profita le products.

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1owever it is not always that an A/C system will greatly improve the .uality of cost allocation nor is it the case that a traditional cost system will produce inaccurate cost reports. Therefore A/C must meet the cost> enefit criterion and improvements should e made in the level of sophistication of the costing system up to the point where the marginal cost of improvement e.uals the marginal enefit from improvement. Dra9;ac:s o A5C %?stems The following pitfalls of A/C $ystems can e noted) aE The calculation of unit of costs under A/C faces the same disadvantages of the traditional cost system. This is so ecause to calculate unit costs of products" the atch level activity costs are divided y the num er of units in the atch. This unitising approach is an allocation which yields a constant average cost per unit of output which vary depending on the level of activity. (or decision+making there is a danger that what started out as a non+volume related. It is not all costs which will e caused y activities that are measura le in .uantitative terms and which can e related to production output. In such situations cost drivers can not e used.

cEThe ehaviour of cost items in a cost pool cannot e e!plained y single cost driver. E6AM#LE Chiatu Plc manufactures three products A" / and C. The following data is availa le for the month of (e ruary) A / C *utput DunitsE A-A-2--Production runs 22%-&irect La our hrs per unit 2 6 2 #achine hrs per unit 2 4 2 #aterial cost per unit D8E %--4--%--La our cost per hour is 8 A--The following overheads were also incurred) 8;--Production $cheduling 7 2A#aterial 1andling 6 %6$et+up Costs A 7'6 22 %76 $e=uiredD Calculate the cost of each Product using A/C and traditional cost system.

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%o!utionD 0nder A/C system the overheads will e allocated to the Products using the num er of production runs as the cost+driver. A / C 8;--8;--8;--Jaw #aterials A-'2-2--&irect La our %2A-'A4-'2--Production $cheduling %-4%-452-#aterial 1andling AAAA44-$et+up %24A %24A 624Cost per unit %676A A-C 82-.B6 Traditional $ystem) Jaw #aterial &irect La our *verheads A 8;--A-%2A-'4%2 %7-%2 / 8;--'2-'A4-%-2'5 5%A'5 C 8;--2--'2--A52B 4252B 4476A A-C 855.B6 4BA42--C 824.B2

:orkings) %. Production $cheduling C 8 7"2A-"--- C 8 52"--- per run %42. #aterials 1andling C 8 6%6---- C 8 44"--- per run %4'. $et+up C 8 A7'6--- C 8 62"4-- per run %44. *verheads a sorption C 8 22%76--C 8 2%'2.' %-4-,*T9) It can e seen that under A/C the allocation of overheads is more reflective of the actual activities in production since Product C" ecause of the many production

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runs" consumes more of those activities D$et+ups" Production runs and Production schedulingE" than Products A and /. 0nder the traditional system Product / has een over+allocated with the overheads since the allocation is ased on the num er of la our hours. 1owever" as stated earlier on" most modern firms have automated operations therefore the use of la our hours like in the case does not reflect the causes of the overheads. Ot>er aspects o A5C (urther approaches which revolve around A/C have een developed. Activity+/ased #anagement DA/#E) Activity+/ased #anagement DA/#E is a system of management which uses activity+ ased cost information for variety of purposes including cost reduction" cost modelling and customer profita ility analysis. Activity+/ased /udgeting DA//E" this is a method of udgeting ased on the activity framework and utili2ing cost driver data in the udget+setting and variance feed ack processes. MANUFACTU$ING $E%OU$CE #LANNING 0M$#II1 Is an e!pansion of #aterial Je.uirements Planning D#JPIIE to give a roader approach than #JPI to the planning and scheduling of resources" em racing areas such as finance" logistics" engineering and marketing. #JPI evolved into #JPII and #JPII plans production Lo s and also calculates resource needs such as la our and machine hours. It therefore attempts to integrate materials re.uirement planning" factory capacity planning" shop+floor and even marketing into single complete Dand computerisedE manufacturing control system. #ost #JPII systems are a collection of computer programs that permit the sharing of information with and etween departments in an organisation. #JPII is used y many companies for manufacturing planning ut with the advent of @IT manufacturing" it has een identified as a planning system. 9ven so #JPII has advantages as a controlling system for planning and controlling manufacturing systems" especially when @IT methods are unsuita le. ENTE$#$I%E $E%OU$CE #LANNING 0E$#1 9JP systems are accounting oriented information systems for identifying and planning the enterprise+wide resources needed to take" make" distri ute and account for customer orders. 9JP has een descri ed as an um rella term for integrated usiness software systems that empowers a corporate information structure" thus helping companies to control their inventory" purchasing" manufacturing" finance and personnel operators.

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*riginally" 9JP systems were simple e!tensions of #JPII systems" ut their scope has now widened. They allow an organi2ation to automate and integrate most of its usiness processes" share common data and practices across the whole enterprise and produce and access information in a real+time environment. 9JP may also incorporate transactions with organisations supplies. They help large national and multi+national in particular to manage geographically dispersed and comple! operations. (or e!ample" an organisation in Zam ia e.g. TATA sales office may e responsi le for marketing" selling and servicing a us assem led in India using parts from China. 9JP ena les the organisation to understand and mange demand placed on the plan in China. There are two groups of applications within an 9JP) 1. CO$E A##LICATION% The applications that need to work in the organisation will e una le to function. They include production" sales" distri ution and planning. These are fully integrated within the 9JP system ,. 5usiness ana!?sis app!ications 9!amples include modelling" decision support" information retrieval" accounting" simulation and Xwhat ifY analysis. $ome 9JP software includes these. $ome provide links into 9JP system to third party software that performs tasks. %ome adBantages o E$# s?stems The advantage of 9JP systems compared to traditional system architectures include) aEIncreased data consistency EJeduced data redundancy cE ?reatly enriched data" including access to .ualitative data y functions that do not typically have access to it. dE ?reatly increased depth and readth of data analysis eE Jeduced response times to information re.uests fE Jeduced need for manual intervention in data access and analysis gE Jeduced risk of errors in data or in its analysis hE ?reatly reduced Lead Times in report generation iE ?reatly increased efficiency in materials ordering" re.uisition and deployment

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)uestions %. :hat is 9nterprise Jesource PlanningM 2. :hat are the advantages of a 9JP systemM '. :hy will those organisations that integrate their 9JP systems with supply chain management enefit more than those that introduce only one of the other" or these two conceptsM C>apter %ummar? The following have een covered under this chapter Throughput Accounting Target Costing $ervice Costing Product Life Cycle Cost /ackflush Accounting Activity /ased Costing DA/CE

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,%AP-.$ /0
CAPITAL INVESTMENT APPRAISAL
TTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTT T Learning outcomes After studying this chapter candidates must e a le to) &emonstrate knowledge of key investment" regarding appraisal methods and the following. The concept of the time value of money ,et present value D,P3E Jeal and normal interest rates Pay ack Internal rate of return #ultiple IJJs 0ne.ual ProLect appraisal W Audit TTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTTT T Introduction Capital /udgeting involves the assessment of how much should e spent on assets or proLect and which assets should e ac.uired. /efore deciding which proLect>assets to invest in" corporations must compare the enefits to e derived from the ac.uisition>investment against the costs involved in the investment. The investment will not purely depend upon financial aspects ut to a large e!tent" the strategic direction of the usiness. Jemem er the financial decisions fall with the long+term corporate strategy formulation process. A::%"&("' M$#13<( The main methods of investment appraisal" which are normally in use" are) aE Pay ack E Internal rate of return cE ,et present value dE Accounting rate of return.

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The investment appraisal methods can e divided into traditional and scientific methods. The traditional methods ignore the fine value of money whilst the scientific methods recognise the fine value of money in the evaluation. "et Present #alue $"P#% The ,et Present 3alue of a proLect is the difference etween the sum of the proLect discounted cash inflows and outflows attri uta le to a capital investment or other long+term proLect. The ,et Present 3alue approach holds that cash received in the future is less valua le than cash received today. In the ,et Present value computations" all cash flows are e!pressed in present day values y the cash flows" which are realised in the future. A comparison is then made" in present day terms of the total costs of the investment Dcash outflowsE and the total receipts from the investment Dcash inflowsE. :hen the present value of the inflows e!ceeds that of outflows Dwhich includes any relevant ta!ation lia ilities" as well as the more o vious initial investment outlayE" the net present value is positive and purely on financial grounds" the investment should e accepted. In contrast" if the present value of the outflows e!ceeds the present value of inflows" the net present value is negative and the investment should e reLected. &iscount 'actors( )nterest Rate The interest rate" at which investors can orrow or lend money" is key to the ,et Present 3alue model D,P3E. The model is ased on the assumption that an investor may invest money in the financial market at an interest rate prevailing or invest money in real assets" undertake a com ination of the two options" or orrow in order to invest in real asset. Jeal assets will only e attractive to a rational investor if they offer a rate of return in e!cess of the cost of money Dthe rate at which the money has een orrowedE. /y discounting the financial costs and enefits associated with real assets at this rate" the investor can determine whether a return in e!cess of discount rate Qr; is availa le from the real asset in .uestion. "P# and The Agenc Theor $enior managers of an organisation normally save the interests of shareholders and they are there y employed to ma!imise the wealth of shareholders. $ince ,et present 3alue models decision rule advocates that a proLect whose financial enefits outweigh its financial cost" henceforth having a positive net present value should e

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accepted and e pursued and vice versa. The net present value upholds the thenetical sole o Lective of usiness of ma!imisation of shareholder;s wealth through ma!imisation of returns from the proLect. Assumption in "et Present #alue The ,et Present 3alue techni.ue is ased on the following assumption.

The &iscount rate must e a measure of the opportunity cost of funds for wealth ma!imisation to result. Perfect capital market and perfect information e!ists The model assumes that a single rate which reflects the opportunity cost for all individuals and companies. All $hareholders have an o Lective of wealth ma!imisation

"et Present #alue* Ris+ and Uncertaint Jisk management does not leave out proLect appraisal and evaluation process. Past e!periences can e new" is a guide in assigning specific possi le outcomes for the action currently proposed. This can also e used as the asis for assigning pro a ilities to these outcomes what we can use to calculate the e!pected cashflows of a proLect for our ,P3 computations. In the a sence of past e!perience" we would have no asis upon which we can ase our pro a ility on. Advanced risk analysis and management are outside the scope of the te!t. E<amp!e C>as9e engineering consu!tants have een engaged in developing four D4E proLects on ehalf of their client" ,insh Corporation. 1owever" the proLect sponsors" ,insh Corporation have asked their management Accountant to evaluate the 4 proLects for their via ility efore it commits its finances to the proLects. The cost of funds for ,I,$1 Corporation is 5O. $e=uiredD In your capacity as #anagement Accountant of ,I,$1 Corporation" evaluate the via ility of the four D4E proLects given that the cash inflows and cash outflows of the proLects are as shown elow on the ,et Present 3alue asis.

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ProLect) Capital D*utlayE year Cash Inflows % 2 ' 4 %o!utionD

A 8;--D4-"---E 2-"--2-"--%-%--

/ 8;--D4-"---E 4-4-'2"--'2"---

C 8;--D2-"---E %2"A-%2"A-4-4--

& 8;--D2-"---E '6"---

$ince the company;s cost of capital is 5O" thus will serve as the discount rate at which the proLect cashflow will e discounted. #roAect A &ear Discount actor C4O Cas> !o9s +N000 D4-"---E 2-"--2-"--%-%-#resent 'a!ue +N000 D4-"---.--E %B"-4A.-%A"%4-.-A6.'A A2.27 D2"64'.'5E

%.---% -.B524 2 -.B-7' -.A6'A 4 -.A227 Net #resent 'a!ue #roAect 5 &ear Discount actor C4O

%.---% -.B524 2 -.B-7' -.A6'A 4 -.A227 Net #resent 'a!ue

Cas> !o9s +N000 D4-"---E 4-4-'2"--'2"---

#resent 'a!ues +N000 D4-"---.--E 'A-.B6 '62.527"64%.626"'26.4%4"7%%.76

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#roAect C &ear % 2 ' 4 Discount actor C 4 O %.----.B524 -.B-7-.A6'A -.A227 Cas> !o9 +N000 D2-"---E %2"A-%2"A-4-4-#resent 'a!ues +N000 D2-"---.--E %2"%B-.72 %%"6-B.6245.52 '2B.-A 4"474.B2

Net #resent 'a!ue #roAect D &ear % 2 ' 4 Discount actor C 4O %.----.B524 -.B-7-.A6'A -.A227 Cas> !o9s +N000 D2-"---E '6"---

#resent 'a!ues +N000 D2-"---.--E 2B"6%7.2B"6%7.2-

Net #resent 'a!ue

ANAL&%I% AND CONCLU%ION

ProLect /" C" W & are giving positive present values indicating that purely on financial information" they are via le and hence management of ,insh Corporation should undertake the proLects in order to ma!imi2e shareholder wealth. ProLect A is yielding a negative net present value and hence" purely on financial grounds" the proLect should not e undertaken as it is posed to destroy value of ,insh Corporation.

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)nternal Rate of Return $)RR% Internal rate of return is achieved y a proLect at which the sum of the discounted cash inflows over the life of the proLects is e.ual to the sum of the discounted cash flow. In other terms" the IJJ of an investment is that rate which when used to discount the cash flows of the investment will result in a rate present value of 2ero. The IJJ of a proLect with conventional cashflows can e calculated using a process of trial and error. The following steps represent a systematic" methodical trial and error approach to the calculation of proLect IJJ. %. The net present value of the proLect at 2ero interest rate needs to e esta lished. This must e a positive figure if an investment with conventional cashflows is to have a positive IJJ. 2. A positive discount rate should e selected and the ,et Present value of the proLect at this rate is calculated. '. The procedure under D2E should e repeated for one or more additional discount rates. The ,et Present 3alue profiles should e sketched and an appro!imate IJJ estimated. E<amp!e $uppose a company has proLect K with the following cashflows to evaluate. 9stimate the IJJ of proLect K using the data given at a cost of capital of %4O. ,.1 #roAect & Kear % 2 ' 4 Cas> !o9s 8;--D2-"---E 2-2-%6-"--%6-"---

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%o!utionD &ears Cas> !o9s Discount Factors 01-O1 %.---.A77 -.76B -.675 -.5B2 #resent 'a!ues +N000 D2-"---.--E %7A.4%5'.A%-A"---.-B4"B2-.-18*.,4,.,0

+N000 D2-"---E % 2-2 2-' %6-"--4 %6-"--Net #resent 'a!ue

&ecision Criteria )n )nternal Rate of Return In case the IJJ" the decision rule is to compare opportunity cost of funds and accept the proLect if the IJJ is greater than the company;s cost of money and reAect it if it is not i.e. purely on financial grounds. This decision rule would always lead to the selection of an identical set of proLects as the application of ,P3 rule given the assumptions that have een made so far namelyN certainty" conventional cashflows and perfect capital markets and the additional assumption of independent proLects. The Reinvestment Assumptions The ,et Present 3alue techni.ue assumes that all cash flows from a proLect will e re+ invested at the discount rate used in the calculation of the proLect;s net present value" which in a real>free world is the prevailing ase interest rate. This assumption is realistic as application of the ,P3 rule means that all proLects offering a return in e!cess of the discount rate will e accepted and the marginal funds are invested at the prevailing interest rate. In contrast IJJ assumes that all cash flows will e reinvested at the proLects own IJJ.There are not practical supporting reasons for this assumption though. This assumption will lead to favour proLects with concentrated cash flows in the early years of the proLect running than those with low cash flows in the early years of running.

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This can e illustrated y using an e!ample of 2 proLects # W 8 and calculations of their terminal values. In the early years of the proLect running than those with low cash flows in the early years of running. The terminal value of an investment is the total value of the cashflows generated y an investment at the end of its life. In calculating the terminal values" interim cash flows must e proLected forward to the end of the investment;s life y the application of a particular reinvestment rate. The ,et terminal value is calculated y su tracting the terminal value of the initial investment from the terminal value of the cashflows. It;s assumed elow that the interim cashflows will e reinvested at 5O. #roAects &ears % 2 ' 4 ProLects &ears % 2 ' 4 M cas> !o9s 8;--D%A"---E %4"--%2"--A"--%"--+ cas> !o9s 8;--D%6"---E %"25%2"--%2"--%2"---

# Terminal values Cas> !o9s +N000 4O D%A"---E %4"--%2"--A"--%"--$einBestment rate termina! Ba!ues +N000 4 D%.-5E 65"'4D%.-5E' 'A"%22 D%.-5E2 22"4-4 D%.-5E% 7"6%6 %.-%"---

(onclusion and /nalysis /y definition" the IJJ is the discount rate of 2ero and you should not e surprised to see that it is also the discount rate which gives a net terminal value of 2ero. This is clearly seen in the case of proLect 8N the small positive ,T3 of # arises ecause 4BO is a slight under estimate of the IJJ as perusal of the a ove analysis. E<amp!e $eakwe Ltd is considering which of two mutually inclusive proLects it should undertake. The finance director thinks that the proLect with the higher net present value should e chosen

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where the managing director thinks that one with the higher IJJ should e undertaken especially as oth proLects have the same initial outlay and length of life. The company anticipates a cost of capital of %-O and the cashflows of the proLects are as follows) &ears #roAect 6 +N000 % 2 ' 4 5 $e=uiredD %. Calculate the ,et Present 3alue and internal rate of return of each proLect. 2. Jecommend with reasons" which proLect you would undertake. '. 9!plain the inconsistency in ranking of the two proLects in the light of the remarks of the two directors. 4. Identify the cost of capital at which your recommendation in D2E would e reversed. %o!ution D%E. K % 2 ' 4 5 (actor %-O %.---.B-B -.A26 -.75% -. 6A' -.62% (actor 2-O %.---.A'' -.6B4 -.57B -.4A2 -.4-2 ProLect < D4--E 7%6%A%54Present value %-O D4--E 6'.6' %'2.%6 %'5.%A %-2.45 24.A4 48.,8 Present value 2-O D4--E 5A.'% %%%.-4 %-4.22 72.'%6.-A 0*8.041 ProLect Present K value %-O D4--E 4'6 22A 6 D4--E 'B6.'2 %6.52 %5.-2 5.46 '.72 *7.0Present value 2-O D4--E '6'.%B %'.AA %%.5A '.A5 2.4% 04.081 D4--E 7%6%A%54#roAect & +N000 D4--E 4'6 22A 6

Therefore as it has een noticed in the calculations. At %-O the ,P3 of ProLect < C +48.,80.000 At %-O the ,P3 of proLect K C +*7.0-0.000

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At 2-O the ,P3 of ProLect < C 0+*8.040.0001 At 2-O the ,P3 of proLect K C 0+4.080.0001 The IJJ of the two proLects are as follows) #roAect 6 %,P3% IJJ C Ja P H%,P3%%P%,P32% ! DJ F JaEI 85A" 2A-"--IJJ C %-O P H85A" 2A-"--- P 8'A" -5-"--- ! D2-O+ %-OEI C %-O P 6.-5--'6'''O C %6.-5O #roAect & %,P3% IJJ C Ja P H%,P3%%P%,P32% ! DJ F JaEI 8'7"-4-"--IJJ C %-O P H8'7"-4-"--- P 5"-A-"--- ! D2-O+ %-OEI IJJC %-O P A.7B'B22%27 IJJC %A.7B'BO IJJC%A.7BO D2E The recommendation should e to undertake ProLect < for the following reasons) ProLect < has a positive ,et Present 3alue" showing that it e!ceeds the company;s cost of capital. In addition" assuming that the company;s o Lect is to ma!imise the Present 3alue of future cashflows ProLect < offers the higher ,et Present 3alue. ProLect < indicates a higher ,P3" whereas proLect K offers a higher internal rate of return where such conflicting indications appear" it is generally appropriate to accept the ,et Present 3alue result" net present

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value eing regarded as technically more sound than internal rate of return. The two proLects have radically different time profiles. ProLects <;s cashflows are grouped in the three middle years of the proLect" while nearly B-O of K;s inflows come in the first year of the proLect" leading to a situation where proLect K shows a higher internal rate of return.

Jisk" uncertainty and timing if cashflows may e considered y the &irectors in making the final investment decisions.
P P

%-AP 6P 4P 2+

% -

2 -

' -

4 &iscou nt rateN O

6 -

24-

Although in the a ove illustration we have shown the graphical representation using straight lines" the true relationship etween the ,et Present 3alue and discount rate is a cumulative one. ,ultiple )RR $,ultiple -ields% At this point in time" we would want to appreciate that in cases where a proLect does not have conventional cashflows" there is a possi ility of having multiple IJJ in the proLect whose cashflows are unconventional. /y a proLect having conventional cashflows" we mean that there will e a cash outflow followed y a stream of inflows. A proLect with non+ conventional cashflows may have a cash outflow followed y an inflow or inflows then followed y a further outflow or y further outflows. As a result of these cashflows coming in and out of the proLect at different times" the IJJ computation might give rise to two or more internal rate of return rates.

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E<amp!e Lunga Plc is proposing making a machine it will use in its manufacturing process" the cost of which will e paid in two stages. Jevenue can e e!pected from its demonstration" although it will e e!pensive to reak up and dispose of at the end of its useful life. The cashflows associated with the proLect are as follows. &ears % 2 ' Cas> !o9s +N000 D7"A2-E D2-"---E A-"--D5'"-2-E

The appropriate discount rate is %5O. %o!utionD This proLect has two internal rates of return as shown elow. &ears Cas> !o9s +N000 D7"A2-E % D2-"---E 2 A-"--' D5'"-2-E Net #resent 'a!ue &ears Cas> !o9s +N000 D7"A2-E % D2-"---E 2 A-"--' D5'"-2-E Net #resent 'a!ue Discount Factor 02O1 %.----.B4'4 -.A'--.A'B6 #' +N000 D7"A2-E D%A"A6AE 7%"2-D46"B-6E 12.000 #' +N000 D7"A2-E %5"'A4 47"''6 24"-'4 78./*-

Discount Factors 0*0O1 %.----.B4'4 -.A'--.A'B6

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,.,

Grap>ica! $epresentation

,P3 Investment ,P3 Z 2-%-D%--E D2--E D'--E D4--E 5 %%5 225 '&iscount rate" O

(onclusion0 +nterpretation and /nalysis As oth IJJs are e.ually valid" the decision whether or not to accept this investment cannot e made y reference to these rates alone. Therefore" ,P3 method can e used to get a clearer result. If ,P3 shows that the ,P3 of the same proLect lower consideration is positive" then the proLect should e accepted as it shows that the net financial enefits far outweigh the financial costs of the proLect and hence demonstrating financial via ility of the proLect. )nternal Rate of Return for Pro.ects /ith Une0ual lines :hen two proLects or more mutually e!clusive investments with une.ual lives are eing evaluated and compared" consideration must e given to the time period over which a comparison of the investments is to e made.

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E<amp!e Consider two proLects &ears #roAect P G +N000 D6-"---E D6-"---E % +N000 4-"--75"%-2 +N000 4-"--+

Compute the IJJs of the two proLects assuming a cost of capital of %-O. A comparison can e made over an e.ual time span for oth investmentsN the lives of P and G can e e.ualised y assuming that the company can invest in another proLect like G at the end of year %. The cashflows of two consecutive investments in G would e as follows)

Y$"%
ProLect G ProLect G repeated Total Cashflow

0
+N000 D6-"---E D6-"---E

1
+N000 75"%-D6-"---E %5"%--

2
+N000 + 75"%-75"%--

D%E 0sing unadLusted Cash flows DI.e. P over 2 yrs And G over % yrE D2E Cashflow adLusted to 9.ualise proLect lives Di.e. P over 2 yrs and G over 2yearsE Conc!usion and ana!?sis

+N000 ,P3P C 4"7%% ,P3G C 4"-B+N000 ,P3P C 4"7%% ,P3G C 7"A%-

I$$ 22O 25O I$$ 22O 25O

Janking proLect P and G on an IJJ asis makes proLect G the superior choice" irrespective of the period over which the comparison is made.

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In conclusion" regardless of the proLect lives" the proLect with a higher IJJ should e chosen as the IJJ does not seem to e affected y the length of the proLect life or repeated reinvestment of the cash flows. T$ADITIONAL A##$AI%AL A##$OAC"E% TO #$OGECT%E CA#ITAL IN'E%TMENT

As you can remem er" from the outset of the chapter" the pay ack period and accounting rate of return are the commonly used traditional methods of appraising capital investments. Pa bac+ Period ,ethod Computation of pay ack period of a proLect is the time re.uired for the cash inflows from a capital investment proLect to e.ual the cash outflows. If we assume that cashflows are received at the end of each year" the pay ack period for the four proLects elow will e) #roAectsD Initial capital outlay Cash inflows &ears A +N000 5 +N000 D2-"---E 4-4-%6"4-'2"4-C +N000 D%-"---E 6"4-%2"A-%'"--%'"2-D +N000 D%-"---E %A"---

- D2-"---E % %-"--2 2-"--' 2-"5-4 2%"---

The pay ack period for the proLects is as follows) #roAect A / C & #a?;ac: period 2 years 4years 2years 4years

In practice corporations will have a enchmark of the pay ack period" which is going to e adopted in their company policy as the threshold or cut off point for appraising and assessing the pay ack periods of proLects. (or instance if the company a ove has a corporate policy of only accepting proLect with pay ack period of ' years only proLect A and C promise to pay ack a three year period. 1ence only proLect A and C would e accepted and e undertaken in this instance.

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1ecision rule*nly proLects with short pay ack periods are preferred. Limitations of Pa bac+ Period ,ethod The pay ack period method has a limitation not taking the time value of money into consideration and it ignores the future cashflows eyond the pay ack threshold as per company policy no matter how healthy the cashflows might e. &iscounted Pa bac+ Period In order to go round the pro lem of the lack of recognition of the time value of money some evaluators opt to use discounted pay ack where the pay ack of the proLect is deferred using discounted cash flows as opposed to simple cashflows. E<ercise Compute the present values of the cashflows from the a ove 4 proLects A" /" C and & at a cost of capital of 5O and you will discover that the discounted pay ack DyearE will e as follows) #roAect A / C & Discounted pa?;ac: 0?ears1 ,o Pay ack 4 years 2 years 4 years

This is a slightly more comprehensive evaluation that the crude simple method of using simple cash flows. The Accounting Rate 1f Return $ARR% (omputing /ccounting 2ate of 2eturn A mathematical e!pression ofN Average annual profit from an investment ! %-Average Investment

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&efines the accounting rate of return asN The model that employs accounting profits rather than cash flows from the proLect as the input data to the model. To find the AJJ of an investment" the average profit over the life of the investment is calculated. This is then e!pressed as a return on either the initial or the average investment in the proLect. An accepta le AJJ must e specified y the decision maker in advance and proLects e!ceeding this return will e accepted and those falling short of the return will e reLected. To illustrate the mechanics of the method" the following illustration can e used. Consider four proLects A" /" C" W & with the following data. E<amp!e #roAect NameD ProLect life) 4 A 4 5 4 C 4 D

Cash FInflows) 82%" ---"--- 8'2" 4--"--- 8%'" 2--" --- 8%A" ---"--&eprecation) 82-" ---"--- 82-" ---"--- 8%-" ---"--- 8%-" ---"--Profit) 8%" ---"--- 8%2" 4--"--- 8'" 2--"--8A" ---"---

In the a ove figures" we are assuming that the deprecation and profit figures shown are for total DaggregateE figures over the lives of the proLects. Average profits for the proLects Total Profit over 4 years C Profit per year ProLect life years #roAectsD A 8%" ---"--4yrs / 8%2" 4--"--4yrs 8'" %--"--C 8'" 2--"--4yrs 8A--" --& 8A" ---"--4yrs 82" ---"---

C 825-" ---

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Computation of average capital investment) Assuming that all the resources invested in the proLect will e consumed and hence the investment at the end of the proLect life will reduce to 2ero D-E" the Average investments are calculated as a simple mathematical mean. ProLect A 82%" ---"--- P 82 years +10. 400.000 ProLect C 8%'"2--"--- P 82 years +2. 200.000 The Accounting Jate of return) ProLects A) ProLects /) ProLects C) 825-" --C 8%-" 5--"--8'" %--"--- C 8%6" 2--"--8A--" --86" 6--"--82" ---"--8B" ---"--C 2.'AO %B.%4O %2.%2O ProLect / 8'2" 4--"--- P 82 years +12. ,00.000 ProLect & 8%A"---"--- P 8 2 years +/. 000.000

ProLects &)

22.22O

(or the techni.ue to find use" the decision maker needs to specify a re.uired rate of return when AJJ is used as the proLect evaluation method. As mentioned under the pay ack period method" corporations need to esta lish and choose as a policy" an accounting rate of return percentage.

%BA

ANNUALI%ED E)UI'ALENT CO%T% E<amp!e #pose Plc is considering the purchase of a new track" which will e re.uired to travel 5-"--kilometers per year. Two suita le models are availa le details of which are as follows) The 8enworth having a life of four D4E years and a price of 82--" ---"--- the running cost is initially 82--- per kilometer ut this will rise y 8'-- per kilometer for each year the truck is in service. $cania will incur the following cost over 6 years &ears % 2 ' 4 5 6 +N000 '5-"--75"--B-"--%-5"--%2-"--%'5"--%5-"---

The cost of capital for #pose Plc is %2O $e=uiredD 9!plain which truck D etween the 8enworth and the $caniaE should e purchased. %o!utionD As we can see the comparison of the two proLects is complicated y their une.ual lines. :e are going to use annuali2ed costs to compare the two proLects. Therefore the annuali2ed cost of the 8enworth is) &ear % 2 ' 4 Costs +N000 2-- --%-- --%%5 --%'- --%45 ---

%BB

The annuali2ed cost of the 8enworth Truck &ear Costs 1,O DCF +N000 % 2 ' 4 Totals% 2--"--%--"--%%5"--%'-"--%45"--%.---.AB'-.7B7-.7%2-.6'6*.0*8

#resent Ba!ue +N000 2--"--AB"'-B%"655 B2"56B2"22424.7*4

The annuali2ed e.uivalent of 8 565"7'5 8 565"7'5 '.-'A 3 +182.,1/.44, This is determined y calculating the ,et Present 3alue of ac.uiring and operating a 8enwork truck over four years and converting it an e.ual annual e.uivalent cost y dividing the ,et Present 3alue y '.-'7. The annuali2ed cost of the $cania truck isN &ear % 2 ' 4 5 6 Costs +N000 '5-"--75"--B-"--%-5"--%2-"--%'5"--%5-"--%.----.AB'-.7B7-.7%2-.6'6-.567-.5-71,O DCF #resent Ba!ue +N000 '5-"--66"BA7%"2'74"7676"'276"5576"-5-

2--

Totals% -.11, The annuali2ed e.uivalent of 87B%" AB-"--- is 8 7B%"AB-"--4.%%2 3 +1/,. 480.,4,./0

7/1.8/0

Therefore in conclusion" the 8enworth Truck is the est option with a lower annuali2ed cost.

&2#,#2#3(# ,42 /&&2/+%/5 6#T741

Investment Appraisal method AdBantages and disadBantages o InBestment Appraisa! Met>ods &/8B/(9 &#2+41 6#T741 AdBantages DaE It is easily understood and interpreted" especially to non+financial managers" and its implications for li.uidity are clear. D E It can e used as preliminary proLect appraisal screening method" efore scientific methods Ddiscounted cash flows are applied for the appraisal processE. DisadBantages DaE It ignores cash flows eyond the pay ack period and it does not take into account of the time value of money. 3#T &2#%#3T )/5*#%

A<2"*#")$(
DaE It takes account the timing of cash flows. D E It takes proper account of the si2e and duration of proLects. DcE It takes into account the greater uncertainty of later years; cash flow y using a higher discount rate for these years. DisadBantages DaE It produces a num er which is less familiar to management than a rate of return. D E It\s comple! in its mechanics. 2-%

DcE ,ot easily understood y non+financial managers. +3T#23/5 2/T# 4, 2#T*23 AdBantages DaE It takes into account of the timing of the cash flow. D E It is easily compared to a given return" which proLect owners are looking for" in assessing a proLect;s via ility. DisadBantages DaE It does not take account of the si2e of the proLect" so a small proLect with a high return looks etter than a large proLect with a lower return" even through the latter will contri ute more to earnings. D E The Internal Jate of Jate DIJJE cannot evaluate properly the duration of proLects. This is ecause IJJ takes no account of what happens to the returns after they are achieved. DcE Another potential difficulty" which may sometimes arise" is the possi ility of two or more solutions to the IJJ calculation. This usually happens when a proLect has unconventional cash flows" meaning that cash flows with negative and positive signs may come through during the life of the proLect. C>apter %ummar? The following have een covered under this chapter)+ ,et Present 3alue D,P3E Internal Jate of Jeturn DIJJE Pay /ack Period DP/PE Accounting Jate of Jeturn DAJJE

2-2

ANSWERS TO END OF CHAPTER QUESTIONS

2-'

C>apter 1 Guestion % Guestion 2 C>apter , C /

C>apter *

Cost6:I,,,7 1igh activity Lo8 activity Change Variable cost per unit $ctivity 0. // + )03 + )*4,, )*,-. )03 > 4.

ixed costs > Total cost < variable cost :I,,, > )4,, < 64. x 0.7 > 3,9/9 Total cost at 4- units > /)4) @ 64. x 4-7 >

6,0/9

Total cost at +, units > /)4) @ 64. x 4-7 >

10,159

2-4

C>apter )UE%TION 1 D 5
C3(# 34 &((8$( 8*<$% #1$ FIFO 5$#13< %ssue -,, 2*,,, 2*),, 3,, /*+,, Value 2*.-, .*4-, 0*03, .*/., 2,*3,,

)UE%TION , D C

>3,,=2.,, x /03,

C3(# 34 &((8$( 8*<$% #1$ LIFO 5$#13< Total Receipts Less %ssues 2*.,, +,, .*2,, 2*-,, /,, /*03, .*-., :;,,, 2)*/2,

>+,,=2),, x 003,

>/,,=2),, x 003,

0*/-, 30, 22*2+, 5,120

C'3(&*) S#3+0

)UE%TION * D D
C3(# 34 &((8$( 8*<$% #1$ AVCO 5$#13< Units $verage price Receipts -,, .D-, Value :;,,, 2*.-,

2-5

Receipts Receipts Receipts T3#"' %ssue 5alance Receipts T3#"'

2*,,, 2*),, 2*.,, !,300 6.*2,,7 .*.,, 2*-,, 3,/00

.D4.D3, .D+, 2@/8 .D43 .D43 .D+, 2@83

.*4-, 0*03, /*03, 11,690 6-*3027 )*22+ 0*/-, 10,!96

2-6

C>apter

)uestion D 1

C $eorder !eBe! 3 ma<imum Usage < ma<imum !ead time -,0 < 14 3 2.*00

* Ma<imum stoc: 3 reorder !eBe! K reorder =uantit? H 0minimum usage < minimum !ead time1 2.*00 K 7.000 H 0180 < 111 3 11.*,0 )uestion D , 5

Minimum stoc: !eBe! 3 $eorder !eBe! H 0aBerage usage < aBerage !ead time1 2.*00 H 0*40 < 1*1 3 1.740 )uestion D * 5

] ]

2 > 55,000> !000 200 C 10D > 200 00,,,,,,, ..,

2*020

2-7

C>apter )uestion 1a

Chila 5asic !ver time Premium < first / 1rs !ver time Premium < next . 1rs Total 5onus standard Time allo8ed 60, min x 4.7 $ctual Time "aving 5onus Pay Total Pay 60- x +.,7 6/ x 2=/ x +.,7 6. x 2=. x +.,7 02*0,, +., +., 0/*.0,

03 0/ 6/ x +., x 4-H7

.*,4, !5,310

Cheta 5asic !ver time Premium < first / 1rs !ver time Premium < next / 1rs Total 5onus standard Time allo8ed 60, min x 2337 $ctual Time "aving 5onus Pay Total Pay 60) x +),7 6/ x 2=/ x +),7 6/ x 2=. x +),7 00*2), +), +), 0)*,3,

04 0) 2 62 x +), x 4-H7

.*2), !8,2!0

Chulu 5asic 600 x +0,7 02*/),

2-A

!ver time Premium < first / 1rs !ver time Premium < first . 1rs Total 5onus standard Time allo8ed 60, min x 0/.7 $ctual Time "aving 5onus Pay Total Pay

6/ x 2=/ x +0,7 6. x 2=. x +0,7

+0, +0, 0/*.0,

-,D0 00 )D0 6)D0 x +), x 4-H7

0*-2. !/,/52

)uestion 1;
&et pay computation 'ross Pay P$EE &$P"$ Mu9uba Pension N$# P"? Chila 0-*/2, 62/*-+/7 6/*,,,7 6.*-,,7 29,21/ Cheta 03*.0, 620*04.7 6/*,,,7 6.*-,,7 28,298 Chulu 04*4-. 620*/.)7 6/*,,,7 6.*-,,7 2/,629

)uestion 1c
Kournal Entry Lages $ccount P$EE &$P"$ Mu9uba Pension "alaries Control T3#"' 1!1,302 (R 202*/,. CR

0.*/+2 +*,,, 4*-,, 3.*022 1!1,302

5eing 8ages cost for the month

2-B

C>apter

)uestion 1.1 Answer is C )uestion 1., Answer is C )uestion 1.* Answer is A )uestion 1.Answer is / )uestion ,a
!verhead $nalysis "heet !verhead %ndirect Material %ndirect Lages Managers "alaries (epreciation of machinery 1eating and Lighting 5uilding insurance %nsurance of Machinery Rent and rates Totals 5asis of apportionment (irect (irect &o of employees Value of Machinery $rea $rea Value of Machinery $rea Total overhead .0-*,,, .4-*,,, 4,*,,, 2-,*,,, -,*,,, .-*,,, 2,,*,,, 4-*,,, ++,*,,,

Production departm Machining $ 2,,*,,, +,*,,, .2*,,, 2.,*,,, 2*.-, ).3,*,,, 2*34020*4-,

2%-

)uestion ,;
!verhead 5asis of apportionment

Totals Maintenance "tores Total

O2$%1$"< A*"'?(&( S1$$# Total overhead Production departments Machining $ssembly :;,,, :;,,, : ++,*,,, 020*4-, .40 < -.*43-, < 202*.)+ -) 660,000 908,80!

381

Machining !ver heads Machine hours :;,,, ),3*3,0 2,,*,,,

$ssembly !ver heads Machine hours :;,,, /32*2+) 3,*,,,

!1$R

: )D,+ per hour

!1$R

:0D4) per hour

)uestion ,c
T3#"' +3(#( 43% E37 X :;,,, (irect Materials D&%$+# L"738% Machining $ssembly O2$%1$"<( Machining $ssembly T3#"' 60,,hrs x : )D,+7 63,,hrs x : 0D4)7 .*0/) /*3,3 1/,2!! .*,,, 6:-*,,, x 2,,, hrs7 6:-*,,, x 3,, hrs7 -*,,, 0*,,,

C>apter

10

2%%

Part DaE
A7(3%:#&3* C3(# S#"#$5$*# "ales 6+*,,, ? :.,7 !pening "toc9 Production cost 622*,,, x :2.7 Closing "toc9 6.*,,, x :2.7 Cost of "ales 'ross Profit 6:23,*,,, < :2,3*,,,7 !ther Expenses Variable selling costs 6:2 ? +*,,,7 ixed selling costs 6:. x 2,*,,,7 Under absorption 6see 8or9ing7 N$# P%34&#

Part D E
:;,,, 23,*,,, < 2/.*,,, 6.0*,,,7 2,3*,,, /2,000 6+*,,,7 6.,*,,,7 0*,,, !/,000 M"%)&*"' C3(# S#"#$5$*# "ales 6+*,,, ? :.,7 !pening "toc9 Production cost 622*,,, x :37 Closing "toc9 6.*,,, x :37 Variable Cost of "ales Variable selling costs 6+*,,, x 27 Total Variable costs C3*#%&78#&3* , 180,000- 66,000. F&>$< +3(#( Production 62,*,,, x 07 "elling 62,*,,, x .7 N$# P%34&# :;,,, 23,*,,, < 33*,,, 62)*,,,7 4.*,,, +*,,, 32*,,, 66,000 60,*,,,7 6.,*,,,7 36,000

U*<$%=O2$% "7(3%:#&3* ixed Production !1 $bsorbed overheads $ctual overheads !ver absorption :;,,, 00*,,, 0,*,,, 0*,,,

Part DcE
Profit Reconciliation $bsorption Cost Profit :;,,, 04*,,,

2%2

Less B =costs in C=stoc9 P%34&# "( :$% 5"%)&*"' +3(#&*)

63*,,,7 /+*,,,

C>apter

11 + :.*,,, x 3)hrs :2*-,, x ..,hrs 24.*,,, //,*,,, -,.*,,, /3.*-,, 1,389,500 --0*),, 1,6!1,100 Kob ?2.0 M"#$%&"' +3(#( (irect Material issued from stores (irect returned to stores (irect Material transfers Material Cost Month ) costs Total material costs L"738% +3(#( (irect Labour hours Rate Per hour Labour cost Month ) costs Total labour cost P%3<8+#&3* 32$%1$"< (irect Labour hours !verhead absorption Rate Per hour Kob ?2.0 )+4*3,, Kob ?2.2*3++*0,, 64,,*,,,7 3)*,,, 2*.3-*0,, 2*.3-*0,, .*/)0 4,, 2*)-0*3,, 2*)-0*3,, Kob ?2.-

)uestion 1 "alary cost per consulting hour 6senior7 "alary cost per consulting hour 6Kunior7 Total Labour cost !verhead absorption rate per consulting hour T3#"' +3(# Profit Mar9 up P%&+$ 43% #1$ "((&)*5$*# )uestion , a7

:2*.-, x /,)hrs

0, H of 2*/3)*-,,

)+4*3,, 4..*,,, 2*02+*3,, 43, 4,, -0)*,,, ),,*4), 2*20)*4),

43, 2*.,,

.*/)0 2*.,,

2%'

Labour cost Month ) costs Total labour cost b7 T3#"' +3(#( "*< :%34&#( Total Production costs (istribution* selling S admin costs Total costs "ales invoices P%34&# C>apter 1,

+/)*,,, 2*,02*),, 2*+44*),, E37 X12! 0*-00*2), +,3*3/. -*0-.*++. )*,,,*,,, 5!/,008

.*3/)*3,, .*3/)*3,, E37X125 -*444*,,, 2*2--*0,, )*+/.*0,, 4*+,,*,,, 69/,900

%OLUTION
:I , , ,

Contract Price Cost to date Estimated future costs Estimated total costs Estimated total profit .+*,, , 4,* ,,,

:;,,, 0-,*,, ,

6/)-*,, ,7 3-*,,, 9 8, 9 6 6

6 a 7

Cost to date Estimated total costs

.+*,, , /)*,, ,

? 3-*,,, >

6 b 7

Lor9 certified Contract Price

/,, *,, , 0-, *,, ,

? 3-*,,, >

5 9, 9 9 /

2%4

C>apter -.1 %o!ution

1*

Cost Item &epreciation of vehicles HD5--"---+ 2-"---E>%- I > 4 Joad fund licence and insurance Tyres DA-"--->4-"---E ! A ! %-5$ervicing DA-"---E>%6"--- ! '25(uel DA-"--->%-E ! 5 &rivers Tota! 8ilometres per year Cost per +i!ometre

8\--7"5-%%"45%6"A-%6"254-"--'6"--%2A"---

A-"--1.20

C>apter

1-

#$OCE%% ACCOUNT
&irect materials &irect La our 0nits 5-"-8;--24"A%7"60nits (inishe d goods Closing :IP A>Loss 6"--Production overheads Tota!s 40.00 0 %2"644.00 0 ,>Loss 2"--Tota!s 40.00 0 A-44.00 0 '-"-%2"-8;--'6"-%%"-7"2--

2%5

A/,*J#AL L*$$ ACC*0,T

Process account 0nits 6"-8;--7"2-Cash>/ank PWL 4"A-Tota!s 100 7.,00 Tota!s 100 7.,00 0nits 6--8;--2"4--

(or:ings :%
T3#"' C3(# ( F000 Closin g L%P 2.*,, , )*,,, Labo ur !ver head s /,*,,, )*,,, /,*,,, )*,,, 0.*,, , 2.*) ,, ,D/, 3*,,, 00*,, , 24*) ,, ,D0, Total 03*,, , .0*, ,,CC ,D-,

C3(# E'$5 $*# Mater ial

-.1.1.1 E=uiBa!ent Units

inished !utput /,*,,, $=Los s )*,,,

Cost #er Unit +N000

T3#"'

1@20

VV 824"A--+ A-- eings scrap value of normal loss :2

V"'8"#&3* 34 C'3(&*) W3%0-I*-P%3)%$(( C3(# E'$5$*# Material Labour !verheads T3#"' EB8&2"'$*# U*&#( G WIP 2.*,,, 3*,,, )*,,, C3(# :$% 8*&# F000 ,D,D0 ,D/ V"'8$ F000 )*,,, /*.,, 2*3,, 11,000

V"'8"#&3* 34 F&*&(1$< G33<( C3(# E'$5$*# EB8&2"'$*# U*&#( G WIP C3(# :$% 8*&# V"'8$

2%6

Material Labour !verheads T3#"'

/,*,,, /,*,,, /,*,,,

F000 ,D,D0 ,D/

F000 2-*,,, 2.*,,, +*,,, 39,000

:'
V"'8"#&3* 34 "7*3%5"' L3(( C3(# E'$5$*# Material Labour !verheads T3#"' EB8&2"'$*# U*&#( G WIP )*,,, )*,,, )*,,, C3(# :$% 8*&# F000 ,D,D0 ,D/ V"'8$ F000 /*,,, .*0,, 2*3,, /,200

C>apter

14

U n i t s

Process costs 0 * , , , (irect materials

C o st s :; , , ,

)* 0 , , -* . , , 2 2* ) , ,

(irect Labour

Total Prime Costs

2%7

actory overhead 62-,H of :22D)m7

2 4* 0 , , . +* , , , 6 ) , , 7 / * 0 , ,

Total Process Costs

Less 5y<product salesCC

6+ , ,7 . 3* 2 , ,

Koint costs to be apportioned

VV ,ote the treatment of the sales value of the y+product which has een deducted from the process costs.

aE
A::3%#&3*5$*# 34 A3&*# +3(#( 8(&*) V3'85$ ? .-,, /*0,, 0,, /*0,, -,, /*0,, ? /+*4,, > :;,,, .+*2+2

? /+*4,, >

0*)42

? /+*4,, >

-*3/3

T3#"' +3(#( "::3%#&3*$<

36,/00

2%A

W3%0&*)( 43% ("'$( 2"'8$( "# #1$ (:'&#-344-:3&*# Product Ruantities in :g "elling price per :g :8acha 2,*2), 2.*)0)*40, :;,,, .-*0,, -*,-3 /*/4, //*3.3

? .*-,, E 0,, F -,, T3#"' ("'$( 2"'8$ "# (:'&#-344-:3&*#

E
A::3%#&3*5$*# 34 A3&*# +3(#( 8(&*) %$'"#&2$ ("'$( 2"'8$( "# (:'&#344 :;,,, ? :.3 .-*0, *2, .,*)) ? , ,> . //*3. 3 ? :.3 *2, ,>

-*,-3 //*3. 3

/*/,)

/*/4, //*3. 3

? :.3 *2, ,>

0*2/.

T3#"' +3(#( "::3%#&3*$<

28,10 0

2%B

C>apter

12

Guestion % ) Answer is C Guestion 2 ) Answer is C Guestion ' ) Answer is A Guestion 4 ) Answer is / (or:ing 25-kg ! 8%-"--25-kg ! %2"--Total 82"5-8'"--85"5--

Guestion 5 ) Answer is & (or:ing %"---kg ! 86"--- C 86 million C>apter Ans9er is D C

R$'$2"*# +3(# 43% 5"#$%&"' P H38'< 7$ !pportunity Cost Extra material re#uired Total cost -*,,, 9g x :2-, /*,,,9g x :-,, 4-,*,,, 2*-,,*,,, .*.-,*,,,

17

22-

C>apter G%. G2. G' /9P

18 C (i!ed cost>C$ ratio C 82%-"---"--->-.' C 87--"---"--->4-"--- C 17.400 units

D82%-"---"---P86-"---"---E>-.' C 8B--"---"--->4-"--- C ,,.400 units Contri ution C 864"--- F 8'4"--- C 8'-"--(>cost C %"-5- units ! 8%-"--- C 8%-"5--"--/9P C 8%-"5--"--->8'-"--- C '5- units #argin of safety C %"-5- F '5- C 7-- units #*$ as a O C 7-->%-5- ! %-- C 22.27O 3olume to achieve a profit of 824million D824"---"--- P %-"5--"---E>'-"--- C 1140 units DaE D E DcE DdE C>$ ratio C 4"--->%-"--- ! %-- C -0O /9P C 82"5--"--->4"--- C 2,4 units #*$ C %"--- F 625 C *74 units D82"---"--- P 82"5--"---E>4"--- C 1.1,4 units

G4 G5

22%

C>apter

,0

S#"*<"%< C3(# C"%<

Direct materia!s
:

Costs : 2)*,,, 23*4-, /0*4-,

%-kg of material < =8%"6-- per kg 7.5kg of material K = 82"5-- per 8g #aterial cost &irect La our) Preparation %4 hours = 8'"75- per hour Assem ly 5 hours = 85"--- per hour #rime Cost The udgeted total overheads for one year are) 3aria le *verheads Preparation %4 hours = 8'"%5- per hour Assem ly 5 hours = 84"25- per hour 'aria;!e #roduction Costs (i!ed *verheads Preparation %4 hours = 8%"25- per hour Assem ly 5 hours = 82"--- per hour

-.*-,, .-*,,, 44*-,, 112,250

00*2,, .2*.-, )-*/-, 1//,900 24*-,, 2,*,,, .4*-,,

Tota! #roduction Cost

205,100

222

(O$+ING%
Total ixed !1 .-*,,,*,,, 03*,,,*,,, 1ours .,*,,, .0*,,, Variable )/*,,,*,,, 2,.*,,,*,,, !1 rate per 1our 2*.-, .*,,,

Preparation Assem ly (i!ed Production *1 Preparation Assem ly

33*,,,*,,, 2-,*,,,*,,, Cost .-*,,,*,,, 03*,,,*,,,

3aria le Production *1 Preparation Assem ly

Cost )/*,,,*,,, 2,.*,,,*,,,

1ours .,*,,, .0*,,,

!1 rate per 1our /*2-, 0*.-,

C>apter

,1

%OLUTION% One
T3#"' 5"#$%&"' +3(# 2"%&"*+$ $ctual units "tandard cost per unit 60*-,, x 07 "tandard material cost $ctual material cost Variance :;,,, 2*,0, 23*,,, 23*4., 20*0,, 0*/.,

M"#$%&"' P%&+$ 2"%&"*+$ = ,SP - AP.AI 60*-,, < 20*0,,*,,,=0*2,,7 x 0*2,, > :;,,, 0,-,

M"#$%&"' U(")$ V"%&"*+$ = ,SI - AI. > SP T62,0,x 07 < 0*2,,U x 0*-,,

.4,

%OLUTION H T(O
T3#"' '"738% +3(# 2"%&"*+$

22'

$ctual units "tandard cost per unit "tandard labour cost $ctual labour cost Variance

:;,,, /*/-, .0*,,, 3,*0,, 4+*3+/ -,4

L"738% R"#$ 2"%&"*+$ = ,SR - AR.AH 6)*,,, < 4+*3+/*,,,=2/*0-,7 2/*0-, > :;,,, 3,4

L"738% $44&+&$*+? V"%&"*+$ = ,SH - AH. > SR T6/*/-,x 07 < 2/*0-,U x )*,,,

</,,

%OLUTION@ T"$EE
T3#"' F&>$< 32$%1$"< 2"%&"*+$ $ctual units "tandard cost per unit "tandard labour cost $ctual labour cost Variance :;,,, 2*2,, .,*,,, ..*,,, .,*0-, 2*--,

E>:$*<&#8%$ V"%&"*+$ 5udgeted Expenditure $ctual Expenditure Expenditure Variance :*,,, .,*,,, .,*0-, 60-,7

V3'85$ V"%&"*+$ $ctual Volume 6Units7 5udgeted Volume 6Units7 5udgeted Rate per unit 6:;,,,7 V"%&"*+$ , ;000. 2*2,, 2*,,, ., 2,000

V3'85$ V"%&"*+$ E44&+&$*+? "tandard 1ours > 22,, units A- hours $ctual 1ours "tandard Rate per 1our 6:;,,,7 -*-,, -*0,, 0

224

V"%&"*+$ , ;000.

!00

V3'85$ C":"+&#? E44&+&$*+? $ctual 1ours 5udgeted 1ours > 2,,, units A- hours "tandard Rate per 1our 6:;,,,7 V"%&"*+$ , ;000. -*0,, -*,,, 0 1,900

C>apter

,*

)uestion one (O$+ING FO$ $ECE#T% F$OM DE5TO$%

K a n ? Mont h of sale :I , , , . 0* , , , e b ? : I , , , Mar ?$pr ?Ma y ?K u n ? : I , , ,

:I, ,,

:I, ,,

:I, ,,

&ov ?0

0,*,,, x ),H

(ec ?0 Kan? eb ?Mar ?-

-,*,,, x ),H --*,,, x ),H )-*,,, x ),H 4,*,,, x ),H

/ , * , , , //* ,,, /+* ,,, 0.* ,,, 0 * , , ,

$pr ?May

4-*,,, x ),H 3,*,,,

225

?Kun ?-

x ),H +,*,,, x ),H . 0* , , , / , * , , , 0 * , , ,

Total

//* ,,,

/+* ,,,

0.* ,,,

226

T>e si<@mont> cas> 5udget

SOLUTION Cash inflo8 Cash sales (ebtors receipts Total inflo8 Kan?:;,,, ..*,,, .0*,,, 0)*,,, eb ?:;,,, .)*,,, /,*,,, -)*,,, Mar ?:;,,, .3*,,, //*,,, )2*,,, $pr ?:;,,, /,*,,, /+*,,, )+*,,,

Creditors Lages !verheads (ividends Capital Expenditure Total !utflo8s

/,*,,, 4*-,, -*,,,

0,*,,, +*-,, 4*-,,

0-*,,, 22*-,, 4*-,, 2,*,,, 2-*,,, 3+*,,,

--*,,, 2/*-,, 4*-,,

0.*-,,

-4*,,,

4)*,,,

!pening 5alance &et cash flo8 Closing 5alance

4*-,, /*-,, 22*,,,

22*,,, 62*,,,7 2,*,,,

2,*,,, 6.3*,,,7 623*,,,7

623*,,,7 64*,,,7 6.-*,,,7

)uestion ,
a7 Production 5udget Product "ales $dd closing "toc9 Less opening stoc9 Production b7 Material Usage 5udget P%3<8+# Units of production Materials per unit Material usage "igma 0*),, 2*2,, 6 3,,7 !,600

0*+,, ) .+*0,,:g

c7

Material Purchases 5udget Production $dd closing "toc9 Less opening stoc9 Purchases Material ? .+*0,, /*,,, 6.*0,,7 30,000

227

)uestion * GM engineering
S"'$( B8<)$# Product $ 5 T3#"' P%3<8+#&3* B8<)$# Product "ales $dd Closing "toc9 Less !pening stoc9 Production $ 3*-,, 2*34, 624,7 2,*.,, 5 2*),, +, 63-7 2*),Volume Units 3*-,, 2*),, "elling Price :;,,, 0D,, -D), Total Revenue :;,,, /0*,,, 3*+), !2,690

M"#$%&"' U(")$ B8<)$# Material To Product $ To Product 5 T3#"' Usage 62,*.,, x 2D-7 62),- x .7 ? 2-*/,, /*.2, 18,510 Usage 62,*.,, x ,D-7 60?2),-7 E -*2,, )*0., 11,520

M"#$%&"' P8%+1"($( B8<)$# Material Production $dd Closing stoc9 Less !pening "toc9 T3#"' Purchase Price 6:;,,,7 T3#"' 5"#$%&"' +3(# , ;000. ? 23*-2, 0+, 6-,,7 18,500 2D2/,/50 E 22*-., 03, 6-,,7 11,500 2 11,500

22A

L"738% B8<)$# Product $ 5 T3#"' Volume 2,*.,, 2*),1ours per unit ) + Total 1ours )2*.,, 20*00Rate=1our 6:,,,7 2D), 2D),

Total Co +4 ./

121

P%3<8+#&3* O2$%1$"< R"#$ $ssembl y ./*,,, .*/,, 10

(epartment 5udgeted !verheads 6:;,,,7 5udgeted $ctivity < Machine 1ours P%3<8+#&3* 32$%1$"< "7(3%:#&3* %"#$ , ;000.

Machining 0-*,,, /*,,, 15

P%3<8+#&3* O2$%1$"< B8<)$# Product $ 62,.,, units7 5 62),- units7 T3#"' Time 1rs /*0,, 2*,4, Machining Rate 6:;,,,7 22-

Total 6:;,,,7 -2*,,, 2)*,-, 9/,050

Time 1rs .*--, ))3D4-

$sse Rate 6: 2, 2,

C>apter

,-

%o!ution 1 D ans9er is A %o!ution , D ans9er is D %o!ution *

P%3<8+# X 1igh Volume 1igh Lo8 Variation Variable Cost per unit 6:I,,,7 Volume 6units7 2,*,,, 0*,,, )*,,, /,*,,, )*,,, Cost 6:I,,,7 ),*,,, /,*,,, /,*,,, -

ixed cost > Total cost < Variable cost

22B

A2,*,,, units> :),*,,, <6 :- x 2,*,,,7 >

:2,*,,,

T3#"' +3(# J 5,000 8*&#( Variable cost > -*,,, x : ixed costs T3#"' +3(#

:I,,, .-*,,, 2,*,,, 35,000

P%3<8+# Y 1igh Volume 1igh Lo8 Variation Variable Cost per unit Volume 2-*,,, 3*,,, 4*,,, 24-*,,, 4*,,, Cost /44*,,, .,.*,,, 24-*,,, .-

ixed cost > Total cost < Variable cost A 3*,,, units> .,.*,,, <6 .- x 3*,,,7 >

.,,,

T3#"' +3(# J 10,000 8*&#( Variable cost > 2,*,,, x ixed costs T3#"' +3(#

.-,*,,, .*,,, 252,000

C>apter

,4

%o!ution 1 D ans9er is C %o!ution , D ans9er is A

2'-

C>apter

,2

/ssume 6onday of the first wee. is !0 ,riday of the third wee. is 14 Guestion %a
b >

n ?E < 6 ?7 6 E7 n ? . < 6 ?7 .

C D%- ! 2"54-"A-- + D2"A--E ! DA-4-E D%- ! B2A"---E + D2"A--E^2 2"A B6" -%"4 4-" -.D , 2 b N ? n .D, 2x .*3 ,, 2,

b >

b > a >

R K
n <

3 , 0 , 2 , > 3 , 0

<

<

-). D3

2'%

.02D.

Guestion % 5 K C :here ! C 25-N Guestion 2a

? Lee9 2 Monday Tuesday Lednesday Thursday riday Lee9 . Monday Tuesday Lednesday Thursday riday Lee9 / Monday Tuesday Lednesday Thursday riday < 2 . / 0 ) 4 3 + 2, 22 2. 2/ 20 E -), 30, 4.3 )-3 0/0 -40 3444, )4+ 003 -33 +2, 32. 4,, 0). Trend )0+ )-. )-)-3 ))2 ))0 ))4 ))+ )4. )4)43 )32 )30 )34 )+, "> T< E 3+ 62337 64/7 6,7 ..4 +, 6.,37 62,27 647 ..4 +, 6..+7 62.37 62/7 ..3

7"477.2 P 2.-% ! " K C24%.2 P 2.-% ! 25C 74'.7

Monday Lee9 2 33D+

Tuesday <233D2)

Lednesday <4/D..

Thursday <,D.3

riday ..)D))

2'2

Lee9 . Lee9 / Total $verage $dMustment inal estimate

3+D) +,D/ .)3D3 3+D) <,D.3 3+D/.

<.,3D0) <..3D4) <).-D/3 <.,3D0) <,D.3 <.,3D40

<2,,D-. <2.4D3. </,2D-) <2,,D-. <,D.3 <2,,D3

<)D-3 <2.D33 <2+D40 <)D-3 <,D.3 <)D3)

..4D/) ..3D,) )3.D,3 ..4D/) <,D.3 ..4D,3

Ruestion . b<

orecast sales

or 8ee9 0 Period Trend T )+/D,, )+-D+0 )+3D33 4,2D3. 4,0D4) "easonal factor 3+D/. 6.,3D407 62,,D3,7 6)D3)7 ..4D,3 F3%$+"(# Y /82@32 !8/@20 568@08 96!@69 631@8!

(ay Lee9 0 Monday Tuesday Lednesday Thursday riday

? 22) 24 23 2+

2''

INDE6 A

Causes of variances" 2Committed costs" 27 C3P Analysis" 4B D

Accounting Jate of Jeturn DAJJE" %B' Activity /ased Costing DA/CE" %7% Annualised 9.uipment costs" %B6 Avoida le costs" 26 5 /ackflush accounting" %65 /reak+even point" 4B /udget centre" 66 /udget committee" 67 /udget manual" 67 /udget period" 67 /udget" 65 /udgetary control" A' /udgetary slack" A7 C Capital /udgeting" %2'" %A-

&ecision making process" 25 &ifferential costs" 26 &irect la our efficiency variance" %&irect la our rate variance" B &irect material price variance" 7 &irect material usage variance" A &irectly attri uta le fi!ed costs" 2A E 9nterprise Jesource Planning" D9JPE" %75

F (inancial Accounting" 2 (inancial planning system" %26

2'4

(i!ed udget" A' (i!ed overhead volume capacity variance" %5 (i!ed overhead volume efficiency variance" %' (i!ed overhead volume variance" %' (le!i le udget" A' (ull cost+plus pricing" 5B (unctional udgets" 74 G ?oal congruence" A6 " 1igh+low method" %-'

O *ne+off contract" 45 *pportunity costs" 27 *ption udgets" %2A # Pay ack period method" %B2 Pproduct life cycle" 5A" %6% Product mi!" 5A Programming planning ased udgetary system" B7" %27 $

I Incremental udgeting" B' Incremental costs" 26 Internal Jate of Jeturn DIJJE" %A' Irrelevant cost"27 L Life cycle udgeting" %5B Life cycle costing" %57 Linear regression" %-' Line+item udget" %22 M #ake of uy decisions" 'B #anagement Accounting" 2 #anufacturing Jesource Planning D#JPE" %75 #argin of safety" 5% #arginal cost+plus pricing" 6#arket penetration pricing" 6% #arket skimming pricing" 62 #arketing strategy" 5A #aster udget" 77 #oving averages" %-A N ,et Present 3alue D,P3E" %7B ,otional costs" 2A Jelevant costs" 26 Jevenue udgets" %2% Jolling or continuous udgets" B5 % $ales volume variance" %6 $carce resource" '7 $catter diagram" %-% $elling price variance" %5 $ervice costing" %52 $unk costs" 27 T Target costing" %4A Target profit" 52" %5% The id system" %24 Throughput accounting" %'B Time series" %-5 0 0navoida le costs" 2A ' 3ariance analysis" 5

2'5

3aria le overhead efficiency variance" %% 3aria le overhead e!penditure variance" %% 3irement policy" %2A I Zero ased udgeting" B4"%27

2'6