Ebook Diploma in business management: Managerial accounting - Part 1

Ebook Diploma in business management: Managerial accounting - Part 1 include all of the following unit: Unit1 management accounting and information, unit 2 cost categorisation and classification, unit 3 direct and indirect costs, unit 4 absorption costing, unit 5 marginal costing, unit 6 activity-based and other modern costing methods, unit 7 product costing, unit 8 cost-volume-profit analysis.

Business Management Study Manuals Diploma in Business Management MANAGERIAL ACCOUNTING The Association of Business Executives 5th Floor, CI Tower  St Georges Square  High Street  New Malden Surrey KT3 4TE  United Kingdom Tel: + 44(0)20 8329 2930  Fax: + 44(0)20 8329 2945 E-mail: info@abeuk.com  www.abeuk.com © Copyright, 2008 The Association of Business Executives (ABE) and RRC Business Training All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form, or by any means, electronic, electrostatic, mechanical, photocopied or otherwise, without the express permission in writing from The Association of Business Executives Diploma in Business Management MANAGERIAL ACCOUNTING Contents Unit Title Page Management Accounting and Information Introduction Management Accounting Information Collection and Measurement of Information Information for Strategic, Operational and Management Control Information for Decision Making 2 11 14 Cost Categorisation and Classification Introduction Accounting Concepts and Classifications Categorising Cost to Aid Decision Making and Control Management Responsibility Levels Cost Units Cost Codes Patterns of Cost Behaviour Influences on Activity Levels Numerical Example of Cost Behaviour 17 19 20 23 32 33 34 35 39 39 Direct and Indirect Costs Introduction Material Costs Labour Costs Decision Making and Direct Costs Overhead and Overhead C 41 42 42 45 50 51 Absorption Costing Introduction Definition and Mechanics of Absorption Costing Cost Allocation Cost Apportionment Overhead Absorption Under and Over Absorption of Overheads Treatment of Administration and Selling and Distribution Overhead Uses of Absorption Costing 53 54 54 55 56 60 65 67 69 Marginal Costing Introduction Definitions of Marginal Costing and Contribution Marginal Versus Absorption Costing Limitation of Absorption Costing Application of Marginal and Absorption Costing 75 76 76 79 82 85 Unit Title Page Activity-Based and Other Modern Costing Methods Introduction Activity-Based Costing (ABC) Just-in-Time (JIT) Manufacturing 99 100 100 114 Product Costing Introduction Costing Techniques and Costing Methods Job Costing Batch Costing Contract Costing Process Costing Treatment of Process Losses Work-In-Progress Valuation Joint Products and By-Products Other Process Costing Considerations 119 121 121 122 126 127 129 132 135 138 142 Cost-Volume-Profit Analysis Introduction The Concept of Break-Even Analysis Break-Even Charts (Cost-Volume-Profit Charts) The Profit/Volume Graph (or Profit Graph) Sensitivity Analysis 143 144 144 149 157 160 Planning and Decision Making Introduction The Principles of Decision Making Decision-Making Criteria Costing and Decision Making 167 168 168 173 175 10 Pricing Policies Introduction Fixing the Price Pricing Decisions Practical Pricing Strategies Further Aspects of Pricing Policy 183 184 184 184 187 195 11 Budgetary Control Introduction Definitions and Principles The Budgetary Process Budgetary Procedure Changes to the Budget Flexible Budgets Budgeting With Uncertainty Budget Problems and Methods to Overcome Them 199 201 201 205 210 221 222 226 229 Unit Title Page 12 Standard Costing Introduction Principles of Standard Costing Setting Standards The Standard Hour Measures of Capacity 235 236 236 238 245 246 13 Standard Costing Basic Variance Analysis Introduction Purpose of Variance Analysis Types of Variance Investigation of Variances Variance Interpretation Interdependence between Variances 249 250 250 253 257 263 264 14 Management of Working Capital Principles of Working Capital Management of Working Capital Components Dangers of Overtrading Preparation of Cash Budgets Cash Operating Cycle Practical Examples 267 268 269 272 272 273 276 15 Capital Investment Appraisal Introduction – The Investment Decision Payback Method Return on Investment Method Introduction to Discounted Cash Flow Methods The Two Basic DCF Methods Appendix: Present Values Tables 281 282 283 284 285 288 296 16 Presentation of Management Information Introduction Information for Management – General Principles Using Diagrams and Charts Using Ratios 301 302 302 306 310 Study Unit Management Accounting and Information Contents Page Introduction A Management Accounting Some Introductory Definitions Objectives of Management Accounting Setting Up a Management Accounting System The Effect of Management Style and Structure 2 4 B Information Information and Data Users of Information Characteristics of Useful Information 4 5 C Collection and Measurement of Information Sources of Information Relevancy Measuring Information Communicating Information Value of Information Quantitative and Qualitative Information Accuracy of Information Financial and Non-Financial Information 6 7 10 10 10 D Information for Strategic, Operational and Management Control Elements of Control Feedback Control Information 11 11 12 12 E Information for Decision Making 14 © ABE and RRC Management Accounting and Information INTRODUCTION We begin our study of this module with some definitions which will make clear what managerial or management accounting is, what it involves and what its objectives are A number of factors must be considered when setting up a management accounting system and the management style and structure of an organisation will affect the system which it creates Information is an important part of any such system and the study unit will go on to examine its various types and sources A MANAGEMENT ACCOUNTING Some Introductory Definitions The Chartered Institute of Management Accountants (CIMA) in its Official Terminology describes accounts as follows:  The classification and recording of actual transactions in monetary terms, and  The presentation and interpretation of these transactions in order to assess performance over a period and the financial position at a given date The American Accounting Association (AAA) supplies a slightly more succinct definition of accounting: " the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of information." Another way of saying this is that accounting provides information for managers to help them make good decisions Cost accounting is referred to in the CIMA Terminology as: "That part of management accounting which establishes budgets and standard costs and actual costs of operations, processes, departments or products and the analysis of variances, profitability or social use of funds The use of the term costing is not recommended." Management accounting is defined as: "The provision of information required by management for such purposes as: (1) formulation of policies; (2) planning and controlling the activities of the enterprise; (3) decision taking on alternative courses of action; (4) disclosure to those external to the entity (shareholders and others); (5) disclosure to employees; (6) safeguarding assets The above involves participation in management to ensure that there is effective: (a) formulation of plans to meet objectives (long-term planning); (b) formulation of short-term operation plans (budgeting/profit planning); © ABE and RRC Management Accounting and Information (c) recording of actual transactions (financial accounting and cost accounting); (d) corrective action to bring future actual transactions into line (financial control); (e) obtaining and controlling finance (treasurership); (f) reviewing and reporting on systems and operations (internal audit, management audit)." Financial accounting is referred to as: "That part of accounting which covers the classification and recording of actual transactions of an entity in monetary terms in accordance with established concepts, principles, accounting standards and legal requirements and presents as accurate a view as possible of the effect of those transactions over a period of time and at the end of that time." All three branches of accounting should be integrated into the company's reporting system  Financial accounting maintains a record of each transaction and helps control the company's assets and liabilities such as plant, equipment, stock, debtors and creditors It satisfies the legal and taxation requirements and also provides a direct input into the costing systems  Cost accounting analyses the financial data into more detail and provides a lot of the information used for control It also provides key data such as stock valuations and cost of sales which are fed back into the financial accounting system so that accounts can be finalised  Management accounting draws from the financial and cost accounting systems It uses all available information in order to advise management on matters such as cost control, pricing, investment decisions and planning Users of financial accounting are usually external – shareholders, the tax authorities etc Management Accounting users are internal – the managers at different levels Objectives of Management Accounting (a) Planning: all organisations should plan ahead in order that they can set objectives and decide how they should meet them Planning can be short- or long-term and it is the role of the management accounting system to provide the information for what to sell, where and at what price Management accounting is also central to the budgetary process which we shall look at in more detail later (b) Control: production of the company's internal accounts, its management accounts, enables the firm to concentrate on achieving its objectives by identifying which areas are performing and which are not The use of management by exception reports enables control to be exercised where it is most useful (c) Organisation: there is a direct relationship between the organisational structure and the management accounting system It is often difficult to determine which has the greater effect on the other, but it is necessary that the management accounting system should produce the right information at the right cost at the right time, and the organisational structure should be such that immediate use is made of it (d) Communication: the existence of a budgetary and management accounting system is an important part of the communication process; plans are outlined to managers so that they are fully aware of what is required of them and the management accounts tell them whether or not the desired results are being achieved © ABE and RRC Management Accounting and Information (e) Motivation: more will be said about the motivational aspects of budgeting later, but suffice to say here that the targets included in any system should be set at such a level that managers and the people who work for them are motivated to achieve them (f) Decision Making: all businesses have to make decisions, may of which are short term like whether a component should be made or bought from an outside supplier, pricing and eliminating loss making activities Setting Up a Management Accounting System There are several factors which should be borne in mind when a system is being set up:  What information is required?  Who requires it?  How often is it required? Further thought will need to be given to such matters as:  What data is required to produce the information?  What are the sources of this data?  How should it be converted?  How often should it be converted? Finally, factors such as organisational structure, management style, cost and accuracy (and the trade-off between them) should also be taken into account The Effect of Management Style and Structure Theories of management style range from the autocratic at one end of the spectrum to the democratic at the other Which style a particular organisation uses very much affects the management accounts system With a democratic style for instance, it is likely that decision making is devolved further down the management structure and information provided will need to reflect this An autocratic style, by contrast, means that decision making is exercised at a higher level and therefore the necessary information to enable the function to be carried out will similarly be provided at this level also In addition, the management structure will also have an impact, a flat management structure will mean that a particular manager will need to be provided with a greater range of reports (e.g on sales, marketing, production matters, etc.) than in a company with a functional structure where reports are only required by a manager for his or her own function, such as sales Note that management structure is much more formalised than management style; it is possible for instance to have both democratic and autocratic managers within a particular management structure B INFORMATION Information and Data You need to read the following as background information to inform your study This section is not Management Accounting as such, but will give you a context for it's study Information can be distinguished from data in that the latter can be looked upon as facts and figures which not add to the ability to solve a problem or make a decision, whilst the former adds to knowledge If, for instance, a memo appears on a manager's desk with the figure "10,000" written on it, this is most certainly data but it is hardly information © ABE and RRC 152 Cost-Volume-Profit Analysis Break-Even Chart for More than One Product You will have noticed that a break-even chart can be drawn only for a single product, because of the assumptions of constant unit costs and revenues It is possible to draw a break-even chart for more than one product, if we can assume a constant product mix Even so, the break-even chart is not a very satisfactory form of presentation when we are concerned with more than one product; a better graph – the profit/volume graph – is discussed later Assumptions and Limitations of Break-Even Charts Apart from the above point about the difficulty of catering for more than one product, the following limitations should be borne in mind  Break-even charts are accurate only within fairly narrow levels of output It is unwise to extrapolate beyond the known range of data This is because if there were a substantial change in the level of output, the proportion of fixed costs could change  Even with only one product, the income line may not be straight A straight line implies that the manufacturer can sell any volume he likes at the same price This may well be untrue: if he wishes to sell more units, he might have to reduce the price Whether this increases or decreases his total income depends on the elasticity of demand for the product Therefore, the sales line may curve upwards or downwards – but, in practice, is unlikely to be straight  Similarly, we have assumed that variable costs have a straight-line relationship with level of output, i.e variable costs vary directly with output This might not be true For instance, the effect of diminishing returns might cause variable costs to increase beyond a certain level of output  Break-even charts hold good only for a limited time-span  Break-even charts assume that sales and production are matched This may not be so, and there may be a change in stocks which would affect profits if absorption costing is used Nevertheless, within these limitations a break-even chart can be a very useful tool Managers who are not well versed in accountancy will probably find it easier to understand a break-even chart than a calculation showing the break-even point © ABE and RRC Cost-Volume-Profit Analysis 153 Interpretation of Break-Even Charts The skeleton break-even chart in Figure 8.2 illustrates the margin of safety and angle of incidence Figure 8.2: Skeleton Break-Even Chart (a) Margin of Safety  Safety of Profit Level The margin of safety is a measure of how far sales can fall before a loss is incurred This can be easily read from a break-even chart, and it gives managers an idea of how 'safe' the profit level is – the larger the margin of safety, the less risk of incurring a loss if the sales volume is allowed to fall From Figure 8.2, you will see that the margin of safety is the difference between the actual output being achieved and the break-even point  Expressing Margin of Safety In Figure 8.1, the company had an actual output of 10,000 units and a breakeven point of 4,000 units Margin of safety may be expressed in any of the following ways: Margin of safety = 4,000 to 10,000 units, or = £16,000 sales to £40,000 sales, or = 40% to 100% of actual output, or = sales may fall by 60% before reaching break-even (b) Angle of Incidence The angle of incidence shows the rate at which profits increase once the break-even point is passed A large angle of incidence means a high rate of earning (also, it means that, if sales fell below break-even point, the loss would increase rapidly) This is also illustrated by the size of the profit and loss wedges © ABE and RRC 154 Cost-Volume-Profit Analysis Changes in Cost Structure If costs increase, the break-even point will be reached at a higher level of sales The breakeven chart in Figure 8.3 illustrates the effect of such changes Figure 8.3: Break-Even Chart and Cost Structure Extending Beyond the Known Range of Activity We have already mentioned that it is unwise to extrapolate beyond the known range of data with break-even charts A common error is to assume that, once break-even point has been passed, then any increase in output must lead to an increase in profit This may not be so – a second break-even point may be reached, beyond which losses will be incurred Figure 8.4 will help to demonstrate this: © ABE and RRC Cost-Volume-Profit Analysis 155 Figure 8.4: Second Break-Even Point  The first break-even point occurs at BEP1 but it would be wrong to assume that a profit will be made at any output above this level, because of the cost-behaviour patterns  At a level of output x, there is a step in the fixed costs (perhaps owing to an extra supervisor's salary), causing a corresponding step in the total cost line  At a level of output y, the angle of the sales line reduces sharply, possibly indicating that a discount is necessary to achieve the higher sales volume  A second point, BEP2, is reached, beyond which total costs exceed sales and, therefore, the assumption that any output above break-even point will produce profit is invalidated For this reason, break-even charts should be used only within the known range of data, and cost and revenue relationships should not be assumed to be valid outside this range This range of data for which the known costs and revenue behaviour patterns are valid is known as the relevant range © ABE and RRC 156 Cost-Volume-Profit Analysis Contribution Break-Even Chart A contribution break-even chart is an important improvement on the traditional break-even chart, since it is possible to read contribution direct from the chart Instead of commencing by measuring the fixed costs from the base line, the variable costs are taken The fixed costs are then shown above the variable costs, drawn parallel to the variable cost line Specimen Break-Even Chart Calculations and Construction Variable costs £2 per unit Fixed costs £80,000 Maximum sales £200,000 Selling price per unit £20 Prepare a contribution break-even chart (see Figure 8.5) Figure 8.5: Contribution Break-Even Chart © ABE and RRC Cost-Volume-Profit Analysis 157 C THE PROFIT/VOLUME GRAPH (OR PROFIT GRAPH) Profit and Activity Level With the traditional break-even chart, it is not easy to read from the chart the profit at any one level of activity The profit/volume graph (or profit graph) overcomes this problem, and it may be more easily understood by managers who are not trained in accountancy or statistics In this graph, the level of activity is plotted along the horizontal axis, against profit/loss on the vertical axis You need, therefore, to work out the profit before starting to plot the graph: Sales revenue  Variable cost = Fixed cost + Profit, or Profit = Sales revenue  Variable cost  Fixed cost, or Profit = Selling price Number of  per unit units sold – Variable cost Number of – Fixed cost, or  per unit units sold Profit = Contribution per unit  Number of units  Fixed cost (The form of the equation which is most convenient will depend on the presentation of the information in the particular question.) Drawing the Graph The general form of the graph is illustrated in Figure 8.6 Figure 8.6: Profit Graph (or Profit/Volume Graph) The distance A0 on the graph represents the amount of fixed cost, since, when no sales are made, there will be a loss equal to the fixed cost © ABE and RRC 158 Cost-Volume-Profit Analysis Specimen Profit/Volume Calculations and Graph Try this practical problem for yourself, using some graph paper if possible MC Ltd manufactures one product only, and, for the last accounting period, the firm has produced the simplified profit and loss statement shown below: Profit and Loss Statement £ Sales £ 300,000 Costs: Direct materials 60,000 Direct wages 40,000 Direct cost 100,000 Variable production overhead 10,000 Fixed production overhead 40,000 Fixed administration overhead 60,000 Variable selling overhead 40,000 Fixed selling overhead 20,000 270,000 £30,000 Net profit You need to construct a profit/volume graph, from which you can state the break-even point and the margin of safety You are again advised to adopt the suggested layout of £ Sales less Variable cost Contribution less Fixed costs Profit Answer £ Sales 300,000 less Variable cost 150,000 Contribution 150,000 less Fixed costs 120,000 Profit 30,000 When sales are nil the company will still have to pay its fixed costs It will therefore incur a loss of £120,000 This provides the first point (A) on the graph When sales are £300,000 there is a profit of £30,000 which provides the second point (B) on the graph © ABE and RRC Cost-Volume-Profit Analysis 159 60 Profit (£000) Margin of safety £60,000  B 40 20 100 200 300 Sales (£000) – 20 – 40 Loss (£000) BEP £240,000 – 60 – 80 – 100 – 120  A Figure 8.7: Profit/Volume Graph for MC Ltd Question for Practice The following information has been extracted from the books of XYZ Ltd XYZ Ltd £ £ Variable costs: Direct material 100,000 Direct labour 50,000 50% of production overhead 50,000 200,000 Fixed costs: Administration 100% 50% of production overhead Profit Sales revenue (80,000 units) 100,000 50,000 150,000* 50,000* 400,000  Note: Fixed costs (£150,000) + Profit (£50,000) = Contribution (£200,000) © ABE and RRC 160 Cost-Volume-Profit Analysis Prepare the following: (a) A break-even chart showing the break-even (B/E) point (in £ and units), and the margin of safety (b) Arithmetical calculations supporting the information required in (a) above Now check your answers with those provided at the end of the unit D SENSITIVITY ANALYSIS Sensitivity analysis involves adjusting one parameter at a time and measuring the effect that this has on the outcome Thus, in terms of break-even analysis, this could involve adjusting the sales price or volume, variable or fixed costs and seeing which has the greater effect on profit The objective is to find those parameters which are the most sensitive, i.e with the greatest relative influence, so that management can be made aware of them Example To illustrate the concept of sensitivity analysis, consider a firm which produces and sells one item which has a selling price of £6, variable cost of £4 and fixed costs of £700,000 per annum Expected sales volume is 400,000 units per annum Examine the sensitivity of each of these items If we assume a 5% movement on each item individually, we can compare how sensitive each parameter is The current profitability is: £ Sales (400,000  £6) 2,400,000 less Variable cost (400,000  £4) 1,600,000 Contribution 800,000 less Fixed costs 700,000 Profit 100,000 A 5% decrease in sales value would have the following effect: £ Sales (400,000  £5.70) 2,280,000 less Variable cost 1,600,000 Contribution 680,000 less Fixed costs 700,000 Profit (20,000) This shows that it has the effect of reducing profit by 120% © ABE and RRC Cost-Volume-Profit Analysis 161 Now consider a 5% increase in variable cost per unit: £ Sales 2,400,000 less Variable cost (400,000  £4.20) 1,680,000 Contribution 720,000 less Fixed costs 700,000 Profit 20,000 This results in an 80% decrease in profit Next let us review a 5% reduction in sales volume: £ Sales (380,000  £6) 2,280,000 less Variable cost (380,000  £4) 1,520,000 Contribution 760,000 less Fixed costs 700,000 Profit 60,000 This is a 40% reduction in profit Finally, consider a 5% increase in fixed cost: £ Contribution (as per original) 800,000 less Fixed costs (including 5% increase) 735,000 Profit 65,000 This is a 35% reduction in profit What these figures show, therefore, is that sales value is the most sensitive item in that a proportionate percentage change causes a disproportionate decrease in profit There is, however, a danger that too much could be read into the figures unless further investigation were to be carried out The decrease in sales value, for instance, may result in increased sales volumes which would partially offset any drop in profits The important thing to remember is that sensitivity is an indication to management of where potential problem areas may be, or, conversely, where improvements should be made which will yield greater results in terms of the effort put in © ABE and RRC 162 Cost-Volume-Profit Analysis Sensitivity Analysis and Break-Even Charts The effects of sensitivity analysis can also be shown using a B/E chart If we take the original example we considered and also show the effect of a decrease in sales revenue, we have a graphical picture of the change Figure 8.8 The original B/E point is £700,000 = 350,000 units £6  £4 The revised B/E point is £700,000 = 411,765 units £5.70  £4 In other words, an additional 61,765 units would need to be sold to achieve the break-even position, which represents an increase of 17.6% Recalculate the break-even point using the other changes outlined earlier to confirm that sales value is the most sensitive item Note that changes in relative costs and sales value will alter the slope of the line P/V charts can also be sensitised but in this instance the slope does not alter Instead, the intersection of the lines will change and hence the B/E point will change also © ABE and RRC Cost-Volume-Profit Analysis 163 ANSWERS TO QUESTIONS FOR PRACTICE Question (a) The sales volume is 400,000 units (£4m divided by £10 per unit) Because it is easier to work per unit first of all, calculate a unit cost which will be: £ Prime cost 4.00 Variable overhead 0.45 (calculated as £180,000 divided by 400,000 units) Commission 0.50 Total variable cost 4.95 Selling price 10.00 Unit contribution 5.05 The fixed costs are £1,010,000 so divide this by £5.05 to give a break-even quantity of 20,000 units or £200,000 (b) Revenue costs and profit at differing levels of activity Present Volume Increase by 12.5% 400,000 450,000 500,000 £10 £9.50 £9 Selling Price £ Total Revenue Prime Cost Increase by 25% £ £ 4,000,000 £ £ 4,275,000 4,500,000 1,600,000 1,800,000 2,000,000 Variable Overhead 180,000 202,500 225,000 Commission 213,750 225,000 200,000 £ Total Variable Cost 1,980,000 2,216,250 2,450,000 Contribution 2,020,000 2,058,750 2,050,000 Fixed Cost 1,010,000 1,010,000 1,010,000 Profit 1,010,000 1,048,750 1,040,000 Clearly we can see that the middle column is the volume and selling price that gives the best profit reward to the company (c) © Before accepting this reduction in the selling price to £9.50 the firm will need to consider what moves may be made by competitors It also needs to be very sure of its costs because an increase in revenue brings with it a relatively small increase in profits It also means that the company is operating at 90% of its full capacity ABE and RRC 164 Cost-Volume-Profit Analysis Question Figure 8.9 shows the required break-even graph Figure 8.9: XYZ Ltd Break-Even Graph (a) © ABE and RRC Cost-Volume-Profit Analysis (b) 165 Calculation of break-even point and margin of safety using formulae Break-even: B/E (£) = = B/E (units) = F S  V    S  where F = Fixed costs; S = Sales; V = Variable costs £150,000 = £150,000  = £300,000 400 , 000  200,000     400,000   F £150,000 = = 60,000 units C per unit  200,000     80,000  Margin of safety: M/S = P  S £400,000 = £50,000  = £100,000 C 200,000 £400,000  £300,000 = £100,000 No of units = £100,000  80,000 = 20,000 units 400,000 (80,000  60,000 = 20,000) © ABE and RRC 166 Cost-Volume-Profit Analysis © ABE and RRC ... Valuation Joint Products and By-Products Other Process Costing Considerations 11 9 12 1 12 1 12 2 12 6 12 7 12 9 13 2 13 5 13 8 14 2 Cost-Volume-Profit Analysis Introduction The Concept of Break-Even Analysis... Principles of Decision Making Decision-Making Criteria Costing and Decision Making 16 7 16 8 16 8 17 3 17 5 10 Pricing Policies Introduction Fixing the Price Pricing Decisions Practical Pricing Strategies Further... Feedback Control Information 11 11 12 12 E Information for Decision Making 14 © ABE and RRC Management Accounting and Information INTRODUCTION We begin our study of this module with some definitions