Acowtancy F2 PDF
Acowtancy F2 PDF
Acowtancy F2 PDF
Cost accounting and management accounting are terms which are often used
interchangeably. It is not correct to do so.
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1.2 ACCA SYLLABUS GUIDE OUTCOME 2:
Compare and contrast financial accounting with cost and management
accounting
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1.3 ACCA SYLLABUS GUIDE OUTCOME 3:
Outline the managerial processes of planning, decision making and control.
1.3.1 Planning
Managers of all levels within an organisation take decisions. Decision making always
involves a choice between alternatives; e.g. decide on the selling price to charge for
a new product introduced on the market.
The first part of the decision-making process is planning. The second part is control.
1.3.3 Control
Managers use the information relating to actual results to take control measures and
to re-assess and amend their original budgets or plans. Actual performance of the
organisation is compared against detailed operational plans; e.g. check whether the
company is over or under spending on materials. Any deviations from the plans are
identified and corrective action is taken.
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1.4 ACCA SYLLABUS GUIDE OUTCOME 4:
Explain the difference between strategic, tactical and operational planning.
LONG TERM
SHORT TERM
DAY-TO-DAY
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1.4.1 Strategic Planning
Senior management formulate long-term (e.g. 5 to 10 years) objectives and plans for
an organization. Such plans include overall profitability, the profitability of different
segments of the business, capital equipment needs and so on.
Senior management make medium-term, more detailed plans for the next year, for
e.g. decide how the resources of the business should be employed, and to monitor
how they are being and have been employed. An example would be: - how many
people should be employed next year?
Lecture Example 2
Each manager must have a well-defined area of responsibility and the authority to
make decisions within that area. An area of responsibility may be structured as: -
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1.5.1 Cost centre
A revenue centre is accountable for revenues only. Revenue centre managers should
normally have control over how revenues are raised; e.g. retail outlet, sales department
and airline reservation department.
A profit centre is a part of the business for which both costs and revenues are
identified; e.g. product division
Cost centres, revenue centres, profit centres and investment centres are also known
as responsibility centres.
Cost centre managers will want information regarding cost of material, labour,
expenses and overheads. The performance of the manager is judged on the extent to
which cost targets have been achieved.
Revenue centre managers will want information on markets and new products and
they will look closely at pricing and the sales performance of competitors – in
addition to monitoring revenue figures
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1.6.3 Profit centres
Profit centre managers will want information regarding both revenues and costs.
They will be judged on the profit margin achieved by their division.
Investment centre managers will want the same information as the profit centre
manager and in addition they will require quite detailed appraisals of possible
investments and information regarding the results of investments already undertaken.
Lecture Example 3
A. Costs only
B. Revenues only
C. Costs and revenues
D. Costs, revenues and investments
Data is the raw material for data processing. Data relate to numbers, letters,
symbols, raw facts, events and transactions which have been recorded but not yet
processed into a form suitable to make decisions. Data on its own is meaningless.
Information is data that has been processed so that it will be meaningful to the
person who receives it. It improves the quality of decision making.
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While management accounting is mainly concerned with the provision of financial
information to aid planning, decision making and control, the management
accountant cannot ignore non-financial influences and should qualify the information
provided with non-financial matters as appropriate.
Lecture Example 4
Data is information that has been processed in such a way as to be meaningful to its
recipients.
A. True
B. False
Complete - An information user should have all the information he needs but it
should not be excessive.
Cost-effective - The benefits obtainable from the information must exceed the costs
of acquiring it. The value of information results from actions by decision makers who
use the information to improve profitability.
Understandable - Information must be clear to the user. If the user does not
understand it properly he cannot use it properly.
Relevant - Information must be relevant to the purpose for which a manager wants to
use it.
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Timely - Information which is not available until after a decision is made will be useful
only for comparisons and longer-term control, and may serve no purpose even then.
Information prepared too frequently can be a serious disadvantage.
Easy to Use
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3. Non-financial information
Managers must not only look at quantitative information. They should also
consider qualitative, behavioural, motivational, even environmental factors,
when taking decisions.
4. External information
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1. The purpose of cost and management accounting is to provide financial
information to managers that will help them to plan the activities, control the
activities for which they are responsible and see the financial implications of
any decisions they may take.
3.
Management Financial Accounting
Accounting
1. Users and decision- Internal use – External use –
makers management and shareholders, banks,
employees government
2. Purpose of information To aid in planning, To record the financial
decision-making and performance and position
control of the business
3. Legal requirements None Limited companies must
produce financial
statements
4. Formats Management decide the According to company
best way to present law
information
5. Nature of information Mostly monetary; but also Monetary information
nonmonetary information
6. Time period Historical and forward- Mainly historical
looking
5. Strategic Planning
Senior management formulate long-term (e.g. 5 to 10 years) objectives and
plans for an organization.
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6. Tactical Planning
Senior management make medium-term, more detailed plans for the next
year
7. Operational Planning
All managers are involved in making day-to-day decisions. Operational
information is derived almost entirely from internal sources. It is prepared
frequently, is highly detailed and is mainly quantitative.
9.
10. Data is the raw material for data processing. Information is data that has been
processed in such a way as to be meaningful to the person who receives it.
Accurate
Complete
Cost-effective
Understandable
Relevant
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Accessible
Timely
Easy to use
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Chapter 2
SOURCES OF INFORMATION
Different sources of information are available to organisations, including those
available within and outside the organisation. Such information will become the input
into an organisation’s decision making and management accounting systems.
Classification of data
1. Primary data are data collected especially for a specific purpose, e.g. raw
data.
Secondary data are data which have already been collected elsewhere, for
some other purpose but which can be used or adapted for the survey being
conducted, e.g. official statistics, data obtained from financial newspapers,
trade journals, etc.
2. Discrete data are data which can only take a finite or countable number of
values within a range, e.g. you cannot have 1.25 units but 1 unit, 2 units etc.
Continuous data are data which can take on any value. They are measured
rather than counted, e.g. a person can be 1.585m tall.
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2.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Describe sources of information from within and outside the organisation
(including government statistics, financial press, professional or trade
associations, quotations and price list.
Explain the uses and limitations of published information/data (including
information from the internet).
The payroll system provides us with important information relating to our employees,
hours of work, output, employee turnover etc.
What information does this strategic planning system provide us with? It may
provide information about the company’s targets and objectives, its capital
investment programme and any long term plans it may have. Hence, this
information can be very sensitive and may not be available to all employees within
the company but only to top management.
Environmental scanning/monitoring: -
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which would assist management in planning the organization's future course of
action1
1. Provide the company with useful information about the industry, e.g. the
tourism industry. This will help both the company and the industry to decide on
the future
2. Provide information for economic planning as most information deals with the
economy as a whole
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2.1.2.4 Professional or trade associations
E.g. The Malta Chamber of Commerce provides a central, national organization for
the representation, promotion and protection of all members’ interests, as well as
acting as an authoritative medium of communication between members’ sectors,
Government, and the EU. The Malta Chamber also aims to establish and support
initiatives which lead to the establishment of new business ventures and employment
opportunities.2
In the UK, particular newspapers such as The Financial Times, the Guardian, The
Times and the Daily Telegraph provide statistics and financial reviews as well as
business economic news and commentary. In Malta, we have the Malta Business
Review and other journals which look into the local and foreign financial aspects.
Such information is now also widely available via electronic media and digital
television services (such as Bloomberg TV). There is also the internet as a widely
available source of up-to-date financial information. But the internet has its
limitations…
Lecture Example 1
i. Government statistics.
ii. The Financial Times.
iii. Data collected for a survey which was commissioned in order to determine
whether the company should launch a new product.
2 http://malta.usembassy.gov/com-link-trade.html
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iv. Historical records of expenditure on light and heat in order to prepare current
forecasts.
A. i and ii only
B. i, ii and iii only
C. i, ii and iv only
D. i, ii, iii and iv
The economic environment affects firms at national and international level, both in
the general level of economic activity and in particular factors, e.g. inflation, interest
rates and exchange rates.
Inflation affects the decisions taken by businesses. An increase in interest rates affects
cash flow especially for those businesses which carry a high level of debt. Exchange
rates affect the imports and exports of the company.
Even the state of the economy will influence the planning process of an organisation.
In times of boom, consumer demand and consumption increases. In times of
recession, the company has to focus on its survival through cost effectiveness and
competition.
2.3.1 Introduction
Sampling:
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Definitions:
Population
the set of individuals, items, or data from which a statistical sample is taken
Sample
A group of items drawn from the population and used to estimate the characteristics
of the whole population.
http://tomhopper.me/2014/11/14/sample-si ze-matters/
1. Random
2. Systematic
3. Stratified random
4. Multi-stage
5. Cluster
Quota sampling is a non-probability sampling method, i.e. the samples are gathered
in a process that does not give all the individuals in the population equal chances of
being selected.
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2.3.2.1 Random Sampling
Each item in the population has to be numbered. In random sampling, we find the
sampling frame. What is this? A list of the items or people forming a population from
which a sample is taken.
For e.g. if I want to use simple random sampling to choose 10 students from my F2
class, I can put each name on the attendance sheet on a piece of paper, put the
papers in a bag and blindly select the name of 10 students.
This method has limitations when the population is large or not known. It does not
guarantee a representative sample BUT eliminates selection bias.
Strictly speaking, systematic sampling is not 100% random as only the first item is
selected randomly.
In the following diagram, we have selected randomly the 2 nd person in the list, then
every 3, will be included in the sample.
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E.g. I would like to sample 8 houses from a long street which has 120 houses. This
means that every 15th house is chosen (120/8) after a random starting point is
chosen.
Limitations:
A systematic random sample can only be carried out if a complete list of the
population is available. Also there is the danger of bias.
We need to divide the entire population into different subgroups or strata, then
randomly select the final subjects proportionally from the different strata. How does it
work? We can divide our population into smokers and non-smokers. A random
sample is taken from each group. But the number in each sample must be
proportional to the size of that group in the population - probability proportional to
size. Hence, a representative cross-section of the strata in the population is
obtained.
https://sites.google.com/a/whps.org/mrs-murray-s-math-site/unit-1---i ntro-to-statistics
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2.3.2.4 Cluster Sampling
1. He can divide the entire Maltese population into different clusters (cities).
2. Then he selects a number of clusters using simple or systematic random
sampling.
3. Then, from the selected clusters (randomly selected cities) the researcher will
interview all the students in that cluster.
Multi-stage sampling is similar to cluster sampling BUT a sample is taken from the
final group.
Advantages
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For example, an interviewer may be told to sample 200 females and 300 males
between the age of 45 and 60. This means that individuals can put a demand on
who they want to sample (targeting).3
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1. Data may be primary (collected specifically for the purpose of a survey) or
secondary (collected for some other purpose). Discrete data can only take on a
countable number of values. Continuous data can take on any value. Sample
data arises as a result of investigating a sample. Population data arises as a
result of investigating the population.
a. Accounting system
b. Payroll system
c. Strategic planning system
a. Government sources
b. Business contacts - customers and suppliers
c. Trade associations and trade journals
d. The financial and business press and other media
6. The term population is used to mean all the items under consideration in a
particular enquiry.
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11. Systematic Sampling (quasi-random)
Only the first item is selected randomly. Then, each nth item is chosen.
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Chapter 3
COST CLASSIFICATION
3.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Explain and illustrate production and non-production costs
For the preparation of financial statements, costs are often classified as: - production
and non-production costs.
Production costs are costs identified with goods produced for resale. Production
costs are all the costs involved in the manufacture of goods, i.e. direct material,
direct labour, direct expenses, variable production overheads and fixed production
overheads.
3.2.1 Materials
3.2.2 Labour
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3.2.3 Overheads
Overheads include all other costs which are not materials or labour. These include
rent, telephone, and depreciation of equipment.
Production Costs
These include all the costs involved in running the general administration department
of an organization.
Selling costs include all costs incurred in promoting sales and retaining customers.
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3.3.3 Distribution costs
Distribution costs include all costs incurred in making the packed product ready for
dispatch and delivering it to the customer.
Finance costs include all the costs that are incurred in order to finance an
organization, for e.g. loan interest.
Non-Production Costs
Non-production costs are taken directly to the income statement as expenses in the
period in which they are incurred.
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3.4 ACCA SYLLABUS GUIDE OUTCOME 4:
Explain and illustrate with examples classifications used in the analysis of the
product/service costs including by function, direct and indirect.
Direct costs: - these are costs which can be directly identified with a specific cost
unit or cost centre. There are 3 main types of direct cost: -
Direct materials: - materials used in making and selling a product (or even
providing a service); e.g. raw material, packing material.
Direct labour: - the specific costs of the workforce used to make a product or
provide a service.
Indirect costs: - these are costs which cannot be directly identified with a specific
cost unit or cost centre. These costs cannot be easily traced to a specific product.
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Indirect labour: - all wages not charged directly to a product. These include
wages of non-productive personnel in the production department, example
supervisor.
Classification by Function
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Please note that research costs are the costs of searching for new or improved
products. Development costs are the costs incurred between the decision to produce
a new or improved product and the commencement of full manufacture of the
product.
To use descriptions only of the items would lead to ambiguities and difficulties in
recording and processing the information. The items need to be logically coded. For
example, 5 cm brass plates may be coded as 05677 and no other class of item
should be coded the same.
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3.5.1 Types of Code
1. Composite codes:
The CIMA terminology describes the use of composite symbols in codes. The first
three digits in the composite code might indicate the nature of the expense whereas
the last three digits might indicate the cost centre or the cost unit to be charged.
For example:
8 – labour
9 – semi-skilled
2 – grade 2
These codes are showing this was semi-skilled labour
1 – indirect cost
1 – Factory XYZ
3 – finishing department
This code shows us this labour expenditure is to be charged as indirect labour
to the finishing department in factory XYZ
A sequential code simply follows a sequence. Imagine we are drafting a register for
employees for salary purposes. We begin with the first employee being assigned the
number 00, the second employee is assigned the number 01 and so on. In this code,
we have allowed for there to be as many as 100 employees, since we have allocated 2
digits to the code and can assign all of the numbers from 00 to 99, 100 numbers, to that
number of employees:
Group classification (block) codes are very common in accounting circles in that they
commonly form the basis of charts of accounts, as depicted below:
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1000 – Non-current assets
2000 - Current assets (excl. inventories)
3000 - Inventories
4000 – Non-current liabilities
5000 - Current liabilities
6000 - Equity
7000 - Revenues
8000 - Expenditures
The 1000 “Block” is allocated to non-current assets. This means that it is possible
to classify up to 1,000 different non-current assets using this block. Of course, there
may be sub blocks so that we can extend the range of non-current assets we can
have.
4. Faceted codes:
A faceted code is one that is broken down into a number of facets or fields, each of
which signifies a unit of information. We could use a chart of accounts, that is
commonly faceted; but let’s work through the faceted code of a furniture
manufacturer. We’ll consider a code that will deal with direct materials, direct
labour, and indirect costs.
Facet 1: 00 Preparation
01 Carpentry
02 Assembly
03 Finishing
04 Upholstery
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Facets 1 and 2 should need little further explanation; but let’s expand Facet 3.
Let's use this code shown now to determine the code for grade 2 labour costs
incurred by the carpentry department. The code is:
01 01 0112;
and the code for buildings insurance for the upholstery department is:
04 03 0161.
These incorporate some digits which are part of the description of the item being
coded.
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6. Hierarchical codes:
The coding systems used by libraries are examples of hierarchical codes. The major
advantage of such systems is that they are, in theory at least, infinitely expandable:
they can be extended for ever; but in a logical, structured, way.
If we assume that code 657 is the library classification number for accounting, then
we can develop the code hierarchically:
657 Accounting
Financial accounting
Financial management
Management accounting
and so on ...
The drawback of infinite expandability is that it would need an infinitely large storage
device to store an infinitely large code!
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1. Production vs. Non-production costs
Production costs are costs identified with goods produced for resale. Non-
production costs are not directly associated with production of manufactured goods.
Administrative costs - all the costs involved in running the general administration
department of an organization.
Selling costs - all costs incurred in promoting sales and retaining customers.
Distribution costs - all costs incurred in making the packed product ready for dispatch
and delivering it to the customer.
Finance costs - all the costs that are incurred in order to finance an organization.
Direct costs – costs which can be directly identified with a specific cost unit or cost
centre. There are 3 main types of direct cost: - direct materials, direct labour and
direct expenses.
Indirect costs – costs which cannot be directly identified with a specific cost unit or
cost centre. These include indirect materials, indirect labour and indirect expenses.
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Chapter 4
COST BEHAVIOUR
4.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Describe and illustrate, graphically, different types of cost behaviour.
Costs can be classified according to the way that they behave within different levels
of activity. Cost behaviour tends to classify costs as: -
Variable cost
Fixed cost
Stepped fixed cost
Semi-variable cost
A variable cost is a cost which tends to vary directly with the volume of output. As total
costs increase with activity levels, the variable cost per unit remains constant. By
their nature, direct costs will be variable costs. Examples of variable costs include raw
materials and direct labour.
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Graph 2: - Variable cost per unit
A fixed cost is a cost which is incurred for an accounting period, and which, within
certain activity levels remains constant.
Examples of fixed costs include the salary of the managing director, the rent of a
building and straight line depreciation of machinery.
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Graph 4: - Fixed cost per unit
The fixed cost per unit falls as the level of activity increases but never reaches zero.
A stepped fixed cost is only fixed within certain levels of activity. The depreciation of
a machine may be fixed if production remains below 1,000 units per month. If
production exceeds 1,000 units, a second machine may be required, and the cost of
depreciation (on two machines) would go up a step.
Other stepped fixed costs include rent of warehouse (more space required if activity
increases) and supervisors’ wages (more supervisors required if number of
employees increase).
Fixed costs increase in steps as activity level increases beyond a certain limit.
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4.1.4 Semi-variable Costs (semi-fixed/mixed)
Semi-variable costs contain both fixed and variable components and are therefore
partly affected by changes in the level of activity.
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Lecture Example 1
i. Electricity bill
ii. Raw materials
iii. Rent of factory
iv. Supervisors’ wages (more supervisors required as the number of
employees increases)
This graph represents a cost which is variable with output, subject to a minimum
(fixed) charge.
There are two main methods which analyse semi-variable costs into their fixed and
variable elements: -
High/low method
Least squares regression (covered in later chapters)
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4.2.1 High-low method
Total cost at high activity level - total cost at low activity level
Total units at high activity level - total units at low activity level
Total cost at high activity level – (Total units at high activity level × Variable
cost per unit)
1. Easy to use
2. Easy to understand
1. It relies on historical cost data – predictions of future costs may not be reliable
2. It assumes that the activity level is the only factor affecting costs
3. It uses only two values to predict costs
4. Bulk discounts may be available at large quantities
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The equation of a straight line is y = a + bx
Lecture Example 4
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Lecture Example 5
Y = 5,000 + 6x
A cost object is any activity for which a separate measurement of cost is undertaken.
E.g. cost of a product, cost of a service, cost of a particular department.
A cost unit is a unit of product or service in relation to which costs are ascertained.
E.g. a hotel room, a course, one litre of paint.
Lecture Example 6
Car Manufacturer
Cigarette Manufacturer
Audit firm
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4.3.3.4 Cost Cards
A cost card lists out all the costs involved in making one unit of a product.
Cost Card: -
$
Direct Materials X
Direct Labour X
Direct Expenses X
Prime Cost XX
Variable Production Overheads X
Marginal Production Cost XX
Fixed Production Overheads X
Total Production Cost XX
Non-production overheads:
Administration X
Selling X
Distribution X
Total Cost XX
Profit X
Sales Price XXX
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1. Different types of cost behaviour
Fixed cost – a cost which, within certain activity level, remains constant
Stepped fixed cost – a cost which is fixed up to a certain level of volume, and then it
increases to an even higher level of fixed cost to a certain level of volume
Semi-variable cost – it contains both a fixed and variable element and therefore is
partly affected by a change in the activity level
This method analyses semi-variable costs into their fixed and variable elements.
Always select the period with the highest activity level and the period with the lowest
activity level.
Total cost at high activity level - total cost at low activity level
Total units at high activity level - total units at low activity level
Total cost at high activity level – (Total units at high activity level × Variable
cost per unit)
y = a + bx
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Cost Equation
y = a + bx
Cost unit - a unit of product or service in relation to which costs are ascertained. E.g. a
hotel room, a course, one litre of paint
Cost cards - lists out all the costs involved in making one unit of a product.
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Chapter 5
PRESENTING INFORMATION
5.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Prepare written reports representing management information in suitable
formats according to purpose
When producing written reports, the management accountant needs to carry out four
steps: -
a. Prepare: determine the type of document required and establish
the user of the information
b. Plan: select the relevant date: summarise, analyse, illustrate to turn
the raw data into useful information
c. Write
d. Review what has been written
Title
At the top of your report show who the report is to, who it is from, the date and
a heading.
Introduction
Showing what information was requested, the work done and where results
and conclusions can be found.
Analysis
Conclusion
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Appendices
Numbered headings and cross referencing between sections make reports easier to
follow (or navigate).
In this section, we will be looking at different ways how information can be presented
through the use of tables, charts and graphs. Scatter graphs will be described in
detail when discussing forecasting methods later on in the course notes.
5.2.1 Tables
b) Source: the source of the material used in drawing up the table should be stated
(usually by way of a footnote).
c) Units: the units of measurement that have been used must be stated.
d) Headings: all column and row headings should be clear and concise.
e) Totals: these should be shown where appropriate, and also any subtotals that
may be applicable to the calculations.
f) Percentages and ratios: these are sometimes called derived statistics and
should be shown, if meaningful, with an indication of how they were calculated.
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g) Column layout: for ease of comparison columns containing related information
should be adjacent and derived figures should be adjacent to the column to
which they refer.
i) Layout: wherever possible ensure that the table is set up so that there is no
need to turn the page. This will affect the choice of columns and rows.
Illustration 1 – Tables
Dept A
2011 2010 % change
$ $ $
Raw Material 120,000 100,000 20%
Labour 56,000 50,000 12%
Overheads 24,000 20,000 20%
Bar charts
Line graphs
Pie charts
Scatter graphs
A bar chart is a widely used method of illustrating quantitative data. Quantities are
shown in the form of bars on a chart, the length of the bars being proportional to the
quantities.
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1. Simple bar charts
A simple bar chart consists of one or more bars, in which the length of each bar
indicates the size of the corresponding information.
A component bar chart is used when each total figure in the data is made up of a
number of different components and it is important that these component elements
are shown as well as the total figure.
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3. Percentage component bar chart
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4. Compound (multiple) bar charts
Compound bar charts are sometimes termed multiple bar charts. A compound bar
chart is one where there is more than one bar for each sub-division of the chart. For
example if the sales per product for each year are given then for each year there
could be a separate bar for each product.
This has obvious similarities to a component bar chart where each component of the
total was shown as part of the total bar. However the difference here is that each
component has its own bar and is not stacked. It is a suitable format if the total of
each component of the bar chart has no significance.
400,000
300,000 A
200,000 B
100,000 C
0
2009 2010 2011
Years
C
Division
B 2011
2010
A
2009
0 100,000200,000300,000400,000500,000600,000700,000
$ Sales
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5.2.2.2 Graphs
In many instances data can be more clearly and understandably presented in the
form of a line graph. The x axis would represent the independent variable whereas
the y axis represent the dependent variable.
Lecture Example 1
You may be required to plot more than one set of variables on the same graph.
If more than one line is to appear on a graph then they must also be drawn to the
same scale and the different line should be clearly indicated by use of a key (e.g.
continuous line, broken line, dotted line) or different colour.
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The y axis must
be labelled - here
it represents the The subject of the graph
value of sales is explained in the title
The legend or
key identifies
each line
A pie chart is a circular chart divided into sectors, illustrating proportion. In a pie
chart, the arc length of each sector (and consequently its central angle and area), is
proportional to the quantity it represents. Together, the sectors create a full disk.
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ABC Ltd
Divisional Sales 2011
26%
42% A
B
C
32%
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5.2.2.4 Frequency Histogram
Example: - Number of students and the marks they obtained in each class
Marks: f Cum f Cum %
90-99 0 50 100
80-89 2 50 100
70-79 6 48 96
60-69 9 42 84
50-59 12 33 66
40-49 10 21 42
30-39 7 11 22
20-29 3 4 8
10-19 1 1 2
0-9 0 0 0
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1. When preparing reports, the management accountant should use the correct
structure including introduction, analysis, conclusion and any appendices.
2. Information can also be presented through the use of tables, charts and graphs.
4. A simple bar chart shows not only the actual amount of the data which can be
read off from the vertical axis but also the relationship between the data.
5. A component bar chart is used when each total figure in the data is made up of a
number of different components.
6. A percentage component bar chart is one where the percentage of the total for
each component is shown.
7. A compound bar chart is one where there is more than one bar for each sub-
division of the chart.
8. In many instances data can be more clearly and understandably presented in the
form of a line graph.
9. A pie chart is a circular chart divided into sectors, illustrating proportion. In a pie
chart, the arc length of each sector (and consequently its central angle and area),
is proportional to the quantity it represents.
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Chapter 6
ORDERING AND ACCOUNTING FOR
INVENTORY
72
Department requires new Ordering and
materials Purchasing
Purchase requisition
Purchasing
department
Supplier
Goods with delivery note
Goods receiving
Receipt
department (stores)
Purchasing department
Proper records must be kept of the physical procedures for ordering and receiving a
consignment of materials to ensure that: -
Current inventories run down to the level where a reorder is required. The stores
department issues a purchase requisition which is sent to the purchasing
department, authorising the department to order further inventory.
73
6.1.2.2 Purchase order
The purchasing department draws up a purchase order which is sent to the supplier.
Copies of the purchase order must be sent to the accounts department and the
storekeeper (or goods receiving department).
6.1.2.3 Quotation
The supplier delivers the consignment of materials, and the storekeeper signs a
delivery note for the carrier. The packages must then be checked against the copy of
the purchase order, to ensure that the supplier has delivered the types and quantities
of materials which were ordered.
If the delivery is acceptable, the storekeeper prepares a goods received note (GRN).
A copy of the GRN is sent to the accounts department, where it is matched with the
copy of the purchase order. The supplier's invoice is checked against the purchase
order and GRN, and the necessary steps are taken to pay the supplier.
74
Lecture Example 1
Materials held in store are asset and are therefore recorded in the statement of
financial position of a company.
Lecture Example 2
The following represent the materials transactions for a company for a year: -
$’000
Material purchases 240
Issued to production 215
Materials written off 12
Returned to stores 6
Returned to suppliers 2
75
The material stock at 1 January 20x8 was $25,000.
Perpetual inventory is the recording as they occur of receipts, issues and the
resulting balances of individual items of inventory in both quantity and value. These
inventory records are updated using stores ledger cards and bin cards.
Bin Card
Commodity :
Package size
76
6.3.2 Stocktaking
The process of stocktaking involves checking the physical quantity of inventory held
on a certain data with the balance on the stores ledger cards or bin cards.
Periodic stocktaking involves checking the balance of every item in inventory at a set
point in time, usually at the end of an accounting year.
This involves counting and valuing selected items of inventory on a rotating basis.
Each item is checked at least once a year.
Inventory losses arising from theft, pilferage or damage must be written off against
profits as soon as they occur.
77
i. FIFO – materials are issued out of stock in the order in which they were delivered
into inventory, i.e. issues are priced at the cost of the earliest delivery remaining
in inventory. This is a logical pricing method but can be cumbersome to operate
since each batch of material has to be identified separately.
i. LIFO – the last items of material received are the first items to be issued. LIFO is
not accepted for financial accounting purposes (IAS 2). The items remaining in
inventory are the first which were produced or purchased.
ii. Cumulative Weighted average cost – AVCO calculates a weighted average price
for all units in inventory. Issues are priced at this average cost, and the balance
of inventory remaining would have the same unit valuation.
78
79
80
1. Procedures for ordering, purchasing and receiving materials
Purchasing
department
Supplier
Goods with delivery note
Goods receiving
Receipt
department (stores)
Purchasing department
i. Purchase requisition
iii. Quotation
81
3. Documents for issuing inventory
5. Perpetual Inventory
Perpetual inventory is the recording as they occur of receipts, issues and the
resulting balances of individual items of inventory in both quantity and value.
6. Stocktaking
i. Periodic stocktaking
Periodic stocktaking involves checking the balance of every item in inventory on the
same date, usually at the end of an accounting year.
This involves counting and valuing selected items of inventory on a rotating basis.
Each item is checked at least once a year.
82
7. Inventory Valuation Methods
i. FIFO – materials are issued out of stock in the order in which they were
delivered.
ii. LIFO – the last items of material received are the first items to be issued.
iii. Cumulative weighted average cost – AVCO values all items of inventory and
issues at an average price, which is calculated after each receipt of goods.
83
..
84
85
Chapter 7:
ORDER QUANTITIES AND REORDER
LEVELS
7.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Identify and explain the costs of ordering and holding inventory (including
buffer inventory)
A business holds inventory so that customer demands are met as soon as they
arise. Buffer (safety) inventory is the minimum inventory level required to prevent
stock-outs from occurring.
There are advantages and disadvantages of holding stock (of buying stock in large
or small quantities). The advantages include:
the need to meet customer demand
taking advantage of bulk discounts
reducing total annual re-ordering cost
Stock-out costs occur when the business runs out of inventory and these include:
i. Loss of sales
ii. Loss of customers
iii. Loss of reputation
iv. Reduced profits
86
Holding Cost =
Cost of holding 1 unit for 1 year x average inventory through the year
= Ch xQ
2
Ordering costs =
Cost per order x no of orders pa
= C0 x D
Q
Where: -
Q is the quantity per order.
This is the quantity of inventory which is to be ordered when inventory reaches the
reorder level. If the re-order quantity is set so as to minimise the total costs
associated with holding and ordering inventory, then it is known as the economic
order quantity.
When determining how much to order at a time, an organisation will recognise that:
as order quantity rises, average stock rises and the total annual cost of holding
stock rises
as order quantity rises, the number of orders decreases and the total annual re-
order costs decrease.
87
The economic order quantity (EOQ) is the order quantity which minimises the total
costs associated with holding and ordering stock. At this quantity, holding costs are
equal to ordering costs.
88
7.2.2.1 EOQ formula
Q = EOQ =
Where:
Ch = cost of holding one unit of inventory for one time period
C0 = cost of ordering a consignment from a supplier
D = demand during the time period
Q = the reorder quantity (EOQ)
Total Annual Costs (TAC) = purchasing costs + holding costs + ordering costs
TAC =
DP + C0 D + Ch Q
Q 2
Where: -
D= demand during the time period
P = purchase price per unit
Ch = cost of holding one unit of inventory for one time period
C0 = cost of ordering a consignment from a supplier
Q = the reorder quantity (EOQ)
89
This formula is not given in the exam.
When bulk orders are placed, it is often possible to negotiate a quantity discount on
the purchase price. Although the purchase price and annual ordering cost will
decrease, the annual holding cost will increase.
7.3.1 Steps involved in calculating the EOQ when discounts are available
90
Example
Epsy Limited uses 15,000 units of its main raw material per month. The material
costs $10 per unit to buy, supplier’s delivery costs are $25 per order and internal
ordering costs are $5 per order. Total annual holding costs are $4 per unit. The,
supplier has offered a discount of 1% if 4,000 units of the material are bought at a
time.
Required:
1. EOQ = 2C0D
Ch
= 2(30)(180,000)
4
= 1,643 units
$
Purchase costs 180,000 units x $10 1,800,000
Holding costs $4 x 1,643/2 3,286
Ordering costs $30 x 180,000/1,643 3,286
1,806,572
91
2.
$
Purchase costs 180,000 units x $9.90 1,782,000
Holding costs $4 x 4,000/2 8,000
Ordering costs $30 x 180,000/4,000 1,350
1,791,350
92
EBQ =
Where: -
When inventories reach the reorder level, an order should be placed to replenish
inventories. The reorder level is determined by consideration of the following.
93
• The maximum rate of consumption
• The maximum lead time
The maximum lead time is the time between placing an order with a supplier, and
that order arriving.
When the reorder level is reached, the quantity of inventory to be ordered is known
at the reorder quantity (EOQ).
This is a warning level to draw management’s attention to the fact that inventories
are approaching a dangerously low level and that stock outs are possible.
This also acts as a warning level to signal to management that inventories are
reaching a potentially wasteful level.
94
7.5.4 Average inventory
The average inventory formula assumes that inventory levels fluctuate evenly
between the minimum (or safety) inventory level and the highest possible inventory
level, i.e. the amount of inventory immediately after an order is received (safety
inventory + reorder quantity).
Lecture Example 6
A company stocks item AZX for which the following information is available: -
95
1. Holding Cost
Holding Cost =
Cost of holding 1 unit for 1 year x average inventory through the year
= Ch xQ
2
2. Ordering Cost
Ordering costs =
Cost per order x no of orders pa
= C0 x D
Q
3. The Economic Order Quantity
The economic order quantity (EOQ) is the order quantity which minimises the total
costs associated with holding and ordering stock. At this quantity, holding costs are
equal to ordering costs.
Q = EOQ =
96
4. Economic Batch Quantity
EBQ =
97
5. Reorder Level
6. Minimum level
7. Maximum level
8. Average inventory
= 1155 units
98
Chapter 8
ACCOUNTING FOR LABOUR
8.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Calculate direct and indirect costs of labour
Direct labour costs include the basic pay of direct workers. Direct workers are those
employees who are directly involved in making the products. Therefore, they are part
of the prime cost of a product.
Indirect labour costs include the basic pay of indirect workers, i.e. those employees
who are not directly involved in making the product, e.g. factory supervisor,
maintenance staff. These costs are part of the overhead cost.
NORMAL HOURS
99
8.1.3 Overtime and overtime premiums
When employees work overtime, they will receive a basic pay + an overtime
premium.
OVERTIME PREMIUM
Direct Indirect
Worker Worker
Shift allowances or shift premiums are similar to overtime premiums and are treated
as an indirect labour cost.
100
8.2 ACCA SYLLABUS GUIDE OUTCOME 2:
Explain the methods used to relate input labour costs to work done
Different methods can be used to determine the time spent doing jobs. These include
time sheets (activity time records), time cards (clock cards) and job sheets. These
methods are required to determine the costs to be charged to specific jobs.
The payroll department carries out functions that relate input labour costs to the work
done. It calculates the gross wages from time and activity records and makes the
required deductions, e.g. NI contributions and PAYE.
Labour A/c
Bank (gross paid) x WIP (direct labour) x
Production overheads:
Indirect labour x
Overtime premium x
Shift premium X
Sick pay x
Training x
Idle time x
x x
Therefore,
1. When gross wages are paid (gross = net pay + National Insurance + PAYE) to
employees, they are accounted for as
2. When labour is used within a particular production process, the direct labour
costs are transferred from the labour account using
101
3. Indirect labour costs are transferred from the labour account to be grouped with
other indirect costs using
The idle time ratio shows the proportion of available hours which were lost as a
result of idle time
1. Time-based systems
2. Piecework systems
102
8.4.1 Time-based systems
Employees are paid a basic rate per hour, day, week or month.
1. Straight piecework systems – these are almost extinct. Today, it is normal for
pieceworkers to be offered a guaranteed minimum wage, so that they do not
suffer loss of earnings when production is low through no fault of their own.
2. Differential piecework systems – these systems involve different piece rates for
different levels of production. They offer an incentive to employees to increase
their output by paying higher rates for increased levels of production. For example:
Incentive (bonus) schemes can also be in place which pay a basic time rate, plus a
portion of the time saved as compared to some agreed allowed time.
103
iii. Morale of employees is likely to improve since they are seen to receive extra
reward for extra effort.
2. Rowan – the proportion paid to the employee is based on the ratio of time taken
to time allowed
104
8.4.3 Individual vs. group bonus schemes
These incentive schemes exclude any bought-in costs and are affected only by costs
incurred internally such as labour.
For example, valued added should be treble the payroll costs and one third of any
excess earned would be paid as a bonus.
Labour turnover is the rate at which employees leave a company relative to the
average number of people employed. This rate should be kept as low as possible.
105
Labour turnover =
Number of leavers who require replacement x
100% Average number of employees
Some employees will leave their job and go to work for another company or
organisation. Sometimes the reasons are unavoidable.
Illness or accidents
A family move away from the locality
Marriage, pregnancy or difficulties with child care provision
Retirement or death
Poor remuneration
Poor working conditions
Lack of promotion prospects
Bullying at the workplace
The costs of labour turnover can be large and management should attempt to keep
labour turnover as low as possible so as to minimise these costs.
Preventative costs
Replacement costs
Replacement costs
These are the costs incurred as a result of hiring new employees. These include: -
106
Preventative costs
These are costs incurred in order to prevent employees leaving and they include:
The labour efficiency ratio measures the performance of the workforce by comparing
the actual time taken to do a job with the expected time.
107
8.6.2 Labour Capacity Ratio
The labour capacity ratio measures the number of hours spent actively working as a
percentage of the total hours available for work.
The labour production volume ratio compares the number of hours expected to be
worked to produce actual output with the total hours available for work.
Lecture Example 6
A company budgets to make 25,000 standard units of output in 100,000 hours (each
unit is budgeted to take four hours each).
Actual output during the period was 27,000 units which took 120,000 hours to make.
Required: -
Calculate the efficiency, capacity and production volume ratios.
108
109
1. Direct Labour Costs
Direct labour costs include the basic pay of direct workers. Direct workers are
those employees who are directly involved in making the products.
Indirect labour costs include the basic pay of indirect workers, i.e. those
employees who are not directly involved in making the product, e.g. factory
supervisor, maintenance staff.
NORMAL HOURS
OVERTIME PREMIUM
Direct Indirect
Worker Worker
110
4. The Labour Account
Labour A/c
Bank x WIP (direct labour) x
Production overheads:
Indirect labour x
Overtime premium x
Shift premium X
Sick pay x
Training x
Idle time x
x x
1. Time-based systems
2. Piecework systems
Time-based systems
Employees are paid a basic rate per hour, day, week or month.
Piecework systems
111
Incentive (bonus) schemes can also be in place, which pay a basic time rate,
plus a portion of the time saved as compared to some agreed allowed time.
7. Labour Turnover
Labour turnover is the rate at which employees leave a company relative to the
average number of people employed.
Labour turnover =
Number of leavers who require replacement
Average number of employees
112
113
Chapter 9
ACCOUNTING FOR OVERHEADS
9.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Explain the different treatment of direct and indirect expenses
As we have seen in Chapter 3, direct expenses are expenses that can be directly
identified with a specific cost unit or cost centre, e.g. the hire of tools and equipment
used directly in producing a particular product. Direct expenses are part of the prime
cost of a product.
Overheads are indirect expenses which cannot be directly identified with a specific
cost unit or cost centre, e.g. factory rent, factory light and heat.
The total of these indirect costs is usually split into the following.
Production overhead
Administration overhead
Selling and distribution overhead
114
9.2 ACCA SYLLABUS GUIDE OUTCOME 2:
Allocate and apportion production overheads to cost centres using an
appropriate basis
115
Stage 2: - Reapportionment of service cost centre overheads to production
cost centres
Since service cost centres/departments are not directly involved in making the
products, the fixed production overheads of these service cost centres must be
shared out between the production departments. Examples of service cost centres
include: - stores, canteen, maintenance and payroll departments.
Two methods are used to reapportion service cost centre costs to production cost
centres: -
1. Basic method – when one service department does work of another service
department but not vice-versa
2. Reciprocal method – when both service departments do work for each other
116
9.3 ACCA SYLLABUS GUIDE OUTCOME 3:
Reapportion service cost centre costs to production cost centres (using the
reciprocal method where service cost centres work for each other).
Many reapportionments are carried out until all of the service departments’
overheads have been reapportioned to the production departments – repeated
distribution method.
The results of the reciprocal method of apportionment may also be obtained using
algebra and simultaneous equations.
Regardless of the method used, the total overheads for production departments will
be the same.
117
9.4 ACCA SYLLABUS GUIDE OUTCOME 4:
Select, apply and discuss appropriate bases for absorption rates
Having allocated and/or apportioned all overheads, the next stage in the costing
treatment of overheads is to absorb them into cost units using an overhead
absorption rate.
118
4. Absorb the overhead into the cost unit by applying the calculated absorption
rate.
Overheads can be absorbed into cost units using the following bases of absorption
(or 'overhead recovery rates'): -
This OAR is calculated for each department. Each product which passes through this
department will be charged this overhead rate.
119
Illustration 1
If budgeted output (activity) for the year was 1,000 units and budgeted fixed
production overhead is $10,000, what is the fixed production overhead absorption
rate (FOAR)?
If each unit takes two labour hours to be produced, what is the FOAR/ labour hour?
120
Under– or over-recovery of overhead will occur in the following circumstances: -
Illustration 27
Assume a company budgeted to work 10,000 direct labour hours in the coming year.
If budgeted fixed production overhead was $50,000 the FOAR would be:
If in the year actual overhead was $60,000 and actual direct labour hours were 9,000
the following under absorption would occur:
121
9.6 ACCA SYLLABUS GUIDE OUTCOME 6:
Apply methods of relating non-production overheads to cost units
122
9.7 ACCA SYLLABUS GUIDE OUTCOME 7:
Prepare journal and ledger entries for manufacturing overheads incurred and
absorbed
The direct costs of production (materials, labour and expenses) are debited in the
work-in-progress (WIP) account.
Any over- or under- absorption should be transferred to the income statement at the
end of the accounting period.
x x
Under-absorption of overheads
Production overheads x Income statement x
x x
123
124
1. Direct vs. Indirect Costs
Direct expenses are expenses that can be directly identified with a specific cost unit
or cost centre, e.g. the hire of tools and equipment used directly in producing a
particular product.
Overheads are indirect expenses which cannot be directly identified with a specific
cost unit or cost centre, e.g. factory rent, factory light and heat.
2. Absorption Costing
Overheads can be absorbed into cost units using different bases of absorption (or
'overhead recovery rates'), the most common are: -
125
6. Under- and Over- Absorption of Overheads
Method 1: Choose a basis for the overhead absorption rate which most closely
matches the non-production overhead such as direct labour hours, direct machine
hours.
The direct costs of production (materials, labour and expenses) are debited in the
work-in-progress (WIP) account.
126
Any over- or under- absorption should be transferred to the income statement at the
end of the accounting period.
x x
Under-absorption of overheads
Production overheads x Income statement x
x x
127
.
128
Chapter 10
MARGINAL AND ABSORPTION
COSTING
10.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Explain the importance of, and apply, the concept of contribution
Fixed costs are treated as a period cost, and are charged in full to the income
statement of the accounting period in which they are incurred.
10.1.2 Contribution
129
10.2 ACCA SYLLABUS GUIDE OUTCOME 2:
Demonstrate and discuss the effect of absorption and marginal costing on
inventory valuation and profit determination.
Marginal costing values inventory at the total variable production cost of a product.
Absorption costing values inventory at the full production cost (including fixed
production overheads) of a product.
Inventory values using absorption costing are therefore greater than those calculated
using marginal costing.
Since inventory values are different, profits reported in the income statement will also
be different.
130
10.3 ACCA SYLLABUS GUIDE OUTCOME 3:
Calculate profit or loss under absorption and marginal costing
In marginal costing, fixed production costs are treated as period costs and are
written off as they are incurred.
In absorption costing, fixed production costs are absorbed into the cost of units and
are carried forward in inventory to be charged against sales for the next period.
In the long run, total profit for a company will be the same whether marginal costing
or absorption costing is used. Different accounting conventions merely affect the
profit of individual accounting periods.
$ $
Sales X
Less: Variable cost of sales:
Opening inventory X
Production Costs:
Variable costs X
X
Less : closing inventory (X)
(X)
X
Variable selling, distribution and
Less: administration costs (X)
CONTRIBUTION X
Less: Fixed costs (actually incurred): -
Production X
Selling & distribution X
Administration X
(X)
NET PROFIT X
131
Absorption costing Income Statement
$ $
Sales X
Less: Cost of Sales:
Opening inventory X
Production Costs:
Variable costs X
Fixed overhead absorbed X
X
Less : closing inventory (X) (X)
X
Fixed overhead (under)/over absorbed X/(X)
GROSS PROFIT X
Less : Selling & administration etc costs (non
production) (X)
NET PROFIT X
Lecture Example 2
Each desk is budgeted to require 4kg of wood at $3 per kg, 4 hours of labour at $2
per hour, and variable production overheads of $5 per unit. Fixed production
overheads are budgeted at $20,000 per month and average production is estimated
to be 10,000 units per month. Fixed production overheads incurred were $22,000 in
January and $18,000 in February.
132
There is also a variable selling cost of $1 per unit and fixed selling cost of $2,000 per
month.
During the first two months, X plc expects the following levels of activity:
January February
Production 11,000 units 9,500 units
Sales 9,000 units 11,500 units
Required:-
Reported profit figures using marginal costing or absorption costing will differ if there
is any change in the level of inventories in the period. If production is equal to sales,
there will be no difference in calculated profits using the costing methods.
If inventory levels increase between the beginning and end of a period, absorption
costing will report the higher profit. This is because some of the fixed production
overhead incurred during the period will be carried forward in closing inventory
(which reduces cost of sales) to be set against sales revenue in the following period
instead of being written off in full against profit in the period concerned.
If inventory levels decrease, absorption costing will report the lower profit because as
well as the fixed overhead incurred, fixed production overhead which had been
carried forward in opening inventory is released and is also included in cost of sales.
Therefore,
133
Profits generated using absorption & marginal costing can also be reconciled as
follows:
134
10.5 ACCA SYLLABUS GUIDE OUTCOME 5:
Describe the advantages and disadvantages of absorption and marginal
costing
135
136
1. Marginal Costing
In marginal costing, only variable costs are charged as a cost of sale. Therefore, the
cost of a unit =
Fixed costs are treated as a period cost, and are charged in full to the income
statement of the accounting period in which they are incurred.
2. Contribution
3. Inventory Valuation
Marginal costing values inventory at the total variable production cost of a product.
Absorption costing values inventory at the full production cost (including fixed
production overheads) of a product.
4. Profit Valuation
In marginal costing, fixed production costs are treated as period costs and are
written off as they are incurred.
In absorption costing, fixed production costs are absorbed into the cost of units and
are carried forward in inventory to be charged against sales for the next period.
In the long run, total profit for a company will be the same whether marginal costing
or absorption costing is used.
137
Marginal costing Absorption costing
Closing inventories are valued at Closing inventories are valued at full
marginal production cost production cost
Fixed costs are period costs Fixed costs are absorbed into unit costs
Cost of sales does not include a share Cost of sales does include a share of fixed
of fixed overheads overheads
5. Reconciliation of Profits/Losses
Profits generated using absorption and marginal costing can also be reconciled as
follows:
138
139
Chapter 11
JOB, BATCH AND PROCESS COSTING
11.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Describe the characteristics of job and batch costing
In job costing, production is usually carried out in accordance with the special
requirements of each customer. Therefore, it is usual for each job to differ in one or
more respects from another job.
The main aim of job costing is to identify the costs associated with completing the
order. Individual jobs are given a unique job number and the selling prices of jobs
are calculated by adding a certain amount of profit to the cost of the job.
Batch costing is similar to job costing in that each batch of similar articles is
separately identifiable. A batch is a group of similar articles which maintains its
identity during one or more stages of production and is treated as a cost unit.
The cost per unit manufactured in a batch is the total batch cost divided by the
number of units in the batch.
The selling prices of batches are calculated by adding a profit to the cost of the
batch, i.e. very similar to job costing.
140
Batch costing is used by manufacturing companies with manufacture products that
are too small to identify the cost per unit; for example, engineering component
industry, footwear and clothing manufacturing industries.
The usual method of fixing prices in a jobbing concern is cost plus pricing. Cost plus
pricing means that a desired profit margin is added to total costs to arrive at the
selling price.
Mark-up profit is calculated as a percentage of the total costs of the job, e.g. 20%
mark-up: -
%
Selling price 120
Total cost (100)
Profit 20
Margin profit is calculated as a percentage of the selling price of the job, e.g. 20%
margin: -
%
Selling price 100
Total cost (80)
Profit 20
141
142
11.3.1 Work in progress
Sometimes, jobs may not be 100% complete at year end. The value of work in
progress is simply the sum of the costs incurred on incomplete jobs.
Process costing is a costing method used where it is not possible to identify separate
units of production, or jobs, usually because of the continuous nature of the
production processes involved. All the products in the process are identical and
indistinguishable from each other.
The essence of process costing involves the averaging of the total costs of each
process over the total output of the process.
143
Average cost per unit = Costs of production
Expected or normal output
The output of one process forms the material input of the next process. Also, closing
work-in-progress (WIP) at the end of one period forms the opening WIP at the
beginning of the next period.
Oil refining
Paper
Foods and drinks
Chemicals
Process costing may also be associated with the continuous production of large
volumes of low-cost items, such as cans or tins.
144
11.6 ACCA SYLLABUS GUIDE OUTCOME 6:
Explain the concepts of normal and abnormal losses and abnormal gains
It is normal that the total of the input units may differ from the total of the output units.
This usually happens when there are losses or gains in the process.
Normal loss is the loss that is expected in a process and is often expressed as a
percentage of the materials input to the process.
If normal loss is sold as scrap, the revenue is used to reduce the input costs of the
process. If normal loss does not have a scrap value, it is valued in the process
account as $Nil.
Average cost per unit = Total cost of inputs – Scrap value of normal loss
Units input – Normal loss
Normal gain is the expected gain in a process. If the loss or the gain in a process is
different to what we are expecting, then we have an abnormal loss or an abnormal
gain in the process. If losses are greater than expected, the extra loss is abnormal
loss. If losses are less than expected, the difference is known as abnormal gain.
1. The costs of abnormal gains and losses are not absorbed into the cost of
good output but are shown as losses and gains in the process account
2. Abnormal loss and gain units are valued at the same cost as units of good
output.
145
11.7 ACCA SYLLABUS GUIDE OUTCOME 7:
Calculate the cost per unit of process outputs
The following steps should be followed when answering questions which include
normal loss, abnormal loss or abnormal gain: -
1. Draw the process account, and enter the inputs, i.e. units and values.
2. Enter the normal loss – units and scrap value if any.
3. Enter the good output – units only.
4. Balance the units. The balancing figure is either abnormal loss or gain.
5. Calculate the average cost per unit: -
Average cost per unit = Total cost of inputs – Scrap value of normal loss
Units input – Normal loss
6. Value the good output and abnormal loss or gain at this average cost per unit.
Process A/c
Units $ Units $
Input cost Raw Material x x Output x x
Labour x Normal Loss x x
Overheads x
Abnormal Gain x x Abnormal loss x x
x x x x
Scrap A/c
Units $ Units $
Normal loss x x Cash Received x x
Abnormal Loss x x Abnormal Gain x x
x x x x
If no scrap value is given, no scrap account can be drawn up and value of normal
loss in process account will be nil.
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Abnormal Loss/Gain A/c
Units $ Units $
Process x x Scrap x x
Income Statement – Income Statement -
Gain x Loss x
x x x x
When units are partly completed at the end of a period (and hence there is closing
work in progress), it is necessary to calculate the equivalent units of production in
order to determine the cost of a completed unit. It would be unfair to allocate a full
unit cost to part-process units so we need to use the concept of equivalent units.
Equivalent units are notional whole units which represent incomplete work, and
which are used to apportion costs between work in process and completed output.
Closing work in progress units become opening work in progress units in the next
accounting period.
Since material is input at the start of the process, it is only the addition of labour and
overheads that will be incomplete at the end of the period. This means that material
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cost should be spread over all units but conversion costs should be spread over the
equivalent units.
Work remaining in process (WIP) and fully-completed units can be valued using
either weighted average method or the FIFO method.
In the weighted average method, opening inventory values are added to current
costs to provide an overall average cost per unit. The cost of opening inventory is
added to the costs incurred during the period, and completed units of opening
inventory are each given a value of one full equivalent unit of production. Therefore,
no distinction is made between units in process at the start of a period and those
added during the period.
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11.10.2 FIFO costing of production
The FIFO method of valuation deals with production on a first in, first out basis. The
assumption is that the first units completed in any period are the units of opening
inventory that were held at the beginning of the period.
This means that if opening WIP units are 60% complete with respect to materials and
30% with respect to conversion costs (labour and overheads), only 40% more work will
need to be carried out with respect to materials and 70% with respect to conversion
costs.
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At the beginning of July, there were 15,000 units of work in progress valued as
follows:
At the end of July, there were 5,000 units of work-in-progress. They were 100%
complete for materials and 50% complete for labour and overheads.
Required: -
FIFO inventory valuation is more common than the weighted average method, and
should be used unless an indication is given to the contrary. You may find that you are
presented with limited information about the opening inventory, which forces you to
use either the FIFO or the weighted average method.
1. If you are told the degree of completion of each element in opening inventory,
but not the value of each cost element, then you must use the FIFO method.
2. If you are not given the degree of completion of each cost element in opening
inventory, but you are given the value of each cost element, then you must
use the weighted average method.
What happens if the losses do not occur at the end of the process (as we have seen
till now) but part way through a process? In this case, equivalent units must be used
to assess the extent to which costs were incurred at the time at which the loss was
identified.
Joint products are two or more products which are output from the same processing
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operation, but which are indistinguishable from each other up to their point of
separation.
Joint products have a substantial sales value. Often they require further processing
before they are ready for sale. Joint products arise, for example, in the oil refining
industry where diesel fuel, petrol, paraffin and lubricants are all produced from the
same process.
11.12.2 By-Products
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11.13 ACCA SYLLABUS GUIDE OUTCOME 13:
Value by-products and joint products at the point of separation
Joint process costs (pre-separation costs) occur before the split-off point. These costs
have to be apportioned between the joint products at the split-off point to obtain the
costs of each of the products in order to value closing inventory and cost of sales.
The main methods of apportioning joint costs, each of which can produce
significantly different results are: -
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11.13.2 Accounting treatment – By-Products
When preparing process accounts, joint costs should be treated as ‘normal’ output
from a process. The treatment of by-products in process costing is similar to the
treatment of normal loss.
The by-product income is credited to the process account and debited to a by- product
account. To calculate equivalent units in a period, by-products (like normal loss) are
zero equivalent units.
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155
156
1. Job costing
2. Batch costing
A batch is a group of similar articles which maintains its identity during one or
more stages of production and is treated as a cost unit. The cost per unit
manufactured in a batch is the total batch cost divided by the number of units in
the batch.
Cost plus pricing means that a desired profit margin is added to total costs to
arrive at the selling price.
4. Process costing
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The output of one process forms the material input of the next process. Also,
closing work-in-progress (WIP) at the end of one period forms the opening WIP at
the beginning of the next period.
o Oil refining
o Paper
o Foods and drinks
o Chemicals
5. Normal loss
Normal loss is the loss that is expected in a process and is often expressed as a
percentage of the materials input to the process.
If normal loss is sold as scrap, the revenue is used to reduce the input costs of
the process. If normal loss does not have a scrap value, it is valued in the
process account as $Nil.
Average cost per unit = Total cost of inputs – Scrap value of normal loss
Units input – Normal loss
6. Abnormal Loss/Gain
If the loss or the gain in a process is different to what we are expecting, then we
have an abnormal loss or an abnormal gain in the process. If losses are greater
than expected, the extra loss is abnormal loss. If losses are less than expected,
the difference is known as abnormal gain.
Abnormal loss and gain units are valued at the same cost as units of good output.
The following steps should be followed when answering questions whi ch include
normal loss, abnormal loss or abnormal gain: -
a. Draw the process account, and enter the inputs, i.e. units and values.
b. Enter the normal loss – units and scrap value if any.
c. Enter the good output – units only.
d. Balance the units. The balancing figure is either abnormal loss or gain.
e. Calculate the average cost per unit: -
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Average cost per unit = Total cost of inputs – Scrap value of normal loss
Units input – Normal loss
f. Value the good output and abnormal loss or gain at this average cost per unit.
7. Process Accounts
Process A/c
Units $ Units $
Input cost Raw Material x x Output x x
Labour x Normal Loss x x
Overheads x
Abnormal Gain x x Abnormal loss x x
x x x x
Scrap A/c
Units $ Units $
Normal loss x x Cash Received x x
Abnormal Loss x Abnormal Gain x x
x x x x
8. Equivalent Units
Equivalent units are notional whole units which represent incomplete work, and
which are used to apportion costs between work in process and completed
output.
Since material is input at the start of the process, it is only the addition of labour and
overheads that will be incomplete at the end of the period. This means that
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material cost should be spread over all units but conversion costs should be
spread over the equivalent units.
Work remaining in process (WIP) and fully-completed units can be valued using
either weighted average method or the FIFO method.
In the weighted average method, opening inventory values are added to current
costs to provide an overall average cost per unit. The cost of opening inventory is
added to the costs incurred during the period, and completed units of opening
inventory are each given a value of one full equivalent unit of production.
Therefore, no distinction is made between units in process at the start of a period
and those added during the period.
The FIFO method of valuation deals with production on a first in, first out basis.
The assumption is that the first units completed in any period are the units of
opening inventory that were held at the beginning of the period.
Joint products are two or more products which are output from the same
processing operation, but which are indistinguishable from each other up to their
point of separation.
Joint products have a substantial sales value. Often they require further
processing before they are ready for sale.
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13. By-Products
Joint process costs (pre-separation costs) occur before the split-off point. These
costs have to be apportioned between the joint products at the split-off point to
obtain the costs of each of the products in order to value closing inventory and
cost of sales.
The main methods of apportioning joint costs, each of which can produce
significantly different results are: -
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Chapter 12
SERVICE AND OPERATIONS COSTING
12.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Identify situations where the use of service/operation costing is appropriate.
Service organisations do not make or sell tangible goods. In fact, the output of
service organisations/departments can be described as: -
1. A company operating in a service industry will cost its services, for which
sales revenue will be earned; examples are electricians, car hire services,
road, rail or air transport services, hairdressers, banks, colleges and hotels.
2. A company may wish to establish the cost of services carried out by some of
its departments, i.e. establishing a specific cost for an internal service. For
example costs of the vans or lorries used in distribution, the costs of the
computer department, or the staff canteen.
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12.2 ACCA SYLLABUS GUIDE OUTCOME 2:
Illustrate suitable unit cost measures that may be used in different
service/operation situations.
The main problem with service costing is the difficulty in defining a realistic cost unit
that represents a suitable measure of the service provided.
Frequently, a composite cost unit may be deemed more appropriate. Therefore, two
variables will be considered. Hotels, for example, may use the 'occupied bed-night'
as an appropriate unit for cost ascertainment and control.
The total cost of providing a service will include labour, materials, direct expenses
and overheads. In service costing, labour may be the only direct cost involved in
providing a service. Overheads will make up the remaining total costs.
The cost per service unit is calculated by establishing the total costs involved in
providing the service and dividing this by the number of service units in providing the
service.
Lecture Example 1
The RCA Worldwide, with annual running costs of $5 million, has the following
students: -
Attendance
Number Weeks p.a. Hours/week
1st year students 2,700 30 28
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2nd year students 1,500 35 30
Required: -
If organisations in the same industry use the same service cost units, then
comparisons between companies can be made easily.
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1. Service/Operation Costing
i. A company operating in a service industry will cost its services, for which
sales revenue will be earned
i. A company may wish to establish the cost of services carried out by some of
its departments
The main problem with service costing is the difficulty in defining a realistic cost
unit that represents a suitable measure of the service provided.
Frequently, a composite cost unit may be deemed more appropriate.
The cost per service unit is calculated by establishing the total costs involved in
providing the service and dividing this by the number of service units in providing
the service.
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Chapter 13
ALTERNATIVE COST ACCOUNTING
TECHNIQUES
After having looked into traditional costing techniques, in this chapter four alternative
cost management techniques will be introduced. These are: -
Differentiate ABC, target costing and life cycle costing from the tradition
costing techniques (note: calculations are not required)
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In ABC, activities are the focus of, the costing process, e.g. equipment preparation,
order handling and quality control. Costs are traced from activities to products based
on the products demands for these activities during the production process
By grouping costs on the basis of cost drivers, we will be able to both manage costs
better (by managing the activity) and to calculate the cost of production.
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13.1.1.3 The Advantages of ABC
2. It provides much better insights into what drives overhead costs. ABC recognises
that overhead costs are not all related to volume. It also identifies activities and
costs that do not add value.
3. ABC can be applied to all overhead costs, not just production overheads.
ABC may not be universally beneficial. There are four major issues to be considered:
1. Cost vs benefit
The need to analyse costs on a radically different basis will require resources,
which will lead to additional costs. Clearly the benefits which will be obtained
must exceed these costs.
While ABC is likely to provide better information for decision makers, it must
still be applied with care. ABC is not fully understood by many managers and
therefore is not fully accepted as a means of cost control.
ABC needs a new set of accounting records, this is often not immediately
available and therefore resistance to change is common. The setting up of new
cost pools is needed which is time-consuming.
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Worked out example (no calculations required for exam)
The following example looks at the different activities within a company, their cost
and their cost driver. The cost per driver is found by dividing the total cost of the
activity by the quantity of the cost drivers. Overhead costs are then charged to products
or services on the basis of activities used for each product or service.
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13.1.2 Target Costing
A target cost is a cost estimate derived by subtracting a desired profit margin from a
competitive market price.
Where a gap exists between the current estimated cost levels and the target cost, it
is essential that this gap be closed. Efforts to close a target cost gap are most likely
to be successful at the design stage. It is far easier to ‘design out’ cost during the pre-
production phase than to ‘control out’ cost during the production phase.
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13.1.2.3 Ways to reduce a cost gap
2. Remove features that add to cost but do not significantly add value to the
product when viewed by the customer.
4. Review the whole supplier chain - each step in the supply chain should be
reviewed, possibly with the aid of staff questionnaires, to identify areas of
likely cost savings. For example, the questionnaire might ask ‘are there more
than five potential suppliers for this component?’ Clearly a ‘yes’ response to
this question will mean that there is the potential for tendering or price
competition.
5. Reduce waste or idle time that might exist. Where possible, standardised
components should be used in the design. Productivity gains may be possible
by changing working practices or by de-skilling the process. Automation is
increasingly common in assembly and manufacturing.
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13.1.3 Life-Cycle Costing
Life-cycle costing tracks and accumulates the actual costs and revenues attributable
to each product from inception to abandonment. It enables a product’s true
profitability to be determined at the end of the economic life.
Traditional cost accounting systems do not accumulate costs over a product’s entire
life but focus instead on (normally) twelve month accounting periods. As a result the total
profitability of a product over its entire life becomes difficult to determine.
3. Growth. The product gains a bigger market as demand builds up. Sales
revenues increase and the product begins to make a profit. Marketing and
promotion will continue through this stage. Unit costs tend to fall as fixed
costs are recovered over greater volumes. Competition also increases and
the company may need to reduce prices to remain competitive.
4. Maturity. Eventually, the growth in demand for the product will slow down and it
will enter a period of relative maturity. It will continue to be profitable. However,
price competition and product differentiation will start to erode profitability. The
product may be modified or improved, as a means of sustaining its demand.
5. Decline. At some stage, the market will have bought enough of the product
and it will therefore reach 'saturation point'. Demand will start to fall and prices
will also fall. Eventually it will become a loss maker and this is the time when
the organisation should decide to stop selling the product or service. During
this stage, the costs involved would be environmental clean-up, disposal and
decommissioning. Meanwhile, a replacement product will need to have been
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developed, incurring new levels of research and development and other setup
costs.
The level of sales and profits earned over a life cycle can be illustrated
diagrammatically as follows.
1. All costs (production and non production) will be traced to individual products
over their complete life cycles and hence individual product profitability can be
more accurately measured.
2. The product life cycle costing results in earlier actions to generate revenue or
to lower costs than otherwise might be considered.
3. Better decisions should follow from a more accurate and realistic assessment
of revenues and costs, at least within a particular life cycle stage.
4. Product life cycle thinking can promote long-term rewarding in contrast to short-
term profitability rewarding.
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6. Identifying the costs incurred during the different stages of a product’s life
cycle provides an insight into understanding and managing the total costs
incurred throughout its life cycle. Non production costs will become more
visible and the potential for their control is increased.
13.1.4.1 Introduction
Total quality management (TQM) describes the situation where all business functions
are involved in a process of continuous quality improvement. It focuses on delivering
products or services of consistent high quality in a timely fashion. In the past most
companies considered quality to be an additional cost of manufacturing, but recently
they have begun to realize that quality saves money.
Costs of prevention (getting things right first time) are less than the costs of
correction.
Therefore companies should focus on getting things right first time (zero defect
philosophy) and then getting them better next time (continuous improvement). There
must be real commitment to continuous improvement in all processes by all
management.
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In his article, Mark Lee Inman9 listed eight requirements of quality: -
A cost of quality report should be prepared to indicate the total cost to the
organisation of producing products or services that do not conform with quality
requirements. Four categories of costs should be reported:-
2. Appraisal Costs are the costs incurred to ensure that materials and products
meet quality conformance standards. They include the costs of inspecting
purchased parts, work in process and finished goods, quality audits and field
tests.
3. Internal Failure Costs are the costs associated with materials and products
that fail to meet quality standards. They include costs incurred before the
product is dispatched to the customer, such as the costs of scrap, repair,
downtime, and work stoppages caused by defects.
4. External Failure Costs are the costs incurred when products or services fail to
conform to requirements or satisfy customer needs after they have been
delivered. They include the costs of handling customer complaints, warranty
replacement, repairs of returned products and the costs arising from a
damaged company reputation. Costs within this category can have a dramatic
impact on future sales.
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Prevention and appraisal costs are sometimes referred to as the costs of quality
conformance or compliance. Costs of compliance are incurred with the intention of
eliminating the costs of failure.
Internal and external failure costs are also known as the costs of non-conformance
or non-compliance. Costs of non-compliance are the result of production
imperfections and can only be reduced by increasing compliance expenditure.
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1. Activity Based Costing (ABC)
ABC links overhead costs to the products or services that cause them by
absorbing overhead costs on the basis of activities that ‘drive’ costs (cost
drivers).
2. Target Costing
Three steps: -
Take the selling price
Deduct the desired margin
The remainder will be the target cost. If the expected cost is higher
than the target cost, there is a cost gap.
3. Life-cycle Costing
Life-cycle costing tracks and accumulates the actual costs and revenues
attributable to each product from inception to abandonment. It enables a
product’s true profitability to be determined at the end of the economic life.
Costs of prevention (getting things right first time) are less than the costs of
correction.
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iv. External Failure Costs - costs incurred when products or services fail to
conform to requirements or satisfy customer needs after they have
been delivered.
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Chapter 14
NATURE AND PURPOSE OF
BUDGETING
14.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Explain why organisations use budgeting
The budget is 'a quantitative statement for a defined period of time, which may
include planned revenues, expenses, assets, liabilities and cash flows. A budget
facilitates planning'.
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14.2 ACCA SYLLABUS GUIDE OUTCOME 2:
Describe the planning and control cycle in an organization
The overall planning and control cycle is summarized in the diagram below: -
Set mission
Identify objectives
Long-term
planning process Gather data about alternatives
Budget
process Monitor actual results Control
process
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Stage 1:- Set Mission
This involves establishing the broad overall aims and goals of the organization – its
mission may be both economic and social. Most organizations now prepare and
publish their mission in a mission statement.
This requires the company to specify objectives towards which it is working. The
objectives chosen must be quantified and have a timescale attached to them.
Objectives should be SMART: -
Specific
Measurable
Achievable
Relevant
Time limited
To formulate its strategies, the firm will consider the products it makes and the
markets it serves. E.g. of strategies are: -
Developing new markets for existing products
Developing new products for existing markets
Developing new products for new markets
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Stage 5:- Select course of action
Having made decisions, long-term plans based on those decisions are created.
This stage shows the move from long-term planning to short-term plans – the annual
budget. The budget provides the link between the strategic plans and their
implementation in management decisions.
Detailed financial and other records of actual performance are compared with budget
targets (variance analysis)
This is the control process in budgeting, responding to divergences from plan either
through budget modifications or through identifying new courses of action
Lecture Example 1
a) Budget centres: Units responsible for the preparation of budgets. A budget centre
may encompass several cost centres.
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b) Budget committee: This may consist of senior members of the organisation, e.g.
departmental heads and executives (with the managing director as chairman). Every
part of the organisation should be represented on the committee, so there should be
a representative from sales, production, marketing and so on. Functions of the budget
committee include:
i. liaising between the budget committee and managers responsible for budget
preparation
ii. dealing with budgetary control problems
iii. ensuring that deadlines are met
iv. educating people about budgetary control.
d) Budget manual:
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14.4 ACCA SYLLABUS GUIDE OUTCOME 4:
Describe the stages in the budgeting process
The long-term plan forms the framework within which the budget is prepared. It is
therefore necessary to communicate the implications of that plan to the people who
actually prepare the budget.
Generally there will be one factor which restricts performance for a given period.
Usually this will be sales, but it could be production capacity, or some special labour
skills.
On the assumption that sales is the principal budget factor, the next stage is to
prepare the sales budget. This budget is very much dependent on forecast sales
revenue.
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Stage 5: Co-ordination and review of budgets
At this stage the various budgets are integrated into the complete budget system.
Any anomalies between the budgets must be resolved and the complete budget
package subject to review. At this stage the budget income statement, balance sheet
and cash flow must be prepared to ensure that the package produces an acceptable
result.
All of the budgets are summarized into a master budget, which is presented to top
management for final acceptance.
The budget process involves regular comparison of budget with actual, and
identifying causes for variances. This may result in modifications to the budget as the
period progresses.
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1. A budget is a quantified plan of action for a forthcoming accounting period.
Set mission
Identify objectives
Long-term
planning process Gather data about alternatives
Budget
process Monitor actual results Control
process
a. Specific
b. Measurable
c. Achievable
d. Relevant
e. Time limited
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4. Budget centres: units responsible for the preparation of budgets
7. Budget manual:
a. charts the organisation
b. details the budget procedures
c. contains account codes for items of expenditure and revenue
d. timetables the process
e. clearly defines the responsibility of persons involved in the budgeting
system.
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Chapter 15
BUDGET PREPARATION
15.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Explain the importance of principal budget factor in constructing the budget.
Lecture Example 1
A. Demand
B. Labour hours
C. Materials
D. Cash
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1. Sales budget
2. Production budget
3. Raw material usage budget
4. Raw material purchases budget
5. Labour budget
6. Overheads budget
Budgeted production =
Forecast sales + closing inventory of finished goods – opening inventory of
finished goods
Material usage = Budgeted production for each product x the quantity required
to produce one unit of the product
The overhead budget will be made up of variable costs and fixed costs
Lecture Example 2
The XYZ company produces three products, X, Y, and Z. For the coming accounting
period budgets are to be prepared using the following information:
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Budgeted sales
M1 M2
(kg per unit) (litres per unit)
Product X 5 2
Product Y 3 2
Product Z 2 1
Standard cost of raw material $8 $4
Labour
X Y Z
Standard hours per unit 4 6 8
Labour is paid at the rate of $3 per labour hour
Variable overheads at $2 per labour hour
Fixed overheads at $1 per labour hour
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SALES BUDGET
units/value
MATERIAL USAGEBUDGET
Kg/Liters etc
Cash budgets are vital to the management of cash. They show the expected inflows and
outflows of cash through the company. They help to show cash surpluses and cash
shortages.
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Management can therefore use cash budgets to plan ahead to meet those
eventualities – arranging borrowing when a deficit is forecast, or buying short-term
securities during times of excess cash.
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15.4 ACCA SYLLABUS GUIDE OUTCOME 4:
Prepare master budgets (income statement and statement of financial
position)
When all the functional budgets have been prepared, they are summarized and
consolidated into a master budget which consists of:
1. Budgeted income statement
2. Budgeted statement of financial position
3. Cash budget
‘What if’ analysis is a form of sensitivity analysis which allows the effects of changing
one or more data values to be quickly recalculated. It enables each of the input values
to be changed both individually and in combination to see the effects on the final
result.
Michelle Ltd is considering launching a new product which has the following details:
Sales volume will now be 800, i.e. 200 less. Total contribution will be lower by 200 x
$3 = $600. Hence profit will now be $1000 - $600 = $400, i.e. 60% lower
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15.5.2 Scenario Planning
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201
1. Principal Budget Factor
i. Sales Budget
Budgeted production =
Forecast sales + closing inventory of finished goods – opening
inventory of finished goods
v. Overhead Budget
The overhead budget will be made up of variable costs and fixed costs
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3. Cash Budget
Cash budgets are vital to the management of cash. Management can use
cash budgets to plan ahead to arrange borrowing when a deficit is forecast, or
buy short-term securities during times of excess cash.
4. Master Budget
5. What If Analysis
‘What if’ analysis is a form of sensitivity analysis which allows the effects of
changing one or more data values to be quickly recalculated
6. Scenario Planning
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204
205
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Chapter 16
FLEXIBLE BUDGETS
16.1 Introduction
Budgetary control involves controlling costs by comparing the budget with the actual
results and investigating any significant differences between the two. Any differences
(variances) are made the responsibility of key individuals who can either exercise
control action or revise the original budgets.
If this control process is to be valid and effective, it is important that the variances
are calculated in a meaningful way. One of the major concerns is to ensure that the
budgeted and actual figures reflect the same activity level.
A fixed budget is a budget which is normally set prior to the start of an accounting
period, and which is not changed in response to changes in activity or
costs/revenues. It is produced for a single level of activity, i.e. based on estimated
production.
Comparison of a fixed budget with the actual results for a different level of activity is
of little use for budgetary control purposes. This is because we will not really be
comparing like with like.
A flexible budget is a budget that adjusts or flexes for changes in the volume of
activity. The flexible budget is more sophisticated and useful than a fixed budget,
which remains at one amount regardless of the volume of activity.
For example, a firm may have prepared a fixed budget at a sales level of $100,000.
Flexible budgets may be prepared at different activity levels e.g. anticipated activity
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100% and also 90%, 95%, 105% and 110% activity. Flexible budgets can be useful but
time and effort is needed to prepare them.
A flexed budget is a budget prepared to show the revenues, costs and profits that
should have been expected from the actual level of production and sales.
If the flexed budget is compared with the actual results for a period, variances will be
much more meaningful.
The high-low method may have to be used in order to determine the fixed and
variable elements of semi-variable costs. However, please note that fixed costs
remain unchanged regardless of the level of activity and should not be flexed.
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16.3 ACCA SYLLABUS GUIDE OUTCOME 4:
Define the concept of responsibility accounting and its significance in control
Each manager must have a well-defined area of responsibility and the authority to
make decisions within that area. This is known as a responsibility accounting unit. As
discussed in Chapter 1, an area of responsibility may be structured as: -
A common problem is that the responsibility for a particular cost or item is shared
between two (or more) managers. For e.g. the responsibility for material costs will be
shared between production and purchasing managers. It is important that the
reporting system should be designed so that the responsibility for performance
achievements is identified as that of a single manager.
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16.4 ACCA SYLLABUS GUIDE OUTCOME 5:
Explain the concept of controllable and uncontrollable costs and revenues
The main problem with measuring performance is in deciding which costs are
controllable and which costs are traceable. The performance of a manager is
indicated by the controllable profit and the success of the division as a whole is
judged on the traceable profit.
Controllable costs and revenues are those costs and revenues which result from
decisions within the authority of a particular manager within the organization. These
should be used to assess the performance of the managers.
Most variable costs are controllable in the short term because managers can influence
the efficiency with which resources are used.
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CONTROLLABLE PROFIT STATEMENT 10
$ $
(internal) XXX
XXX
The following control report will be presented only to the responsible manager. It will
include a number of recommendations how any variance will be controlled or
eliminated
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Budget Actual Variance
Current Year Current Year Current Year
month to date month to date month to date
Managing Director
Factory A
Factory B
Administration costs
Selling costs
Distribution costs
R&D costs
Production director
Factory A
Machining department
Casting department
Assembly department
Inspection and quality
control
Factory manager’s office
Head of machining
department
Direct materials
Direct labour
Indirect labour
Power
Maintenance
Other
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1. Budgetary Control
Budgetary control involves controlling costs by comparing the budget with the
actual results and investigating any significant differences between the two.
Any differences (variances) are made the responsibility of key individuals who
can either exercise control action or revise the original budgets.
2. Fixed Budgets
A fixed budget is a budget which is normally set prior to the start of an
accounting period, and which is not changed in response to changes in
activity or costs/revenues. It is produced for a single level of activity, i.e.
based on estimated production.
3. Flexible Budgets
A flexible budget is a budget that adjusts or flexes for changes in the volume
of activity. The flexible budget is more sophisticated and useful than a fixed
budget, which remains at one amount regardless of the volume of activity.
4. Flexed Budgets
A flexed budget is a budget prepared to show the revenues, costs and profits
that should have been expected from the actual level of production and sales.
If the flexed budget is compared with the actual results for a period, variances
will be much more meaningful.
5. Responsibility Accounting
Each manager must have a well-defined area of responsibility and the
authority to make decisions within that area.
a cost centre – the manager is responsible for cost control only
a revenue centre – the manager is responsible for revenues only
profit centre – the manager has control over costs and revenues
investment centre – the manager is empowered to take decisions
about capital investment for his department. Later on, we will be
discussing two measures of performance in investment centres: return
on investment and residual income
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215
Chapter 17
STATISTICAL TECHNIQUES IN
BUDGETING
In this chapter, we will be looking at different statistical techniques which can be
used to arrive at budgeted figures. The main problem faced when forecasting costs is
that of trying to find how costs vary with the level of activity. Useful techniques in cost
estimation are: -
Sales forecasts may also make use of past sales data. Techniques which may be
useful here are: -
As described in chapter 3, the high low method is one of the methods used to
analyse semi-variable costs into their fixed and variable elements.
Total cost at high activity level - total cost at low activity level
Total units at high activity level - total units at low activity level
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3. Find the fixed costs
Total cost at high activity level – (Total units at high activity level × Variable cost per
unit)
1. Easy to use
2. Easy to understand
3. Quick method
1. It relies on historical cost data – predictions of future costs may not be reliable
2. It assumes that the activity level is the only factor affecting costs
3. It uses only two values to predict costs – all data falling between the highest
and lowest values are ignored
4. Bulk discounts may be available at large quantities
Lecture Example 1
Calculate the variable cost per unit and the total fixed costs and use these to
forecast the cost expected if production is 6,500 units. Note that when
production is greater than 5000 units, an additional machine must be used and
depreciation increases by $500/month.
Information about two variables that are considered to be related in some way can
be represented on a form of graph known as a ‘scatter diagram’, each axis
representing one variable. For example, the level of advertising expenditure and
217
sales revenue of a product, or the level of electricity cost and the number of units
produced can be plotted against each other.
The values of the two variables are plotted together to show a number of points on
the graph. The way in which these are scattered or dispersed indicates if any
relationship is likely to exist between the variables.
For example; the following scatter graph shows the relationship between 2 variables;
the independent variable can be the units, the dependent variable can be production
cost.
The "best-fit" line (trend line) is the straight line which passes as near to as many of
the points as possible. By drawing such a line, we are attempting to minimise the
effects of random errors in the measurements.
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The line of best fit would be drawn as follows: -
When we have our line of best fit drawn on the scatter diagram, we can use it to read
off values for the variables at any points on the axes.
In doing this, we have to assume that the line of best fit is accurately drawn and that
the relationship established, based on past data, will also apply in the future - this is
known as extrapolating the trend.
Using scatter diagrams with lines of best fit is useful as a forecasting technique and
has the advantage of relative simplicity.
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17.3 ACCA SYLLABUS GUIDE OUTCOME 3:
Analysis of cost data.
i. Explain the concept of correlation coefficient and coefficient of
determination
ii. Calculate and interpret correlation coefficient and coefficient of
determination
iii. Establish a linear function using regression analysis and interpret the
results
Use linear regression coefficients to make forecasts of costs and revenues
Explain the advantages and disadvantages of linear regression analysis
Linear regression analysis is based on working out an equation for the line of best fit.
These formulae are given in the exam. Remember always start working ‘b’,
then move to ‘a’.
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17.3.1 Correlation
One way of measuring ‘how correlated’ two variables are, is by drawing the ‘line of
best fit’ on a scatter graph. When correlation is strong, the estimated line of best fit
should be more reliable.
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17.3.2 Different degrees of correlation
No correlation
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17.3.3 The correlation coefficient (r)
r = 0 indicates no correlation
94% of the variation in the dependent variable (y) is due to variations in the
independent variable (x). 6% of the variation is due to random fluctuations.
Therefore, there is high correlation between the two variables.
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17.3.5 Advantages and Disadvantages of Linear Regression
Advantages
2. Unlike the high low method, which uses only two past observations,
regression analysis can build into the regression line a large number of
observations - this is likely to make the relationship derived more accurate.
Disadvantages
2. It still uses past data to forecast future values of the variables - if the
relationship which existed in the past is not valid for the future, the forecast
will be inaccurate.
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17.4 ACCA SYLLABUS GUIDE OUTCOME 4:
Explain the principles of time series analysis (cyclical, trend, seasonal
variation and random elements)
Calculate moving averages
Calculation of trend, including the use of regression coefficients
Use trend and seasonal variation (additive and multiplicative) to make budget
forecasts
Explain the advantages and disadvantages of time series analysis
A time series is a series of figures or values recorded over time. The data often
conforms to a certain pattern over time. This pattern can be extrapolated into the
future and hence forecasts are possible. Time periods may be any measure of time
including days, weeks, months and quarters.
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Example: -
Y = T+S+C+R
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In the exam, it is unlikely that you will be expected to carry out any calculation of ‘C’.
Therefore, ‘C’ will be ignored.
Please note that when the number of time periods is an even number, we must
calculate a moving average of the moving average. This is because the average
would lie somewhere between two periods.
These seasonal variations can be estimated using the additive model or the
proportional (multiplicative) model.
This is based upon the idea that each actual result is made up of two influences.
The SV will be expressed in absolute terms. Please note that the total of the
average SV should add up to zero.
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The multiplicative model
The SV will be expressed in proportional terms, e.g. if, in one particular period the
underlying trend was known to be $10,000 and the SV in this period was given as
+12%, then the actual result could be forecast as:
Please note that the total of the average SV should sum to 4.0, 1.0 for each quarter.
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17.4.5 Advantages and Disadvantages of Time Series Analysis
Advantages
Disadvantages
1. it assumes that past trends will continue indefinitely and that extrapolating
data based on historic information will give valid conclusions. In reality, the
sales of products may be influenced by the actions of competitors, particularly
in relation to new products becoming available on the market.
The product life cycle concept suggests that all products pass through a number of
stages from development to decline. We have looked into this concept in Chapter 13.
If an organisation knows where a product is in its life cycle, they can use this
knowledge to plan the marketing of that product more effectively and, the
organisation may be able to derive an approximate forecast of its sales from a
knowledge of the current position of a product in its life cycle.
1. It is over-simplistic to assume that all products comply with a life cycle curve
that follows the standard model shown above.
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17.6 ACCA SYLLABUS GUIDE OUTCOME 6:
Adjust historical and forecast data for price movements.
An aspect of budgeting which requires great care is the estimation of future costs
based on historical figures in an environment of rising prices. When using past
accounting data as the basis for forecasting future figures, old costs need to be
adjusted to show what they would be at current, or rather at next year’s, prices. The
Retail Price Index (RPI) is a government produced index used to measure the general
rate of price change in the economy.
231
For example, if a product costs $100 in 2015 but it cost $50 in 2010,
$50 = 100
$100 = 200
The year that is used as the initial year for comparison is known as the base year.
The base year should also be fairly recent on a regular basis.
1. Simple Indices
A simple index measures the changes in either price or quantity of a single item in
comparison to the base year.
A price index – this measures the change in the money value of a group of
items over time.
q0
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2. Chain Base Index Numbers
A value in any specific time period is based on the value of the same entity in the
preceding period. Each index number is calculated using previous year as base.
3. Composite Indices
Composite indices are used when we have more than one item.
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Worked out example
2010 2011
$ $
Product A 2.00 2.25
Product B 2.50 2.65
Product C 3.50 3.00
This index ignores the amounts of each product which was consumed. To overcome
these problems, we can use a weighting which is an indicator of the importance of
the component
4. Weighted Indices
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5. Laspeyres, Paasche and Fisher Indices
Paasche index is a multi-item index using weights at the current date. Hence, the
weights are changed every time period.
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236
17.8 Advantages and Disadvantages of Indices
Advantages
2. The use of indices makes comparison between items of data easier and more
meaningful- it is relatively easy to make comparisons and draw conclusions
from figures when you are starting from a base of 100.
Disadvantages
1. The Laspeyres and Paasche approaches give different results. This suggests
that there may be no single correct way of calculating an index, especially the
more sophisticated index numbers. The user of the information should bear in
mind the basis on which the index is calculated.
2. The overall result obtained from multi-item index numbers, such as Laspeyres
and Paasche are averages - they may hide quite significant variations in
changes involved in the component items.
4. Index numbers are relative values, not absolute figures and may not give the
whole picture. For example, Division A has achieved growth of 10% compared
to last year while Division B has only achieved 5%. At first glance it may appear
that Division A is performing better than Division B. The actual sales figures for
the period are $27,500 for Division A and $262,500 for Division B. The absolute
increase in sales revenue compared to last year is $2,500 for Division A
($2,200/$25,000 x 100% = 10% increase) but $12,500 for Division B
($12,500/$250,000 x 100%= 5 % increase)
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238
1. High Low Method
The high low method is one of the methods used to analyse semi-variable
costs into their fixed and variable elements. To find the variable cost per unit:
Total cost at high activity level - total cost at low activity level
Total units at high activity level - total units at low activity level
Total cost at high activity level – (Total units at high activity level × Variable cost per
unit)
2. Scatter Diagram
Two variables that are considered to be related in some way can be
represented on a form of graph known as a ‘scatter diagram’.
These formulae are given in the exam. Remember always start working
‘b’, then move to ‘a’.
5. Correlation
Correlation measures the strength of the relationship between two variables.
239
This formula is also given in the exam.
7. Time Series
A time series is a series of figures or values recorded over time. The data
often conforms to a certain pattern over time. This pattern can be extrapolated
into the future and hence forecasts are possible.
Y = T+S+C+R
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An index number is a technique for comparing, over time, changes in some
feature of a group of items by expressing the property each year as a
percentage of some earlier year.
Fisher’s ideal index is found by taking the geometric mean of the Laspeyre
index and the Paasche index.
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242
Chapter 18
BEHAVIOURAL ASPECTS OF
BUDGETING
18.1 Introduction
(a) The managers who set the budget or standards are often not the managers who
are then made responsible for achieving budget targets.
(b) The goals of the organisation as a whole, as expressed in a budget, may not
coincide with the personal aspirations of individual managers. This is known as
dysfunctional behaviour.
(c) When setting the budget, there may be budgetary slack (or bias). Budget slack
is a deliberate over-estimation of expenditure and/or under-estimation of revenues in
the budgeting process. This results in a budget that is poor for control purposes and
meaningless variances.
Motivation is the drive or urge to achieve an end result. Hence, if employees and
managers are not motivated, they will lack the drive or urge to improve their
performance and to help the organization to achieve its goals and move forward.
The management accountant should therefore try to ensure that employees have
positive attitudes towards setting budgets, implementing budgets and feedback of
results.
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Factors such as financial and non financial rewards, prestige and esteem, job
security and job satisfaction may all play a part to motivate management and
employees.
Management accounting planning and control systems can have a significant effect
on manager and employee motivation.
These include: -
The level at which budgets and performance targets are set
Manager and employee reward systems
The extent to which employees participate in the budget setting process
• if targets are very low, actual performance can be pulled down from where it might
naturally have been
• if targets are habitually very high, then employees might give up and, again,
performance can be reduced – if you know that no matter how hard you try you will
fail to meet the target, it’s easy to conclude that you might as well not try at all.
So, the aim is to set budgets which are perceived as being possible, but which entice
employees to try harder than they otherwise might have done. The concept of a
‘motivating budget’ is a powerful one, although the budget which is best for
motivating might not represent the results which are actually expected. Managers can,
and perhaps should, build in a margin for noble failure.
When the budget is very easy, actual performance is low. It has been pulled
down by the low demands made of employees.
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When the budget is very difficult, actual performance is low. Why try when you
are doomed to failure?
When a budget is set at the level of the expectations (the best estimate of
what performance will actually be), employees are likely to perform as
expected.
If a more difficult aspirational budget is set, employees will try harder, and if
the budget is judged just right then their actual performance will be at its
maximum, though often falling short of the budget.
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18.5 ACCA SYLLABUS GUIDE OUTCOME 5:
Discuss managerial incentive schemes
Managers may receive financial rewards (for e.g. bonuses) or non-financial rewards
(for e.g. promotion or greater responsibility) based on their ability to meet budget
targets.
246
These budgets will begin with upper level management establishing parameters
under which the budget is to be prepared. Lower-level personnel have very little
input in setting the overall goals of the organization as they are essentially reduced
to doing the basic budget calculations consistent with directives.
One disadvantage of the top-down approach is that lower-level managers may view
the budget as a dictatorial standard. They lack ownership of the budget and as such,
they will be reluctant to take responsibility for it. Further, such budgets can sometimes
provide ethical challenges, as lower-level managers may find themselves put in a
position of ever-reaching to attain unrealistic targets for their units.
However, it can be argued that this top down approach may be the only approach to
budgeting which is feasible if: -
the organisation is newly-formed
the business is very small
low level employees have no interest in participating in the process
they are not technically capable of participating in budget setting
only top level management have access to information which is necessary for
budgeting purposes
The budget holders have the opportunity to participate in setting their own budgets.
In fact, the lowest level organisational units are asked to submit their estimates of
expenditure for the next year. Senior management, meanwhile, has made a forecast of
the income it expects to receive. There may be a negative variance between the
forecast revenue and the sum of the departments’ budgets. The variance is resolved
by lengthy discussions or arbitrary decisions. This type of budget is also called
participative budget.
It is argued that bottom-up budgets improve employee morale and job satisfaction.
Furthermore, the budget is prepared by those who have the best knowledge of their
own specific areas of operation. This type of budget leads to better communication
and increases managers’ understanding and commitment.
On the negative side, a bottom-up approach is generally more time consuming and
expensive to develop and administer. Another potential shortcoming has to do with
the fact that some managers may try to "pad" their budget, giving them more room
for mistakes and inefficiency. As we have already discussed, this is known as
‘budgetary slack’.
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18.6.3 Negotiated budget
Goal congruence ensures that all members of the organisation pull in the same
direction towards helping the organisation to achieve its overall goals and objectives.
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249
250
1. Budgetary Control
The purpose of a budgetary control system is to assist management in
planning and controlling the resources of their organisation by providing
appropriate control information.
2. Dysfunctional Behaviour
The goals of the organisation as a whole, as expressed in a budget, may not
coincide with the personal aspirations of individual managers.
4. Motivation
Motivation is the drive or urge to achieve an end result. What affects
motivation?
The level at which budgets and performance targets are set
Manager and employee reward systems
The extent to which employees participate in the budget setting
process
7. Goal Congruence
Goal congruence ensures that all members of the organisation pull in the
same direction towards helping the organisation to achieve its overall goals
and objectives.
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252
Chapter 19
CAPITAL EXPENDITURE BUDGETING
AND DISCOUNTED CASH FLOWS
19.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Discuss the importance of capital investment planning and control
i. Growth
Without capital investment companies cannot grow and expand. The decisions
made affect the long term.
If the wrong capital investment decisions are done, then this can burden a
company unnecessarily. However a company must invest in order to maintain its
market share and hopefully grow.
ii. Risk
Capital investment is a long term investment. It requires long term funding. This long
term commitment brings with it risks; e.g. the risks of defaulting on the financing.
However, the potential gains made from the investment may fluctuate more than the
previous gains made by the business. Such fluctuations make the company more risky.
iii. Funding
Capital investment is often a large amount - this means the company will need
to look for finance, both internally and externally. The choice of finance type is
crucial, as it needs to be appropriate for the investment type and the company at
the time
iv. Complexity
Investment decisions are often based on future estimates, often in many years
time. Estimates and variables are used which are often interrelated.
253
The estimates and variables will also change over time due to changes in the
environment in which the company operates (economic, political, social,
technological, environmental and legal).
All the costs incurred in self constructed assets (a business builds its own non-
current asset) should be included as a non-current asset in the statement of
financial position.
This expenditure is on day to day items, i.e. where the benefit is received short
term. This includes salaries, telephone costs or rent. It is incurred for the
purpose of trade, i.e. for expenditure classified as selling and distribution expenses,
administration expenses and fixed charges or to maintain the existing earning capacity
of non-current assets.
Capital income is the proceeds from the sale of non-current assets and non-
current asset investments.
Revenue income is derived from the sale of trading assets and from interest and
dividends received from investments held by the business.
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Lecture Example 1
Very large proposals may require approval by the board of directors, while
smaller proposals may be approved at divisional level
255
Step 4: Implement, monitor and review investments
The time required to implement the investment proposal or project will depend
on its size and complexity. Following implementation, the investment project
must be monitored to ensure that the expected results are being achieved and
the performance is as expected: - this is known as post-completion audit. The whole
of the investment decision-making process should also be reviewed in order to
facilitate organisational learning and to improve future investment decisions.
Example
You invest $100 for 3 years and you receive a simple interest rate of 10% a year
on the $100. This would be $10 each year. Simply $100 x 10% = $10.
The important thing to remember is that you get interest on top of the previous
interest. This is called compound interest.
Example
Suppose that a business has $100 to invest and wants to earn a return of 10%.
What is the future value at the end of each year using compound interest?
FV = PV (1+r)n
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Where FV is the future value of the investment with interest
PV is the initial or ‘present’ value of the investment
r is the compound annual rate of return or rate of interest
expressed as a proportion
n is the number of years
The effective interest rate, on the other hand, can be compared with another
effective rate as it takes into account the compounding period automatically, and
expresses the percentage as an annual figure.
In fact, when interest is compounded annually the nominal interest rate equals
the effective interest rate.
To convert a nominal interest rate to an effective interest rate, you apply the
formula:
= (1 + i/m)mt 1
Example
257
Example
What effective rate will a stated annual rate of 6% p.a. yield when compounded
semi-annually?
Effective Rate = (1 + (0.06/2))2 - 1 = 0.0609 = 6.09%
Lecture Example 2
19.5.1 Compounding
FV = PV (1+r)n
19.5.2 Discounting
A present value is the amount that would need to be invested now to earn the
future cash flow, if the money is invested at the ‘cost of capital’.
PV = FV
(1 + r) n
If the future value is in one year’s time, then you take this FV and multiply it by
1/interest rate (discount rate)
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Example
A business is to receive $100 in one year’s time and the interest rate/discount
rate is 10%. What is the PV of that money?
PV = 100 /1.10
PV = $90.9
Example
A business is to receive $100 in two years’ time and the interest rate/discount
rate is 10%. What is the PV of that money?
PV = 100 /1.102
PV = $82.6
Example
$133 is received in 3 years time. Interest rate 10%. What is the PV?
The present value can also be calculated using a discount factor (saving all the
dividing by 1.1 etc.)
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1/1.13 = 0.751
There are also tables that give you a list of these ‘discount factors’ – a copy of
these tables is included at the end of these notes.
Hence, to calculate a present value for a future cash flow, you simply multiply
the future cash flow by the appropriate discount factor.
Let’s say you buy some goods for $100 and sell them for $200. However, $80 of
the receipt is on credit and you have not received it yet.
Profit looks solely at the income and costs. It matches these together, regardless
of timing of the actual cash payment or receipt.
Sales $200
osts (100)
Profit 100
Cash flow, on the other hand, does not attempt to match the sale with the cost
but rather the actual cash paid and received.
Therefore, cash flows look at when the amounts actually come in and out: - the
money actually spent, saved and received. This is vital to capital investment decision
making - as the timing of inflows and outflows have a value too - the time value of
money.
Not only should the timing of the cash flows be taken into account when
planning on investments but also the type of cash flows to include. We call these
relevant costs.
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19.7 ACCA SYLLABUS GUIDE OUTCOME 7:
Identify and evaluate relevant cash flows for individual investment
Relevant costs are those whose inclusion affects the investment decision.
The cash flows that should be included in a capital budgeting analysis are those
that will only occur if the project is accepted
You should always ask yourself “Will this cash flow change ONLY if we accept
the project?”
Hence, the only cash flows that should be taken into consideration in capital
investment appraisal are: -
Future (ignore past / sunk costs)
Incremental (A cost that would have been paid anyway can be ignored.
Examples of relevant incremental costs include repair costs arising from
use, hire charges and any fall in the resale value of owned assets which
results from their use)
Cash (Accounti ng items like depreciation ignore as they are not cash)
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A special order has now been received from a customer which would require the use
of the machine for five months. The current net realizable value of the machine is
$10,000. If it is used for the job, its value is expected to fall to $7,000. The machine
has a carrying value of $6,000.
Required
Determine the relevant cost of using the machine for the special order.
Discounted cash flow, or DCF, is an investment appraisal technique that takes into
account both the timing of cash flows and also the total cash flows over a project’s
life.
The NPV is the value obtained by discounting all the cash outflows and inflows for
the project capital at the cost of capital and adding them up. Hence, it is the sum of
the present value of all the cash inflows from a project minus the PV of all the cash
outflows.
NPV is positive – the cash inflows from a capital investment will yield a return in
excess of the cost of capital. The project is financially attractive
NPV is negative – the cash inflows from a capital investment will yield a return
below the cost of capital. From a financial perspective, the project is therefore
unattractive
NPV is exactly zero - the cash inflows from a capital investment will yield a return
exactly equal to the cost of capital. The project is therefore just about financially
attractive.
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If a company has 2 projects under consideration it should choose the one with
the highest NPV.
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19.8.2 Internal Rate of Return
The internal rate of return (IRR) is essentially the discount rate where the initial
cash out (the investment) is equal to the PV of the cash in. So, it is the
discount rate where the NPV = 0. If the IRR is higher than a target rate of
return, the project is financially worth undertaking.
Consequently, to work out the IRR we need to do trial and error NPV
calculations, using different discount rates, to try and find the discount rate
where the NPV = 0. This is known as the interpolation method.
Step 1: - Calculate two NPV for the project at two different costs of capital. It is
important to find two costs of capital for which the NPV is close to 0, because
the IRR will be a value close to them.
Step 2: - Having found two costs of capital where the NPV is close to 0, we can
then estimate the cost of capital at which the NPV is 0, i.e. the IRR. A formula is
used: -
L+ NPV L
NPV L - NPV H x (H - L)
Worked Example
If a project had an NPV of $50,000 when discounted at 10%, and -$10,000 when
discounted at 15%, what is the IRR?
Answer
10 + (50,000/60,000) x 5% = 14.17%
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19.8.3 Mutually Exclusive Investments
Both NPV and IRR use discounted cash flow techniques. NPV provides an absolute
measure of return, whereas IRR provides a relative measure. The rule for deciding
between mutually exclusive projects is to accept the project with the higher NPV.
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19.9 ACCA SYLLABUS GUIDE OUTCOME 9:
Calculate present value using annuity and perpetuity formulae(s)
19.9.1 Annuity
Example
$100 will be received at the end of every year for the next 3 years. If cost of
capital is 10%, what is the PV of these amounts together?
Yr 1 1/1.1 = 0.909
Yr 2 1/1.1/1.1 = 0.826
Yr 3 1/1.1/1.1/1.1 = 0.751
All added together 2.486 = Annuity factor (or get from annuity table)
266
19.9.2 Perpetuity
Worked Example
What is the present value of an annual income of $50,000 for the foreseeable
future, given an interest rate of 5%?
Answer
50,000 / 0.05 = $1,000,000
The payback period is the length of time that it takes for a project to recoup its
initial cost out of the cash receipts that it generates. This period is sometimes
referred to as "the time that it takes for an investment to pay for itself."
267
The basic premise of the payback method is that the more quickly the cost of an
investment can be recovered, the more desirable is the investment. Hence, this
method focuses on liquidity.
The payback period is expressed in years. When the net annual cash inflow is
the same every year, the following formula can be used to calculate the payback
period.
Formula / Equation:
*If new equipment is replacing old equipment, this becomes incremental net
annual cash inflow.
Take the decimal (0.1429) and multiply it by 12 to get the months - in this case
1.7 months
Lecture Example 15
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Example - Irregular Cash Flows
When the cash flows associated with an investment project change from year to
year, the simple payback formula that we outlined earlier cannot be used. To
understand this point, consider the following data:
When the cumulative cashflow becomes positive then this is when the initial
payment has been repaid and so is the payback period
So in the final year we need to make $10 more to recoup the initial 800. So,
that’s $10 out of $120. 10/120 x 12 (number of months) = 1.
The payback period incorporates the time value of money into the payback
method. All the cash flows are discounted at the company’s cost of capital. The
discounted payback period is therefore the time it will take before the project’s
cumulati ve NPV becomes positive.
269
Example
0 -1,700
1 500
2 500
3 600
4 900
5 500
NPV = $428,100
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271
272
A. Capital Expenditure
Capital expenditure includes expenditure on productive assets which are
intended for use on a continuing basis
B. Revenue Expenditure
Revenue expenditure is on day to day items, i.e. for the purpose of trade
D. Simple Interest
Simple interest is calculated on the original principal only
E. Compound Interest
FV = PV(1 + r)n
(1 + i/m)mt 1
H. Discounting
PV = FV
(1 + r) n
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IRR formula: -
L+ NPV L
NPV L - NPV H x (H - L)
M. Annuity
An annuity is a fixed periodic payment which continues either for a specified
time or until the occurrence of a specified event
N. Perpetuity
Perpetuity is a periodic payment or receipt continuing for a limitless period.
The PV of a perpetuity: -
Cash flow
Interest Rate
274
275
Chapter 20
STANDARD COSTING AND
BASIC VARIANCE ANALYSIS
20.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Explain the purpose and principles of standard costing
276
20.2 ACCA SYLLABUS GUIDE OUTCOME 2:
Explain and illustrate the difference between standard marginal and
absorption costing
Absorption costing systems focus on profit per unit, and the standard profit
per unit of product is the difference between its standard sales price and
standard full cost.
A standard cost card shows full details of the standard cost of each product.
277
Standard Cost Card – Product x
$ $
Direct Material x kgs @$x x
x liters @$x x
x
Direct labour x hrs @$x x
x hrs @$x x
x
Standard Direct Cost x
Variable production overheads x
Standard variable cost of (Marginal
production x Costing)
Fixed production overhead x
(Absorption
Standard full production cost x Costing)
Administration & marketing
overhead x
Standard cost of sale x
Standard profit x
Standard sales price X
A variance is the difference between a planned, budgeted, or standard cost and the
actual cost incurred. The same comparisons may be made for revenues.
The process by which the total difference between standard and actual results is
analysed is known as variance analysis.
When actual results are better than expected results, we have a favourable variance
(F). If, on the other hand, actual results are worse than expected results, we have an
adverse variance (A).
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20.4 ACCA SYLLABUS GUIDE OUTCOME 4:
Calculate sales price and volume variance
The sales price variance shows the effect on profit of selling at a different price
from that expected.
The sales price variance = Actual units should have sold for $x
Actual units did sell $x
Sales Price Variance $ x (F/A)
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The sales volume variance = Budgeted sales volume x units
(marginal costing) Actual sales volume x units
Sales Volume Variance in units x units (F/A)
x standard contribution per unit $x
Sales Volume Variance in $ $x (F/A)
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20.5 ACCA SYLLABUS GUIDE OUTCOME 5:
For given or calculated sales variances, interpret and explain possible causes,
including possible interrelationships between them
The selling price variance is a measure of the effect on expected profit of a different
selling price to standard selling price. It is calculated as the difference between what
the sales revenue should have been for the actual quantity sold, and what it was.
The sales volume profit variance is the difference between the actual units sold and
the budgeted (planned) quantity, valued at the standard profit (under absorption
costing) or at the standard contribution (under marginal costing) per unit. In other
words, it measures the increase or decrease in standard profit as a result of the
sales volume being higher or lower than budgeted (planned).
The direct material total variance can be subdivided into the direct material price
variance and the direct material usage variance.
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Total Materials Variance
The direct material total variance is the difference between what the output actually
cost and what it should have cost, in terms of material.
282
The direct material price variance calculates the difference between the standard
cost and the actual cost for the actual quantity of material used or purchased. In
other words, it is the difference between what the material did cost and what it
should have cost.
The direct material usage variance is the difference between the standard quantity of
materials that should have been used for the number of units actually produced, and
the actual quantity of materials used, valued at the standard cost per unit of material.
In other words, it is the difference between how much material should have been
used and how much material was used, valued at standard cost.
The total labour variance can be subdivided between labour rate variance and labour
efficiency variance.
283
Total Labour Variance
The direct labour total variance = Actual units should have cost $x
Actual units did cost $x
Direct Labour Total Variance $ x (F/A)
The direct labour rate variance = Actual hrs should have cost $x
Actual hrs did cost $x
Direct Labour Rate Variance $ x (F/A)
The direct labour total variance is the difference between what the output should
have cost and what it did cost, in terms of labour.
The direct labour rate variance is the difference between the standard cost and the
actual cost for the actual number of hours paid for. In other words, it is the difference
between what the labour did cost and what it should have cost.
284
The direct labour efficiency variance is the difference between the hours that should
have been worked for the number of units actually produced, and the actual number
of hours worked, valued at the standard rate per hour. In other words, it is the
difference between how many hours should have been worked and how many hours
were worked, valued at the standard rate per hour.
The variable production overhead total variance can be subdivided into the variable
production overhead expenditure variance and the variable production overhead
efficiency variance (based on actual hours).
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Total Variable Overhead Variance
Variable overhead efficiency variance Actual units should have taken X hrs
Actual units did take X hrs
Efficiency Variance in hrs X hrs (F/A)
x standard rate per hr $x
Efficiency Variance in $ $x (F/A)
The variable production overhead expenditure variance is the difference between the
amount of variable production overhead that should have been incurred in the actual
hours actively worked, and the actual amount of variable production overhead
incurred.
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The variable production overhead efficiency variance is exactly the same in hours as
the direct labour efficiency variance, but priced at the variable production overhead
rate per hour.
The fixed production overhead total variance can be subdivided into an expenditure
variance and a volume variance. The fixed production overhead volume variance
can be further subdivided into an efficiency and capacity variance.
287
Total Fixed Overhead Variance
288
The volume efficiency variance is calculated in the same way as the labour efficiency
variance.
Fixed overhead vol efficiency variance actual units should have taken x hrs
Actual units did take x hrs
Vol Efficiency Variance in hrs x hrs (F/A)
x standard OAR rate per hr $x
Vol Efficiency Variance in $ $x (F/A)
The volume capacity variance is the difference between the budgeted hours of work and the
actual active hours of work (excluding any idle time).
Fixed overhead total variance is the difference between fixed overhead incurred and
fixed overhead absorbed. In other words, it is the under– or over-absorbed fixed
overhead.
Fixed overhead expenditure variance is the difference between the budgeted fixed
overhead expenditure and actual fixed overhead expenditure.
Fixed overhead volume variance is the difference between actual and budgeted
(planned) volume multiplied by the standard absorption rate per unit.
Fixed overhead efficiency variance is the difference between the number of hours
that actual production should have taken, and the number of hours actually taken
(that is, worked) multiplied by the standard absorption rate per hour.
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Variance Favourable Adverse
Fixed overhead Savings in costs incurred Increase in cost of services used
Expenditure Changes in prices relating to fixed Excessive use of services
overhead expenditure Change in type of services used
Fixed overhead volume Labour force working more efficiently Labour force working less efficiently
Efficiency Lost production through strike
Fixed overhead volume Labour force working overtime Machine breakdown, strikes, labour
Capacity Shortages
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20.15 ACCA SYLLABUS GUIDE OUTCOME 15:
Reconcile budgeted profit or contribution with actual profit or contribution
under standard marginal costing
The main differences between absorption and marginal costing operating statements
are: -
1. The marginal costing operating statement has a sales volume variance that is
calculated using the standard contribution per unit (rather than a standard
profit per unit as in absorption costing)
2. There is no fixed overhead volume variance
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20.16 ACCA SYLLABUS GUIDE OUTCOME 16:
Calculate actual or standard figures where the variances are given
Variances can be used to derive actual data from standard cost details.
Rather than being given actual data and asked to calculate the variances, you may
be given the variances and required to calculate the actual data on which they were
based.
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20.17 ACCA SYLLABUS GUIDE OUTCOME 17:
Explain factors to consider before investigating variances
2. Materiality. The size of the variance may indicate the scale of the problem and
the potential benefits arising from its correction.
4. The inherent variability of the cost or revenue. Some costs, by nature, are quite
volatile (oil prices, for example) and variances would therefore not be surprising.
Other costs, such as labour rates, are far more stable and even a small variance
may indicate a problem.
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8. Costs and benefits of correction. If the cost of correcting the problem is likely
to be higher than the benefit, then there is little point in investigating further.
The control action which may be taken will depend on the reason why the variance
occurred.
The variance may be a result of a measurement error, e.g. wastage has been
unrecorded, scales have been misread or employees may adjust their records to
‘improve’ their performance. Control action is required to improve the accuracy of
the recording system so that measurement errors do not occur.
Spoilage and wastage will both negatively affect the efficiency of operations. It is
important to highlight the cause of the inefficiency that will lead to control action to
eliminate the efficiency being repeated.
294
295
Illustration 112
Its budgeted contribution for the last month was $20,000. The actual contribution for
the month was $15,000, and the following variances have been calculated:
A. $9,000 adverse
B. $9,000 favourable
C. $12,000 adverse
D. $12,000 favourable
The total variance between budgeted contribution and actual contribution is $5,000
adverse ($20,000 - $15,000). The sales volume and sales price variances sum to
$4,000 favourable (5,000 A – 9,000 F), so to balance, the variable cost variance
must be $9,000 adverse.
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Illustration 213
A. $25,000
B. $26,000
C. $28,000
D. $29,000
Add back adverse variances and deduct favourable variances to actual profit to
arrive at budgeted profit.
Avoid double-counting: -
The fixed overhead volume variance ($3,000F is equal to the sum of the fixed
overhead capacity variance ($4,000 F) and the fixed overhead efficiency variance
($1,000 A), so it is important not to include all three and only to deduct $3,000 not
$6,000.
Hence,
Actual profit 27,000
Add Sales price variance 5,000
Less Fixed overhead volume variance 3,000
Budgeted profit 29,000
297
298
1. Standard Cost
i. Basic standards
ii. Ideal standards
iii. Attainable standards
iv. Current standards
2. Variance
When actual results are better than expected results, we have a favourable
variance (F). If, on the other hand, actual results are worse than expected results,
we have an adverse variance (A).
3. Sales Variances
The sales price variance = Actual units should have sold for $ x
Actual units did sell $x
Sales Price Variance $ x (F/A)
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The sales volume variance = Budgeted sales volume x units
(marginal costing) Actual sales volume x units
Sales Volume Variance in units x units (F/A)
x standard contribution per unit $x
Sales Volume Variance in $ $x (F/A)
4. Materials Variances
The direct material total variance = actual units should have cost $x
actual units did cost $x
Direct Material Total Variance $ x (F/A)
The direct material price variance = actual kgs should have cost $x
actual kgs did cost $x
Direct Material Price Variance $ x (F/A)
The direct material usage variance = Actual units should have used x kgs
Actual units did use x kgs
Usage Variance in kgs x kgs (F/A)
x standard cost per kg $x
Usage Variance in $ $x (F/A)
5. Labour Variances
The direct labour total variance = Actual units should have cost $x
Actual units did cost $x
Direct Labour Total Variance $ x (F/A)
The direct labour rate variance = Actual hrs should have cost $x
Actual hrs did cost $x
Direct Labour Rate Variance $ x (F/A)
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The direct labour efficiency variance = Actual units should have taken x hrs
Actual units did take x hrs
Efficiency Variance in hrs x hrs (F/A)
x standard rate per hr $x
Efficiency Variance in $ $x (F/A)
Variable overhead efficiency variance = Actual units should have taken X hrs
Actual units did take X hrs
Efficiency Variance in hrs X hrs (F/A)
x standard rate per hr $x
Efficiency Variance in $ $x (F/A)
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Fixed overhead volume variance = actual units produced x units
budgeted units produced x units
Volume Variance in units x units (F/A)
x standard rate per unit $x
Volume Variance in $ $x (F/A)
The volume efficiency variance is calculated in the same way as the labour efficiency
variance.
Fixed overhead vol efficiency variance = actual units should have taken x hrs
Actual units did take x hrs
Vol Efficiency Variance in hrs x hrs (F/A)
x standard OAR rate per hr $x
Vol Efficiency Variance in $ $x (F/A)
The volume capacity variance is the difference between the budgeted hours of work and the
actual active hours of work (excluding any idle time).
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8. Operating Statement – Absorption Costing
The main differences between absorption and marginal costing operating statements
are: -
1. The marginal costing operating statement has a sales volume variance that is
calculated using the standard contribution per unit (rather than a standard
profit per unit as in absorption costing)
2. There is no fixed overhead volume variance
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Operating Statement for the period ending …….(under Marginal Costing)
$
Budgeted contribution x
Sales Volume Variance x F
Sales Price Variance (x) A
x
Cost Variances $F $A
Materials Price x
Usage X
Labour Rate X
Idle x
Efficiency X
Variable Overheads Expenditure X
Efficiency X
X x (x) A
Actual Contribution x
Fixed Overheads
Budgeted Fixed Overhead x
Expenditure Variance x
Actual Fixed Overheads (x)
Actual Profit X
304
305
Chapter 21
SPREADSHEETS
21.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Explain the role and features of a computer spreadsheet system
A spreadsheet is a computer package which is divided into rows and columns. The
intersection of a row and a column is known as a cell.
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Cell contents
307
21.1.2 Formula bar
The formula bar allows you to see and edit the contents of the active cell. The bar
also shows the cell address of the active cell.
All Excel formulae start with the equals sign =, followed by the elements to be
calculated (the operands) and the calculation operators. Each operand can be a
value that does not change (a constant value), a cell or range reference, a label, a
name, or a worksheet function.
Formulae can be used to perform a variety of calculations. Here are some examples:
-
1. =C4*5. This formula multiplies the value in C4 by 5. The result will appear in the
cell holding the formula.
4. =C4*B10-D1. This multiplies the value in C4 by that in B10 and then subtracts
the value in D1 from the result.
Note that generally Excel will perform multiplication and division before addition or
subtraction
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5. =C4*117.5%. This adds 17.5% to the value in C4, for example in sales tax.
6. = (C4+C5+C6)/3. Note that the brackets mean Excel would perform the addition
first.
Without the brackets, Excel would first divide the value in C6 by 3 and then add
the result to the total of the values in C4 and C5.
1. 2^2 gives you 2 to the power of 2, in other words 22. Likewise = 2^3 gives you 2
cubed and so on.
2. = 4^ (1/2) gives you the square root of 4. Likewise 27^(1/3) gives you the cube
root of 27 and so on.
In Excel, the standard toolbar has a button Σ that simplifies adding a column or row
of numbers. When you click the AutoSum button, Excel creates a sum function for
the column of numbers directly above or the row of numbers to the left. Excel pastes
the SUM( ) function and the range to sum into the formula bar.
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21.2 ACCA SYLLABUS GUIDE OUTCOME 2:
Identify applications for computer spreadsheets and their use in cost and
management accounting
For example, the spreadsheet above has been set up to calculate the totals
automatically. If you changed your estimate of sales for one of the departments, the
totals will change automatically.
Spreadsheets can be used for a wide range of tasks due to its ability to manipulate a
large amount of data very quickly to answer ‘what-if’questions.. Some common
applications of spreadsheets are:
Management accounts
Cash flow analysis and forecasting
Reconciliations
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Revenue analysis and comparison
Cost analysis and comparison
Budgets and forecasts
‘What if?’ analysis / sensitivity analysis
1. since formulae are hidden, the underlying logic of a set of calculations may
not be obvious.
2. a high proportion of large models contain errors
3. a database may be more suitable to use with large volumes of data
Lecture Example 2
311
312
313
1. What is a spreadsheet?
2. Cell contents
3. Uses of spreadsheets
314
+ Closing inventory – opening Inventory
315
Chapter 22
PERFORMANCE MEASUREMENT
22.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Discuss the purpose of mission statements and their role in performance
measurement
Discuss the purpose of strategic and operational and tactical objectives and
their role in performance measurement
A mission statement contains the overall goals and objectives of the organisation
which are not time specific and not quantified, i.e. what the organization should be
doing in the longer term and how it should go about doing it. Mission statements
often include the following information:
Strategic objectives are often the responsibility of the senior management and will be
measured by indicators that reflect the performance of the whole organisation, e.g.
ROI, net profit %.
Tactical objectives are often the responsibility of middle management and measures
may be used that summarise the performance of a department or division, e.g.
actual profit compared to budget produced monthly.
Operational objectives are often concerned with the day-to-day running of the
organisation and are often physical measures, e.g. quantity of rejects, number of
customer complaints produced daily.
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Corporate and unit objectives
Corporate objectives concern the firm as a whole; e.g. profitability, market share,
customer satisfaction quality.
Unit objectives are specific to individual units of an organisation, e.g. increase the
number of customers by x%; reduce the number of rejects by x%, respond more quickly
to calls (especially in the case o hospital ambulance service, local police, and
firemen).
Some objectives are more important than others. Secondary objectives should
combine to ensure the achievement of the primary corporate goals.
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22.2 ACCA SYLLABUS GUIDE OUTCOME 2:
Discuss the impact of economic and market conditions on performance
measurement
Explain the impact of government regulation on performance measurement
General economic conditions influence the demand and supply for a company’s
products. Government economic policy affects demand quite rapidly. Changes in
interest rates are determined largely by government policy and have a direct effect
on credit sales.
Market conditions
Government regulation
a. The government may raise the taxes on sales and profits and this will surely
affect demand
b. It may provide funds towards new investment and may offer tax incentives
c. It will influence business through the different legislation, e.g. companies act,
employment law, consumer protection rights
d. The government’s economic policy will affect business activity, e.g. interest
rates (mentioned above), inflation, economic growth.
A key aspect of performance measurement is ratio analysis. Ratios are of little use in
isolation. Firms can use ratio analysis to compare: -
318
1. budgets, for control purposes
2. last year’s figures to identify trends
3. competitors’ results and/or industry averages to assess performance
Capital employed is defined as total assets less current liabilities or share capital and
reserves plus non-current liabilities. It is important to exclude all assets of a non-
operational nature, e.g. trade investments and intangible assets such as goodwill.
Profit before interest and tax (operating profit) represents the profit available to pay
interest to debt investors and dividends to shareholders. If we wish to calculate
return on ordinary shareholders funds (the return to equity holders), we would use
profit after interest and tax divided by total equity14.
ROCE represents the percentage of profit being earned on the total capital
employed; and relates profit to capital invested in the business. Capital invested in a
corporate entity is only available at a cost – corporate bonds or loan stock finance
generate interest payments and finance from shareholders requires either immediate
payment of dividends or the expectation of higher dividends in the future.
ROCE rewards investors for the risks they are taking by investing in the company. The
higher the ROCE figure, the better it is for investors. It should be compared with returns
on offer to investors on alternative investments of a similar risk.15
The primary ratio measuring overall return is analysed in more detail by using
secondary ratios:
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Asset turnover
Return on sales
Good performance is often explained by costs not being controlled and selling
prices being high. It looks at profits after charging non-production overheads.
The trading activities of a business can be analysed using the gross profit margin.
When particular areas of weakness are found, subsidiary ratios are worked out: -
The asset turnover indicates how well the assets of a business are being used to
generate sales or how effectively management have utilised the total investment in
generating income.
The higher the asset turnover the better but do watch out for the problems caused by
overtrading, i.e. operating the business at a level not sustainable by its capital
employed.
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22.3.2 Measuring Liquidity
Liquidity is the ability of an organization to pay its debts when they fall due. There
are two main measures of liquidity: -
If current assets exceed current liabilities then the ratio will be greater than 1 and
indicates that a business has sufficient current assets to cover demands from
creditors.
321
A very high current ratio could indicate that a company is too liquid. Hence this is
not necessarily good as cash is an ‘idle asset as it earns no return. The company
can make use of cheap short-term finance.
Inventory often takes a long time to convert into cash. Hence inventory often takes a
long time to convert into cash. If this ratio is 1:1 or more, then clearly the company is
unlikely to have liquidity problems. If the ratio is less than 1:1 we would need to analyse
the structure of current liabilities, to those falling due immediately and those due at a
later date.
In practice, a company’s current ratio and acid test should be taken into account with
the company’s operating cashflow. A healthy cashflow often compensates for weak
liquidity ratios.
This is an indicator of the effectiveness of the company’s credit control systems and
policy. The faster the money is collected, the better for liquidity purposes. Usually, the
longer customers are given to pay their dues, the higher the level of bad debts. But, on
the other hand, if customers are pressured to pay quickly, the company may find it hard
to generate sales.
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22.3.3.2 Accounts payable payment period
The creditor days is a measure of how much credit, on average, is taken from
suppliers. Long payment periods are good for the customer as they increase liquidity.
However, they may damage the relationship with suppliers.
It is expressed as:
Cost of sales
For how long does a company carry inventory before it is sold? This is expressed
as:
The shorter the period the better for liquidity purposes as less cash is tied up in
inventory. The holding period may increase because of: -
Too little inventory may result in stoppages in production and inability to satisfy
customers’ demand.
The working capital period identifies how long it takes to convert the purchase of
inventories into cash from sales.
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22.3.4 Measuring Risk
22.3.4.1 Gearing/leverage
Long-Term Debt x
100% Long-term Debt + Equity
If the firm has excessive debt, then the need to pay interest before dividends will
increase the risks faced by shareholders if profits fall. Remember that interest and
capital repayments are legal obligations and must be met if the company is to avoid
insolvency. The payment of equity dividend is a legal obligation. Despite its risks,
borrowed capital is attractive to companies as lenders accept a lower rate of return
than equity investors due to their secured positions. Also interest payments, unlike
equity dividends, are tax deductible.16
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22.3.4.2 Interest Cover / income gearing
This ratio represents the number of times that interest could be paid out of profit
before interest and tax. The higher the figure, the more likely a company is to be able
to meet is interest payments. If the ratio is more than 4, it is usually considered to be
safe.
On the other hand, non-financial indicators can provide managers with incentives to
improve long-term financial performance. For example, if customer satisfaction is
325
low, this could imply that sales demand will fall in the future and this will have a
negative effect on profits.
In recent years, the trend in performance measurement has been towards a broader
view of performance, covering both financial and non-financial indicators. The most
well-known of these approaches is the balanced scorecard proposed by Kaplan
and Norton.
The scorecard contains four key groupings of performance measures. These four
groupings, called ‘perspectives’, were considered sufficient to track the key drivers of
both current and future financial performance of the firm. The perspectives focused
on the achievements of the firm in four areas: -
2. The customer perspective focuses on the question, what must the firm do to
satisfy its customers so as to achieve its financial objectives?
Outcome measures for the customer perspective generally include measures
of customer satisfaction, market share, customer retention and customer
profitability. These outcome measures can be sub-divided into driver
measures, such as measures relating to lead times, on-time delivery, product
quality and product cost.
3. The internal business perspective considers the question, what must the
firm do well internally in order to support the product/market strategy and to
achieve its financial objectives? Typical outcome measures include those
relating to innovation (product and process) and operations (cycle times, defect
rates).
4. In the learning and growth perspective, the measures focus on the question
what infrastructure must the firm build to create long-term growth and
improvement? In other words, what capabilities must be improved or acquired
to achieve the long-term targets for the customer and internal business
process perspectives? Outcome measures may include metrics on employee
satisfaction, training and retention.
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The balanced scorecard approach to performance measurement offers several
advantages:
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22.4.2 Critical Success Factors and Key Performance Indicators
specific
measurable (i.e. be capable of having a measure placed upon it, for example,
number of customer complaints rather than the 'level of customer satisfaction')
relevant, in that they measure achievement of a critical success factor.
The following table demonstrates critical success factors and key performance
indicators of a college training ACCA students.
The main difficulty with the balanced scorecard approach is setting standards for
each of the KPIs. This can prove difficult where the organisation has no previous
experience of performance measurement. Benchmarking with other organisations is
a possible solution to this problem.
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329
22.5 ACCA SYLLABUS GUIDE OUTCOME 5:
Describe performance measures which would be suitable in contract and
process costing environments
In view of the large scale of many contracting operations, cost control is very
important.
Effectively, the level of profit being earned on the contract can be checked as each
architect or quantity surveyor’s certificate is received.
Accounting standards only allow revenue and contract costs to be recognised when
the outcome of the contract can be predicted with reasonable certainty. This means
that it should be probable that the economic benefit attached to the contract will flow
to the entity.
330
If a loss is calculated, then the entire loss should be recognised immediately. If a
profit is estimated, then revenue and costs should be recognised according to the
stage that the project has completed.
2. Cost method
Illustration
$
Contract Price 1,000
Estimated total costs 800
Costs to date 600
Agreed value of work done 700
Progress billings invoiced 600
Stage of Completion
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Cost method
In addition, inventory levels and cost targets would be monitored as well as any
bottlenecks identified and removed.
In recent years, the service sector has grown in importance. Banks, accountancy
and consultancy firms, transport companies have all increased. We shall consider six
main aspects of performance in relation to service organisations: -
1. Financial performance
2. Competitive performance
3. Service quality
4. Flexibility
5. Resource utilization
6. innovation
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1. Financial Performance
Because it is difficult to trace many common costs to different units of output and
because of the high level of stepped fixed costs, detailed financial ratio analysis is of
limited use.
2. Competitive Performance
3. Service Quality
333
4. Flexibility
5. Resource Utilization
6. Innovation
Innovation can be measured in terms of how much it costs to develop a new service,
how effective the process is and how quickly it can develop new services. Hence, we
can calculate the proportion of new services to the total services provided or the time
between identification of a new service and making it available.
a) Cost
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b) Quality
c) Time
d) Innovation
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22.7 ACCA SYLLABUS GUIDE OUTCOME 7:
Discuss the meaning of each of the efficiency, capacity and activity ratios
Calculate the efficiency, capacity and activity ratios in a specific situation
As mentioned in Section 8.6, the following are the three main control ratios for
measuring performance in manufacturing businesses: -
The efficiency ratio measures the performance of the workforce by comparing the
actual time taken to do a job with the expected time.
Efficiency Ratio =
Expected hours to produce output x 100%
Actual hours to produce output
The capacity ratio measures the number of hours spent actively working as a
percentage of the total hours available for work.
Capacity Ratio =
Number of hours actively spent working x
100% Total hours available
The activity ratio compares the number of hours expected to be worked to produce
actual output with the total hours available for work.
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22.8 ACCA SYLLABUS GUIDE OUTCOME 8:
Discuss measures that may be used to assess managerial performance and
the practical problems involved
The personal performance of the manager is not the same as the overall
performance of the responsibility centre he/she manages due to external factors
which are outside of the control of the organization. Hence measures which reflect
the performance of the unit as a whole may not reflect the performance of the
manager.
1. use measures based on controllable costs and revenue e.g. variance analysis in
cost and revenue centres
2. set specific managerial objectives against which performance can be measured
at regular intervals
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In investment centres, divisional performance is measured using: -
1. Internal benchmarks
Comparisons between different departments or functions within an organization
2. Competitive benchmarks
Comparisons with competitors in the business sector through techniques e.g.
reverse engineering (buying a competitor’s product and dismantling it to
understand its content and configuration)
4. Strategic benchmarks
A type of competitive benchmarking aimed at strategic action and organizational
change
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22.9.2 The Benchmarking Process
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22.10 ACCA SYLLABUS GUIDE OUTCOME 10:
Produce reports highlighting key areas for management attention and
recommendations for improvement
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1. Mission Statement
2. Objectives
Strategic objectives are often the responsibility of the senior management and
will be measured by indicators that reflect the performance of the whole
organisation
Tactical objectives are often the responsibility of middle management and
measures may be used that summarise the performance of a department or
division
Operational objectives are often concerned with the day-to-day running of the
organisation and are often physical measures
Mission Statement
Strategic Objectives
Critical Success
Factors
3. Measuring Profitability
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Turnover
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Gross Profit Margin = Gross Profit x 100
Turnover
4. Measuring Liquidity
5. Measuring Efficiency
6. Measuring Risk
7. Balanced Scorecard
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The financial perspective concentrates on how the firm appears to its
shareholders and considers what the firm’s financial objectives are.
The customer perspective focuses on the question, what must the
firm do to satisfy its customers so as to achieve its financial objectives?
The internal business perspective considers the question, what must
the firm do well internally in order to support the product/market
strategy and to achieve its financial objectives?
In the learning and growth perspective, the measures focus on the
question what infrastructure must the firm build to create long-term
growth and improvement?
9. Contract Costing
Six dimensions: -
Financial performance
Competitive performance
Service quality
Flexibility
Resource utilization
Innovation
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12. Manufacturing Sector
Cost
Quality
Time
Innovation
Production volume/activity
Efficiency ratio x Capacity ratio = ratio
14. Benchmarking
1. Internal benchmarks
Comparisons between different departments or functions within an
organization
2. Competitive benchmarks
Comparisons with competitors in the business sector
3. Functional benchmarks
Comparisons with organisations with similar core activities and practices
4. Strategic benchmarks
A type of competitive benchmarking aimed at strategic action and
organizational change
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Chapter 23
ECONOMY, EFFICIENCY AND
EFFECTIVENESS
A not-for-profit organisation is ‘… an organisation whose attainment of its prime goal
is not assessed by economic measures. However, in pursuit of that goal it may
undertake profit-making activities.’ (Bois); for example charities, statutory bodies
offering public transport or the provision of services such as leisure, health or public
utilities such as water or road maintenance.
In not for profit organisations, performance is judged in terms of inputs and outputs
and hence the value for money criteria of economy, efficiency and
effectiveness.
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23.1.2 Indicators to assess overall performance
1. Effectiveness
Financial indicators
Non-financial indicators
a. Workplace morale
b. Staff attitude to dealing with the public
c. Client satisfaction in the service being provided
2. Efficiency
3. Economy
A-value-for-money (VFM) audit will look also at the economy of the use of resources,
for e.g. in the case of state education, it will look into the cost wages of school
teachers, the cost of books, equipment.
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Which of the three Es best describes the above measure?
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1. Not-For-Profit Organisation
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Chapter 24
RETURN ON INVESTMENT AND
RESIDUAL INCOME
Decentralisation is the delegation of decision-making responsibility. Decentralisation
is a necessary response to the increasing complexity of the environment that
organisations face and the increasing size of most organisations.
Illustration 1
In 2011 a division’s controllable return on investment was 25% and its controllable
profit was $80,000. The cost of capital was 18% per annum.
What was the division’s controllable residual income in the last year?
$80,000 = 25%
Capital Employed
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Capital Employed = 80,000 = $320,000
25%
Profit 80,000
Imputed Interest (320 x 18%) 57,600
Residual Income 22,400
Lecture Example 1
Division X is a division of XYZ plc. Its net assets are currently $10m and it earns a
profit of $2.2m per annum. Division X's cost of capital is 10% per annum. The division
is considering two proposals.
Proposal 1 involves investing a further $1m in fixed assets to earn an annual profit of
$0.15m.
Proposal 2 involves the disposal of assets at their net book value of $2.3m. This
would lead to a reduction in profits of $0.3m.
Proceeds from the disposal of assets would be credited to head office not Division X.
Required:
Calculate the current ROI and residual income for Division X and show how
they would change under each of the two proposals.
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3. the measure may be distorted by inflation as historical cost accounts do not
reflect the current value of the assets
4. ROI may discourage investment and re-equipment in more technologically up to
date assets. Old assets, almost fully depreciated, will give a low asset base in the
ROI calculation, which will result in an increased figure for ROI and give the
impression of an improved level of performance
5. ROI may lead managers to take decisions which are to their advantage but
which do not benefit the organization as a whole - it leads to dysfunctional
behaviour
24.2.3 Advantages of RI
1. investment centre managers see the imputed interest charge – this makes them
aware of the financial implications of their investment decisions
2. RI should avoid dysfunctional decision making – it ensures decisions are taken
which benefit both the investment centre and the company or group as whole –
goal congruency
24.2.4 Disadvantages of RI
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1. Decentralisation
3. Residual income
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Chapter 25
COST REDUCTIONS AND
VALUE ENHANCEMENT
25.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Compare cost control and cost reduction
Cost control essentially involves the setting of targets for cost centre managers and
then monitoring performance against those targets.
Cost reduction is the reduction in unit cost of goods or services without impairing
suitability for the use intended, i.e. without reducing value to the customer. Hence, it
looks at methods of improving profitability by reducing costs without necessarily
increasing prices.
This relates to a policy of reducing the variety ad range of materials and components
purchased by the manufacturer and of components produced.
Its advantages are: -
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i. The manufacturer can buy or make large quantities, hence gaining the benefit
of reduced unit cost
i. Having proved the efficiency of a material or component, the manufacturer
knows that the quality and content will not change
ii. Inventory control will be easier as there is a reduction in variety
iv. Better service can be provided to customers in the provision of spare parts
v. Less time will be needed to train operatives who handle the component
i. If there is only one supplier of the material or component, the manufacturer will
be at risk if supplies are interrupted
i. There may be restriction on the design of a new model if the manufacturer
wishes to continue the policy for economic reasons
ii. For the same reason, a standard component may be used in one model when
it would be better technically if a special component was used.
2. Standardisation of product
This refers to the production of articles to the same standard, or a range of products
each of which is standardised, e.g. a particular model of a car may be available in
different colours but apart from this, the cars are identical.
i. The manufacturer derives the benefit of long runs of production with reduced
unit cost
i. Tooling is simpler because it is geared to one method of production
ii. Mechanization can be extensive because of the uniformity of the production
method
iv. The consequent buying of large amounts of the same materials and parts
results in a reduction of unit cost
v. Production management is simpler, being confined to standard processes
vi. Less training of operatives is required because the processes do not change
vii. There are fewer demands on the design staff
viii. Inspection costs are low
ix. Customers know they are buying a proven product and that the quality will not
change
i. the manufacturer may feel safe in doing what he knows best and may become
complacent about the success of the product, so that when the product faces
new competition or the public becomes disloyal, he is too slow to recognise it
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i. if the product has to be altered, then equipment, technical knowledge and
managerial experience may be too fixed to adapt successfully
Method study is the systematic recording and critical examination of existing and
proposed ways of doing work in order to develop and apply easier and more
effective methods, and reduce costs.
Work measurement involves establishing the time for a qualified worker to carry out
a specified job at a specified level of performance.
A cost reduction team can be used to identify scope for achieving cost reductions but
it is important that costs saved do not outweigh the costs of the team itself.
A cost reduction scheme will also bring about changes. These changes may harm
morale and upset the proper working of departments. Hence, a cost reduction
scheme should have a definite start and finish and should incorporate well-defined
targets.
17 Valueengineering – design the best possible value at the lowest possible cost: focus is on the
design stage
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25.3 ACCA SYLLABUS GUIDE OUTCOME 3:
Describe and evaluate value analysis
Value analysis is a form of cost reduction. Hence, it examines the factors affecting
the cost of a product or service, in order to devise means of achieving the specified
purpose most economically at the required standard of quality and reliability. Are
customers willing to pay for upholstery which is relatively expensive for the
manufacturer to buy? If customers would pay the same price for a car produced with
cheaper upholstery, the company will modify the specification.
Step 1: establish the precise requirements of the customer for a particular product or
service. Hence the manufacturer can establish whether each function incorporated
into the product contributes some value to it.
Step 2: Establish and evaluate alternative ways of achieving the requirements of the
customers. The least cost alternative should be selected.
Step 5: Evaluate feedback from new proposals to establish the benefits from the
change.
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3. Economic and financial benefits arise from the elimination of unnecessary
complexity and the better use of resources.
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1. Cost Control
Cost control involves the setting of targets for cost centre managers and then
monitoring performance against those targets.
2. Cost Reduction
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3.
Cost reduction is the reduction in unit cost of goods or services without
impairing suitability for the use intended, i.e. without reducing value to the
customer.
5. Value Analysis
Value analysis is a form of cost reduction. Hence, it examines the factors
affecting the cost of a product or service, in order to devise means of
achieving the specified purpose most economically at the required standard of
quality and reliability.
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