DE3J 36 PFFpack

Recording financial information Unit Student Guide
Scottish Qualifications Authority
Contents
1 Introduction to the Scottish Qualifications Authority..............................................1 2 Introduction to the Unit.............................................................................................2 2.1 What is the Purpose of this Unit?......................................................................2 2.2 What are the Outcomes of this Unit?.................................................................2 2.3 What do I Need to be Able to do in Order to Achieve this Unit?......................3 2.4 Approximate Study Time for This Unit...............................................................3 2.5 Equipment/Material Required for this Unit.........................................................3 2.6 Symbols Used in this Unit..................................................................................7 3 Assessment Information for this Unit.......................................................................8 3.1 What Do I Have to Do to Achieve This Unit?.....................................................8 4 Suggested Lesson Plan.............................................................................................9 5 Learning Material.....................................................................................................10 5.1 Learning Outcome 1..........................................................................................10 5.2 Learning Outcome 2 - Analyse Costing Data and Provide Information for Decision-making......................................................................................................39 5.3 Learning Outcome 3..........................................................................................73 5.4 Learning Outcome 4 - Use Investment and Project Appraisal Techniques to Assess the Viability of a Project..........................................................................109 6 Additional Reading Material.................................................................................130 7 Solutions to Self Assessed Questions and Activities.........................................131 8 Copyright References............................................................................................163 9 Acknowledgements...............................................................................................163
Scottish Qualifications Authority 2004
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1 Introduction to the Scottish Qualifications Authority

This Unit, DE3J 35 has been devised and developed by the Scottish Qualifications Authority (SQA). Here is an explanation of the SQA and its work: The SQA is the national body in Scotland responsible for the development, accreditation, assessment, and certification of qualifications other than degrees. Its website can be viewed on: www.sqa.org.uk SQA's functions are to: devise, develop and validate qualifications, and keep them under review accredit qualifications approve education and training establishments as being suitable for entering people for these qualifications arrange for, assist in, and carry out, the assessment of people taking SQA qualifications quality assure education and training establishments which offer SQA qualifications issue certificates to candidates.
In order to pass SQA units, students must complete prescribed assessments. These assessments must meet certain standards. The Unit Specification outlines the 4 Outcomes that students must complete in order to achieve this unit. The Specification also details the knowledge and/or skills required to achieve the outcome or outcomes. The Evidence Requirements prescribe the type, standard and amount of evidence required for each outcome or outcomes.
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2 Introduction to the Unit

2.1 What is the Purpose of this Unit?
This unit is designed to provide you with an understanding of the use of Management Accounting information within a business organisation. You will develop abilities and learn the financial techniques used to assist decision-making in relation to costing, budgeting, pricing and investments. Specifically, you will learn how to prepare an operating statement to cost a product, process or service. You will also consider the use of alternative costing methodologies (Full/Absorption versus Marginal) within the decision-making processes of organisations. In addition you will learn how to compare budgeted activity with actual activity and analyse the resultant variances. Finally, the Unit will consider capital investment projects and the basic techniques used to estimate potential returns.
2.2
What are the Outcomes of this Unit?
There are four outcomes within this unit. Each outcome is designed to provide you with essential knowledge and understanding regarding a specific area of Management Accounting. In Outcome 1, you will be provided with skills and develop abilities in the preparation of an operating statement. You will be shown initially how to classify costs between direct and indirect costs, and between variable and fixed costs. Secondly, you will be shown techniques to allocate and absorb overheads to the operating activities of an organisation. Thirdly, techniques associated with the determination of profit (using markup and margin) will be shown. These areas will be collated to provide you with sufficient knowledge and understanding to produce an operating statement for an organisation. In Outcome 2, the focus is on the development of an understanding of marginal costing and its application in relation to the provision of relevant data to in form short-term decision-making. A comparison of different costing methodologies (Full/Absorption versus Marginal) will be made. You will be encouraged to calculate the effect of changing costs and revenue levels (associated with alternative courses of action) on total contribution. You will also be shown how to calculate break-even point and the number of units required to achieve the desired level of profit. In Outcome 3, you will be shown how to construct the functional budgets of an organisation, although this will not be formally assessed. This understanding will assist you to develop skills and abilities in the comparison of budgeted activity with actual activity. You will be shown how to construct a flexed budget and to determine the resultant variances as well as the possible causes of the variances. It would be useful if a suitable spreadsheet package were used to aid calculation of the variances, though you will be shown the mechanics involved in calculating the appropriate variances.
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In outcome 4, you will develop skills and abilities in the application of investment appraisal techniques (both traditional and discounted cash flow) as an aid to longer-term decision-making. This will include an examination of the effects of limited funds on selecting projects as well as the normal appraisal techniques. Once again, the use of a suitable spreadsheet package would be a useful tool to aid calculation of the Net Present Value factors (NPV). The effects of taxation will be excluded from the analysis.
2.3
What do I Need to be Able to do in Order to Achieve this Unit?
The Unit will be assessed using two Instruments of Assessment. These will be computational in nature and cover the preparation of operating statements and an analysis of costing data (Outcomes 1 + 2). This will take the form of a closed book test, that is, a test in controlled conditions without reference to study texts. You will be provided with appropriate pro-forma statements as a guide a layout. Outcomes 3 and 4 will be assessed by the use of a home-based exercise. This will require the presentation of data, computation and analysis as well as a report, in which you will be required to provide comment and recommendations to management.
2.4
Approximate Study Time for This Unit
The study and achievement of this Unit should take in the region of 40 hours
2.5
Equipment/Material Required for this Unit
Beyond this study guide you will require a calculator with simple arithmetic functions, pencil, eraser, ruler and paper. Access to a suitable spreadsheet package may be desirable. Learners may find the undernoted glossary useful as an aid in understanding some of the technical language used within the study guide. Additional webbased resources are supplied at section 6, which may be of use.
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Glossary Common Terminology applied in Preparing Financial Forecasts Absorption Costing A technique to determine unit cost of commodities. This includes the variable cost of production and a proportion of the firm's fixed costs. Accountant Suitably experienced individual, trained to prepare and analyse accounting (financial and management) data. Activity based costing A costing technique, which allocates overheads to commodities on the basis of the activity, which most closely incurs the overhead. Book value The value of an asset, as quoted in a firm's financial statements, as opposed to its realisable value. Break even point (BEP) The volume of activity at which revenues exactly equal expenses. Accordingly, neither a profit nor a loss is made. Budget A financial statement of future activities. Budgetary Control The comparison of actual with budget performance. CBA analysis (cost A technique for quantifying qualitative factors, applied in long-term benefit analysis) decision-making. C-V-P analysis (costThe technique, which analyses cost and revenue, based upon the volume-analysis) volume of activity. Most frequently seen in short-term decision making relating to budget setting and profit forecasting. Capital budgeting The budgeting process applied to investments in fixed assets. Cash budget A forecast of future cash movements, over a specific period of time. Cash flow The actual flow of cash. Cash forecast A forecast of future cash movements, over a specific period of time. Common costs Costs which are applicable to large parts of the firm, such as business rates. Company A legal entity granted its own status to conduct business, governed by the requirements of the Companies Act and other statutes. Contribution The figure calculated by subtracting variable costs of an activity from the revenue generated by it. Contribution approach An alternative method of preparing income statements, which (Marginal costing) subtracts variable costs of an activity from the revenue, generated by it, before subtracting appropriate fixed costs. The object is to emphasise the relationship between cost and revenue for planning and control of activities. Contribution chart A depiction of BEP, used in short term decision making and creation by plotting revenue and total costs. Controllable cost A cost that can be directly influenced by a cost centre supervisor or manager. Cost The sacrifice that is entailed in acquiring or using a commodity. Cost centre An area of activity, which is assessed in terms of the service provided and the cost of providing that service.
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Cost-volume-profit analysis (C-V-P)
A short-term decision-making technique applied to analyse the relationship between costs and revenues at various levels of activity. Costing An approach to identifying the true cost of a commodity, which involves charging the commodity with those costs involved in its production (direct costs) and with overhead costs. Direct cost A cost specifically identified with a unit of activity. Expenses Depletions in the asset base of a firm. Fixed Cost A cost, which does not vary with activity. Rather. it is time related. Fixed overheads Costs, which are not attributable to a unit of activity. Full costing (Absorption A technique to determine unit cost of commodities, including the costing) variable cost of production and a proportion of the firm's fixed costs. Income Statement Also known as the Profit and Loss Account. This statement aggregates income and expenses of the firm, over a period of time, to determine whether a profit or loss has been achieved. A company is obliged to publish an Income Statement at least once every twelve months. Indirect costs Those costs necessary for the completion of an activity, which are not identifiable with a unit of activity. Inputs Measure of resources required in the production of commodities. Inventory Accumulated value of stock of finished goods, work in progress and raw materials. Just in time (JIT) stock A method of stock management, which attempts to reduce stock to nil. Products and components are manufactured just as they are needed. Marginal Cost An economic concept applied to accounting to measure the change in total cost from an alteration in activity by one unit. Net Profit Gross profit less operating expenses. Opportunity Cost Another expression adapted from economics, which pertains to the cost (benefit) of using a resource in one activity compared with the cost (benefit) of its use in another activity. Of particular importance when considering limited resources in short term decision-making. Overhead absorption A technique whereby the fixed costs of a firm are allocated to rate commodities. Overhead costs Indirect costs incurred in producing commodities. These are costs, which are not directly attributable to the commodity. Profit centre An area of responsibility within a firm whose performance may be judged on the revenues it generates compared with the expenses of generating those revenues. Reorder level The stock level at which an order for replenishment should be placed so that, ideally, more stock arrives just as stock runs out.
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Semi-variable costs Turnover Unit cost Variable cost Variance Variance analysis
Costs incurred by the firm, which possess a fixed (standing charge) element and an element, which increases with activity, such as a telephone account. Sales revenue generated by a firm from its normal business activities, i.e. it excludes income received from the sale of fixed and intangible assets. The full cost of producing one unit of activity and includes direct costs and a proportion of overhead costs. Costs that vary in direct proportion with activity. Difference between the actual cost of producing a unit and its budgeted cost of production. The interpretation, undertaken by management, of all variances. The degree of investigation is determined by the degree of significance the variance has in relation to the nature of the activities of the firm.
Glossary of Arithmetical Symbols used in this Study Guide ARITHMETICAL SYMBOL + * / = % p
MEANING Add Subtract Multiply Divide Is equal to Percentage Pound sterling Pence
EXAMPLE 2+2=4 74=3 3 * 4 = 12 8/4=2 80% 95.00 67p or 0.67
Glossary of Acronyms used in this Study Guide ACRONYM ph pu kg pkg Ltr MEANING Average per hour Average per unit Kilogram Average kilogram per unit Litre EXAMPLE 4.50 ph 3.00 pu or 3kg pu 2 kgs 1 pkg 5 Ltrs
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2.6
Symbols Used in this Unit
The various Learning Materials sections are designed so that you can work at your own pace, with tutor support. As you work through the Learning Materials (see Section 5), you will encounter symbols. These symbols indicate that you are expected to do a task. These tasks are not Outcome Assessments. They are exercises designed to consolidate learning or encourage thought, in preparation for the Outcome Assessment (see Section 3 - Assessment Information for this Unit). Activity
This symbol indicates an Activity (A). Usually, activities are used to improve or consolidate your understanding of the subject in general or a particular feature of it. The activities will not serve this purpose if you refer to the responses prior to having attempted the Activity. Self Assessed Question 1
This symbol indicates a Self Assessed Question. Using a Self Assessed Question helps you check your understanding of the content that you have already covered. Everything is provided for you to check your own responses. Answers to the Self Assessed Questions are to be found at the back of the Unit Student Guide. Where suggested responses to activities are provided in the Unit Student Guide, students are strongly discouraged from looking at these responses before they attempt the activity. The activities throughout the Unit Student Guide will help you to prepare yourself for the formal assessments and to identify topic areas in which you will require clarification and additional tutor support. The activities will not serve this purpose if you look at the answers before trying the activity! Self Assessed Questions and activities are designed to be checked by you. No tutor input is necessary at this stage unless special help is requested, although from time to time your tutor may wish to view your responses to Self Assessed Questions to see how you are progressing.
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3 Assessment Information for this Unit

3.1 What Do I Have to Do to Achieve This Unit?
In Outcome 1, you will be asked to produce an operating statement, which accurately and legibly provides details of cost, suitably subtotalled, together with anticipated profit calculated using both mark-up and margin methods. In Outcome 2, you are asked to produce a marginal costing statement, together with an accurate and legible report containing a recommendation of an appropriate course of action based upon your analysis of cost. In Outcome 3, you are required to analyse budgetary information and prepare a variance report. This will require accurate and legible construction of a flexed budget, together with computation of five variances and a report correctly identifying likely causes for these five variances. Your report must, accurately and legibly, include recommendations for management action that are consistent with the significance and direction of the variances. In Outcome 4, you will apply investment and project appraisal techniques to produce a report, which assesses the viability of a proposed capital project. Your report should accurately and legibly state conclusions and recommendations, together with any assumptions you have made. The undernoted table provides an indication when you may be asked to undertake the assessment for each of the four Outcomes contained within this Unit. Learning Outcome 1 and 2 3 and 4
Item Operating Statement and Marginal Costing Analyse Budgetary Information and variance analyses, and Analyse Investment and Project appraisal techniques
Methodology Closed Book 6
Week
Open book computation and report. To be issued in week 9 and due for submission in week 11.
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4 Suggested Lesson Plan

The Learning Materials (see Section 5) are designed to lead you through a series of activities, which will allow you to consolidate your learning and check on your own progress. The under-noted teaching schedule is designed to provide you with a week by week guide as which part of the study guide you ought to be reviewing. Week 1 Date L.O. Introduction 1 2 3 1 1 Types of costs Overhead absorption, allocation and apportionment Mark-up + margin Operating statement 4 5 6 7 8 9 10 11 2 2 2 3 3 4 4 Marginal Costing Marginal costing Marginal costing Budgets Variances Variances Investment + Project appraisal Investment + Project appraisal Break even Decision making Flexed Budget Materials + Labour Overheads Payback Accounting rate of return Discounted cash flow Open Book Closed Book Closed book Open Book Closed Book Topic Assessment
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5 Learning Material
The Learning material for this unit is divided into four sections with each section corresponding to a learning outcome (see section 2.2 for details of these learning outcomes).
5.1
Learning Outcome 1 Prepare an Operating Statement
1.1
Accounting is reckoned to be the second oldest profession in the world. It was devised to record the monies being earned from the oldest profession! Whatever you do, you probably feel that you spend all your time filling in forms and reading reports. Why? You need information to enable us to be more efficient and effective in planning and controlling the operations you are responsible for. Accounting provides information to help you do a better job. Secondly, accounting provides information that allows firms to meet their legal responsibilities. It is not the purpose of this learner guide to teach you to become an accountant, even if you have the inclination. Rather, this guide will introduce you the terminology and some of the techniques used within accounting. It is hoped that you will find this unit informative and interesting. Please remember to maintain contact with your tutor, particularly if you encounter any specific difficulties or require clarification on some technical detail. Learning Objectives When you have completed your study of section 5.1 you should be able to: Prepare an accurate operating statement that includes details of the classification and analysis of costs. List the order of costs identified in the operating statement in a logical manner, with accurate subtotals for the main categories of cost. Outline the process of overhead absorption and accurately absorb overheads on an appropriate basis. Accurately calculate profit in accordance with given policy ( or margin).
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1.2
Cost and Revenue Classification
The collecting of past costs and the projection of future costs is an important area in management accounting. As an objective of a business enterprise is to make profit, management must be sure that revenue from any future undertaking will be greater than costs. For the purposes of control it is necessary to know the overall cost of a project and to cost each part of the operation. Thus management can pinpoint a problem within the organisation and correct it. For this reason we classify costs according to their nature. Classification of Costs The management accountant will classify costs into different categories according to the nature of the cost. This is important for the control function where it is necessary to know in which specific area problems are occurring. The following are examples of functions by which costs can be classified: Production; Administration or Selling and Distribution. Within these functions costs will be further sub-divided into cost centres and cost units. Cost Centres are locations: for example a department or part of a department, an individual employee or group of employees or a machine or group of machines. Cost Units are sub-divisions of the cost centre and may be a single job, a batch, a contract or a product group, depending on the type of business. Consider the following: A firm produces leather goods consisting of shoes, gloves, handbags and wallets. There are four departments, each of which produce one of the four types of product. Each department is a cost centre. Within the handbag department there are ten different styles of bag produced, each in batches of one hundred. Each batch produced is a cost unit. The company is therefore concerned with allocating costs to each batch of one hundred.
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Elements of Production Cost Within the cost unit itself we can distinguish between different elements of cost: Material Cost: which is the cost of the raw materials used in the production or service process; Labour Cost: which includes wages, salaries and bonuses, which are incurred in the production of the goods or provision of services; Direct Expenses: are fairly rare but may consist of the hire of a piece of which is a necessary part of the process. equipment,
These costs can be defined as direct costs. Direct costs are costs which can be directly allocated to the production of the goods or provision of services. The total of these three elements is called the Prime Cost of Production / Service. Indirect Costs Any cost, which does not fall into the category of direct cost, is defined as an indirect cost. An indirect cost cannot be directly allocated to production or service provision. It has to be apportioned to the cost centre and absorbed by the cost unit. Example In our example of the firm that produces leather goods, there will be typists, salesmen and accountants. The wages and salaries, of these employees cannot be directly allocated to production. However, at the end of the day these costs must be included in the total cost of the production. As it is from the revenue received from the sale of these goods, that we must recoup our total expenditure and earn a profit. These costs must therefore be absorbed into our unit costs. Typical methods of absorbing overheads are shown in part 5.1.3. As well as indirect labour costs we will also have indirect material costs, for example; stationery and indirect expenses, for example gas and electricity. These indirect costs are called overheads and will be sub-divided into production or factory overheads, administration overheads and selling and distribution overheads. Once we have found the Prime Cost we add our factory overheads to give us the total Factory / Service Cost. Factory overheads can consist of supervisors salaries, factory gas and electricity or rent and rates.
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When we have found the factory / service cost we can charge Administration overheads and Selling and Distribution overheads to find the Total Cost. Examples of Administration overheads include stationery, typists' wages and employee insurance. Selling and Distribution overheads include salesmen's commission, advertising, sales department costs, etc. Once all of these costs have been collected, allocated and absorbed, then the price at which the goods must be sold, in order to make the required profit, can be calculated. Cost Behaviour As well as the nature of costs it is necessary to consider cost behaviour. There are three classes of behavioural classification: Fixed Costs, Variable Costs and Semi variable costs. Fixed Costs Some costs will be incurred by the organisation, regardless of the level of activity. For example the rates on the factory will have to be paid, regardless of the level of production. If the firm decides to double output by working a night shift as well as a day shift, the rates bill will not be affected. These costs are called Fixed Costs and also include costs like rent and insurance costs. They are often termed 'period costs' since they are incurred on a time basis as opposed to an output basis. It is also important to note that they will also only be fixed over a relevant production scale. If the firm has to rent a second factory in order to double production then the cost of rent and rates will change. However, it will now be fixed at the new level! Variable Costs These are the opposite of a fixed cost, since variable costs vary directly with activity. For example if we double the output / level of service, we could also double the labour required and therefore, the cost. Once again this will only be the case over a relevant production scale, since the increase in provision may lead to economies of scale, for example bulk ordering, which may entitle the company to large discounts. Therefore, a large increase in provision may not lead to a directly proportional increase in costs. Semi-Variable Costs These are costs that will change when the level of output changes but not directly. Indirect labour costs are an example of a semi-variable cost. If a supervisor can control six men, then the point at which output requires a seventh man to be employed is the point at which a second supervisor must be employed. However, output can now increase to a level where thirteen men must be employed before a third supervisor is necessary. Semi-variable costs are, therefore, a mixture of fixed and variable costs and are often described as 'stepped costs'. Revenue
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Most members of the public would accept that revenue behaves in a similar way as a variable cost, that is if activity doubles, direct labour may also double, as would revenue. This is likely in the contracting industry, where an engineer may be asked to undertake a task estimated to last 20 hours. The direct labour cost would be: the engineer's time - 20 hours at the firm's hourly rate (say 30.00 ph) resulting in a direct labour cost of 600. But if the estimated time was 40 hours (i.e. double), the direct labour would be 1,200 (i.e. double), (40 hours x 30ph). Yet it is not always like this. Your firm may have won a fixed term preventative maintenance contract to service the freezers of a major supermarket chain. Initially, management would have estimated the number of hours per service and quoted on that estimate. So far, so good. However, if we have a blistering hot summer.and.the freezers are now working harder, do we charge the supermarket chain with the extra hours? It is unlikely, so management may add a few extra hours to the estimate, just in case. In this case, revenue is fixed - the contract with the supermarket chain and the direct labour cost in fulfilling the contract is variable. Other Cost Classifications Table 1 summarises the remaining classifications of costs you are likely to encounter in this study guide. Alongside each definition is an example. You should try to identify other definitions and examples, which may be relevant to your firm.
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Table 1: Other Cost Classifications COST TYPE Committed DEFINITION EXAMPLE EXAMPLES FROM YOUR EXPERIENCE
Fixed costs which management Rent of a factory. are obliged to pay, if they follow a course of action. Controllable Costs which may be altered by a Re-work on scrap to cost centre manager. turn it into a saleable commodity. Discretionary Fixed costs which management Training. may or may not elect to incur. Irrelevant Fixed costs which the firm are Rent of a factory. currently paying and which will not alter if a new contract is taken on. Incremental Additional costs arising from Material. extra activity. Opportunity Revenue foregone when Lost revenue from choosing an alternative. transferring a machine working on one contract to a new contract, when there is no replacement machine available. NonCosts which a cost centre Insurance premium of controllable manager cannot influence. the factory. Relevant Future, discretionary costs Overheads associated with a new contract. Sunk Resources acquired, cash paid. Cost of a factory.
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Example 1 An organisation has identified that it possesses the following type of expenses you have been asked to classify them to aid the Chief Operating Officer. Types of Cost for Classification 1. Sales Advertising 2. Depreciation of production machinery 3. Office Expenses 4. Heating of factory 5. Plastic used in the product 6. Colouring for the above plastic 7. Foremans wages 8. Hire of crane for job number 542 9. Accountants salary 10. Courier costs inwards on raw materials 11. Wages traceable to jobs 12. Courier costs outwards 13. Depreciation of delivery vans 14. Lighting of showrooms 15. Factory managers salary 16. Bad debts 17. Insurance of factory 18. Office rent 19. Depreciation of word processors 20. Salesmans commission The Chief Operating Officer has given you the following classifications to use: Direct labour Direct material Direct expense Production overhead Administration overhead Selling and distribution overhead.
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Solution to Example 1 Direct Labour 11 Direct Material 5 6 10 Direct Expense 8 Production Overhead 2 4 7 15 17 Administration Overhead 3 9 16 18 19 Selling and Distribution Overhead 1 12 13 14 20
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Classify the following costs under the appropriate headings given: Prime cost Production overhead Administration overhead Selling and distribution overhead Types of Cost for Classification 1. Raw material purchases 2. Office salaries 3. Indirect factory labour 4. Courier costs on finished goods 5. Advertising 6. Direct labour 7. Factory rent and rates 8. Office stationery 9. Salesmens commission 10. Insurance of plant and machinery 11. Discount allowed 12. Office rent and rates 13. Machine maintenance 14. Customs duty on raw materials 15. Bank overdraft interest 16. Warehouse wages
As in example 1, complete this table with the number corresponding to the type of cost. Prime Cost Production Overhead Administration Overhead Selling and Distribution Overhead
Check your answers in Section 7 Solutions to Self Assessed Questions and Activities 1
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Analyse the following types of costs into their pertinent classifications. Choose from: Direct Labour Direct Material Direct Expense Production Overhead Administration Overhead 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Selling and Distribution Overhead Factory storekeeper's wages 15 Cost of paper used in mail shots to customers. Hire of Motor Vehicle for Managing 16 Postal charges for parcels sent to customers. Director's use Motor Tax for vans used to deliver 17 Wages of crane operator hired for this job commodities. Lubricants for machine used for this 18 Maintenance costs for accounting PCs. job. Wages for Quality Inspectors in 19 Wages for skilled labour in factory. factory. Salary of telephonist. 20 Costs of electricity for photocopier equipment. Advertising agency fee. 21 Haulage costs bringing materials to factory. Wages of factory cleaner. 22 Cost of packaging used to wrap finished commodities prior to despatch. Courier costs in on a sub-assembly. 23 Site night watchman's wage. Raw material cost 24 Training cost for skilled labour certified to a new industry standard. Hotel costs for sales staff. 25 Cost of producing quotation to new customer. Accountants salary. 26 Cost of cleaning consumables used for this job Repairs to factory roof. 27 Production supervisor overtime payment. Hire of crane for this job 28 Cost of maintenance contract on new machine
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Self Assessed Question Continued 1
Complete this table to respond to the requirements of the self assessed questions. Selling and Distribution Overhead
Direct Labour
Direct Material
Direct Expense
Production Overhead
Administration Overhead
Check your answers in Section 7 Solutions to Self Assessed Questions and Activities
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Costing Methods There are several types of Costing system since production is undertaken by different methods, depending on the nature of the product / service. The costing system must provide the information required by management for planning, decision-making and control within their particular organisation. The following is a description of the different types of costing system. Basic costing methods Specific Order Costing Job Service costing costing Job Costing We shall be reviewing Job Costing in greater detail commencing on page 30. Contract Costing This, like job costing, is used where work is carried out to customers' special requirements but each order is of a long duration, usually of a constructional nature for example a new motorway. Batch Costing This is used where similar articles are manufactured in batches. The unit cost is calculated: Cost per unit = The total batch cost divided by the total number of units
produced in batch.
Operation Costing Batch costing Process costing
Contract costing
Process Costing This system is employed where the product passes through stages or processes which make it impossible to identify any one unit of product. For example, what is the exact cost attributable to 1 litre of petrol - or 1 kilo of flour. The cost of an individual order can only be calculated by reference to the cost per unit passing through the process over a period of time: Cost per unit =The total cost of period divided by the total production of
period (litres or kilos)
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Service Costing Mainly used in the hospitality and catering industries, this system divides the total cost of the operation by the anticipated number of customer servings and adding a small percentage for profit.
1.3
Calculating Overhead Absorption Rates
Introduction We have discussed charging overheads to cost centres, to establish the cost of operating those cost centres. However, the only income many firms have from which to pay overheads is from the sale of units. To ensure that sufficient is raised from the sale of units, overheads must be absorbed into the units. The main components of a typical selling price are: Direct Materials + Direct Labour + Direct Expenses + Non-specific overheads* + Profit = SELLING PRICE * using "absorption costing" METHODOLOGY This technique is called "absorption of overheads", and there are various methods of carrying it out. The following five are most common and are the ones you should know: 1 3 5 percentage of direct materials percentage of prime cost machine hour 2 4 percentage of direct labour direct labour hour
For example, where the customer is quoted a price before work begins the actual amount of overhead to be absorbed will not be known and so the business must project a budgeted figure which can be used. Assuming, therefore, that we are using budgeted figures, the formulae for calculating the method of overhead absorption mentioned above are: 1 2 3 4 Percentage of Direct Materials Percentage of Direct Labour Percentage of Prime Cost Direct Labour Hour Total Budgeted Overheads x 100 Budgeted Material Cost 1 Total Budgeted Overheads x 100 Total Direct Labour 1 Total Budgeted Overheads x 100 Total Prime Cost 1 Total Budgeted Overheads
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Total Direct Labour Hours 5 Total Budgeted Overheads Total Machine Hours Please note, that in all five formulae, the value, which appears on top, is always the value of the budgeted total overheads. Example 1 The following information with regard to ABC Limited has been ascertained and you are to calculate the five rates. Budgeted overheads to be absorbed Budgeted material cost Budgeted direct labour cost Budgeted direct labour hours Budgeted machine hours Solution to Example 1 The rates are calculated as follows: 1 Percentage of Direct Materials 2 3 4 5 Percentage of Direct Labour Percentage of Prime Cost Direct Labour Hour Direct Machine Hour 56,000 x 100 280,000 1 56,000 x 100 112,000 1 56,000 x 100 392,000 1 56,000 336,000 56,000 224,000 = = = = = 20% 50% 14.3% 16.7p ph 25p ph 56,000 280,000 112,000 336,000 hours 224,000 hours Direct Machine Hour
Each of the departments in an organisation would have the budgeted overhead absorbed according to one of these methods. The method used will be determined by the departmental costs and the firm's policy. Now we can look at an example and see how using the different rates will lead to quite substantial differences in the absorption of overheads.
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Please remember that Prime Cost is calculated by adding the costs of Direct Material, Direct Labour and Direct Expenses. In Example 2: Calculation of Prime Cost Direct Material 280,000 Direct Labour 112,000 Direct Expenses 0 Prime Cost 392,000
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Example 2 Department 3 makes 2 products, Gamma and Delta. The departmental budgeted overheads are 120,000 and the budgeted production for Gamma is 2,000 units and for Delta is 800 units. The estimated prime cost per unit of Gamma and Delta would be: GAMMA MATERIAL 24 kgs @ 2.50 pkg LABOUR and MACHINE TIME 5 hrs @ 4.00 ph 60.00 20.00 MATERIAL 15 kgs @ 2.00 pkg LABOUR and MACHINE TIME 25 hrs @ 2.00 ph DELTA 30.00 50.00
PRIME COST
80.00
PRIME COST
80.00
Calculate the various overhead recovery rates and show the overhead for one unit of Gamma and 1 unit of Delta. Solution to Example 2 If we take the direct material percentage, the overhead charged to Gamma would be 50 for Delta 25. Workings GAMMAS material cost will be 2,000 units * 24 kgs * 2.50 = DELTAS material cost will be 800 units * 15kgs * 2.00 = Budgeted Material Cost 120,000 24,000 144,000
Absorption rate to be applied is Percentage of Direct Materials (see page 24) Total Budgeted Overheads * 100 Budgeted Material Cost 1 120,000 * 100 144,000 1 = 83.33%
This represents the proportion of overheads, which must be charged to each unit of production in order to recover the full overhead costs.
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If we use this figure (83.33%) in an example we can see how the budgeted overhead cost can be absorbed. The amount of overhead to be charged to GAMMA would be, based upon Direct Material 60.00 * 83.33% = 50 and the amount charged to DELTA would be, based upon Direct Material 30.00 * 83.33% = 25 The 50 charged to each unit of GAMMA and 30 charged to each unit of DELTA represents the proportion of total overheads, which must be charged to each unit of production in order to recover the full overhead costs. If production were to be as budgeted, namely: GAMMA DELTA 2,000 units 800 units
then it can be seen that total budgeted overheads would be absorbed, see below. 2,000 units * 50pu 800 units * 25pu Total overhead charged to production = 100,000 = 20,000 = 120,000
Now if we were to use method 5 (seepage 24) different overhead figures would be applied. Direct Machine Hour Total Budgeted Overheads Total Machine Hours
One unit of GAMMA requires 5 hours of machine time and DELTA 25 hours. Therefore, total machine time would be GAMMA DELTA = 2,000 units * 5 hours pu = 800 units * 25 hours pu = = 10,000 hours 20,000 hours 30,000 hours 120,000 30,000 =
Total machine hours required for production =
The absorption rate what become Total Budgeted Overheads 4phr Total Machine Hours
Resulting in 20 (5 hours machine time * 4phr) being charged to each unit of Gamma and 100 (25 hours machine time * 4phr) being charged to each unit of DELTA. Total budgeted overheads would be absorbed, see below.
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2,000 units * 20pu 800 units * 100pu Total overhead charged to production
= 40,000 = 80,000 = 120,000
You can see from the answer that the different methods lead to widely varying overhead rates being applied to each unit. In method 1 each unit of Gamma will be charged 50 overhead while each unit of Delta will be charged 25, While in method 5, each unit of Gamma will be charged only 20 while each unit of Delta will have to bear 100 overhead charge to each unit. It would be for management to determine which method is best based upon market conditions and the final selling price that may be charged for products. One of the problems here is that we have applied a blanket overhead rate, that is, we have calculated a rate for the whole organisation. That is why it is more useful to apportion the overheads to departments then to calculate departmental overhead rates.
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Identify how an overhead absorption rate may be calculated for an organisation known to you. Write down a few notes to remind yourself why the chosen method(s) would be appropriate.
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Different firms will calculate their absorption rates differently, dependent on the history of the firm; nature of the work being undertaken; industry standards; and so on. Remember there is no prescribed method. It is ultimately down to the discretion of management to determine. We are required to review how a firm is likely to produce an estimate for a small contract. Again some firms may apply different techniques, but in general the following will apply. It is assumed that most firms will absorb overheads using the Direct Labour Hour rate described in page 24. However, just to make this part of the guide more interesting a couple of other methods are also incorporated.
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Job Costing and Construction of Operating Statements This is defined as the type of costing statement used where work takes the form of individual jobs undertaken to a customers requirements. When preparing job cost operating statements, we divide costs into direct costs, manufacturing overheads and administration, selling and distribution overheads. The following example provides us with the information we need to construct a job costing statement in which we calculate Prime Cost, Factory Cost and Total Cost. RELEVANT DATA: ESTIMATE 1200 PREPARATION FINISHING time 12 hours 5 hours rate ph 4.40 3.82
21 Kgs at 3.10 pkg
Total labour hours
Direct Labour Direct Materials Annual overhead budget
PACKAGING 2 hours 3.65 1,600 4,000
5,000 8,000
2,000 6,000
overhead
Selling and distribution overheads are to be absorbed at 20% of prime cost and administration costs are to be absorbed at 10% of factory cost. The selling price negotiated with the customer is 299.95. Prepare a job costing statement showing the profit that will be made from the job. Working Notes Estimate No 1200 1. 2. Direct materials 21 kilos x 3.10 = 65.10 Direct Wages a) Preparation b) Finishing c) Packaging 12 hours x 4.40 = 52.80 5 hours x 3.82 = 19.10 2 hours x 3.65 = 7.30
3.
Overheads To calculate the factory overheads we divide the annual overhead budgeted cost by the annual overhead budgeted hours. This gives us an hourly rate, which we can charge to each job by multiplying the hours spent on the job by the hourly rate to find the overhead charge. a) Preparation 8,000 5,000 hours = 1.60 per hour; 12 hours x 1.60 = 19.20pu b) Finishing c) Packaging 6,000 2,000 hours = 3.00 per hour; 5 hours x 3.00 = 15.00pu 4,000 1,600 hours = 2.50 per hour; 2 hours x 2.50 = 5.00pu Job Cost Operating Statement Job Number 1200 Working note
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Direct materials Direct labour Preparation Finishing Packaging Prime Cost Factory Overheads Preparation Finishing Packaging Total factory cost
1 2 52.80 19.10 7.30
65.10
79.20 144.30 3 19.20 15.00 5.00 39.20 183.50 18.35 28.86 230.71 69.24 299.95
Administration Overheads (10% of 183.50) Selling and Distribution Overheads (20% of 144.30) Total cost Profit Selling Price
Please Note, all figures have been rounded to the nearest penny.
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1.4
Profit Calculation
Mark-Up and Margin At this point it is appropriate to bring in Mark-up and margin since it its often necessary to calculate these in a job costing situation. Mark-Up The Mark-up is calculated on the COST PRICE. From the above job cost operating statement (Job number 1200) the Total Cost was 230.71 and if the Mark-up is 30%, then the selling price will be 253.78 Cost price Mark-up (30% * 230.71) Selling Price Margin The margin is calculated on the Selling Price. Once again, from the above job cost operating statement (job number 1200) the selling price is 299.95 and if the margin is 23 1% then the cost price will be 230.71 Cost price Margin (23.1% of 299.95) Selling price 230.67 69.28 299.95 230.71 69.21 299.92
You will see that the key difference is in the percentage rate when we know the actual value the profit is to be. However, many firms do not know this actual value rate, but prefer to charge each job with a universal pre-determined or margin percentage. Therefore, if the Mark-up is to be 10% on all jobs and the total cost is estimated at 100, then the selling price can be calculated as follows: Total cost + Mark-up (10% * 100) Selling price 100 10 110
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However, if the margin is to be 10% with a selling price of 100, then the total cost price of manufacture will have to be 90, thus giving a targeted cost price for production to achieve. Selling price - Margin (10% * 100) Total cost 100 10 90
We can also calculate the cost price if we know the selling price and percentage, for example the selling price is 86.25 and the mark-up is 15%, therefore the cost price must be 75. If the selling price is the cost price plus 15%, then the selling price must be 115% of the cost price. Cost price = Selling price * Cost Price = 86.25 * 100 115 Cost Price = 75.00 It is also possible to calculate the selling price if we know the cost price and the percentage margin. (that is the selling price equals 100%). For example, the cost price is 1093.75 and the margin is 12.5% therefore the selling price is 1, 250.00. Selling price = Cost price * Selling price = 1,093.75 * Selling Price = 1,250.00 100 87.5 100 87.5 100 115
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From the following budgeted information calculate the Overhead Absorption Rates for the following departments: WELDING based on Direct Labour Hours GRINDING based on Direct Labour Hours FINISHING based on Machine Hours Budgeted Data Department Welding Grinding Finishing Total Overhead 60,625 71,000 55,000 186,625 Labour Hours 48,500 35,500 25,000 109,000 Machine Hours 30,000 25,000 25,000 80,000
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Using the Overhead Absorption Rates calculated in Activity 4 complete the Job Cost Operating Statement for Job 1512. The following costs are involved in Job 1512: Direct Material Direct Wages: Welding: Grinding Finishing 30 kg at 12 per kg 16 hours at 5.00 per hour 12 hours at 4.00 per hour 4 hours at 6.00 per hour
Machine time booked in the Finishing Department for Job 1512 is 10 hours. Administration Overheads are added at a rate of 10% on Prime Cost (rounded to the nearest ). Selling and Distribution Overheads are charged at 20% of Production Cost (rounded to the nearest ). The Selling Price is determined by a mark-up of 30% on Total Cost (rounded to the nearest ).
JOB COST OPERATING STATEMENT JOB 1512 Calculations Direct Materials Direct Labour Direct Expenses PRIME COST Overheads PRODUCTION COST Administration Selling TOTAL COST PROFIT SELLING PRICE Preparation Machining Machine hire Preparation Machining 10% of PRIME COST 12.5% of PRODUCTION COST 33.33% of TOTAL COST
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According to the Costing Office of Munro Engineering Limited, Job No. 15/98 has incurred the following Costs: Direct Material 2 kgs @ 1.00 per kg Direct Labour: Preparation: 8 hours @ 8.00 per hour Machining: 2 hours @ 5.00 per hour Hire of special machine in the Machining Department 424 The budgeted Production Overheads for the year are: Production Overhead Absorption Rates are based on: Preparation 60,000 Machining 100,000 Preparation: Labour Hours Machining: Machine Hours
Budgeted Labour Hours in Preparation are 4,000 hours per annum, with 8 Labour hours allocated to Job 15/98. Budgeted Machine Hours in Machining are 10,000 hours per annum, with 2 Machine hours allocated to Job 15/98. Administration Overheads are added at 10% of Prime Cost Selling and Distribution Overheads are absorbed at a rate of 12.55% of Production Cost Selling Price is determined by a Mark-up on Total Cost of 33.33%. Required: (a) Prepare the Job Cost Operating Statement for Job No.15/98, Calculating the Total Cost and the Subsequent Selling Price, Using the Attached Pro Forma. (b) Calculate and State the Margin in Terms of Profit as a Percentage of Sales.
SAQ Continues overleaf
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SAQ 2 Continued Please use this Pro-forma to Complete Question 2(a) Munro Engineering Limited JOB COST OPERATING STATEMENT JOB 15/98 Calculations Direct Materials Direct Labour Direct Expenses PRIME COST Overheads
PRODUCTION COST
Preparation Machining Machine hire Preparation Machining

10% of PRIME COST 12.5% of PRODUCTION COST
Administration Selling TOTAL COST PROFIT SELLING PRICE
33.33% of TOTAL COST
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1.5
Summary
To assist various users, costs and revenues must be classified in various ways. In this section pack we have identified a number of ways of classifying costs, namely: Prime costs comprising Direct Labour, Direct Material and Direct Expenses Variable costs or Fixed Costs, where variable costs are deemed to vary with activity, while fixed costs alter with time Overheads, which are usually indirect costs - that is they are essential costs paid by the organisation but are not linked with the organisations activity. These overheads are charged to units of activity using overhead absorption rates.
As you will have gathered, there can be a number of problems with pre-determined overhead absorption rates, not least: The calculation of the rate Forecasting future activity, costs and revenues If activity is not as anticipated, then we have an under- or over-recovery of overheads to contend with The likely effect an absorption rate can have on the selling price of a unit of activity.
The main purpose of this section has been to explain how an organisation can identify the cost of a job or small contract. The next section will explain the principles of shortterm decision-making by applying the principles of Marginal Costing and Cost Volume - Profit analysis. Later sections will provide information about planning and controlling the expenses of an organisation. It is very important that you possess a good understanding of cost and revenue classification, in order that you can advise on the viability of various activities. If you possess any concern, you should review this section and look at relevant chapters in the books identified in the additional reading section given at the back of this pack.
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5.2
Learning Outcome 2 - Analyse Costing Data and Provide Information for Decision-making Introduction
2.1
In this section you will be introduced to management accounting techniques that will assist you to analyse costing data to provide information for decision-making. The technique is generally known as Marginal Costing and definitions will be provided which will lead to an examination of specific tools, which will require understanding. The specific tools referred to will include Break-Even Analysis, which identifies the sales volume required to achieve a 0.01 profit by referring to the contribution to fixed costs the sale of one unit can achieve. This will lead on to an analysis of the relationship that exists between cost, volume and profit, which examines the best mix of products that will result in maximum profit being achieved. Management will use cost-volume-profit analysis when making decisions relating to: Changing selling prices Changing variable costs of production Changing fixed costs of production.
Marginal Costing, as a technique can provide suitable information to assist management in planning, decision-making and control. It can be used with other techniques such as Budgetary Control, which we will examine in section 5.3. Please note: to ease your understanding, we will apply the term 'unit' to mean a 'unit of commodity', which may be a finished product, for example, a litre of paint or a chargeable hour, for example, the hourly rate charged by a lawyer. Therefore, this technique works equally as well if the organisation sells products or provides a service by selling chargeable labour hours.
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2.2
Marginal Costing
This technique is used to identify the marginal cost of a cost unit by charging only the variable costs of production. To identify a profit for a period, the fixed costs attributable to that relevant period are written off in full against the contribution for that period. The contribution results when variable costs of production are subtracted from the sales revenue - see page 49. This definition makes it clear that Marginal Costing goes further than the ascertainment of cost. It also provides a means of calculating how profit will be affected by changes in volume, in cost, in selling price, or in the mixture of sales.
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In your own words write down the definitions for the following terms.
Term
The definition (In your own words)
Contribution Fixed Cost Marginal Cost Profit Selling price Variable Cost
If you are struggling to recall the definitions refer to the glossary of terms (page 7).
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What Is Contribution? Activity 6 provided you with a definition for contribution, namely: the figure calculated by subtracting variable costs of an activity from the revenue generated by it. In Marginal Costing, Fixed Costs are not allocated to products. Each product makes a "Contribution" to a fund or pool towards covering Fixed Costs. The balance remaining in the pool after such costs have been fully covered is profit. Therefore: Contribution = Sales Revenue - Variable Costs, Example 3 The variable cost of producing a bottle of shampoo is 50p. Fixed costs amount to 1,500 per month. The selling price is 1.20 per bottle and, in the month of March, 5,000 bottles were produced and sold. Solution to Example 3 We have to draw up a Marginal Cost Statement for March
MARGINAL COST STATEMENT Per unit 1.20 0.50 0.70 5,000 bottles 6,000 2,500 3,500 1,500 2,000
SALES REVENUE Less: Variable Costs CONTRIBUTION Less: Fixed Costs Profit
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The following example gives a better illustration of the principle, whereby only Variable Costs are charged to cost units and Fixed Costs are written off against Contribution for the period. Example 4 You are given the following information for products A, B and C. Selling Price per unit Variable Costs per unit Number of units sold in March Fixed Costs for the month of March were 5,000. Solution to Example 4 MARGINAL COST STATEMENT for MARCH A B C Total Number of units sold Note 4,000 7,000 2,500 13,500 Sales Revenue 2.00 8,000 1.50 10,500 1.30 3,250 21,750 Less: Variable Costs a 1.20 4,800 1.10 7,700 080 2,000 14,500 CONTRIBUTION b 0.80 3,200 0.40 2,800 0.50 1,250 7,250 Fixed Costs c 5,000 Profit 2,250 You Should Note: (a) (b) (c) As the Variable Cost per unit is the same for each additional unit of A, B or C produced, the contribution per unit will also be unchanged. Contribution per unit = selling price per unit - variable costs per unit. Total Contribution per Product = Units sold x Contribution per unit. No attempt is made to apportion the Fixed Costs to the various products. A B C 2.00 1.50 1.30 1.20 1.10 0.80 4,000 7,000 2,500
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2.3
Cost - Volume - Profit Analysis (also known as CVP Analysis)
The behaviour of costs and profits at various levels of activity is important to management and this information can be provided through the use of CVP analysis. A key factor in business is the volume of production; the greater the volume of production, the more thinly Fixed Costs can be spread over the units produced (using absorption costing techniques identified in section 5.1.3 page 24). This aspect will be seen clearly, in the examples shown. CVP Analysis is an application of marginal costing that seeks to study the relationship between costs, volume and profit at differing activity levels and can be a useful guide for short-term planning and decision-making. It is of particular benefit where the proposed changes in activity are relatively small, so that established cost patterns and relationships are likely to be consistent. With greater changes in activity and over a longer period of time, existing cost structures involving the amount of Fixed Costs and the Marginal Cost per unit, are likely to change so that this type of analysis is unlikely to prove useful in that longer time period. However, some of the short-term decisions, which are based on CVP, include those mentioned previously, such as: To make or buy a component To accept or reject a special order To retain or discontinue a department or product.
Before we look at CVP Analysis in detail, let's list some of the assumptions: All costs can be divided into fixed, semi-variable or variable. Semi-variable costs contain a fixed element and a variable element, with only the variable element moving in proportion with activity. Over the range of activity levels, costs and revenues change in exact proportions. Volume is the only factor affecting costs and revenues. Technology, production methods and efficiency remain unchanged. There are no stock level changes or that stocks are valued at Marginal Cost only. There is assumed to be no uncertainty.
It is unlikely that all these conditions will be met in real life, so CVP analysis should be used with caution.
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An important concept in CVP Analysis is the link that exists between profit and volume. This can be calculated, using the Contribution To Sales Ratio (C/S ratio), which can be determined by solving the relevant formula, namely: Total Contribution *100 Sales 1 By using Marginal Costing, Contribution can be expressed as a percentage of Sales for a particular product. This then enables the calculation of contribution provided by different levels of output. Example 5 To help with the calculation of the C/S ratio, we can use the information from example 2 (pages 49 and 50). As a reminder, the table given in the solution is copied below: MARGINAL COST STATEMENT for MARCH A B C Total Number of units sold Note 4,000 7,000 2,500 13,500 Sales Revenue 2.00 8,000 1.50 10,500 1.30 3,250 21,750 Less: Variable Costs a 1.20 4,800 1.10 7,700 080 2,000 14,500 CONTRIBUTION b 0.80 3,200 0.40 2,800 0.50 1,250 7,250 Fixed Costs c 5,000 Profit 2,250 Solution to Example 5 The C/S ratio for A would be: Total Contribution *100 Sales 1 3,200 * 100 8,000 1 40%
= =
We can then use this ratio to find the Contribution made towards covering Fixed Costs if Sales Revenue, of A, was either 10,000 or 11,000. (a) (b) 10,000 11,000 Answer: Answer: 10,000 x 40% = 4,000 11,000 x 40% = 4,600
Where a business manufactures a number of product types, it is desirable to calculate the C/S ratio for each product type.
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Using the data provided in the following table, calculate the C/S ratio for products B and C. MARGINAL COST STATEMENT for MARCH A B C Total Number of units sold Note 4,000 7,000 2,500 13,500 Sales Revenue 2.00 8,000 1.50 10,500 1.30 3,250 21,750 Less: Variable Costs a 1.20 4,800 1.10 7,700 0.80 2,000 14,500 CONTRIBUTION b 0.80 3,200 0.40 2,800 0.50 1,250 7,250 Fixed Costs c 5,000 Profit 2,250
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Management should always try to improve this ratio. The higher the percentage, the greater the contribution towards Fixed Costs and Profit. Such an improvement can be achieved by: (a) An Increase in the Selling Price. However, there is the risk, especially where there is fierce competition, that the organisation might suffer a fall in demand. (b) A Reduction in the Variable Cost Per Unit. This could be achieved, say, by purchasing the latest machinery which would cut the number of Direct Labour Hours to complete each operation. However, higher Fixed Costs, for example Depreciation, may offset this reduction. Note: This ratio is sometimes referred to as the PROFIT / VOLUME (P/V) ratio which is misleading as the calculation is based on Contribution and Sales, not on Profit. If management wish to increase profit in an organisation producing various products, they would wish to concentrate on those products which provide the higher ratio. The ratio should be calculated, whenever possible, at product level. One overall percentage for a department can be used to forecast the contribution provided at various output levels. However, if products vary widely in the department, the use of the ratio would produce misleading conclusions.
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Valante Limited uses general purpose machines which are equally suitable for making any of the company's products. Fixed costs total 300,000. The relevant data for the year ended 31/10/2003 is: Products Estimated Sales (Units) Selling Price per Unit Variable Costs per Unit Required: 1. Calculate the C/S ratio for each product. 2. Identify which of these three products, should receive the largest promotional budget and briefly explain why. Supa 10,000 20 10 Dupa 20,000 20 15 Good 40,000 20 12
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Key or Limiting Factor As a general rule, a business should concentrate on the product which makes the highest contribution towards Fixed Costs and, ultimately, to achieve the greatest profit. The product giving the highest C/S ratio of scarce resource can also be used to generate this evidence. When sales demand is in excess of the company's capacity, it is essential that the factor restricting output is identified and that the greatest contribution to profit is obtained each time that this scarce or limiting factor is used. Examples of such limiting factors would be: (a) the availability of raw materials (b) skilled labour or (c) the level of demand for the product. Marginal Costing supplies the data to assist management in making the decision as it identifies the product that makes the largest contribution to profit. In such circumstances, the decision may have to be reviewed and requires the calculation of the contribution per unit of limiting factor. The following example explores this further. Example 6 Let us re-use the data obtained from SAQ 3 Valente Limited are limited to a maximum of 120,000 machine hours per year, with the under-noted machine hours required to make one unit of each product type. Supa Dupa Good 5 hours 1 hour 2 hours
If Valente Limited possessed an objective of maximising profit, which product should receive the greatest allocation of scarce machine hours?
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Solution to Example 6 To maximise profit, Valente Limited would plan production to maximise production of the unit which gives the greatest contribution per machine hour (the limiting factor). Therefore, the starting point should be to calculate the contribution per machine hour, as follows; Products Selling Price per Unit Variable Cost per unit CONTRIBUTION per unit Machine Hours per Unit CONTRIBUTION per unit of Limiting Factor Ranking (i.e. which product to make first, second etc.) Supa 20 10 10 5 hours 2 per hour 3rd Dupa 20 15 5 1 hour 5 per hour 1st Good 20 12 8 2 hours 4 per hour 2nd
Valante Limited should produce and sell as much of product Dupa as possible, followed by product Good, then finally product Supa, according to the greatest contribution per limiting factor and dependent upon market demand. Producing and selling Dupa would use 20,000 UNITS @ 1 hour = 20,000 HOURS Producing and selling Good would use 40,000 UNITS @ 2 hours = 80,000 HOURS Total hours used to produce Dupa and Good 100,000 This would leave 20,000 machine hours (120,000 [available) - 100,000 [used]) in order to produce Supa. At 5 machine hours per unit = 4000 Units The profit statement would look like this: Valante Limited PROFIT STATEMENT For the year ending 31/10/2003 Contribution from Product: Dupa = 20,000 hours x 5 = Good = 80,000 hours x 4 = Supa = 20,000 hours x 2 = TOTAL CONTRIBUTION Less FIXED COSTS PROFIT 100,000 320,000 40,000 460,000 300,000 160,000
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Difficulties may arise in applying this procedure when there is more than one scarce resource. It could Not be applied if, for example, skilled labour hours were also scarce. In this situation, it is necessary to resort to Linear Programming methods in order to determine the optimal production programme. Management ought to maintain a control over costs and revenues, as well as to ensure every effort is made to operate at optimum capacity to ensure maximum profitability from the available resources. This responsibility results in management giving consideration to the following factors: (a) (b) (c) Selling price changes resulting from changes in competition WILL affect contribution and profitability. Variable cost changes such as an increase (or decrease) in direct materials WILL affect contribution and profitability. Fixed cost changes such as an increase (or decrease) in rent or rates WILL Not affect contribution, but as we will see in section 5.2.4 will have an impact upon the Break-Even Point and profitability.
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2.3
Break-Even Analysis
In terms of Sales Revenue or Volume, the Break-Even Point is the level at which the organisation makes neither a profit nor a loss. This is an important concept as it informs management of the level of activity at which a firm (product or department) may start to make a profit. As we will see, the BEP can also be applied to assist management in decisions regarding the viability of certain operations. Thus at Break-Even Point (BEP), Sales less Variable Costs is exactly equal to Fixed Costs (because profit is zero). In Marginal Costing terms, the Break-Even Point (BEP) is: Contribution = Fixed Costs (because profit is zero). At BEP it is necessary to earn enough to pay for all the Fixed Costs before any profit is earned. After the BEP is reached, ALL contribution will result in additional profit. Up to that point, a loss will be earned. The calculation of Break Even Point (BEP) can be done in several ways: (a) (b) In terms of Units BEP = BEP = Fixed Costs Contribution per Unit Fixed Costs Total Contribution Fixed Costs C/S Ratio * Sales
In terms of Sales Value
(c)
In terms of Sales Value
BEP =
Example 7 Lauder Limited sold one product. Last year 5,000 units were sold at a selling price of 2.00 pu. The variable cost per unit was 1.50, and fixed costs totalled 2,000. What is the BEP?
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Solution to Example 7 (a) In terms of Units BEP = Fixed Costs = Contribution per Unit = 4,000 units 2,000 (2.00-l.50) = 2,000 0.50
(b)
In terms of Sales Value BEP = Fixed Costs Total Contribution
* Sales
Total Contribution = Sales Revenue Less Variable Costs = (5,000 x 2.00) - (5,000 x 1.50) = 10,000 - 7,500 = 2,500 which is placed in the above formula 2,000 * 10,000 = 0.80 * 10,000 2,500 = 8,000
(c)
In terms of Sales Value BEP =
Fixed Costs C/S Ratio
So firstly we are required to work out the C/S Ratio, which is 2,500 * 100 = 25% 10,000 The C/S Ratio is then replaced in the formula to give: 2,000 = 8,000 25% = = 2,000 * 100 25 8,000 (calculated thus:)
Please Note: if you have already worked out the BEP in terms of units, you can quickly calculate Sales Revenue by multiplying the Selling Price by the number of BEP units, that is 2.00 x 4,000 = 8,000
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As we have said, the BEP is a very useful concept for management. The BEP can assist in working out the desired level of sales (in units) to achieve a targeted profit: To do so, we add the desired profit to the level of anticipated fixed costs and then divide by the likely contribution per unit achieved when selling one unit. The formula becomes: Fixed Costs + Target profit Contribution per Unit If management wish to know how many units will need to be sold to achieve a targeted profit, we can adjust the calculation to the following: Fixed Costs + Target Profit * Selling Price per Unit Contribution per Unit Example 8 Lauder Limited sold one product. Last year 5,000 units were sold at a selling price of 2.00 pu. The variable cost per unit was 1.50, and fixed costs totalled 2,000. Let us assume that Lauder Limited wish a profit of 10,000. How many units would have to be sold? Solution to Example 8 The Sales Volume would, therefore, have to be: 2,000 + 10,000 = 0.50 = 24,000 Units In terms of Sales Value 12,000 x 2 = 24,000 Units x 2 0.50 = 48,000 These calculations can be verified. For every unit sold above BEP(4,000 Units) the firm will make a profit of 50p (as all fixed costs have already been covered) the amount of Contribution per unit (0.50) will be profit . 24,000 Units - 4,000 Units = 20,000 additional Units x 50p profit = l0,000 which is the targeted profit. We have covered a lot in this section. Let us reinforce our learning with a SelfAssessment Question. 12,000 0.50
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Assume an organisation has provided you with the undernoted data: Sales 10,000 units Total Sales Revenue 200,000 Variable costs 120,000 Fixed costs 60,000 You are required to calculate: (a) Total contribution; (b) Anticipated profit; (c) On a per unit basis calculate:
(i) The selling price; (ii) The variable cost; (iii) The contribution;
(d) BEP in units; (e) BEP in sales value (f) How many Extra units must be sold to increase sales revenue to 300,000?
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The Margin of Safety This may be defined as the excess of normal or actual sales over sales at BEP and may be expressed as a percentage of either normal or actual sales. Therefore, it is the extent to which sales revenues may fall before the BEP is reached and losses are incurred. The Margin of Safety indicates whether the business is susceptible to a fall in demand. A narrow margin of safety would mean that a small reduction in volume would have a significant effect on profits. It goes without saying that a wide Margin of Safety is desirable. Short-Term Decision-Making One of the most important activities of management lies in decision-making. A manager must often make a choice regarding varying courses of action from a number of alternatives. This involves predicting possible outcomes. It is, therefore, essential for a manager to have an understanding of the manner in which costs behave in relation to sales and output. Marginal Costing is a useful technique for short-term decision-making because, in the short term, fixed costs remain the same, and the only costs that alter (and, therefore, the only ones that are relevant) are the variable costs. Accordingly, the selection of the option, which maximises Contribution, is usually the correct decision. Marginal Costing provides management with information that is appropriate and relevant to decisionmaking such as: the relative contribution to profit which are made by a number of products, and where the sales effort should be concentrated; whether a branch, department or factory should be closed; which products should be manufactured by the organisation and which should be purchased from outside sources; whether a special order should be accepted; selling a product or to process it further, with a view to improving its selling price or changing its market
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Megan Limited have produced the following data for the year to 31/12/2003, based on anticipated sales of 20,000 units. The budgeted selling price is 12 per unit. Direct Material Direct Labour Production Overhead Administration Overhead Selling and Distribution Overhead TOTAL COSTS 80,000 50,000 52,000 26,000 10,000 238,000 Fixed element including 12,000 Fixed cost all Fixed Cost all Fixed Cost
You are Required to Produce: (a) (b) (c) (d) Marginal Cost Statements based on Actual Sales for this year of 24,000 units and projected sales next year (2004) of 18,000 units. To calculate the Break Even Point. Identify this year's Margin of Safety for actual sales. Prepare an informal report to the Directors, commenting upon your findings and advising what action should be considered, taking account of the increased competition anticipated next year.
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Changes in Selling Prices It is very important for management to know the responsiveness of demand for its product(s) to changes in prices. It may be that a small DECREASE in price could result in a large increase in demand. Naturally, the reverse is also true, namely, a small increase in price could adversely affect demand. By using Marginal Costing techniques, management will be able to assess the likely result on the performance. Management will also need to consider the affect of these changes upon: (a) (b) (c) (d) Capacity; Distribution; The reaction of competitors; Quality of the commodity provided to customers. Example 9 The following data has been extracted from the Management Accounts of Mann Limited, a manufacturer of piggy banks: Current Activity 50,000 units Selling price Variable costs Contribution Fixed Costs Current Profit BEP 30,000 units The management of Mann Limited have asked their Management Accountant to report upon the likely effect on profits and break-even under the following conditions: (a) (b) (c) an increase of 20% in the selling price, resulting in a 30% decrease in sales an increase of 20% in the selling price, resulting in a 20% decrease in sales an increase of 20% in the selling price, resulting in a 5% decrease in sales 10 4 6 180,000 120,000
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Solution to Example 9 Mann Limited Marginal Cost Statement Demand Activity (units) Revenue Variable Costs Contribution Fixed Costs Profit Current 50,000 500,000 200,000 300,000 180,000 120,000 -30% 35,000 420,000 140,000 280,000 180,000 100,000 -20% 40,000 480,000 160,000 320,000 180,000 140,000 -5% 47,500 570,000 190,000 380,000 180,000 200,000
We can see that, where the price demand is responsive, the profit decreases. BEP will shift to 180,000 / 8 = 22,500 units
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Changes in Variable Costs Using the original data from example 7, let us consider changes in the variable costs when management decide to improve packaging, costing an extra 25%:
Mann Limited Marginal Cost Statement Original Revised Variable Costs Increased by 25% Per Unit 10 5 5 50,000 units 500,000 250,000 250,000 180,000 70,000 36,000 units
Activity Sales Revenue Variable costs CONTRIBUTION Fixed Costs Profit BEP
Per Unit 10 4 6
50,000 units 500,000 200,000 300,000 180,000 120,000 30,000 units
180,000 6
180,000 5
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Changes in Fixed Costs Have a limited effect, as they affect Profit and the BEP but do not affect the C/S ratio. Once more, let us use the original data from example 7. On this occasion, imagine a change in fixed costs caused by an increase in rent of 25,000.
Mann Limited Marginal Cost Statement Original Revised Variable Costs Increased by 25% Per Unit 10 4 6 50,000 units 500,000 200,000 300,000 205,000 95,000 34,167 units
Activity Sales Revenue Variable costs CONTRIBUTION Fixed Costs Profit BEP
Per Unit 10 4 6
50,000 units 500,000 200,000 300,000 180,000 120,000 30,000 units
180,000 6
205,000 6
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Relevant Costs Short-term planning decisions require information for the purpose of making decisions involving choice, where the choice is the preference of one alternative against other less desirable options. In this analysis, relevant costs are costs that will enable the preferred options to be identified. Relevant costs are future, differential costs that come into existence when a decision is made. They also differ depending on the option selected. Example 10 Beta Limited is to launch a new instrument, which requires the purchase of a special machine. Two rival companies produce this machine. Each machine performs the same functions: Machine A Machine B 200,000 250,000 5,000 5,000 20,000 10,000 15,000 10,000
Cost of purchasing Installation costs Operating costs per annum for standard output of 25,000 units Expected re-sale value of machine after 5 years
Those future costs that remain the same irrespective of which alternative is chosen are irrelevant costs and may be ignored. In this example, the irrelevant costs are the Installation costs of 5,000. Likewise, we can ignore the expected scrap value of the machines after five years, as they will both possess the same value (10,000). Accordingly the relevant costs are: Solution to Example 10 Machine A Machine B 200,000 250,000 100,000 300,000 75,000 325,000
Cost of purchasing Operating costs for the 5 year projected life of the project Total relevant cost for the projected 5 year life of the project.
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Opportunity Costs The accounting process restricts the recording of costs to product costs and costs associated with running an organisation. So, when reviewing a set of accounts published by a local organisation, you will discover items of costs and revenues. You will not see activity level costs and relevant costs as these are cost classifications that are required for decision-making and are Not recorded as such in the accounts. Another type of cost classification we need to review is known as Opportunity Cost. This concept has been borrowed from Economics, where it defines the relevant advantage gained as a result of choosing one alternative against another. A formal definition for Opportunity Cost would be: "The value of the next best opportunity lost as the result of preferring the chosen alternative to the rejected alternative". (Oxford English dictionary) Since accounting is able to deal only with monetary values, an opportunity cost may be redefined as "the net cash inflows or cash savings Lost as the result of preferring the chosen alternative to the rejected alternative." Example 11 Hair Limited has 5 million available to invest. The directors are considering two alternative projects. The profit margin, (see page 34 for a definition of margin), which may be achieved from Project A is 10% per year, whereas it is estimated that Project B will achieve a profit margin of 8%. In every other respect, both projects are comparable. Solution to Example 11 The relevant cost of choosing Project A lies in the Opportunity Cost resulting from losing the cash inflows from Project B. The justification for preferring Project A to Project B may be seen in terms of the comparative advantage associated with Project A, as follows: Estimated profit margin from Project A 10% of 5 million Less: the Opportunity Cost of losing annual return from Project B 8% of 5 million Net benefit of Project A 500,000 450,000 50,000
By their nature, Opportunity Costs arise only at the moment when a choice is being made, and their usefulness lasts only as long as a decision has not been reached. Relevant costs must include Opportunity Costs whenever the objective of the decision-making process is to place the organisation in a better position, as the result of choosing one alternative rather than another.
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Make or Buy Decisions Let us assume Bravo Limited is currently making a component, product number X1. Bravo Limited has spare capacity to make X1 and has received a quote from Delta Limited who will manufacture X1. The management of Bravo Limited should compare the quote from Delta Limited with the costs that would be saved if production ceased. These costs would normally include the variable costs of making X1 plus any directly attributable fixed costs associated with the manufacture of X1. Any common fixed costs, of Bravo Limited, absorbed into X1 will continue irrespective of whether Bravo Limited decide to continue to make X1 or to buy this component from Delta Limited. An arithmetic example will help your understanding of this concept. Example 12 An offer has been made by Delta Limited to supply your organisation, Bravo Limited, on an annual contract with a component AA1 for the sum of 40,000 per year. For next year, the Management Accountant of Bravo Limited has identified the annual costs of producing component AA1. Bravo Limited Estimated costs of making component AA1 Materials Labour Variable Overheads Fixed Overhead (direct). These costs will stop if we buy component AA1 from Delta Limited. Fixed Overhead (common). These costs will continue if we buy component AA1 from Delta Limited. TOTAL COST 14,000 12,000 3,000 6,000 12.000 47,000
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Solution to Example 12 We should never make the comparison of the 47,000 total cost of manufacturing AA1 with the buying-in cost of 40,000. This is because Bravo Limited have allocated 12,000 common fixed costs which will continue, even if the manufacture of component AA1 should cease. All other costs, totalling 35,000 might be saved, depending on whether labour can be deployed elsewhere. Bravo Limited Revised estimated costs of making component AA1 To allow comparison with quote from Delta Limited Materials Labour Variable Overheads Fixed Overhead (direct). These costs will stop if we buy component AA1 from Delta Limited. TOTAL COST 14,000 12,000 3,000 6,000 35,000
A comparison of this 35,000 avoidable cost with the offer of 40,000 is the correct one to make. In this example, it is cheaper for Bravo Limited to continue to make component AA1. This conclusion might well be different if we are working to full capacity, when buying in the component would release capacity to do other work.
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Example 13 If we use the same data from Example 12 and now add that Bravo Limited is working at full capacity. The labour employed on making component AA1 can be re-deployed to other work which would earn Bravo Limited Contribution of 19,000. What decision should the management of Bravo Limited make? Solution to Example13 Bravo Limited Revised Estimated Costs of Making Component AA1 To Allow Comparison with Quote from Delta Limited Materials Labour contribution from alternative work Variable Overheads Fixed Overhead (direct). These costs will stop if we buy component AA1 from Delta Limited. TOTAL COST 14,000 19,000 3,000 6,000 42,000
It can be seen that the Opportunity Cost for labour increases our avoidable costs to 42,000, which is now greater than the 40,000 offered by Delta Limited. Whether this 2,000 saving is sufficient to warrant buying-in is debatable, when other factors are considered.
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Acceptance of a Special Order This concept of marginal costing is useful to consider when a customer requests goods at a price that is less than these goods normally sell for. The crucial factors to consider are: The available capacity of your factory The Opportunity Cost of deploying scarce resources to make the goods The chance of future work from this customer The chance for future orders for these goods at a higher price The likelihood of other customers, who are currently paying the higher price, finding out that you sold goods at a cheaper price and, therefore, demanding a price cut for further work.
Example 14 Echo Limited manufactures a product with variable costs of 8 per unit and a selling price of 10.50. Foxtrot Limited asks if they can have 2,000 units in addition to their ordinary order but at a special price of 10 per unit. Should the company agree to the new order? Solution to Example 14 From a marginal costing point of view, the solution is simple. As the variable costs of the product are 8, any selling price above this amount will give a contribution; if any activity gives a contribution, it is worthwhile undertaking. On financial grounds, therefore, it is worthwhile accepting the order at the reduced selling price. There are other factors, which would need to be considered before a decision is taken: a) b) c) d) Will the acceptance of one order at a lower price lead other customers to demand lower prices as well? Is this special order the most profitable way of using spare capacity? Will the special order lock up capacity, which could be used for future full- price business? Is it absolutely certain that Fixed Costs will not alter?
The management of Echo Limited will require to take these considerations into account, before arriving at a decision.
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Sell or Process Further Decision As with other marginal costing concepts we have considered in the last six pages, the concept associated with sell or process further is also an entire category of managerial decisions. These decisions have one common characteristic, namely, doing something additional with a view to adding value to the firm. The most obvious example is a decision to process a semi-finished product further, rather than selling it in its present condition. The justification for processing further must be a net advantage over the decision to sell now. Other common examples of the sell or process further decision lie in the marketing of products, such as improving the presentation of a product by improved packaging, and selling a product in a differentiated market at a higher price. The sell or process further decision is another example of choice involving two mutually exclusive alternatives. For example, the decision to sell now is an alternative that precludes the possibility of further processing. Given the exclusive nature of these alternatives, the preferred alternative is the one yielding the higher profit. The costs relevant to the decision of choosing the preferred alternative are the opportunity costs of losing the profits associated with the rejected alternative. Example 15 Golf Limited sell a product for 10 per unit. The variable cost is 4 per unit. The product could be sold as a finished product for 12 in a different market by further processing which would add an extra 1 to the variable cost.
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Solution to Example 15 Golf Limited Sell Process Further Per unit Per unit 10 12 4 5 6 7
Sales Revenue Variable cost Contribution
Once the decision has been made, one of the alternatives will no longer be available. The problem is to identify the alternative that yields the highest differential profit. The relative advantage of the choice will take account of the Opportunity Cost of losing the other alternative, as follows: Return per unit of processing further: Opportunity Cost, of losing the return from processing further Compared with the sell decision Additional contribution of choosing process further 1 7pu. 6
In this example, it would be wiser for the management of Golf Limited to process further in the hope of gaining the extra contribution.
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Hunter Limited produces a component for the building trade. The following information has been extracted from the Management Accounts of Hunter Limited Per unit 50 19 7 17,000 per month
Selling Price Direct Material Direct Labour 4 hours Fixed Costs
Labour is very scarce at present and demand for the company's product is high. (i) (ii) You are required to calculate: Contribution per unit. Contribution per labour hour. A contract worth 4,800 is on offer to the company. The following information is relevant: Labour time would amount to 300 hours Material Cost would amount to 1,800 A special component would be required to fulfil this contract. Hunter Limited could manufacture this component at a cost of 150 for material plus 20 hours of labour. Alternatively, the component could be purchased from an outside supplier for 300.
If Hunter Limited accept the contract, all labour will have to come from the existing workforce because of the scarcity of the skilled workers required. (iii) (iv) Advise Hunter Limited whether to make or buy the special component. If Hunter Limited decide to buy the component, calculate: (a) the cost of the contract; (b) the additional profit or loss if the contract is accepted.
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Ferguson Limited produces 3 products R, S and T. R has a selling price of 3 per unit. The selling price of S is 7 per unit, whilst the selling price of T is 4. Direct Labour is paid at the rate of 4 per hour. Trading results for the next six months are expected to be: R S T Total Sales Revenue 120,000 87,500 120,000 327,500 Less: Variable Costs Direct Materials 47,000 55,000 45,000 147,000 Direct Labour 21,000 15,000 24,000 60,000 Direct Overhead 42,000 30,000 21,000 93,000 110,000 100,000 90,000 300,000 Contribution 10,000 -12,500 30,000 27,500 Less: Fixed Costs 20,000 Profit 7,500 Required (a). On the basis that Fixed Costs can be charged to products on a basis of 33.33% of departmental Direct Labour Cost, calculate the BEP in terms of units and sales values for Products R, S and T.
The management of Ferguson Limited are considering two projects to improve profitability. (b). Project one would be to reduce labour hours to 10,000 by ceasing production of Product S and reducing production of either Product R or Product T. Employees affected by this reduction in manufacturing would lose their jobs. All of the fixed costs attributable to Product S would be reduced to zero. However the fixed costs associated with Product R and Product T would remain unchanged. Calculate the Change in Profit. The second project involves the manufacture of component W, which is a vital part of Product R. Half the time in department K (where R Is produced) is spent in making 80,000 units of component W. This component incurs material costs of 20p per unit and variable overhead costs of 10p per unit. This component can be bought from an outside supplier for 23,000. Assuming that Ferguson buy-in the component, the labour released could do other work, which would make a contribution of 2,000 to Ferguson Limited.
(c)
Advise the Management of Ferguson Limited if the Projects Should Proceed.
2.6
Summary
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This section of the guide has reviewed short-term decision-making techniques. The tools applied have adopted the principles of marginal costing. In marginal costing, it is the contribution to fixed costs which is considered to be of paramount importance. By maximising contribution, it is assumed that the firm will maximise profit. These concepts are borrowed from Economics, where profit maximisation, as you may recall, is considered the prime motivator for economic activity. We have considered these principles, in some detail, by applying them to a variety of typical management decisions, namely: Make a commodity ourselves, or buy in Changing the selling price of a commodity Changes in the cost structure Acceptance of an order with special conditions; etc. Whilst marginal costing is a powerful technique, it is also subject to a number of limitations, namely: It assumes costs can be classified between fixed and variable Linearity, where revenue and variable costs increase in proportion with activity It ignores qualitative factors (i.e. those which can not be quantified) The relevant range may be fairly narrow. It should be emphasised that these techniques will not, by themselves, improve efficiency and profitability. However, they will aid management in their quest for greater leverage, by way of efficiency and when combined with other techniques - discussed in later units - will assist the decision-making process. By now you should be aware of the undernoted concepts associated with marginal costing: CVP BEP Make or Buy Sell or Process Further Keep open or close. If you possess any doubt, it is suggested you re-visit the relevant area of this section. Alternatively contact your tutor.
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5.3
Learning Outcome 3 Introduction
3.1
Having reviewed the techniques available for applying a cost to a commodity, we now turn over to investigating the basic budgeting processes undertaken by a firm. At an early stage in our discussions, we recognised the differences between a control system in an organisation and the planning system. In this section we shall examine budgets, which are a mechanism that allows management both to control and to plan the operations of an organisation. We shall be reviewing the role of budgeting in the planning and control of activities, which help to define objectives for departments, divisions and the organisation. Finally, we shall look at the control mechanisms that management can introduce as an aid to identifying whether or not the objectives are being met. Firstly, though, we are required to investigate the basic unit cost of a commodity, known as the Standard Cost. This is important as it assists management in the planning and controlling of activity.
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3.2
Standard Costing
Standard costs are predetermined costs. They are the building blocks of a budgeting and feedback system. They may be used in a wide variety of firms and in conjunction with any kind of product costing, whether it be job costing, process costing or service costing. As target costs, they assist in the preparation of budgets, gauge performance, obtain product / service costs and save bookkeeping costs. A set of standards outlines how a task should be accomplished and how much it should cost. As work proceeds, actual costs are compared with standard costs to reveal variances. This feedback helps discover better ways of adhering to standards and of accomplishing objectives. What is the difference between a standard amount and a budget amount? The standard cost is a cost for each unit produced, or for each process, in advance of the unit being manufactured or the process being undertaken. Standards for the coming periods are established, using historical data gleaned from the accounting system. This data is analysed to department or process level where the responsible line manager, with advice from his superior and the Accounting / Marketing departments , identifies the likely costs involved in producing the required commodities. Once this is achieved, it is then straightforward to set the standard cost for each unit. A number of assumptions are made when setting standards, and it is the veracity of these assumptions which ultimately determine the accuracy of the standard cost established. Note: the role of the accounting department is: (a) (b) To price physical standards and To report operating performance in comparison with standards.
Three types of standards may be devised: (1). Basic Cost Standards are unchanging standards, which provide the base for comparing with the actual costs over a long period. As such, they are frequently found in long-term planning scenarios, where the establishment of a trend is considered important. They have very little use at operational level. (2). Ideal Standards are those considered achievable under the best conceivable operating conditions, using existing specifications and equipment. Management apply ideal standards when there is a need to provide psychologically productive goals. Otherwise, their use is limited at operational level. (3). Currently Attainable Standards are the costs that should be incurred under forthcoming efficient operating conditions. They are difficult but possible to achieve. Attainable standards are looser than ideal standards because of allowance for normal spoilage, ordinary machine breakdowns and lost time. However, attainable standards are usually set tight enough so that the operating people will consider the achievement of standard performance to be a satisfying accomplishment. A major benefit from using the currently attainable standards is the multipurpose use of the resultant standard costs. They may be used simultaneously for product costing, master budgets and motivation. Thus, if actual results differ from the standard costs, the
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difference (known as a variance) may be investigated and corrective action taken to prevent recurrence. If the standards set do not use currently, attainable standards, then the amounts budgeted will differ from actual results due to the occurrence of anticipated lost time or material spoilage, frequently out of the control of line managers. Establishing a Standard Cost Physical standards are the foundation of a standard cost system. Ideally, they should represent reliable engineering or physical estimates, which may be expressed in tons or gallons produced and in minutes or hours of labour. These standards are often constructed from systematic observation, measurement and controlled experiment. Analysis of the kinds and amounts of materials, labour time and methods, and necessary overhead items lead to the establishment of these physical standards. Standard costs multiply the physical standards by appropriate price factors (obtained from the accounting information system). The use of price factors allows all standards in the organisation to be expressed in pounds sterling. Material price standards will be set by the procurement or purchasing departments working jointly with the Accounting Department. The Design or Engineering department will set material standards. Labour price standards and labour efficiency standards are set by agreeing upon the grades of labour employed and by reference to personnel / payroll for identification of the rates payable to each grade. The Accounting Department will set overhead standards based upon: duration of the job (machine or labour hours), prime cost of the job, space occupied by the process, or another appropriate rate applied by the organisation. When new processes are initiated, the standards set will need to reflect this and frequently assistance will need to be sought from agencies outside the organisation, such as customers, consultants, suppliers or even competitors.
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3.3
Budgeting
Planning Budgeting should be a continuous activity, divided into a number of stages: 1 Long-term plans determined by the Senior Management in line with the objectives 2 Short-term plans determined by the Managing Director 3 Results of past performance 4 Financial and other quantitative data relating to such factors as: labour; capacity; raw material Interpretation of external data for example: economic growth; inflation. Limiting Factor The starting point with budgeting is to identify the key or limiting factor. This restricts the firm's growth at this moment in time. In many organisations, this could be sales volume, or shortage of space, skilled labour; raw materials or even working capital. The technical aspects of budgeting are fairly straightforward, whereas the behavioural issues are much more complex. The critical problems arise out of: how managers perceive budgets, how they use the information provided by the budget system and how the effects of such uses feedback on the information that is entered into the budget. Before we consider the procedures involved in budgeting, we shall review the benefits of budgeting. As detailed budgets are usually required for each activity in the business, managers of various sections or departments will be asked for their ideas. This, in itself, leads to the problem of co-ordination. An efficient budgetary process will ensure that this takes place and that each subsidiary budget relates to another. Each stage of the operation will contribute to the overall plan. By introducing budgets for various activities, top management will ensure that authority and responsibility go together. To facilitate this, we assume the areas of responsibility, known as cost centres, are set up. The designated person will be given clear a statement of their responsibility. Thus control is maintained, whilst ensuring individuals are responsible for their own action. Each cost centre manager will be involved in the budget discussions. Two advantages accrue from this: a) b) Each person feels part of the process and is, thereby, motivated to work efficiently; There is continual communication between managers at all levels and between management in various sections.
The "devolved management" mentioned above can free top management from having to oversee the day-to-day running of the overall plan. When activities are not going to plan,
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any major discrepancies will be reported to top management. The latter group need to concentrate on variations; namely "management by exception". There is of course the CONTROL aspect. The process of comparing actual with budgeted results and agreeing on the corrective action needed will exercise a control discipline. This is particularly important for keeping expenditure within agreed levels. Budgets force managers to look at future events, expressed in the cold hard figures of quantitative and financial data. The people involved are therefore forced to consider economic and financial reality. The "planning" aspect is a major advantage. In many cases, the organisation's directors will wish to stay ahead of competitors and there is no harm in planning for the future. Similarly, the manager asked to produce a budget will be encouraged to examine what has been done in relation to what could be done. Management Use of Budgets The following are necessary for the effective system of budgetary control: 5 Necessary Conditions for Effective Budgetary Control 1 2 3 4 5 Authority and responsibility must be clear Managers must consider budgets to be attainable to be accepted The manager must be able to understand the budget, so standardisation of format is very useful Training in budgetary control must be effective, allowing freedom to discuss issues with colleagues The manager must understand the aims underpinning the construction of the budgets
This section aims to address these issues. Participation Allowing managers to participate in the budget-setting process improves the attitude of managers toward the control process. The fact that managers have been involved in setting the budget makes it more likely that they will accept the budget, and generate a positive attitude toward the organisation. Budgets should be more accurate, since the managers who have knowledge of local conditions will have been involved in the setting of the budget. Some organisations claiming to use participative budgeting are not really using it, since the work completed by lower level managers is ignored and replaced by figures produced by senior managers. This has been referred to as pseudo-participation and is, in fact, more de-motivating than a situation where no participation takes place at all. Budgets as Targets
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It is suggested that the highest level of performance is achieved by setting the most difficult specific goal, which will be accepted by management. The precise effect is determined by the way in which the target influences the participant's own goals. Budgets as Forecasts It is important to recognise that budgetary biasing may take place when budgets are being prepared in organisations. Budgetary biasing allows targets to be achieved more easily. There is evidence that managers operating in tough environments may bias their estimates in the opposite direction and set themselves budgets that they are unlikely to achieve. The reasoning behind this is that managers may be feeling insecure because of past poor performance and feel that, by promising improvement, they would gain immediate approval, despite the risk of future disappointment. The important message for organisations is that they need to try to understand the reasons why biasing takes place. It may be because of the way that budgets are used in performance evaluation within organisations, and this is the next issue we will deal with.
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The Use of Budgets in Performance Evaluation Budgetary control systems are often viewed very negatively. The major problem is the way in which budgetary control information is used in performance evaluation. It is possible to identify three different approaches of using budget and actual cost information in performance evaluation: 1 Budget-constrained style - is based on the ability of the manager to meet the budget on a short-term basis. This criterion of performance is stressed at the expense of other valued and important criteria. Budget data is, therefore, used in a rigid manner - not achieving budget targets results in punishment, whereas achieving results gains rewards. Profit-conscious style - the performance of the manager is evaluated on his or her ability to increase the general effectiveness of his or her unit's operations in relation to the long-term goals of the organisation. The accounting data must be used with some care and in a rather flexible manner, with the emphasis for performance evaluation on contributing to long-term profitability. Given good reasons for overspending, non-attainment of the budget can still result in rewards, whereas the attainment of a budget in undesirable ways may result in punishment. Non-accounting style - accounting data plays an unimportant part in the evaluation of performance - the budget is relatively unimportant because rewards and punishment is not associated with its attainment.
You should now be aware that budgeting within organisations is quite complex, from a behavioural perspective. The designers and participants need to recognise these complexities in order to create a budgeting system, which helps the organisation to achieve its objectives. Budgeting for Control Where budgeting is used for control purposes, it must be remembered that a manager can only be held accountable for those costs which are within his control. No-one can be expected to take responsibility for costs over which they have no authority. Having exhausted our review of the behavioural aspects of budgeting, let us now turn our attention to functional budget computation. However, please note you will not be assessed on the computation of functional budgets.
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Departmental or functional budgets are first produced, starting with the most important the Sales Budget, which normally requires assistance from the Marketing Department. Having identified the demand for our commodity, we can now consider how that demand is to be satisfied by way of production. This necessitates consideration of the manufacturing or service process and requires investigation of the material and labour requirements. Finally, an Overhead Budget will be drawn up, using overhead absorption rates. These were discussed in section 5.1.3 starting on page 24. These departmental or functional budgets will be drawn together into a Master Budget, which consists of a budgeted Profit and Loss Account and a budgeted Balance Sheet. This Master Budget is a forecast of the expected profit level and the expected financial position of the firm at some future date. Assuming Senior Management are content with the output of the budgets, a Cash Budget would be produced to identify the inflow and outflow of funds over the budgetary period. To aid your understanding review the under-noted example, taking care to see where the associations are made. Example 16 The following relates to the Aardvark Limited Sales (UNITS) Opening Stock Closing Stock To make 1 unit requires 3 components To make 1 unit requires 2 grades of labour 40 per unit January 2,000 800
To be calculated
February 2,500
To be calculated To be calculated
March 3,100
To be calculated
1,000 C kg 4.00 Production 2 hours 3.50
Component Quantity Price per kg Department Number of hours Rate per hour
A 2kg 0.50
B 1kg 2.00 Preparation hour 3.00
Variable overheads 3.00 per unit Fixed overheads 8,000 per month Stocks of raw materials are purchased in the month of production.
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Solution to Example 16
Sales Budget for Number of Units SOLD Selling price per unit Anticipated Revenue January 2,000 40 80,000 February 2,500 40 100,000 March 3,100 40 124,000
This is a difficult budget to prepare, as it is dependent on many external factors influencing consumer behaviour. It is prepared from research and may be analysed by product, markets or distribution channels. Where there is seasonal demand, this will be reflected in detail.
Production Budget for Estimated Sales Add closing stock Available to sell Less opening stock Production this month January 2,000 1,400 3,400 800 2,600 February 2,500 1,700 4,200 1,400 2,800 March 3,100 1,000 4,100 1,700 2,400
The Production Budget is very closely co-ordinated with the Sales Budget. It will show the quantities and costs for each product and will match the Sales Budget, productive capacity and Stock (Inventory) Budgets. It is unlikely that production and sales will exactly match, with any shortfalls being met by overtime or even sub-contracting. If capacity is in excess of demand, short-time working may be introduced. After discussion and revision, the Production Budget will allow the Labour, Materials and Overhead Budgets to be developed. The production figure is initially unknown. It will be derived from three previously estimated figures. The first estimated figure is sales to which we add a figure for closing stock. Closing stock is estimated to take account of forecasted sales in the first few days of the next month. The resultant figure (3,400 units) is available for sale from which we deduct unsold stock from last period, which is available for sale early in this period and is known as opening stock. The resultant figure is the production figure for this month. The Raw Materials Budget is the next budget produced. It looks rather daunting at first, but detailed review identifies that, into each period, we identify the production target. This is multiplied by the component required per unit, before multiplying the resultant figure by the cost per kg, to give us the total cost per component.
Raw Materials Budget for
January
February
March
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Component Production Kg per unit Kg requirement Cost per kg
A B C A B C A B C 2,600 2,600 2,600 2,800 2,800 2,800 2,400 2,400 2,400 2kg 1kg kg 2kg 1kg kg 2kg 1kg kg 5,200 2,600 1,300 5,600 2,800 1,400 4,800 2,400 1,200 0.50 2.00 4.00 0.50 2.00 4.00 0.50 2.00 4.00
2,600 5,200 5,200 2,800 5,600 5,600 2,400 4,800 4,800
Total cost ()
This budget is determined by the Production Budget and by company policy concerning bulk buying. However, for our purposes, we will assume that the raw materials are purchased in the month in which production takes place. If we take account of opening and closing stocks of raw materials then we will adjust the purchases accordingly. Where there are several components used in production, then these would all have to be included in the budget. Labour Budget for Preparation Production Hours per unit Hours required per hour Total cost Labour Budget for Production Production Hours per unit Hours required per hour Total cost January 2,600 0.5 1,300 3.00 3,900 January 2,600 2.0 5,200 3.5 0 18,200 February 2,800 0.5 1,400 3.00 4,200 February 2,800 2.0 5,600 3.50 19,600 March 2,400 0.5 1,200 3.00 3,600 March 2,400 2.0 4,800 3.50 16,800
These budgets are similar to the Raw Materials Budget but this time the cost of labour is involved.
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Overhead Budget for Production Variable Overhead per unit Fixed Overhead per month Total cost Important Note
January 2,600 3.0 7,800 8,000 15,800
February 2,800 3.0 8,400 8,000 16,400
March 2,400 3.0 7,200 8,000 15,200
This example included 3 different components in raw materials and 2 different grades of labour. Please remember there is no correct format in management accounts. You may lay them out as you wish, provided they are clear and easily understood.
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Master Budget This is a simplified Profit and Loss account for the firm and would be reviewed by management prior to further detailed work being undertaken on the budgetary process. This review would consider the achievement of management's objectives for the period and decide whether the anticipated profit was sufficient Aardvark Limited For the period
January
Master Budget February

80,000 100,000
March
124,000
SALES Less: Materials A B C Total material Labour: Preparation Production Total labour Total Cost GROSS PROFIT Overheads NET PROFIT
2,600 5,200 5,200 13,000 3,900 18,200 22,100 35,100 44,900 15,800 29,100
2,800 5,600 5,600 14,000 4,200 19,600 23,800 37,800 62,200 16,400 45,800
2,400 4,800 4,800 12,000 3,600 16,800 20,400 32,400 91,600 15,200 76,400
Each month's column is sub-divided into three columns. The first identifies the component cost, the second the sub-total, with the final column providing the total revenue and cost for that month. This format is quite normal, though may be varied at the discretion of the management of the firm. This budget summarises the departmental (functional) budgets previously prepared, and allows management to review proposed activity in financial terms. If they are content with the figures and the projected profit levels, the remaining budgets will be prepared. If management are dissatisfied, the budgets will be returned to the departmental mangers for review and amendment.
In our example, management may be dissatisfied with the lower projected profit for February. In which case Marketing and Production Managers would have to review their assumed levels of activity. Marginal Costing techniques may be applied to assist their deliberations. Alternatively, they, may elect to alter production levels These were reviewed in section 5.2 page 45. If management are content with the projections, they will sanction production of the remaining budgets. (N.B. Modern spreadsheets allow for budget preparation. In fact, it is most unlikely that these would be produced manually! When a spreadsheet is used, it is possible to alter one variable and immediately note the effect of that change)
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The organisation may decide to produce additional budgets to cover: Capital Expenditure, which will identify when and why major pieces of expenditure are required. It allows management to project when the necessary cash is required. Cash forecasting assists the management in making estimates of capital, overheads and labour, when cash will be received and when cash will be paid to suppliers,. Indeed, the cash budget indicates the effect of the budgeted activities of all the functional areas of business on the flow of the firm's cash, which represent the lifeblood of the organisation. Cash budgets are prepared and revised monthly.
Neither of these will be assessed in this unit.
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Summary Benefits of budgeting include: Planning Coordination Communication Control Leading Evaluation By anticipating problems, they can be circumvented, mitigated or insured against. Enables synergies to be developed and helps to resolve conflict Facilitates the transfer of knowledge so that all departments understand their role. Assists organisation to keep on target toward objectives. Helps the planning process and the setting of future plans. Enables easy computation of bonus payments etc., when performance indicators are reached.
Disadvantages include: Motivation Maintaining motivation throughout the budget period can sap energy and, in poorly managed situations, lead to stress. Feedback Constructive, accurate and timely feedback is important, particularly when activities are not going to plan. Negotiation Dependent upon the management style but, if that style is too directional negotiation may mean consultation - where the manager is listened to, but little or no notice is taken of the manager's opinion. Budgetary Budgets are set too low. As a result resources are not stretched slack and under-achievement is the result. Incrementalism The figures from last year are taken with an across the board increase to account for inflation and a general improvement in profitability - say 5%. Therefore, the increase would be, say, 10%.
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3.4
Flexible Budgets
An advantage of budgeting is that it provides a measure to judge actual performance. However, a concern of using budgets, as a basis for comparison, is that the basic assumptions underlying their completion may be incorrect. For example, increased demand may lead to a rise in the number of units sold. As a consequence, the original budgeted results may be misleading if used for direct comparison with actual data. The main reason for construction of our original budget is to assist in the planning stage, when it serves to define the broad objectives of the organisation over a period of time. It is unlikely to be of any real value for control purposes, except if the level of activity turned out to be exactly as planned. When the original budget is drawn up, all figures are forecasts, including the level of activity. If, during the year, the level of activity alters, the anticipated revenues and costs will also alter (but not necessarily in direct proportion). If budgets were used as a method of control, the original budget would no longer provide a picture of the situation. It would be necessary to draft a new budget, which would not be a cost-effective use of resources. Flexible Budgets take account of changes in activity and allow for the variable levels of revenues and costs. For control purposes, it is vital that flexible budgeting is used. The technique allows for the comparison of Actual with Budgeted Data, When Output Varies. The principal difference between the original Budgets and Flexible Budgets is that, in the Flexible Budgets, cost behaviour is taken into account. By recognising the different behaviour of costs (fixed, variable, and semi-variable), we can produce a budget which can be used for control across a range of levels of output.
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Example 17 The following abstract of a Flexible Budget relates to the costs incurred by Aardvark Limited for January. Anticipated production is 2,600 units. However, the Production Director advises that this can increase or decrease by 5 or 10%, dependent upon demand. You have been asked to produce a Flexible Budget to take account of this variation. Aardvark Limited Flexible Budget For January Percentage of normal activity
Per Unit 2,600 units 100% 13,000 5.00 8.50 3.00 22,100 7,800 8,000 50,900
Direct Material
2kgs of A at 0.50 1kg of B at 2.00 kg of C at 4.00
1.00 2.00 2.00
Direct Labour Variable Overhead * Fixed Overheads Total Cost of production Solution To Example 17
Costs are categorised into variable, semi-variable or fixed. Like costs may then be grouped. Aardvark Limited Flexible Budget For January Percentage of normal activity
2,340 units 90% 11,700 19,890 7,020 8,000 46,610 2,470 units 95% 12,350 20,995 7,410 8,000 48,755 2,600 units 100% 13,000 22,100 7,800 8,000 50,900 2,730 units 105% 13,650 23,205 8,190 8,000 53,045 2,860 units 110% 14,300 24,310 8,580 8,000 55,190
Direct Material Direct Labour Variable Overhead * (3pu) Fixed Overheads Total Cost of production * Please note that it is only the variable element that would be flexed. Having calculated the budgeted figures for each anticipated level of production, it is now possible to take this a step further and compare with the ACTUAL costs incurred in producing this component for any one month. Example 18 Using the information from Example 17, identify if Production have been successful in controlling their costs for January, if production was 2,730 units and actual costs were as shown below.
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Solution To Example 18 Aardvark Limited Flexed Budget For January Direct Material Direct Labour Variable Overhead * (3pu) Fixed Overheads Total Cost of production
Budget 2,730 Actual 2,730 Variance F/A 1,150 795 100 0 255 F A A F
units units 13,650 12,500 23,205 24,000 8,190 8,290 8,000 8,000 53,045 52,790
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Clearlite Limited is a company producing household lamps. You are required to produce a Flexible Budget based upon the following levels of production: 8,000; 9,000; 10,000; 11,000 and 12,000 lamps per month. The following budgeted information is provided. 1 Sufficient raw material can be purchased from supplier ABC Limited at a cost of 2 per lamp to fulfil production of 9,000 lamps per month. Above this level, any balance must be sought from an importer (XYZ gmbh) at 2.20 per lamp. At 8,000 lamps of output, 10 operators are required. 1 additional operator is required for each additional 1,000 lamps produced. Operators are paid 1,000 per month. Supervisors are paid 1,600 per month. Supervisors can oversee only 4 operators. Electricity costs consist of a standing charge of 100 per month plus running costs of 0.05 per lamp produced. Minimum heating costs of 1,500 per month will be incurred up to an output of 8,000 lamps. For output of between 8,001 and 10,000 units, a 20% increase in those costs will apply. Output above 10,001 units will incur costs of 2,100 per month. Fixed overheads, comprising depreciation of existing machinery and rent, amounts to 2,200. If production exceeds 10,001, a new machine would be hired costing an additional 300 per month.
3 4
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Clearite Limited (2) Refer to your answer for self assessed question 8, Clearlite Limited.
1
Prepare a flexed budget, assuming actual production is 9,000 units and the actual costs are: Raw material 18,200 Labour 11,220 Salaries 4,800 Heating + Electricity 2,550 Fixed Costs (Depreciation + Rent) 2,000 Identify the likely reasons for each of the variances. Identify the managers responsible for the controllable costs. What remedies would you recommend to prevent a recurrence of the variances? Discuss why the unanticipated use of unskilled labour could be the reason for the labour variance.
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3.5
Variances
A variance is the difference between actual and budgeted cost. A favourable (F) variance results from actual costs being lower than, budgeted and, therefore, is likely to increase budgeted Profit. An adverse (A) variance identifies actual costs being more than, anticipated and will lead to a decrease in anticipated Profit. From a review of example 16 (page 101), it is relatively easy to determine that the Production Department have done well. Actual costs were 255 less than budgeted for. However, if we analyse the individual costs, we see this is due to a large saving in Direct Material, which is compensating for increased spending in Direct Labour and Variable Overheads. Further investigation will be needed to identify precisely where the problem lies and corrective action taken by the Production Department to prevent recurrence. Even though a favourable variance was achieved with variable overhead, this also requires investigation to determine the cause. If necessary, the reasons for these variances will require to be incorporated into the flexible budget, if the budget is to be of use for control purposes. This method of analysing variances is known as management by exception, where areas of over / under spend are highlighted and only those areas investigated. This technique allows management more time to concentrate on problem areas. We do require to be cautious, as the total variance of 255 (F) is very low, constituting less than %. However, labour at 795 (A) is considerably more. In our example, we may decide not to investigate variable overheads since the adverse variance is only 100. That is less than 1% of the budgeted total and is, therefore, not significant. On the other hand, materials are over budget and therefore, a cause for concern. Frequently, simplistic assumptions are made about cost behaviour, which are unrealistic and potentially misleading. For example: *The arbitrary assumption of variable costs varying in direct proportion to activity and that fixed costs remain completely static *The assumption that semi-variable costs behave in a stepped manner *The arbitrary manner used to determine the fixed and variable elements of costs *The assumption that all variable costs are flexed in relation to the same activity indicator (for example sales or production) when in reality variable costs vary in relation to different activity indicators. These problems aside, a Flexible Budget is essential for the control aspect of budgeting. It is, therefore, usual to carry out the required cost analysis and breakdowns at the planning stage, so that the budget may be flexed in due course.
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Standard Costing is mainly applied to products and processes and predetermined costs and sales are compared with actual results to establish differences or Variances. Managers, within the company, can be held responsible for these variances and, by careful analysis, the underlying reasons for these variances can be ascertained. Variances are important, as they mean that our actual profit is likely to be different from that anticipated when our budgets were compiled. Budgets are used by many organisations to plan future operations; and any differences between anticipated sales and costs and actual results could have catastrophic implications. The term variance is rarely used on its own. Usually it is qualified in some way; for example, direct materials price variance or direct labour efficiency variance. Variances arise from differences between standard and actual quantities and / or differences between standard and actual prices. The reasons underpinning the causes for the differences have to be established by investigation. The nature of the variance and its cause (for example material price), must be reported quickly to the manager responsible, so that the reason can be discovered to enable effective action to be taken promptly. Both adverse and favourable variances should be investigated as they both represent a deviation from the standard, which requires explanation. Variances are calculated using the undernoted formulae. Whilst it is important that you know how to calculate them and understand what the answer is indicating, it is not imperative that you memorise the formulae. In our discussion, we will concentrate on the fundamental meaning of the formulae.
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Material Variances The costs of the materials used in a commodity are determined by two factors; the price paid and the quantity used in production. This gives rise to the possibility that the actual cost will differ from the standard cost because the actual quantity of materials used will be different from the standard quantity and/or that the actual price paid will be different from the standard price. We can therefore, calculate three variances: 1 DIRECT MATERIAL TOTAL VARIANCE
(STANDARD UNITS OF ACTUAL PRODUCTION * STANDARD PRICE) - (ACTUAL QUANTITY * ACTUAL PRICE)
2 DIRECT MATERIAL USAGE VARIANCE

STANDARD PRICE * (STANDARD UNITS OF ACTUAL PRODUCTION - ACTUAL QUANTITY)
3 DIRECT MATERIAL PRICE VARIANCE

ACTUAL QUANTITY * (STANDARD PRICE - ACTUAL PRICE)
Labour Variances The cost of labour is determined by the price paid for labour and the quantity of labour used. Thus, a price and quantity will also arise for labour. Unlike material variances, labour cannot be stored because the purchase and usage of labour takes place simultaneously. Hence, the actual quantity of hours purchased will be equal to the actual hours used for the period. For this reason, the rate variance plus the quantity variance should equal the total variance. As with material variances, within the labour variances three variances will be calculated: 1 DIRECT LABOUR TOTAL VARIANCE
(STANDARD HOURS OF ACTUAL PRODUCTION * STANDARD RATE ph) - (ACTUAL HOURS * ACTUAL RATE ph)
2 DIRECT LABOUR RATE VARIANCE

ACTUAL HOURS * (STANDARD RATE ph - ACTUAL RATE ph)
3 DIRECT LABOUR EFFICIENCY VARIANCE

STANDARD RATE ph * (STANDARD HOURS OF ACTUAL PRODUCTION - ACTUAL HOURS)
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Example 19 Within our discussions on flexing budgets, see Example 18, you were introduced to Flexed Budgets. In this example the original budget had been set for an activity level of 20,000 units, for March 2004. However, activity of 18,000 units was achieved. The following table displays the process for adjusting the original budget (20,000 units) to the flexed budget (18,000 units). It is the flexed budget, which is compared with the actual results to arrive at any variances. Halbeath Limited Flexed Budget For March 2004 Original Budget Flexed Budget 20,000 units 18,000 units 10,000 9,000 10,000 9,000 20,000 18,000 20,000 18,000 15,000 13,500 67,500
Direct Material A B Direct Labour Variable Overheads Fixed Overheads Total Notes:
Actual results 18,000 units 9,990 9,000 19,960 18,000 13,500 70,450
Variance F/A 990 A 0 1,960 A 0 0 2,950 A
During the budgeting process, it was anticipated that each unit would comprise: (a) (b) (c) (d) 15 minutes of labour to manufacture; labour would be paid @ 4.00 ph; 0.5 kg of Material A @ 1.00 p. kg; 1 kg of Material B @ 0.50 p. kg.
An analysis of the actual results, for the period under review, indicated the following: (i) (ii) (iii) (iv) 5,994 labour hours were worked on the manufacture of this product; labour was paid 3.33 p. h.; 9,000 kg of Material A, was used @ 1.11 per kg. 1 kg of Material B, was used in each unit, @ 0.50 p. kg.
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Solution to Example 19 The calculation of the variances would be: (1) DIRECT MATERIAL A TOTAL VARIANCE ((0.5 kg *18,000) * 1.00) - (9,000 kgs * 1.11) = (9,000 kgs * 1.00) - 9,990 = 9,000 - 9,990 = 990 (A) (2) DIRECT MATERIAL A PRICE VARIANCE ACTUAL QUANTITY * (STANDARD PRICE - ACTUAL PRICE) 9,000 kgs * (1.00 - 1.11) = 9,000 kgs * 0.11 = 990 (A) (3) DIRECT MATERIAL A USAGE VARIANCE STANDARD PRICE * (STANDARD UNITS OF ACTUAL PRODUCTION - ACTUAL UNITS) 1.00 * ((0.5 kg *18,000) - 9,000 kgs) = 1.00 * (9,000 - 9,000) = 1.00 * 0 = 0 Note When adding the price and usage variances the result must equal the TOTAL variance. Therefore 990 (A) (PRICE) + 0 (USAGE) = 990 (A) (TOTAL). (4) DIRECT MATERIAL B TOTAL VARIANCE
(STANDARD UNITS OF ACTUAL PRODUCTION * STANDARD PRICE) - (ACTUAL QUANTITY x ACTUAL PRICE)
((1.0 kg *18,000) * 0.50) - ((18,000 units * 1 kg) * 0.50) = (18,000 kgs * 0.50) - (18,000 kgs * 0.50) = 9,000 - 9,000 = 0 (5) DIRECT MATERIAL B PRICE VARIANCE ACTUAL QUANTITY * (STANDARD PRICE - ACTUAL PRICE) 18,000 kgs * (0.50 - 0.50) = 18,000 * 0 = 0
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Solution to Example 19 continued (6) DIRECT MATERIAL B USAGE VARIANCE STANDARD PRICE x (STANDARD UNITS OF ACTUAL PRODUCTION - ACTUAL UNITS) 0.50 * ((1.0 kg *18,000) - 18,000 kgs) = 0.50 * (18,000 - 18,000) = 0.50 * 0 = 0 (7) DIRECT LABOUR TOTAL VARIANCE
((15 minutes * 18,000) * 4.00) - (5,994 hrs * 3.33 ) = (4,500 x 4.00) - 19,960 = 18,000 - 19,960 = 1,960 (A) (8) DIRECT LABOUR RATE VARIANCE ACTUAL HOURS x (STANDARD RATE p. h. - ACTUAL RATE ph) 5,994 hrs * ( 4.00 - 3.33) = 5,994 hrs * 0.67 = 4,015 (F) (9) DIRECT LABOUR EFFICIENCY VARIANCE
4.00 * ((15 minutes * 18,000 ) - 5,994) = 4.00 * (4,500 - 5,994) = 4.00 * 1,494 = 5,975 (A) Note: When adding, rate and efficiency variances the result must equal the TOTAL variance. Therefore, 4,015 (F) (RATE) + 5,975 (A) (EFFICIENCY) = 1,960 (A) (TOTAL).
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10
The standard material content of component DD4 is 45 kg @ 4.80 per kg. During the period 89 components were produced and actual material usage was 4,020 kg at a total cost of 19,698. The standard labour content of component DD4 is 14 hours @ 7.20 ph. Actual hours worked were 1,157 @ 7.40 ph. Use the undernoted formulae to calculate all the relevant variances.
1 DIRECT MATERIAL TOTAL VARIANCE



4 DIRECT LABOUR TOTAL VARIANCE



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11
The following data refers to Product P for the month of March during which 5,000 units were produced. Standard for One Unit material: 10 kg @ 0.50 pkg.; labour: 5 hours @ 0.80 ph; Actual 49,500 kg; 24,999 25,200 hours; 20,199
There was no work in progress at the beginning nor end of the month. Use the under-noted formulae to calculate all the relevant variances.






Check your answers in Section 7 Solutions to Self Assessed Questions and Activities Overhead Variances
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The analysis of overhead variances explains the difference between the actual amount of production overhead incurred and the amount charged to production through previously determined overhead absorption rates. (It is easier to analyse if the actual overheads incurred and the amounts charged to production are split into their fixed and variable components) However, this is not a requirement of this unit. The definition for this variance explains that the likeliest reason for any variance is that the overhead absorption method chosen was inappropriate. The definition is: The difference between the standard overhead cost specified for the production achieved, and the actual cost incurred. The formula to be applied is:
Total Overhead Variance Total Standard Overhead for actual production Total Actual Overheads Please remember, that in order to work out the Total standard overhead for actual production we first need to establish the overhead absorption rate. Overhead absorption rate = Total budgeted overhead Total budgeted activity level. Having completed this calculation, the remainder of the formula is fairly easy to work out. The Overhead absorption rate is multiplied by actual production before the total actual overheads are subtracted. The variance will be favourable (F) if less money has been spent. That is, total actual overheads are lower than total standard overhead for actual production. An adverse (A) variance will be caused by more money than anticipated, has been spent. Two likely events cause a total overhead variance. Firstly, labour or machinery efficiency is actually, not as anticipated, and secondly, the overhead absorption rate was calculated using incorrect measures of anticipated overhead costs and / or budgeted activity level. In short, the overhead absorption rate is wrong. However, the Accountant would work with other members of the Management Team to establish the reasons for the variance. This aspect of the Accountants work is known as Variance Analysis, and is the next topic we shall review.
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12
Calculate the total overhead variance for Jones Limited. The following budgeted information is provided for the month of June 2004. Budgeted data Budgeted activity Budgeted labour hours Fixed Overheads Variable Overheads Actual data Actual Production Total labour hours Fixed Overheads Variable Overheads 1,000 units 2 hours per unit 5,000 8,000
980 units 2,100 hours 5,400 7,900
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3.6
Variance Analysis and Reporting
Once the variances have been calculated, they can be analysed to find what the problems are. Standard Costing and Variance Analysis allow management to control the organisation on the principle of management by exception. The variances highlight problem areas that require detailed investigation to identify the possible reasons for the lack of control. This makes it possible for management to concentrate on the problem areas. Centres with modest variances are most likely to be ignored. The undernoted table summarises possible reasons for variances: VARIANCE MATERIAL USAGE MATERIAL PRICE LABOUR EFFICIENCY LABOUR RATE FAVOURABLE 1 Higher quality 2 Higher grade workforce 3 New machinery 1 Inferior quality 2 Bulk discounts 3 Exchange rate fluctuations 1 Higher grade workforce 2 High morale/incentives 3 Higher quality materials 1 Lower grade workforce 2 Unused planned overtime 3 Salary increase not awarded ADVERSE 1 Inferior quality 2 Lower grade workforce 3 Machinery problems 1 Higher quality 2 Loss of discounts 3 Specification changes 1 Lower grade workforce 2 Low morale/incentives 3 Inferior material 1 Higher grade workforce 2 Shortage of skilled labour 3 Unplanned overtime
The Purpose of Variance Analysis The process by which a total variance is sub-divided between standard (budgeted) and actual costs is known as Variance Analysis. This process may be defined as "that part of variance accounting which relates to the analysis into constituent parts of variances between planned and actual performance". The only purpose of Variance Analysis is to provide practical pointers to the causes of deviation from standard performance so that management can improve efficiency, utilise resources more effectively and reduce costs. It follows that elaborate Variance Analysis, which is not understood, or calculated too long after the event, does not fulfil the central purpose. The types of variances which are identified, must be those, which fulfil the needs of the organisation and are costeffective. There is little point incurring 500 additional costs investigating a 5 Direct Material Price Variance. The only criterion for the calculation of a variance is its usefulness. If it is not useful for management purpose, it should not be produced.
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Responsibility for Variance Ideally, variances should be detailed enough so that responsibility can be assigned to an individual for a specific variance. Ideally, that individual should be at the lowest level of the organisation; one who shoulders the primary responsibility for the process. Cost control is made much more difficult if responsibility for a variance is spread over several managers. In such circumstances, it is all too easy to "pass the buck". The underlying philosophy implied is that top management have delegated decisions to a subordinate employee who should accept the responsibility for the results. So responsibility accounting is a mechanism that supplies the desired balance to the freedom of action that individual employees are given. However, this philosophy can only apply when costs are distinguishable between those controllable by the individual and those that remain uncontrollable. Controllable and Uncontrollable Costs Controllable Costs are defined as: those that are directly influenced by an INDIVIDUAL ROLE within a GIVEN TIME SPAN. The definition has two important ingredients. First, we cannot distinguish controllable from uncontrollable costs without specifying the level and scope of authority. That is, we must circumscribe the activity that is under the authority of the individual. For example, insurance costs on machinery are unlikely to be controllable by manager of the Production Department. However, such costs may indeed be controllable by the manager of the Insurance Department. Second, the time period assumption is important. If it were long enough, virtually all costs would be controllable by somebody in the organisation. On the other hand, as the time period shortens, very few costs may be controllable. In the insurance example, note that the cost of a one-year insurance policy might not be controllable, even by the Insurance Manager, if the time period for evaluation were a week or a month. Controllability of costs is a matter of degree: (a) There are usually a few costs that are clearly the sole responsibility of one individual; (b) The time period problem is almost impossible for many costs. Therefore, the individual considered responsible for controlling the costs is the one individual within the organisation, with the most decision-making power over the item of cost in question. This is usually the individual who most closely supervises the day-today activities that influence that cost. That individual typically has the authority to accept or reject the material or service in question. Therefore, it is that individual who must bear responsibility, and under delegation procedures, so must that individual's superiors. However, the diffusion of control throughout the organisation complicates the task of allocating controllable costs. For example, raw material prices may be most affected by the decisions of the Buyer, whereas the Production Operator may influence raw material usage.
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Uncontrollable Costs are all costs which may not be classified as controllable. Uncontrollable costs are usually allocated to a central department (cost centre), where they are subsequently apportioned to other (appropriate) costs centres for absorption into the organisation's products or processes by a predetermined rate. There can also be Links between the variances which can help to explain events taking place in a business. For example, changes to costs affected by hours worked or efficiencies. Example 20 In Example 19, we identified a number of variances for Halbeath Limited which occurred during the month of March 2004. The total variance of 2,950 (A), can be attributed to: MATERIAL A PRICE LABOUR RATE LABOUR EFFICIENCY = = = 990 (A) 4,015 (F) 5,975 (A)
One of the functions of management is to exercise control over operations. With such large variances it is evident that Halbeath Limited is lacking control in at least three areas of its operations. Management must investigate and report to all concerned why the variances have occurred and what can be done to prevent a recurrence. Solution to Example 20 The starting point is to bullet point possible reasons for the variances occurring. VARIANCE MATERIAL PRICE LABOUR EFFICIENCY LABOUR RATE 1 Lower grade workforce 2 Unused planned overtime 3 Salary increase not awarded FAVOURABLE ADVERSE 1 Higher quality 2 Loss of discounts 3 Specification changes 1 Lower grade workforce 2 Low morale/incentives 3 Inferior material
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It is frequently the case that reasons for variances will be linked, namely the actual use of a lower grade of labour, when a higher grade was anticipated, could result in: (i) A favourable Labour Rate Variance (ii) An adverse Labour Efficiency Variance, and (iii) An adverse Material Usage Variance. Management recognise that substantial variances could result in failure to achieve operational objectives: (a) (b) (c) (d) Overall profitability Market share Product reliability Employee efficiency, retention and commitment.
It is for these and associated reasons that management place a substantial emphasis on the investigation of, and eradication (where humanly possible) of, controllable variances. The investigation phase, referred to as Variance Analysis, is frequently a time-consuming operation which may involve: (a) (b) (c) (d) (e) (f) The Production Operator(s) Production supervisor Buyer(s) Estimator(s) Quality controller(s) Accounts staff
who will form a quality circle, to brainstorm a solution for onward communication to management via a report. The solutions may be unwelcome and could include: (a) (b) (c) (d) (e) (f) (g) (h) Re-drafting the budget Re-calculating standards Seeking new material suppliers Assigning alternative operators that are more appropriately skilled Re-training existing operators Investment in new technology Closure of cost centres Setting alternative objectives, etc.
It should be self evident that, by taking great care in the setting of the original standards and in the efficient supervision of controllable costs by responsible individuals, such drastic action may be alleviated. Ultimately, management bear the overall responsibility for ensuring that the objectives set, and the consequential budgets are fair and achievable, in the light of the organisation's operating environment. A degree of management flexibility is required, to prevent constant re-drafting of objectives and of budgets, targets and standards. However, the principles underlying budget preparation are still important: (a) To assist in planning and control, and (b) To act as a motivational tool.
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13
Davidson Limited Davidson Limited produces trampolines. You are required to produce budgets for 3 activity levels as follows, for the month of August: 50 units, 70 units and 90 units. The budgeted information is: Selling Price COSTS Raw Material Labour Variable overhead Rent of buildings Local authority tax Per Trampoline 500 200 160 35 50
20 hours of production 5 hours of packing 2 per direct labour hour 300 per month 4,800 per annum Activity Level 70 units 35,000 14,750 12,500 2,550 2,800 300 200
The actual information for August 2003 is: Sales Revenue COSTS Raw Material Labour: Production (1,400 hours) Packing (350 hours) Variable overhead Rent of buildings Local authority tax
SAQ 13 Continued Overleaf
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SAQ 13 Continued
Required 1 2 3 You are asked to produce budgets for the 3 activity levels in August 2003 identifying profit at each level of activity. Prepare a comparison between the budgeted figures and actual figures at the relevant activity level. As the Accountant, you are required to prepare a report for the Managing Director highlighting: a. All variances that have occurred during August. b. Recommendations for corrective action. Draft a report to your colleagues, the Purchasing Manager and Production Manager, indicating actions they could take to ensure budget targets are met.
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Summary This section has focused on how variances can be calculated and how those variances may be interpreted in order to remedy their causes. As any variance is likely to impact upon budgeted profit and organisational plans, an accurate calculation of variances is crucial in assisting management measure performance. By itself, a variance is meaningless! It is the analysis of that variance which is crucial! Prior to calculating variances, it is important to flex the original budget by incorporating actual output. By doing so, it is possible to determine whether processes are under control. Only seven variances have been explained within this section. These seven are vital, as they compare the standard costs of actual production with actual costs for the majority of costs incurred by an organisation. However, they are among a plethora of variances that may be calculated within a sophisticated accounting system. Should you wish to find out more, you may do so by referring to the relevant chapter in one of the textbooks referred to at the back of this Student Learner Guide. The techniques we have discussed, so far are an aid to controlling the operations of an organisation in the short-term. In the next section, we shall review techniques designed to help with decisions that impact upon the long-term viability of an organisation. These decisions will impact upon: Capital expenditure Cash-flow projections Viability of project Sources of long-term funds And, many other areas.
Collectively, the topic is known as Investment Appraisal. However, it is one that will impinge upon the long-term future of an organisation.
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5.4
Learning Outcome 4 - Use Investment and Project Appraisal Techniques to Assess the Viability of a Project Introduction
4.1
Investment appraisal decisions are long-run decisions where consumption and investment alternatives are balanced over time in the hope that investment now will generate extra returns in the future. There are some similarities with the short-term decisions we examined in section 4.2, namely: Choosing between alternatives Consideration of future costs and revenues Uncertainty. However, there is a major difference, which is to do with: The time period involved. The longer time period forces consideration of an important concept within investment and project appraisal techniques, namely: The time value of money. This concept will be examined in greater detail in section 5.4.4. There are a large number of situations where investment and project appraisal may be used these include decisions regarding: Expansion, where the acquisition of more Fixed Assets and Working Capital are being considered New product/diversification, where the viability of a risky investment is being considered Cost saving, where a new machine may be purchased to replace a manual process Alternative choice between, say, two models of a similar machine, where one may cost double the other but may have a life extending to double the cheaper model Consideration of different financing options. For example, purchasing outright using cash reserves versus leasing.
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Assuming an organisation possesses the necessary finance, the decision to invest will be based on three major factors: 1 The investors belief in the future. In diverse organisations the beliefs would be based on forecasts of internal and external factors including: 2 Costs Revenues Inflation Interest rates Taxation Estimates of demand, and numerous other factors. The choices available in which to invest. This is the stage at which the various techniques used to appraise the competing investments would be used. The various techniques are covered in detail in this section. The investors attitude to risk. Because investment decisions are often on a large scale, analysis of the investors attitude to risk and the project uncertainty are critical factors in this type of decision.
Investment and project appraisal is, invariably, a senior management exercise. This is due to the scale and long-term nature of the consequences of such decisions. The accountants task is to: Gather the essential data from various sources Consider the financing implications, Analyse the data, preferably using more than one of the under-noted appraisal techniques Present the senior management team with the results to enable more informed and, hopefully, better decisions. Throughout this section, numerous activities will lead you through the practical application of investment and project appraisal decision-making. The self assessed questions will ask you to consider alternative techniques of capital investment decisionmaking and to conduct an appraisal based upon a variety of scenarios. All investment and project appraisal methods require an estimate of the yearly cash flows attributable to the investment(s) or project(s) under review. The initial cash outflow could include the purchase of physical assets or the build-up of stocks. Cash inflows, across the life of the investment or project, could include additional profit or cost savings generated by the investment(s) or project(s). The profit referred to, is that generated by the investment or project, and is calculated by deducting attributable costs from the sales revenue.
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4.2
Traditional Investment and Project Appraisal Techniques
Two particular methods of comparing investment and project appraisal have become known as the traditional techniques. These are the Payback and Accounting Rate of Return, which are described below. Payback Generally considered to be the simplest of the investment and project appraisal techniques, it has become the most popular, either on its own or in conjunction with other methods. This method of investment and project appraisal measures the number of years it is expected to take to recover the cost of the original investment. The usual decision rule is to accept the project with the shortest payback period. To calculate the payback period we calculate the ratio of: Initial Fixed Investment Annual Cash Flows The following example demonstrates the technique. Example 21 We have to calculate the payback period for the following project, which has an initial cost of 9,000 and is estimated to generate additional profit of 3,000 for each of the next five years: Solution to Example 21 Year 0 1 2 3 4 5 Net Cash Benefit Yearly Net Cash Flow (9,000) 3,000 3,000 3,000 3,000 3,000 6,000 Cumulative Cash Flow (9,000) (6,000) (3,000) NIL 3,000 6,000 6,000
Payback will take exactly 3 years to complete. The usual investment and project appraisal assumptions have been applied, namely: Year 0 means now Year 1 means at the end of 12 months from now Year 2 at the end of 2 years from now, and so on Figures in brackets (), designate an outflow
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Payback may also be used if the cash inflows are not equal over the life of an investment or project. However, the calculations are more difficult. Example 2 displays the technique. Example 22 Initial Investment Cash Inflows: Year 1 Years 2 and 3 Years 4 and 5 Solution to Example 22 The Payback period would be: Cash outflow Year 0 Cash Inflows: Year 1 Year 2 Year 3 Year 4 (half of 4,000) Year 4 (2nd half of 4,000) Yearly Net Cash Flow (18,000) 4,000 6,000 6,000 2,000 2,000 Cumulative Cash Flow (18,000) (14,000) ( 8,000) ( 2,000) NIL 2,000 18,000 4,000 6,000 per annum 4,000 per annum
In Year 4 the cash inflows for the full year are 4,000 but only 2,000 is required to recoup the initial investment. Therefore, this is reached in 6 months. Payback period is 3 years 6 months To summarise this fairly basic technique you should follow the undernoted stages: 1 2 3 4 5 6 Identify all of the costs that will be committed to the investment or project appraisal. Assume that they will be paid now. Find the cash inflow for each project. Add up the cash flows each year until, cost of project is covered. Pick the project with the shortest payback period. If the payback period is only one year then it should be compared with an internal figure. Accept a project, which repays the initial investment within the target period, or rank projects according to payback period and pick the investment or project appraisal.
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Advantages of the Payback Method The technique is considered to be simple to operate and easy to understand Uses cash flows rather than accounting profits and hence is more objectively based It is to be considered that, the shorter the payback period, the less risky the project Shows how soon the cost of purchasing an asset will be recovered Short-term approach reduces the risk of loss through obsolescence Acts as a yardstick in comparing profitability of projects Useful as a measure of liquidity - more immediate return of cash is preferred.
Disadvantages of the Payback Method Ignores cash flows after initial outflow has been met Ignores risk Ignores time value of money Ignores the fact that benefits from different projects may accrue at an uneven rate No allowance is made for interest on the initial capital investment.
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14
Alpha Limited Using the undernoted data for two Projects. Calculate the payback period
Project A Project B
Initial Cost 10,000 25,000
Cash Flows 1 3,000 2,000
2 3,000 5,000
3 3,000 9,000
4 3,000 12,000
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4.3
Accounting Rate of Return
Our second traditional investment and project appraisal method is the Accounting Rate of Return, commonly referred to as ARR. This is the ratio of average annual profits to the capital investment (cash outflow). The ARR is usually expressed as a percentage, using the undernoted formula: Estimated Average Profit Estimated Initial Investment * 100% 1
This can be compared with an alternative return, say from a savings account rate, to determine whether the investment is worthwhile, or if it would be wiser for the organisation to place the amount of the investment in the savings account. Note: a number of organisations have devised a desired rate of return in percentage terms. This equates to the cost of the organisations long-term borrowings and may be applied as an alternative barometer. To work out the average profit for the investment, the following formula may be applied: Total profits earned over lifetime of project Expected life of project in years Note that Total profit = Net Cash Flows - Depreciation Example 23 An organisation is considering two alternative projects. The following data has been provided. Project Capital Cost Profit in year Profit in year Profit in year Profit in year Total Profit
after depreciation
A 40,000 1 2 3 4 3,000 5,000 3,000 5,000 16,000
B 42,000 5,000 8,000 7,000 4,000 24,000
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Solution to Example 23 Step 1 Find the average profit by dividing the total profit by the project life. Total Profit Profit life in years Average Profit A 16,000 4 4,000 B 24,000 4 6,000
Step 2 Find the Accounting Rate of Return by dividing the average profit by the capital cost of the profit. We then multiply the answer by 100 to quote in percentage terms. A 4,000 * 100 40,000 1 10% B 6,000 * 100 42,000 1 14%
If the company wished simply to choose between the two investments, they would choose Machine B. However, if the Rate of Return required by the company was 20%, they would not choose either investment. Advantages of the Accounting Rate of Return Method Simple to calculate Takes into account the profits over the life of the project. Disadvantages of the Accounting Rate of Return Method Based upon accounting profit, not cash flows Fails to take account of timing of profits Time value of money is ignored Treats projects which have high income in early years the same as projects with low income in early years and high in later years Length of project life and size of project not specifically considered.
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15 Beta Limited A company has a target ARR of 20%, and is now considering the following project: Capital cost, 140,000; estimated life is 7 years. Year Year Year Year Year Year Year 1 2 3 4 5 6 7 Estimateprofit: 20,000 30,000 40,000 50,000 40,000 20,000 10,000
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4.3
Discounted Cash Flow (DCF)
There is an increasing use of DCF techniques for investment and project appraisal. Its use overcomes some of the disadvantages of the traditional techniques, discussed in section 5.4.2, but it must be stressed that DCF itself has problems and contains many assumptions. It should, therefore, be applied with great care. It is most unusual for investment and project appraisal techniques, themselves, to determine alone which investment should proceed. Rather, they are commonly applied to eliminate the least attractive alternatives. This leaves the senior management team to determine which investment should proceed, based upon non-accounting criteria discussed in our introduction, section 5.4.1. The main DCF techniques of Net Present Value (NPV) and Internal Rate of Return IRR) are described in this section but it is necessary first to consider two features common to all DCF methods: The use of cash flows, and The Time value of money. The use of cash flows All DCF methods use cash flows and not accounting profits. Accounting profits are frequently calculated for stewardship (management) purposes and are period-orientated (usually annual), thus necessitating adjustments for late payment / receipt of funds. For investment appraisal purposes, a project-orientated approach using cash flows, is to be preferred for the following reasons: Cash flows are more objective and, in the end, are what an organisation requires to survive. Profits are unable to be spent! Using cash flows can make complicated adjustments necessary to calculate accounting to profit irrelevant The whole life of a project is to be considered. Therefore, it becomes unnecessary and misleading to consider accounting profits which are time bound The timing, or expected timing, of cash flows is easier to ascertain.
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What to Include in Cash Flows The simple answer is to include all relevant cash flows generated by the investment. This is simply undertaken by comparing the organisations projected cash flows (including the investment) with those projected cash flows (excluding the investment). Indeed, many cash flow items are easily identifiable, for example: The initial cost of new equipment and / or a new building Additional labour costs to man the new equipment Additional insurance costs Additional local authority charges on the extra building.
Additional cash inflows can also be identified, relatively easily, for example: Additional revenues generated by the investment Government grants.
Note: The relevant costs in investment decisions, as with all other decisions, are opportunity costs and not historic accounting costs. See section 5.2, page 69, for a review of relevant costs. Interest payments, on funds borrowed to finance the investment, are ignored. This is due to the fact that the discounting process, itself, takes account of the time value of money.
Time Value of Money Any serious investment appraisal must consider the time value of money. This is due to the fact that investment and project appraisal decisions are, by their very nature, longterm decisions. Sums of money arising at different times are not directly comparable. They must be converted to equivalent values at some common date and DCF methods typically use the present time as the common date. Both discounting and compounding methods allow for the time value of money and could thus be used for investment and project appraisal but, on the whole. discounting methods are more frequently used. In general, it is preferable to receive a given sum earlier rather than later because the sum received earlier can be put to use by earning interest on some productive investment within the organisation. Please note that the time value of money concept applies even if there is NO INFLATION. Inflation obviously increases the difference in value between monies received at different times but it is not the basis of the concept.
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Assumptions in Basic DCF Appraisal Many organisations would use a spreadsheet to ease the burden of the numerous repetitive calculations usually associated with DCF techniques. In order to operate one of these spreadsheet packages, it is incumbent upon the Accountant to understand what is occurring. This unit concentrates upon providing that underpinning knowledge, with the understanding of spreadsheet design coming from your other studies. For our purposes in describing basic DCF methods, certain assumptions are made initially, so that the underlying principles can be more easily understood. These are as follows: Uncertainty does not exist There is no inflation The appropriate discount rate to use is known, to avoid unnecessary calculations. When undertaking DCF questions, the discount rates have been computed for you, and are given in the discount tables provided on pages 160 - 162 Unlimited funds can be raised at a competitive rate.
Note: If you decide to further your studies of investment and project appraisal techniques, these assumptions would be removed and the problems in dealing with uncertainty, inflation, choosing an appropriate discount rate and scarcity of funds would be dealt with.
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DCF Using the Net Present Value (NPV) Method The NPV method calculates the present values of cash inflows and outflows and establishes whether, in total, the present value of cash inflows is greater than the present value of cash outflows. Example 24 A firm is considering investing 150,000 on a lathe to make and sell a product. Cash inflows are expected to be 60,000 for each of the first 4 years, tapering off to 40,000 in Year 5 and only 20,000 in Year 6. The firm normally require a minimum rate of return of 20%. Solution to Example 24 Calculation of Net Present Value at 20% Annual Cash Flow (150,000) 60,000 60,000 60,000 60,000 40,000 20,000 Present Value Factors at 20% 1.000 0.833 0.694 0.579 0.482 0.402 0.335
Present Value 49,980 41,640 34,740 28,920 16,080 6,700 (150,000)
Year 0 1 2 3 4 5 6 Net Present Value
178,060 28,060
The surplus means that the annual cash flows are big enough to allow more interest to be deducted and still repay the original investment. This investment is, therefore, worthwhile as it more than fulfils the requirement of a 20% return. The word Net means the addition of the negative and positive present values.
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In Example 24, the minimum rate of return was stated. This required rate (20% in this case) is alternatively referred to as the cut-off rate. However, managers sometimes want to know, not just whether a project is viable, but what rate of return they can expect to earn on it. The present value method can be taken a stage further. The annual cash flows are discounted again, this time at a higher trial rate of interest. Example 25 Using the same basic data from Example 24 assume a rate of 30%. The annual cash flows can be discounted by Present Value factors at 30% as follows: Solution to Example 25 Calculation of Net Present Value at 30% Present Value Factors at 30% 1.000 0.769 0.592 0.455 0.350 0.269 0.207
Year 0 1 2 3 4 5 6 Net Present Value
Annual Cash Flow (150,000) 60,000 60,000 60,000 60,000 40,000 20,000
Present Value 46,140 35,520 27,300 21,000 10,760 4,140 (150,000)
144,860 (5,140)
The actual rate of return must be less than 30%. This is because too much interest has been deducted to allow all the capital to be repaid. If, instead of going for an estimated 30%, the annual cash flows had been repeatedly discounted at 1% intervals from the 20% required rate, then a zero Net Present Value would have been found at approximately 28%. This is the true rate of return on the project and is known as the Discounted Cash Flow Yield. In other words, the DCF yield is the solution rate of interest, which results in a Net Present Value of Zero.
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The Directors of Embro Limited are considering two new projects: Beanos 10,000 Year 1 2 3 4 4,000 6,000 6,000 4,000 Dandies 12,000 4,000 6,000 8,000 6,000
Initial Capital Cost Net Inflows -
Calculate:
(i) (ii)
Payback in years Net Present Value at current rates of 9%.
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16
Charlie Limited A business is considering whether to expand in one of the three ways: (a) (b) (c) buying a delivery van purchasing a computer to help with stock adding to its premises. Computer (6,000) 2,000 3,000 4,000 6,000 6,000 6,000 27,000 21,000 Premises (50,000) 12,000 12,000 15,000 15,000 15,000 20,000 89,000 39,000
The estimated data is as follows: Van Capital Costs (18,000) Yearly Cash Net Flows Year 1 4,800 2 4,800 3 8,400 4 8,400 5 9,600 6 10,800 Total Inflows Total Profit Required: Payback period in years Net Present Value at current rates of 10% 46,800 28,800
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Advantages of the Net Present Value Method NPV provides an objective basis for evaluating and selecting investment projects Takes account of both magnitude and timing of expected cash flows in each period of a projects life Focuses on cash inflows and outflows rather than on accounting profits. Takes into account required rate of return of company Takes into account time value of money.
Disadvantages of the Net Present Value Method Assumes that we live in a world of certainty; that we are sure of the cash flows and that they occur regularly and evenly Assumes that we can borrow as required, and at a competitive rate of interest The cost of capital used to calculate the discount factor is usually hard to forecast The concept is difficult for the layman to grasp.
However, these assumptions (as long as we are aware of them) do not take anything away from the DCF method, which is often preferred to other methods of investment and project appraisal.
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Internal Rate of Return (IRR) With this method the intention is not solely to find out whether or not a project satisfies the desired rate of return, but, in addition, to calculate exactly the rate, which would discount inflows to match precisely the outflows. This method gives the TRUE rate of return on capital investment as it is based on the actual cash flows. To work efficiently at least one discount rate must be chosen which gives a negative NPV. The procedure is as follows: The same routine is carried out as for the NPV method; the cash flows are discounted at a specific rate If the NPV found is POSITIVE, then the rate selected is too low and discounting must now take place at a higher rate If the NPV found is NEGATIVE, then the rate, which has been used is too high; in which case, the cash flows must be discounted at a lower rate Assuming that the NPV obtained, one positive and the other negative, are from rates which are either side of the true rate, this may now be found by interpolation.
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Marischal Limited is considering two projects. The relevant data is supplied. Calculate the NPV for both projects and, for the optimum project, work out its IRR. First of all, assume an acceptable rate of return of 10%. Project A Initial Capital Cost Net Cash Flow: Year 1 2 3 4 5 10,000 4,000 3,000 3,000 2,000 2,000 Project B 20,000 5,000 5,000 3,000 10,000 3,000
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17
Delta Limited Compare the following alternative projects at 14% interest: Project A 100,000 20,000 30,000 40,000 40,000 20,000 20,000 20,000 Project B 150,000 40,000 30,000 30,000 40,000 70,000 70,000 60,000
Initial Capital Cost Net Inflows - Year 1 2 3 4 5 6 7
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Advantages of the Internal Rate of Return Method The information is more easily understood Finds the TRUE rate of return of a project Takes account of the time value of money.
Disadvantages of the Internal Rate of Return Method Slightly more difficult to understand than NPV method The IRR and ARR may be confused, where they are quite different methods Calculations can be time-consuming by trial and error Ignores the size of the investment.
4.4 a b c
Summary Investment and Project Appraisal are long-run decisions where consumption and cash flows are balanced over time. The decision to invest is based on many factors, one of which, is the implications for cash flow and financial management. The traditional investment appraisal techniques are the Payback and Accounting rate of Return methods. These are widely regarded
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6 Additional Reading Material

The author recommends the following texts for selected reading, in the event that you feel this would be beneficial. Atrill P & McLaney E Dyson J R 6th Ed. McLaney E & Atrill P Management Accounting for Non-specialists
Prentice Hall
Accounting for Non Accounting Students Prentice Hall Accounting an Introduction

Prentice Hall
Electronic Resources and the Internet Here are some useful subject gateways which can be accessed via the Internet. BIZ/ED http://bized.ac.uk/ Internet Resources Gateway covering business and economics related subjects BUBL LINK BUSINESS http://link.bubl.ac.uk/business/ The gateway to Business resources on the Internet BUBL LINK MANAGEMENT Online Management resources http://link.bubl.ac.uk/management/
PINAKES http://www.hw.ac.uk/libWWW/irn/pinakes/pinakes.html Provides links to most of the major Internet Subject gateways BUSINESSED http://www.businessed.net/ Contains weekly business and company news plus archive. SOSIG http://www.sosig.ac.uk/welcome.html The Social Sciences gateway to information on the Internet. Contains sections on Business and Management BBC BUSINESS Information from the BBC HUMAN RESOURCES Online version of the magazine http://news.bbc.co.uk/1/hi/business/ http://www.humanresourcesmagazine.com
RESOURCE DISCOVERY NETWORK http://www.rdn.ac.uk/ Links to internet resources on a variety of topics including Business
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7 Solutions to Self Assessed Questions and Activities

Suggested Answer to Activity 1
Hopefully, you arrived at these answers, if not, you should read pages 12 to 16 and try again.
Prime Cost 1 6 14
Production Overhead 3 7 10 13 16
Administration Overhead 2 8 12 15
Selling and Distribution Overhead 4 5 9 11
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Answer to Activity 3
Departmen t Formula Calculatio n Answer
Welding
Total Budgeted Overhead Direct Labour Hours
60,625 48,500hrs
1.25
Grinding
Total Budgeted Overhead Direct Labour Hours
71,000 35,500hrs
2.00
Finishing
Total Budgeted Overhead Machine Hours
55,000 25,000hrs
2.20
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JOB COST OPERATING STATEMENT JOB 1512 Direct Materials Direct Labour Welding Grinding Finishing Calculation 30kg @ 12 pkg 16hrs @ 5 ph 12 hrs @ 4 ph 4 hrs @ 6 ph 80 48 24 152 0 512 Welding Grinding Finishing 10% of PRIME COST 20% of PRODUCTION COST 30% of TOTAL COST 16 hrs * 1.25 ph 12 hrs* 2.00 ph 10 hrs * 2.20 ph 10% * 512 20% * 578 30% * 745 20 24 22 66 578 51 116 167 745 223 968 360
Direct Expenses PRIME COST Overheads
PRODUCTION COST Administration Selling TOTAL COST PROFIT (Mark-up) SELLING PRICE
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Suggested Answer to SAQ 1

Direct Labour Direct Material 19 24 9 10 21 Direct Expense 4 14 17 26 28 Production Overhead 1 5 8 13 23 27 Administration Overhead 2 6 12 18 20 Selling and Distribution Overhead 3 7 11 15 16 22 25
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Answer to SAQ 2 a)
Munro Engineering Limited JOB COST OPERATING STATEMENT JOB 15/98 Direct Materials Direct Labour Direct Expenses PRIME COST Overheads
PRODUCTION COST
Preparation Machining Machine hire Preparation Machining

10% of PRIME COST 12.5% of PRODUCTION COST
Calculations 2 kgs * 1 pkg 8hrs * 8 ph 2 hrs * 5 ph
64 10
2 74 424 500
8 hrs * 15 ph 120 2 hrs * 10 ph 20 140 640 10% *500 12.5% * 640 33.33%*770 50 80 130 770 257 1,027
Administration Selling TOTAL COST PROFIT (Mark-up) SELLING PRICE
33.33% of TOTAL COST
Please Note, the Mark-up of 257 is rounded to the nearest . (The actual answer was 256.64).
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b)
Munro Engineering Limited Margin for job 15/98 = Profit Selling Price * 100 = 1 257 * 100 = 25% 1,027 1
It is hoped you arrived at definitions, in your own words, similar to the ones given below.
Term
The definition (In your own words) The figure calculated by subtracting variable costs of an activity from the revenue generated by it. A cost, which does not vary with activity; rather it is time related.
Contribution Fixed Cost Marginal Cost Profit Selling price
Marginal Cost is: The amount at any given volume of output by which aggregate cost is changed if the volume of output is increased or decreased by one unit. Cost of production and associated organisation costs subtracted from the sales revenue. The value of a product when sold to a customer Costs that vary in direct proportion with activity.
Variable Cost
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It is beneficial if you copy out the formula in full, then replace the terms used with the relevant values. Contribution * 100 Sales 1 The solution for product A, was given above, to simplify comparison, here it is again. C/S ratio for A, 3,200 * 100 = 40% 8,000 1 2,800 * 100 = 26.7% 10,500 1 1,250 * 100 = 38.5% 3,250 1
therefore the C/S ratio for B is,
and finally the C/S ratio for C is,
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Answer to SAQ 3
Valante Limited Marginal Cost Statement For year ending 31/10/2003 Supa Dupa Per 10,000 Per 20,000 Unit units Unit units 20 200,000 20 400,000 10 100,000 15 300,000 10 100,000 5 100,000
Product type
Selling Price Less: Variable Cost CONTRIBUTION
Per Unit 20 12 8
Good 40,000 units 800,000 480,000 320,000
Supa Per Unit

10 * 100 20 1
10,000 units
100,000 * 100 200,000 1
1. Calculation of the C/S ratio. Dupa Per 20,000 Unit units

5 * 100 20 1 100,000 * 100 400,000 1
Good Per Unit

8 * 100 20 1
40,000 units
320,000 * 100 800,000 1
50% 50% 25% 25% 40% 2. The largest promotional budget should be allocated to Supa, as it generates the highest C/S ratio. Note: For each of the products; Supa, Dupa and Good, the C/S ratio remains constant regardless of the level of activity.
40%
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Answer to SAQ 4
(a) contribution; (b) profit; (c) per unit: (i) selling price; (ii) variable cost; (iii) contribution; (d) BEP in units; 7,500 units 20 12 8 80,000 20,000
(e) BEP in sales value 150,000 (f) The extra units to be sold to increase sales revenue to 300,000 is 5,000 units.
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Answer to SAQ 5
Megan Limited Marginal Cost Statement For the year to 31/12/2003 Per Unit Sales Revenue Less: Variable Costs Direct Material Direct Labour Direct Production Overhead (50,000 - 12,000) Contribution Less: Fixed Costs Production Overhead Administration Overhead Selling and Distribution Overhead Profit 4.00 2.50 2.00 8.50 3.50 BEP =
Fixed Costs Contribution pu
12.00
20,000 units 240,000 80,000 50,000 40,000 170,000 70,000 12,000 26,000 10,000 48,000 22,000
48,000 3.50 =13715 units,
Megan Limited Proposed MARGINAL COST STATEMENT Per Unit This year Activity 24,000 units Sales Revenue 12.00 288,000 Less: Variable Costs Direct Material 4.00 96,000 Direct Labour 2.50 60,000 Direct Production Overhead 2.00 48,000 8.50 204,000 3.50 84,000 Less: Fixed Costs Production Overhead 12,000 Administration Overhead 26,000 Selling and Distribution Overhead 10,000 48,000 Profit 36,000
Next year 18,000 units 216,000 72,000 45,000 36,000 153,000 63,000 12,000 26,000 10,000 48,000 15,000
The margin of safety for next year is 18,000 units 13,715 units = 4,285 units. Any report would draw out the above and identify ways of competing more effectively, such as controlling costs.
Answer to SAQ 6
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Hunter Limited (i) Per Unit Selling Price Less: Variable costs Direct Material Direct Labour (4 hours at 1.75) Contribution (ii) 19 7 26 24 50
Contribution per labour hour = Contribution Number of hours to make one unit 24 = 6 4 hours Cost of making Component Materials Labour (20 hours x 1.75) Opportunity Cost: (20 hours x 6) 150 35 120 305
(iii)
Advice: Buy the component from the outside supplier at 300. (iv) (a) Cost of Contract Materials Component Labour (300 hours x 1.75) Opportunity Cost: (300 hours x 6) (b) Additional Profit if Contract accepted Contract Price Less: Contract Cost Additional Profit Advice: Hunter Limited should accept the contract 1,800 300 525 1,800 4,425 4,800 4,425 375
Answer to SAQ 7
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Ferguson Limited
a)
a
Selling Price Per Unit
R 3 40,000 units 120,000
S 7 12,500 units 87,500 55,000 15,000 30,000
T 4 30,000 units 120,000 45,000 24,000 21,000
Total
Activity
147,000 60,000 93,000
Sales Revenue Less: Variable Costs Direct Materials 47,000 Direct Labour 21,000 Direct Overhead 42,000 Contribution Less: Fixed Costs
33.33% of Direct Labour Cost
327,500
110,000 10,000 7,000 3,000 10,000 40,000 units = 0.25
100,000 -12,500 5,000 -17,500 -12,500 12,500 units = -1.00 As a negative contribution is made, there can be no BEP. 30,000 30,000
90,000 30,000 8,000 22,000
300,000 27,500 20,000 7,500
Profit /Loss Contribution per unit
= 1.00 Fixed Cost Contribution pu 8,000 1.00 = 8,000 units BEP * Selling Price per unit 8,000 units * 4 = 32,000
BEP (units) BEP (units)
Fixed Cost Contribution pu 7,000 0.25 = 28,000 units
BEP (Sales value) BEP (Sales value)
BEP * Selling Price per unit 28,000 units * 3 = 84,000
Answer to SAQ 7
Ferguson Limited continued
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b)
We must establish contribution per direct labour hour, which is the scarce resource. We can ignore Product S, as production is to be stopped. which equals Labour cost (21,000) divided by Labour cost per hour (4). which equals Labour cost (24,000) divided by Labour cost per hour (4).
Product R requires 5,250 hours, Product T requires 6,000 hours,
Contribution per direct labour hour is established by dividing labour hours used to make each product into the total contribution derived from making and selling each product. Thus Total Contribution Labour Hours Priority Product R 10,000 5,250 1.90 per hour 2nd Product T 30,000 6,000 5.00 per hour 1st
Therefore, we should concentrate on Product T Total hours available Less: to make Product T Available to make R Less: Fixed costs (R & T only from a) Revised Profit Less: Profit from a Change in Profit from Project One 10,000 Contribution per Labour Hour 6,000 5.00 4,000 1.90
30,000 7,600 37,600 15,000 22,600 7,500 15,100
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Answer to SAQ 7
Ferguson Limited continued
c)
Department K + Component W note Per Unit 0.20 0.10 23,000 2,000 21,000 34,500 21,000 13,500 80,000 units 16,000 10,500 8,000 34,500
Component W
Direct Material Direct Labour 50% of R Direct Overhead Cost of making W Buy-in cost Less: extra contribution Net cost of purchase Cost of Making W Net cost of Purchase Saving if W is bought Conclusion
Ferguson Limited should undertake both projects (b + c) a, if taken together, profit would be increased by 15,100 (b) + 13,500 (c) = 28,600
Answer to SAQ 8
Clearite Limited Units of Output 9,000 10,000 11,000 18,000 20,200 22,400 11,000 12,000 13,000 550 600 650 4,800 4,800 6,400 1,800 1,800 2,100 2,200 2,200 2,200 0 38,350 0 41,600 300 47,050
Raw materials Labour Electricity Supervisor Heating Fixed Overheads New Machine
8,000 16,000 10,000 500 4,800 1,500 2,200 0 35,000
12,000 24,600 14,000 700 6,400 2,100 2,200 300 50,300
Answer to SAQ 9Solution 9

Scottish Qualifications Authority 2004 144 DE3J 35
Clearite Limited (2) 1. Raw materials Labour Electricity 550 Heating 1,800 Supervisors salaries Fixed Overheads New Machine 3. Raw Material Price Increase Poorer Quality of material resulting in increased scrap 4. Labour Rate increase Poorly maintained machines resulting in loss of productive hours Loss of Productivity to clean machines due to poorer quality of Raw Material Budget 9,000 18,000 11,000 2,350 4,800 2,200 0 38,350 Actual 9,000 18,200 11,220 2,550 4,800 2,000 0 38,770 Variances F/A 200 A 220 A 200 0 200 420 A F A
5. Electricity + Heating Cooler temperatures requiring increase in heating Poorly maintained machines
6. Fixed Overheads Incorrect Absorption rate Rent increase Taking on extra space
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Answer to SAQ 9 Continued 3. Raw Materials are the responsibility of purchasing. If raw material scrap is caused by machine breakdown, the Maintenance Department would be the responsible department. For the Materials and the Labour lost to cleaning the scrap out of the machines. The Accounting Department would review absorption rates. Facilities Management would identify reasons for the Rent increase and the extra space taken on. Improve maintenance schedules. Negotiate discounts for raw materials Improve training of labour force. The use of unskilled labour can cause a number of variances, namely: Incorrect handling of fragile raw materials causing unforeseen breakages, which requires extra hours being spent clearing the breakage from the production line They may take longer than the standard time to manufacture the product, due to lack of knowledge about the process If they fail to handle the machine correctly, they could cause a breakdown, due to running a poorly calibrated machine. This could result in lost productive time as the wait for the machine to be repaired.
4.
5.
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Answer to SAQ 10
DD4

((45kgs * 89)* 4.80) 19,698 = (4,005kgs * 4.80) - 19,698 = 19,224 - 19,698 = 474 (A)
DIRECT MATERIAL USAGE VARIANCE STANDARD PRICE * (STANDARD UNITS OF ACTUAL PRODUCTION - ACTUAL QUANTITY) 4.80 * ((45kgs * 89) 4,020kgs) = 4.80 * (4,005kgs 4,020kgs) = 4.80 * 15 = 72(A) DIRECT MATERIAL PRICE VARIANCE ACTUAL QUANTITY * (STANDARD PRICE - ACTUAL PRICE) 4,020kgs * (4.80 - 4.90) = 4,020kgs * 0.10 = 402 (A)
((14hrs * 89) * 7.20) (1,157hrs * 7.40) = (1,246hrs * 7.20) 8,562 = 8,971 - 8,562 = 409 (F)
ACTUAL HOURS * (STANDARD RATE ph - ACTUAL RATE ph) 1,157hrs * (7.20 - 7.40) = 1,157hrs *0.20 = 231 (A)
STANDARD RATE ph * (STANDARD HOURS OF ACTUAL PRODUCTION - ACTUAL HOURS) 7.20 * ((14hrs * 89) 1,157hrs) = 7.20 * (1,246hrs 1,157hrs) =7.20 * 89 =640 (F)
Answer to SAQ 11
Scottish Qualifications Authority 2004 147 DE3J 35
Product P
DIRECT MATERIAL TOTAL VARIANCE
((10kgs * 5,000) * 0.50) - 24,999 = 1 (F)

DIRECT MATERIAL USAGE VARIANCE
2 STANDARD PRICE * (STANDARD UNITS OF ACTUAL PRODUCTION - ACTUAL QUANTITY) 0.50 * ((10kgs * 5,000) 49,500kgs) = 250 (F)
DIRECT MATERIAL PRICE VARIANCE 3 ACTUAL QUANTITY * (STANDARD PRICE - ACTUAL PRICE)
49,500kgs * (0.50 - 0.505) = 249 (A)
4 DIRECT LABOUR TOTAL VARIANCE ((5hrs * 5,000) * 0.80) - 20,199 = 199 (A) 5 DIRECT LABOUR RATE VARIANCE 25,200hrs * (0.80 - 0801547) = 39 (A)
STANDARD RATE ph * (STANDARD HOURS OF ACTUAL PRODUCTION - ACTUAL HOURS) 0.80 * ((5hrs * 5,000) 25,200hrs) = 160 (A)
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1. Answers to SAQ 12
Jones Limited Overhead Absorption Rate = = = = Variable + Fixed budgeted overheads Total budgeted activity 8,000 + 5,000 1,000 units 13,000 1,000 13 per unit
Note: If we divide the overhead absorption rate by the standard labour hours per unit, the rate may be quoted per hour.
Total Overhead Variance= = = =
Total standard overhead for actual production Total actual overheads (13 * 980) (7,900 + 5,400) 12,740 - 13,300 560 (A)
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Answer to SAQ 13
Davidson Limited 1. Flexible Budget for August 2003: Selling Price Raw Material
Labour: Production (20 hours pu) Packing (5 hours pu)
Per Unit 500
50 Units 25,000
70 Units 35,000
90 Units 45,000
Variable overhead Rent of buildings Local authority tax PROFIT 2. The Flexed Budget for August 2003 is: Sales Revenue Raw Material Labour: Production Packing Variable overhead Rent of buildings Local authority tax PROFIT
200 10,000 14,000 18,000 160 8,000 11,200 14,400 35 1,750 2,450 3,150 50 2,500 3,500 4,500 300 300 300 400 400 400 22,950 31,850 40,750
Actual 70 units 35,000 35,000 14,000 14,750 11,200 12,600 2,450 2,800 3,500 2,800 300 300 400 200 31,850 33,450 3,150 1,550
Flexed Budget
Variance 0 750 1,400 350 700 0 200 1,600 F/A A A A F F A
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SAQ 13 continued
DIRECT MATERIAL TOTAL VARIANCE
(70 * 200) - 14,750 = 750 (A)

DIRECT MATERIAL USAGE VARIANCE
2 STANDARD PRICE * (STANDARD UNITS OF ACTUAL PRODUCTION - ACTUAL QUANTITY) 200 * (70 - 70) = 0
DIRECT MATERIAL PRICE VARIANCE
3 ACTUAL QUANTITY * (STANDARD PRICE - ACTUAL PRICE) 70 * (200 - 14,750) 70 = 70 * (200 - 210.714) = 750 (A) PRODUCTION 4 DIRECT LABOUR TOTAL VARIANCE ((20 * 70) * 8) - 12,600 = 1,400 (A) 5 DIRECT LABOUR RATE VARIANCE 1,400 * (8 12,600) 1,400 = 1,400 * (8 - 9) = 1,400 (A) 6 DIRECT LABOUR EFFICIENCY VARIANCE
STANDARD RATE ph * (STANDARD HOURS OF ACTUAL PRODUCTION - ACTUAL HOURS) 8 * ((20 * 70) 1,400) = 0
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SAQ 13 continued 3. continued PACKING 7 DIRECT LABOUR TOTAL VARIANCE ((5 * 70) * 7) - 2,800 = 350 (A) 8 DIRECT LABOUR RATE VARIANCE 350 * (7 2,800) 350 = 350 * (7 - 8) = 350(A) 9 DIRECT LABOUR EFFICIENCY VARIANCE
STANDARD RATE ph * (STANDARD HOURS OF ACTUAL PRODUCTION - ACTUAL HOURS) 7 * ((5 * 70) 350) = 0
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SAQ 13 continued Overhead Absorption Rate = = = = Variable + Fixed budgeted overheads Total Budgeted Activity 3,500 + 300 + 400 70 units 4,200 70 60
Remember to note: If we divide the overhead absorption rate by the standard labour hours per unit, the rate may be quoted per hour.
Total Overhead Variance

Overheads
= = = =
Total standard overhead for actual production Total Actual
(60 * 70) (2,800+ 300 + 200) 4,200 - 3,300 900 (A)
Recommendations: 1. 2. 3. 4. Attempt to source material at a cheaper price. Investigate the use of lower grade / cheaper material Investigate the use of lower grade / cheaper labour. Investigate assumptions made in calculating overhead absorption rate of 60 pu.
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SAQ 13 continued 4. Report for August 2003
Colleagues Sales activity and revenue were on target. However, August proved a very tough month for the control of costs. Consequently Profit was 53% below budget at 1,550. These disappointing figures require immediate attention. It is vital that our colleagues in the Purchasing Department identify the rise in material costs of over 10 per unit. We should investigate whether it is possible to: Source an alternative supplier offering the current grade at a lower price Identify if it would be possible to use a lower grade of material at a cheaper price, without compromising the quality of our product too severely Establish if it would be beneficial to negotiate a bulk order with the prospect of obtaining the material at a cheaper unit cost.
We have established that the number of hours it took to make the 70 units was exactly as budgeted. Even so our labour costs were much higher than anticipated. In total, labour costs were 1,750 above budget, an enormous 13% extra! It is likely that this increase in cost may have been caused by: Increase in the hourly rates Payment of a bonuses Overtime payments
Whatever the cause of the labour variances, we need to identify: Whether it would be possible to use a lower grade of labour at a cheaper rate, without compromising the quality of our product, too severely? How to incorporate the rise in rates into future budgets How to obtain efficiency savings, working fewer hours to produce more units, without increasing rates.
Overheads require close scrutiny, as well. Our Accounting Department are, at present, trying to identify the principal causes for the favourable variances. One likely reason is that the anticipated increase in local authority taxes has not yet occurred. To ensure we achieve the targets we have set, it is imperative that measures are taken promptly to prevent a recurrence. Future plans are put in jeopardy if costs are not back under control. We all have a responsibility.
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Answer to SAQ 14
Alpha Limited Project A Year Year Year Year 0 Cash Outflow 1 Inflow 2 Inflow 3 Inflow (10,000) 3,000 3,000 3,000 ( 1,000) Project B Year Year Year Year 0 Cash Outflow 1 Inflow 2 Inflow 3 Inflow (25,000) 2,000 5,000 9,000 (9,000)
requires only 1000/3000 in Year 4 = 1/3 x year = 4 months Payback = 3 years 4 months
requires only 9000/12000 in Year 4 = x year = 9 months Payback = 3 years 9 months
So Project A would be considered in preference to B. However, if we were to consider the trend in cash flows, which project would be chosen?
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Answer to SAQ 15
Beta Limited Accounting Rate of Return Capital cost = (140,000) Year 1 2 3 4 5 6 7 Profit 20,000 30,000 40,000 50,000 40,000 20,000 10,000 210,000 210,000 7 = = 30,000 21.4%
Average profit = ARR =
30,000_ 140,000
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Beanos Annual Cash flow (10,000) 4,000 6,000 6,000 4,000 20,000 9% PV Factor (10,000) 6,000 6,000 10,000 1.000 0.917 0.842 0.772 0.708 Present value (10,000) 3,668 5,052 4,632 2,832 6,184 NPV
0 1 2 3 4
Payback = 2 years Dandies Annual Cash flow (12,000) 4,000 6,000 8,000 6,000 24,000 9% PV Factor (12,000) (8,000) (2,000) 6,000 12,0000.708 1.000 0.917 0.842 0.772 Present value (12,000) 3,668 5,052 6,176 4,248 7,144 NPV
0 1 2 3 4
Payback = 2,000/8,000 * Year 3 = Year 3 = 2 years 3 months
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Answer to SAQ 16
Charlie Limited Annual Cash flow Van (18,000) 4,800 4,800 8,400 8,400 9,600 10,800 46,800 Annual Cash flow Computer (6,000) 2,000 3,000 4,000 6,000 6,000 _6,000 27,000 Annual Cash flow Premises (50,000) 12,000 12,000 15,000 15,000 15,000 20,000 89,000
0 1 2 3 4 5 6
Cum (18,000) (13,200) ( 8,400) 8,400 18,000 28,800
Cum (6,000) (4,000) (1,000) 3,000 9,000 15,000 21,000
Cum (50,000) (38,000) (26,000) (11,000) 4,000 19,000 39,000
Payback = 3 years NPV @ 10% Factors 0 1 2 3 4 5 6 1.000 0.909 0.826 0.751 0.683 0.621 0.564 Van (18,000) 4,800 4,800 8,400 8,400 9,600 10,800 PV
1000/4000 * Year 3 = 2 years 3 months Computer (6,000) 2,000 3,000 4,000 6,000 6,000 6,000 12,508 PV (6,000) 1,818 2,478 3,004 4,098 3,726 3,384
11/15 *Year 4 = 3 years 9 months Premises PV
(18,000) 4,363 3,965 6,308 5,737 5,962 6,091 14,426
(50,000) (50,000) 12,000 10,908 12,000 9,912 15,000 11,265 15,000 10,245 15,000 9,315 20,000 11,280 12,925
Van would be selected as having the highest NPV. Also, the van has a slightly longer payback period than best (computer). Other company considerations may also require to be taken into account.
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Marischal Limited Year Present Value Factors at 10% 0 1.000 1 0.909 2 0.826 3 0.751 4 0.683 5 0.621 Net Present Value Project A Present Value (10,000) 3,636 2,478 2,253 1,366 1,242 975 Project B Present value (20,000) 4,545 4,130 2,253 6,830 1,863 (379)
From this, it can be seen that Project A is suitable and Project B is not. Using the example of Project A, it can be seen that the 10% rate selected is too low. Let us now set a rate of 20% Year Present Value Factors at 20% Present Value (10,000) 3,332 2,082 1,737 964 804 (1,081)
0 1.000 1 0.833 2 0.694 3 0.579 4 0.482 5 0.402 Net Present Value
The IRR for Project A can be calculated as follows: Note: 975 is the NPV at the lower rate of 10%, And (1,081) is the NPV at the higher rate of 20%. change in interest rate = 10% + 10 % * __975_____ (975 (1,081))
Activity 8 Continued Overleaf
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Activity 8 Continued Note: When a double negative appears in arithmetic, you add the figures, as we are wanting to find the range! = = = = 10% 10% 10% + + + 10 % * 975 2,056 10% * 0.474 4.74%
14.74%
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Answer to SAQ 17
Delta Limited Project A (100,000) 20,000 30,000 40,000 40,000 20,000 20,000 20,000 190,000 Project A (100,000) 20,000 30,000 40,000 40,000 20,000 20,000 20,000 190,000 Cumulative
For Payback Calculations
0 1 2 3 4 5 6 7
(100,000) ( 80,000) ( 50,000) ( 10,000) 30,000 50,000 70,000 90,000 PV @ 14% Present Value 1.000 (100,000) 0.877 17,540 0.769 23,070 0.675 27,000 0.592 23,680 0.519 10,380 0.456 9,120 0.400 8.000 4.288 18,790
Payback = 10/40ths of Year 4 = 3 months = 3 years 3 months
0 1 2 3 4 5 6 7
PV @ 20% Present Value 1.000 (100,000) 0.833 16,660 0.694 20,820 0.579 23,160 0.482 19,280 0.402 8,040 0.335 6,700 0.279 5,580 3.604 __240
NPV at 14% = 18,790 which is good NPV at 20% is 240, so the IRR is approximately 20%
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SAQ 17 Continued Delta Limited continued Project B (150,000) 40,000 30,000 30,000 40,000 70,000 70,000 60,000 340,000 Project B (150,000) 40,000 30,000 30,000 40,000 70,000 70,000 60,000 340,000 Cumulative
For payback calculations
0 1 2 3 4 5 6 7
(150,000) (110,000) ( 80,000) ( 50,000) ( 10,000) 60,000 130,000 190,000 Present Value @ 14% (150,000) 35,080 23,070 20,250 23,680 36,330 31,920 24,000 44,330
Payback = 4 years plus 10/70th of Year 5, which is approximately 2 months = 4 years 2 months
0 1 2 3 4 5 6 7
1.000 0.877 0.769 0.675 0.592 0.519 0.456 0.400
Present Value PV @ 30% 1.000 (150,000) 0.769 30,760 0.592 17,760 0.455 13,650 0.350 14,000 0.269 18,830 0.207 14,490 0.159 _ 9,540 (30,970)
NPV at 14% = 44330 very high, much better than A Note change in interest rates is 30% - 14% = 16% The IRR is: change in NPV between the two calculations = = = = 14% 14% 14% 14% + + + + 16% 16% 16% 9.4% * 44,330 (44,330 (30,970)) * * = 44,330 75,300 0.588 23.4%
Although payback is later, B is more worthwhile, achieving a higher NPV and IRR.
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8 Copyright References
All materials in this guide are the authors originals.
9 Acknowledgements
SQA gratefully acknowledge the contributions made from the Scottish Further Education Sector in the authoring, editing and publishing of this material.
Scottish Qualifications Authority - All rights reserved.
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Preparing Financial Forecast Unit Student Guide
Years 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 25 30
1% 0.990 0.980 0.971 0.961 0.951 0.942 0.933 0.923 0.914 0.905 0.896 0.887 0.879 0.870 0.861 0.853 0.844 0.836 0.828 0.820 0.780 0.742
2% 0.980 0.961 0.942 0.924 0.906 0.888 0.871 0.853 0.837 0.820 0.804 0.788 0.773 0.758 0.743 0.728 0.714 0.700 0.686 0.673 0.610 0.552
3% 0.971 0.943 0.915 0.889 0.863 0.838 0.813 0.789 0.766 0.744 0.722 0.701 0.681 0.661 0.642 0.623 0.605 0.587 0.570 0.554 0.478 0.412
4% 0.961 0.925 0.889 0.855 0.822 0.790 0.760 0.731 0.703 0.676 0.650 0.625 0.601 0.577 0.555 0.534 0.513 0.494 0.475 0.456 0.375 0.308
5% 0.952 0.907 0.864 0.823 0.784 0.746 0.711 0.677 0.645 0.614 0.585 0.557 0.530 0.505 0.481 0.458 0.436 0.416 0.396 0.377 0.295 0.231
6% 0.943 0.890 0.840 0.792 0.747 0.705 0.665 0.627 0.592 0.558 0.527 0.497 0.469 0.442 0.417 0.394 0.371 0.350 0.331 0.319 0.233 0.174
7% 0.935 0.873 0.816 0.763 0.713 0.666 0.623 0.582 0.544 0.508 0.475 0.444 0.415 0.388 0.362 0.339 0.317 0.296 0.276 0.258 0.184 0.131
8% 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463 0.429 0.397 0.368 0.340 0.315 0.292 0.270 0.250 0.232 0.215 0.146 0.099
9% 0.917 0.842 0.772 0.708 0.650 0.596 0.547 0.502 0.460 0.422 0.388 0.356 0.326 0.299 0.275 0.252 0.231 0.212 0.194 0.178 0.116 0.075
10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386 0.350 0.319 0.290 0.263 0.239 0.218 0.198 0.180 0.164 0.149 0.092 0.057
11% 0.901 0.812 0.731 0.659 0.594 0.535 0.482 0.434 0.391 0.352 0.317 0.286 0.258 0.232 0.209 0.188 0.170 0.153 0.138 0.124 0.074 0.044
12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 0.287 0.257 0.229 0.205 0.183 0.163 0.146 0.130 0.116 0.104 0.059 0.033
13% 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295 0.261 0.231 0.204 0.181 0.160 0.142 0.125 0.111 0.098 0.087 0.047 0.026
14% 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308 0.270 0.237 0.208 0.182 0.160 0.140 0.123 0.108 0.095 0.083 0.073 0.038 0.020
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Years 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 25 30
15% 0.870 0.756 0.658 0.572 0.497 0.432 0.376 0.327 0.284 0.247 0.215 0.187 0.163 0.141 0.123 0.107 0.093 0.081 0.070 0.061 0.030 0.015
16% 0.862 0.743 0.641 0.552 0.476 0.410 0.354 0.305 0.263 0.227 0.195 0.168 0.145 0.125 0.108 0.093 0.080 0.069 0.060 0.051 0.024 0.012
17% 0.855 0.731 0.624 0.534 0.456 0.390 0.333 0.285 0.243 0.208 0.178 0.152 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.043 0.020 0.009
18% 0.847 0.718 0.609 0.516 0.437 0.370 0.314 0.266 0.226 0.191 0.162 0.137 0.116 0.099 0.084 0.071 0.060 0.051 0.043 0.037 0.016 0.007
19% 0.840 0.706 0.593 0.499 0.419 0.352 0.296 0.249 0.209 0.176 0.148 0.124 0.104 0.088 0.074 0.062 0.052 0.044 0.037 0.031 0.013 0.005
20% 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194 0.162 0.135 0.112 0.093 0.078 0.065 0.054 0.045 0.038 0.031 0.026 0.010 0.004
25% 0.800 0.640 0.512 0.410 0.328 0.262 0.210 0.168 0.134 0.107 0.086 0.069 0.055 0.044 0.035 0.028 0.023 0.018 0.014 0.012 0.004 0.001
30% 0.769 0.592 0.455 0.350 0.269 0.207 0.159 0.123 0.094 0.073 0.056 0.043 0.033 0.025 0.020 0.015 0.012 0.009 0.007 0.005 0.001 0.000
35% 0.741 0.549 0.406 0.301 0.223 0.165 0.122 0.091 0.067 0.050 0.037 0.027 0.020 0.015 0.011 0.008 0.006 0.005 0.003 0.003 0.001
40% 0.714 0.510 0.364 0.260 0.186 0.133 0.095 0.068 0.048 0.035 0.025 0.018 0.013 0.009 0.006 0.005 0.003 0.002 0.002 0.001 0.000
45% 0.690 0.476 0.328 0.226 0.156 0.108 0.074 0.051 0.035 0.024 0.017 0.012 0.008 0.006 0.004 0.003 0.002 0.001 0.001 0.001
50% 0.667 0.444 0.296 0.198 0.132 0.088 0.059 0.039 0.026 0.017 0.012 0.008 0.005 0.003 0.002 0.002 0.001 0.001 0.000 0.000
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Recording financial information Unit Student Guide

Scottish Qualifications Authority

Scottish Qualifications Authority 2004

Recording financial information Unit Student Guide

Scottish Qualifications Authority

1 Introduction to the Scottish Qualifications Authority

Scottish Qualifications Authority 2004

Recording financial information Unit Student Guide

Scottish Qualifications Authority

2 Introduction to the Unit

What are the Outcomes of this Unit?

Scottish Qualifications Authority 2004

Recording financial information Unit Student Guide

Scottish Qualifications Authority

What do I Need to be Able to do in Order to Achieve this Unit?

Approximate Study Time for This Unit

Equipment/Material Required for this Unit

Scottish Qualifications Authority 2004

Recording financial information Unit Student Guide

Scottish Qualifications Authority

Recording financial information Unit Student Guide

Scottish Qualifications Authority

Cost-volume-profit analysis (C-V-P)

Scottish Qualifications Authority 2004

Recording financial information Unit Student Guide

Scottish Qualifications Authority

Glossary of Arithmetical Symbols used in this Study Guide ARITHMETICAL SYMBOL + * / = % p

EXAMPLE 2+2=4 74=3 3 * 4 = 12 8/4=2 80% 95.00 67p or 0.67

Scottish Qualifications Authority 2004

Recording financial information Unit Student Guide

Scottish Qualifications Authority

Symbols Used in this Unit

Scottish Qualifications Authority 2004

Recording financial information Unit Student Guide

Scottish Qualifications Authority

3 Assessment Information for this Unit

Methodology Closed Book 6

Scottish Qualifications Authority 2004

Recording financial information Unit Student Guide

Scottish Qualifications Authority

4 Suggested Lesson Plan

Scottish Qualifications Authority 2004

Recording financial information Unit Student Guide

Scottish Qualifications Authority

Learning Outcome 1 Prepare an Operating Statement

Scottish Qualifications Authority 2004

Recording financial information Unit Student Guide

Scottish Qualifications Authority

Cost and Revenue Classification

Scottish Qualifications Authority 2004

Recording financial information Unit Student Guide

Scottish Qualifications Authority

Scottish Qualifications Authority 2004

Recording financial information Unit Student Guide

Scottish Qualifications Authority

Recording financial information Unit Student Guide

Scottish Qualifications Authority

Scottish Qualifications Authority 2004

Recording financial information Unit Student Guide

Scottish Qualifications Authority

Scottish Qualifications Authority 2004

Recording financial information Unit Student Guide

Scottish Qualifications Authority

Scottish Qualifications Authority 2004