CIMA REVISION CARDS Management Accounting Fundamentals Janet Walker Certificate Level Paper C1
AMSTERDAM l BOSTON PARIS l SAN DIEGO l
HEIDELBERG SAN FRANCISCO
l
l l
LONDON l SINGAPORE
l
NEW YORK SYDNEY
l l
OXFORD TOKYO
Elsevier Butterworth-Heinemann Linacre House, Jordan Hill, Oxford OX2 8DP 30, Corporate Drive, Burlington, MA 01803 First published 2005 Copyright ß 2005, Elsevier Ltd. All rights reserved No part of this publication may be reproduced in any material form (including photocopying or storing in any medium by electronic means and whether or not transiently or incidentally to some other use of this publication) without the written permission of the copyright holder, except in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London, England W1T 4LP. Applications for the copyright holder’s written permission to reproduce any part of this publication should be addressed to the publisher. Permissions may be sought directly from Elsevier’s Science & Technology Rights Department in Oxford, UK: phone: (+44) 1865 843830, fax: (+44) 1865 853333, e-mail:
[email protected]. You may also complete your request on-line via the Elsevier homepage (http://www.elsevier.com), by selecting ‘Customer Support’ and then ‘Obtaining Permissions’ British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data A catalogue record for this book is available from the Library of Congress ISBN 07506 64770 For information on all Elsevier Butterworth-Heinemann publications visit our website at http://books.elsevier.com Printed and bound in Great Britain
Welcome to CIMA’s Official Revision Cards. These cards have been designed to:
. . . . .
Save you time by summarising the syllabus in a concise form Jog your memory through the use of diagrams and bullet points Follow the structure of the CIMA Official Study Systems Refer to relevant questions found within the Preparing for the Assessment section of the study system Provide you with plenty of assessment tips and hints
Ensure assessment success by revising with the only revision cards endorsed by CIMA.
TABLE OF CONTENTS 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.
Basic aspects of cost accounting .................................................. 1 Materials .............................................................................. 11 Labour ................................................................................. 19 Overhead .............................................................................. 25 Specific order costing ............................................................... 31 Continuous operation costing ....................................................... 37 Bookkeeping systems ............................................................... 55 Absorption costing and marginal costing.......................................... 63 Breakeven analysis and decision-making ......................................... 71 Budgetary planning and control .................................................... 87 Standard costing and variance analysis ........................................... 101
Basic Aspects of Cost Accounting The fundamental concepts of the framework of cost accounting
Topics
Key study system questions 1 3
Cost behaviour High-low method
. . . . . .
Cost units and cost centres The classification of costs The coding of costs The elements of cost Cost behaviour patterns Analysing semi-variable costs 1
Basic Aspects of Cost Accounting
Cost units and cost centres Definitions
The link between cost centres and cost units
Cost centre – a production or service location, function, activity or item of equipment for which costs are accumulated
Cost unit – a unit of product or service in relation to which costs are ascertained
Cost unit examples Product: litre of paint, batch of cakes Service: restaurant meal, tonne-mile
Cost centre examples Location: production department A Function: administration
A cost centre acts as a collecting place for costs. The total cost centre cost may then be related to the cost units which have passed through the cost centre to determine a cost per unit
Activity: invoice processing Item of equipment: stamping machine
2 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––– Basic Aspects of Cost Accounting
The classification of costs
Costs are classified so that they can be arranged into logical groups for further analysis
KK K K
Nature of cost: material, labour or expense Direct or indirect Functional analysis: production, selling, distribution, administration Fixed or variable Controllable and non-controllable: important when preparing management information Normal and abnormal: highlighting abnormal events draws them to managers’ attention Relevant and non-relevant: in respect of a particular decision
KKK
Types of cost classifications Indirect costs are also referred to as overheads Semi-fixed, semi-variable or mixed costs are partly fixed and partly variable
3 ——————————————————————————————————————————
Basic Aspects of Cost Accounting
The coding of costs
KKK
Advantages of a coding system A code is usually briefer than a description Reduces ambiguity Assists computerised processing of data
KK KKK
Code – a system of symbols designed to be applied to a classified set of items to give a brief accurate reference, facilitating entry, collation and analysis
Requirements for efficient coding system
K
Definition
Each code should be unique and certain Coding system should be comprehensive and capable of expanding to include new items Code numbers should be as brief as possible Incorporate check digits in computerised codes Only authorised personnel permitted to add new codes to system Code numbers should all be of the same length
4 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––– Basic Aspects of Cost Accounting
The elements of cost
A sound understanding of the difference between total direct cost, total production cost and total cost will help you in assessment questions on a variety of different topics Direct materials þ Direct labour þ Direct expenses ¼ Total direct cost þ Indirect materials þ Indirect labour þ Indirect expenses ¼ Total production cost þ Other overhead ¼ Total cost
Remember this! Direct costs are those that can be specifically identified with a particular cost unit
Study tip
Total direct cost is also referred to as prime cost Indirect materials, indirect labour and indirect expenses associated with production are also referred to as production overhead Other overhead includes selling, distribution and administration overhead
5 ——————————————————————————————————————————
Basic Aspects of Cost Accounting
Cost behaviour patterns Cost behaviour patterns describe the way that costs behave in relation to changes in the level of activity.
Definition Fixed cost – a cost which, within certain activity limits, is not affected by fluctuations in the level of activity
KK
Examples of fixed costs Rent of the factory Accountant’s salary
Definition Stepped fixed cost – a cost which remains constant for a range of activities, but which increases to the next step when a critical level of activity is reached
KK
Examples of stepped fixed costs Supervisors’ salaries Machine rentals 6
——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––– Basic Aspects of Cost Accounting
Cost behaviour patterns Definition Variable cost – a cost which varies in relation to the level of activity
KK
Examples of variable costs Packaging material costs Royalties
Definition Semi-variable cost – a cost containing both fixed and variable components and which is thus partly affected by a change in the level of activity
KK
Examples of semi-variable costs Telephone expenses Gas and electricity bills
Semi-variable costs are also referred to as semi-fixed or mixed costs 7
——————————————————————————————————————————
Basic Aspects of Cost Accounting
Example Activity level 450 units 220 units 800 units
K
K
The high-low method KK
Analysing semi-variable costs
Uses historical data on costs and activity levels Selects the highest and lowest activity levels and assumes that the change in cost between the levels is caused by the change in variable cost Variable cost per unit of activity is determined by dividing change in total cost by change in activity level Fixed cost determined by substituting variable cost per unit into either of the activity levels
Cost £ 4,675 £ 4,330 £ 5,200
Analyse the cost into its fixed and variable components.
Solution £ ð5;200 4;330Þ ð800 220Þ ¼ £ 1:50 Fixed cost ¼ £ 5;200 £ ð1:50 800Þ ¼ £ 4;000
Variable cost per unit ¼
Study tip This is a very important technique. It is vital that you are able to apply it to a wide variety of data. The activity measure will vary but the technique remains the same
8 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––– Basic Aspects of Cost Accounting
Analysing semi-variable costs
KKK
Scattergraph Uses historical data on costs and activity levels All available pairs of data plotted on graph Line of best fit is drawn by eye
Example Fixed cost ¼ vertical axis intercept ¼ £ 200 Variable cost per unit ¼ gradient of line of best fit £ ð500 200Þ ¼ ð150 0Þ ¼ £ 2 per unit
Variable cost per unit is given by gradient of line
Fixed cost is given by intercept on vertical axis, i.e., cost at zero activity
9
——————————————————————————————————————————
Materials Materials accounting and control procedures
Key study system questions
Topics
8 11 12
. . .
Stock level calculations Stock control Stock valuation methods
Recording stock movements Stock control levels Stock valuation 11
Materials
Recording stock movements Ordering and receiving stock Stockholding falls to reorder level
2
Storekeeper raises purchase requisition
3
Buying department completes purchase order
4
Goods received from supplier and goods received note (GRN) completed
5
Supplier’s invoice received
1
Alternatively, a special order item might be required Details goods required. Copy sent to buying department
Copy sent to supplier, to accounts department and to storekeeper to confirm goods are on order Supplier may also leave a delivery note Copy of GRN sent to accounts department and to buying department Invoice checked against purchase order and GRN before being authorised for payment 12
——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––––––––––––––– Materials
Recording stock movements Issuing stock from stores
2
Excess materials returned to stores are recorded on a materials returned note
3
Excess materials transferred to another job without first returning to stores are recorded on a materials transfer note
Details materials required and correct cost centre, or cost, unit to be charged with use of materials
Department requiring materials raises material requisition
1
Ensures that cost of unused material is credited to relevant cost centre, or cost unit, and stock records are updated
Ensures that cost of material is charged to correct cost centre or cost unit
13 ——————————————————————————————————————————
Materials
Recording stock movements
K K
This is known as a perpetual inventory system
Bin cards and/or stores ledger cards record all transactions and show continual record of stock balance Stock may be counted and checked against stock records annually on a particular date Alternatively, a number of items may be counted and checked against records each day. This is continuous stocktaking. Each item is checked at least once a year
K
Recording and checking stock balances
Continuous stocktaking cannot be carried out unless a perpetual inventory system exists
14 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––––––––––––––– Materials
Stock control levels
Reorder level ¼ maximum usage maximum lead time
Minimum level ¼ reorder level (average usage average lead time) Maximum level ¼ reorder level þ reorder quantity (minimum usage minimum lead time) Average stock ¼ safety stock þ ½ reorder quantity
Study tip You must memorize all the formulae on this card. They will not be provided in the assessment
Stock kept at optimum level to minimise risk of stock-outs and the costs of ordering and storing stock. Usually achieved by monitoring free stock balance ¼ physical stock þ stock on order with suppliers outstanding requirements unfulfilled
Reorder level ¼ level of free stock at which an order should be placed for replenishment stock Minimum and maximum are warning levels Minimum stock often used as safety stock in this formula 15
——————————————————————————————————————————
Materials
Stock control levels Definition
EOQ ¼
As carrying costs increase the ordering costs reduce
Economic order quantity – the order size which minimises the sum of stock ordering costs and stockholding qffiffiffiffiffiffifficosts 2Co D Ch
The EOQ formula will be provided in the assessment if you need it. But make sure that you know the meaning of each of the terms in the formula
EOQ theory assumes average stock ¼ order quantity/2, i.e. no safety stock is held
Study tip
EOQ ¼ when total cost is minimised ¼ point at which carrying cost is equal to ordering cost 16
——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––––––––––––––– Materials
Stock valuation
K
K
K
Stock valuation methods First In First Out (FIFO) – prices issues at the price of the oldest items in stock Last In First Out (LIFO) – prices issues at the price of the latest items received into stock Weighted average (AVCO) – prices issues at the weighted average price of items in stock
Example data Opening stock 1st March Purchases 5th March Issues 7th March
200 units at £ 2.00 per unit 500 units at £ 2.35 per unit 300 units
FIFO method Value of issues 7th March ¼ (200 units £ 2.00) þ (100 units £ 2.35) ¼ £ 635 Value of closing stock ¼ 400 units £ 2.35 ¼ £ 940 LIFO method Value of issues 7th March ¼ 300 units £ 2.35 ¼ £ 705 Value of closing stock ¼ (200 units £ 2.00) þ (200 units £ 2.35) ¼ £ 870 AVCO method Average price ¼ ((200 £ 2.00) þ (500 £ 2.35))/700 ¼ £ 2.25 per unit Value of issues 7th March ¼ 300 units £ 2.25 ¼ £ 675 Value of closing stock ¼ 400 units £ 2.25 ¼ £ 900
17 ——————————————————————————————————————————
Materials
Stock valuation When prices are rising Closing stock valuation Charge to cost of sales Reported profit
FIFO Highest Lowest Highest
LIFO Lowest Highest Lowest
AVCO Between FIFO and LIFO Between FIFO and LIFO Between FIFO and LIFO
Calculating the weighted average price Revised average price usually calculated whenever new batch received into stock ¼ cumulative weighted average If single average calculated at period end based on total purchases for period ¼ periodic moving average
18 ——————————————————————————————————————————
Labour Labour accounting and control procedures
Topics Key study system questions 14 15
Labour remuneration Labour remuneration
. . . .
Remuneration systems Labour turnover Time and activity recording systems Classification of labour costs 19
Labour
K
K
KK
KK
K
K K
Employee paid for output achieved: output achieved piecework rate per unit May include guaranteed minimum wage Differential system pays increasing rates for higher output: important to state if higher rates apply to additional units only Important to check quality Suitable where quantity of output is important
K
Bonus schemes
Employee paid for hours attended: hours attended agreed hourly rate Wages not dependent on output achieved Overtime hours usually paid at premium above basic rate Suitable where: output difficult to measure, activities undertaken vary widely, quality of output important
K
Piecework systems
K
Time-based systems K
Remuneration systems
Employee paid a bonus for time saved against agreed target Benefit of efficiency shared between employee and employer Many different schemes May be applied to groups where: operations carried out in groups, not possible to measure individual performance, whole group must work faster to exceed targets
20 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––––––––––––––––– Labour
Labour turnover Benefits
Labour turnover – a measure of the number of leavers relative to the size of the workforce. Usually expressed as a percentage
Labour turnover ¼
number of leavers replaced average number of employees 100%
May help to reduce turnover and encourage higher morale among workforce. For example: KKKKKK
Definition
company cars staff discounts subsidised canteen health insurance pension scheme cre`che facilities
Study tip Learn this formula. It will not be provided in the exam
21 ——————————————————————————————————————————
Labour
K
K
Important for time-based employees Also important for reconciling analysis of total time in jobbing environment Clock cards: record starting and finishing times. May be mechanical or electronic Important, with flexible time working for employees, to know cumulative hours worked in current period
KKKK
Activity recording systems
K
Time recording systems KK
Time and activity recording systems
Important for employees who are paid according to output Also important in a jobbing environment Piecework/bonus ticket Time sheets: daily or weekly Important to record and report on idle time ¼ when employee is being paid but not doing productive work
22 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––––––––––––––––– Labour
Usually treated as indirect labour KK
Basic pay of direct workers Basic rate of direct overtime hours worked Overtime premium and bonus payments which can be identified with specific customer or job
Example data Basic pay O/time pay (time þ ½) Idle time Bonuses paid Total
Direct employees £ 37,800
Indirect employees £22,300
£ 3,900 £ 400 £ 2,700 £ 44,800
£5,100 £ 3,400 £ 30,800
KK
Usually treated as direct labour KKK
Classification of labour costs
All payments to indirect workers Overtime premium and bonus payments unless directly attributable to specific job Idle time payments Holiday pay, sick pay, etc.
Solution Direct wages ¼ £ 37;800 þ ð2=3 £ 3;900Þ ¼ £ 40;400 Indirect wages ¼ £ 30;800 þ ð1=3 £ 3;900Þ þ £ 400 þ £ 2;700 ¼ £ 35; 200
23 ——————————————————————————————————————————
Overhead The analysis of overhead
Topics Key study system questions 17 18 21
Overhead absorption Overhead absorption rates Overhead analysis
. . . .
Overhead analysis Overhead apportionment Overhead absorption Under/over absorption 25
Overhead
Overhead analysis Definitions
Remember
Overhead – expenditure on labour, materials or services which cannot be economically identified with a specific saleable cost unit
Service cost centre – a cost centre that provides support services to the production cost centres, e.g., maintenance, stores, canteen
K K
Production cost centre – a cost centre that is directly involved with the production of the organisation’s output
Three stages in overhead analysis
K
Absorption costing – a method of costing that, in addition to direct costs, assigns production overhead costs to cost units by means of overhead absorption rates
Overhead costs are also called indirect costs
Allocation. Allot whole items of overhead to individual cost centres, e.g., allocate storekeeper’s wages to stores cost centre Apportionment. Apportion remaining overhead between cost centres on an equitable basis, e.g., apportion factory rent over several cost centres on basis of floor area Absorption. Absorb total cost centre production overhead costs into cost units 26
——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––––––––––––––– Overhead
K
Once all possible direct allocations have been made, apportion the remaining production overhead costs to production and service cost centres on an equitable basis Then re-apportion the total of the service cost centre costs to production cost centres
K
Reciprocal servicing
K
Apportionment and re-apportionment K
Overhead apportionment
Occurs when service cost centres provide service to each other Take account of reciprocal servicing by repeated distribution of service cost centre total overheads to production cost centres and to other service cost centres until amounts involved become negligible
Remember After the apportionment stage you should end up with overheads attributed to production cost centres only
27 ——————————————————————————————————————————
Overhead
Overhead absorption
budgeted production overhead for cost centre budgeted units of absorption base
K K
OAR ¼
Main bases of overhead absorption
K
Total overhead of production cost centre is absorbed into unit costs, using pre-determined overhead absorption rate (OAR):
Rate per unit – only suitable if identical units produced Direct labour hour rate – suitable for labour-intensive cost centres Machine hour rate – suitable for machine-intensive cost centres
K
K
K
Reasons for pre-determined OARs Overhead not incurred evenly over period: actual rates per unit subject to wide fluctuation Activity levels may fluctuate during period: OAR would also fluctuate Managers have an overhead rate available for use in product costing, price quotations, etc.
Study tip A common error is to use the actual overhead and activity figures to determine the OAR. Remember that OARs are pre-determined, based on budgeted figures for the period.
28 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––––––––––––––– Overhead
Under/over absorption
KK
Pre-determined OARs result in under or over absorption due to either or both of the following: actual overhead is different from budget actual activity level is different from budget
Actual overhead > absorbed overhead ¼ under absorbed Actual overhead < absorbed overhead ¼ over absorbed
Example Machining department results for latest period: Actual Budget Machine hours 23,800 22,700 Production overhead £ 8,330 £ 9,080 Solution Pre-determined OAR ¼ £ 9,080/22,700 ¼ £ 0.40 per machine hour Overhead absorbed ¼ 23,800 hr £ 0.40 ¼ £ 9,520 £ 8,330 Overhead incurred £ 1,190 Over-absorbed overhead
29 ——————————————————————————————————————————
Specific Order Costing Job, batch and contract costing systems
Key study system questions 22 25 26
Specific order costing Job/batch costing Specific order costing
Topics
. .
Job and batch costing Contract costing 31
Specific Order Costing
Job and batch costing
KK
Specific order costing – the basic cost accounting method applicable where work consists of separately identifiable contracts, jobs or batches
Characteristics of batch costing
K
Definition
Similar to job costing Each batch is a group of similar articles, which is separately identifiable from all other batches Cost per item within batch ¼ total batch cost number of items in batch
KKK
Customer-driven production. Jobs are undertaken as the result of a customer request Each job is a separately identifiable unit Jobs are of relatively short duration Each job has a unique number. Costs are accumulated against the number on a job card
K
Characteristics of job costing
Relatively short duration Compared with those to which contract costing is applied
32 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––––––––– Specific Order Costing
Job and batch costing Example Data for job no. 9364 is as follows: Direct material cost Direct labour cost Hire of special machine
£ 465 £ 790 £ 250
Production overheads are absorbed at a rate of 30 per cent of direct labour cost. Other overheads are added at a rate of 10 per cent of total production cost. The required profit margin for each job is 15 per cent of the sales price. Calculate the selling price of job no. 9364, to the nearest penny. Show separate subtotals for prime cost, total production cost and total cost
Solution Direct material Direct labour Direct expense Prime cost Production o’head (£ 790 30%) Total production cost Other overhead (£ 1,742 10%) Total cost Profit margin (£ 1,916.20 15/85) Selling price
£ 465.00 £ 790.00 £ 250.00 £ 1,505.00 £ 237.00 £ 1,742.00 £ 174.20 £ 1,916.20 £ 338.15 £ 2,254.35
Study tip Be careful! Sometimes the required profit is expressed as a percentage of the total job cost 33 ——————————————————————————————————————————
Specific Order Costing
K K K KK
K K K
Customer-driven production. Contracts are undertaken as the result of a customer request Each contract is a separately identifiable unit, usually constructional in nature Contracts are of relatively long duration and often span more than one accounting period Costs accumulated in separate account for each contract Architect’s certificates state the value of work completed to date. Progress payments are made by customer according to value of work certified, less any retention money
K
The contract account
K
Characteristics of contract costing K
Contract costing
Acts as a collecting place for costs incurred on contract Debit all costs incurred during period, e.g., materials issued to contract, wages paid, plant delivered to site, head office charges Credit value of plant or material returned or transferred from site during period Credit value of plant and material on site at end of period Credit cost of work not yet certified Balance on account ¼ cost of work certified during period
34 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––––––––– Specific Order Costing
Contract costing
K
K
K
K
Recognising profits on contracts Profit recognised in stages as contract progresses. Otherwise wild fluctuations in profits reported year on year Requirements of prudence concept must be adhered to No profit recognised if contract in early stages and final outcome cannot be foreseen with reasonable certainty If difficulties or a loss are foreseen the whole of the final estimated loss on contract should be recognised immediately
Study tip Many different methods exist for calculating the profit to be recognised on an incomplete contract. In the assessment you should assess the information available and follow any instructions concerning the calculation of profit
35 ——————————————————————————————————————————
Specific Order Costing
Contract costing Example Agreed contract price Value of work certified to date Progress payments received from customer Cost of work certified to date Cost of work to complete contract (a)
(b)
Solution £ 380,000 £ 340,000 £ 289,000 £ 275,000 £ 35,000
Profit to be recognised is a percentage of the notional profit to date, based on the proportion of the certified value received from the customer Profit to be recognised is a percentage of the estimated final contract profit, based on the proportion of total contract costs incurred to date
(a)
(b)
Profit to be recognised ¼ notional profit to date (cash received/value of work certified) ¼ £ (340,000 275,000) £ (289,000/340,000) ¼ £ 55,250 Profit to be recognised ¼ estimated final profit (cost incurred to date/estimated final contract cost)
Estimated final contract cost ¼ £ ð275;000 þ 35;000Þ ¼ £ 310;000 Profit to be recognised ¼ £ ð380;000 310;000Þ £ ð275;000=310;000Þ ¼ £ 62;100
36 ——————————————————————————————————————————
Continuous Operation Costing Service costing and process costing systems
Topics Key study system questions 27 28 29 32
Process costing Joint products Process costing Service costing
. . . . . .
Introduction to continuous operation costing Service costing Fundamentals of process costing Work in progress Process losses Joint products and by-products 37
Continuous Operation Costing
Introduction to continuous operation costing Definition Continuous operation costing – the costing method applicable where goods or services result from a sequence of continuous or repetitive operations or processes. Costs are averaged over the units produced during the period, being initially charged to the operation or process
Costs cannot be identified with individual cost units, therefore an averaging process is necessary to derive a unit cost Average cost per unit ¼
total costs incurred number of units produced
Unlike specific order costing, which is applicable when each cost unit can be separately identified from all others, continuous operation costing is used in situations where operations result in a continuous flow of identical units
38 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––––– Continuous Operation Costing
Service costing
K
K
K
K
K
K
Characteristics of service costing High levels of indirect cost as a proportion of total costs Can be difficult to establish a measurable cost unit ‘Output’ is often intangible, i.e., cannot be physically seen and touched Often provided instantaneously, rather than for stock, e.g., office cleaning service Many services ‘perish’ immediately. Cannot be stored for later use, e.g., seat on coach journey. Capacity utilisation is therefore an important issue May be provided for external customer, e.g., hotel service, or for internal use, e.g., canteen
Composite cost units Often used in services because of problem of comparability of unit costs, e.g., cost per tonne transported will depend on distance travelled. Comparison easier for control purposes with cost per tonne-kilometre Cost per service unit ¼
total costs incurred number of units supplied
39 ——————————————————————————————————————————
Continuous Operation Costing
Service costing Example
Solution
A hotel’s records for last period include the following information:
No. of guests
No. of guests 150 230 76 460 334
Length of stay (nights) 1 2 4 7 14
Laundry cost
£ 18,530
150 230 76 460 334
Length of stay (nights) 1 2 4 7 14
Guestnights 150 460 304 3,220 4,676 8,810
Laundry cost per guest-night ¼ £ 18,530/8,810 ¼ £ 2.10
Calculate the laundry cost per guest-night
40 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––––– Continuous Operation Costing
K K KK K
KK K K
Production consists of a continuous flow of identical units, e.g., food manufacture Usually a sequence of processes, where output from one process becomes input of next Separate account maintained for each process Work in progress (WIP) at period end may be complete to different degree for each cost element Losses may occur in process. The losses may have a scrap value Joint products or by-products may be produced
KK
Preparing process accounts
K
Characteristics of process costing K
Fundamentals of process costing
Include a column for units as well as value on both sides of account Debit units and value of any opening WIP If not first process in sequence, debit units and value of transfer from previous process Debit all costs incurred, including absorbed overhead if appropriate Credit units of normal loss and any scrap value Credit abnormal loss/debit abnormal gain units and full cost value (not scrap value) Credit units and value of finished output and closing WIP
41 ——————————————————————————————————————————
Continuous Operation Costing
Work in progress Closing work in progress (WIP)
Solution
If closing WIP is complete to a different degree for each cost element, it is necessary to calculate equivalent units of production for each cost element
Equivalent units Output units Materials Conv. costs F. Goods 900 900 900 60 Closing WIP 100(100%) 100(60%) 1,000 1,000 960 Costs £ 4,000 £ 2,400 Cost per equiv. unit £ 6.50 £4 £ 2.50
Example Opening WIP Input materials Conversion cost Outputs:
Valuation: Finished goods £ 5,850 Closing WIP £ 550
WIP is completed:
nil 1,000 units @ £ 4 per unit £ 2,400 Finished goods: 900 units Closing WIP: 100 units 100% as to material cost 60% as to conversion cost
£ 400 (100 £ 4)
£ 150 (60 £ 2.50)
Conversion cost ¼ labour and overhead cost 42
——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––––– Continuous Operation Costing
Work in progress
KK
Opening work in progress (average cost method) Cost of opening WIP added to costs incurred Cost per equivalent unit calculated as before
Example Using data from last example, assume that finished output was 1,050 units and that opening WIP was as follows: Opening WIP 150 units, valued: Material cost £ 830 Conversion cost £ 264
Solution Equivalent units Output units Materials Conv. costs 1,050 1,050 F. Goods 1,050 Closing WIP 100(100%) 100(60%) 60 1,150 1,150 1,110 Opening WIP cost £ 830 £ 264 £ 4,000 £ 2,400 Costs this period £ 4,830 £ 2,664 Cost per equiv. unit £ 6.60 £ 4.20 £ 2.40 Valuation: Finished goods £ 6,930 Closing WIP £ 564
£ 420 £ 144 (100 £ 4.20) (60 £ 2.40)
43 ——————————————————————————————————————————
Continuous Operation Costing
Determining the amount of losses
Normal loss – the level of loss expected in a process for a given volume of input
Remember this!
K
Abnormal gain – if the actual loss is lower than the normal loss the difference is an abnormal gain
K
Abnormal loss – if the actual loss is greater than the normal loss the difference is an abnormal loss
K
Definitions
K
Process losses
Sum the total volume of input (opening WIP þ input during period) Sum the total volume of output (completed units þ closing WIP) Reconcile input with output and difference is number of units of total loss Deduct normal loss from total loss. Positive difference ¼ abnormal loss. Negative difference ¼ abnormal gain
The scrap value of only the normal loss units reduces the process costs. Abnormal losses and gains are valued at full production cost and their scrap value is not entered in the process account
44 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––––– Continuous Operation Costing
K K
Value at full cost per unit. Debit: Abnormal loss a/c; Credit: Process a/c Scrap value of abnormal loss ¼ Debit: Scrap stock a/c; Credit: Abnormal loss a/c Transfer Abnormal loss account balance to P/L
Abnormal gain
K
K
K
K
Does not absorb any process costs. Do not include as output in equivalent units calculations Value at scrap value only. Debit: Scrap stock a/c; Credit: Process a/c When calculating cost per equivalent unit, deduct scrap value of normal loss from first cost element (either previous process cost or added materials cost)
K
Abnormal loss
K
Normal loss K
Process losses
Value at full cost per unit. Debit: Process a/c; Credit: Abnormal gain a/c Scrap value of abnormal gain ¼ Debit: Abnormal gain a/c; Credit: Scrap stock a/c Transfer Abnormal gain account balance to P/L
45 ——————————————————————————————————————————
Continuous Operation Costing
Process losses Example: abnormal loss Process account kg Materials Conversion costs
£
500
6,000 4,000
500
10,000
kg Output Normal loss Abnormal loss
430 50 20 500
£/kg
£
21.67 5.00 21.67
9,317 250 433 10,000
Cost incurred scrap value of normal loss £ 10;000 £ 250 ¼ ¼ £ 21:67 Expected output 450
The abnormal loss units are valued at the same rate per unit as the good output units. The normal loss is valued at its scrap value only.
46 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––––– Continuous Operation Costing
Process losses Example (continued): abnormal loss Abnormal loss account £ Process
433
£ Scrap stock: 20 £ 5 Profit and loss
433
100 333 433
Scrap stock account £ Process – normal loss Abnormal loss transfer
250 100 350
£ Debtor/cash: (50 þ 20) £ 5
350 350
47 ——————————————————————————————————————————
Continuous Operation Costing
Process losses Example: equivalent units/abnormal gain Equivalent units Materials
Conversion cost
Input
Units
Output
Units
%
O.WIP Materials
100 800
F. goods Normal loss Abnormal gain C. WIP
810 80 (30) 40 900
100
810
100
810
100 100
(30) 40 820
100 60
(30) 24 804
900
%
48 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––––– Continuous Operation Costing
Process losses Example (continued): equivalent units/abnormal gain Costs
Total
Materials
£8
£ 280 £ 3,900 (£ 80) £ 4,100/820* £5
Opening WIP This period Scrap value n. loss Cost per unit
Conversion cost £ 190 £ 2,222 — £ 2,412/804** £3
*£4,100/820 ¼ £5 **£2,412/804 ¼ £3
49 ——————————————————————————————————————————
Continuous Operation Costing
Process losses Example (continued): equivalent units/abnormal gain
F. goods: 810 £ 8 ¼ £ 6,480 A. gain: 30 £ 8 ¼ £ 240
C. WIP
Total
Materials
Conversion cost
£ 272
£ 200*
£ 72**
Process account
Opening WIP Material Conversion cost Abnormal gain
Units
£
100 800
470 3,900 2,222 240 6,832
30 930
F. goods Normal loss Closing WIP
Units
£
810 80 40
6,480 80 272
930
6,832
*40 £ 5 ¼ £200 **24 £ 3 ¼ £ 72
50 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––––– Continuous Operation Costing
Joint products and by-products
Definition
Study tip
Joint products – two or more products produced by the same process and separated in processing, each having a sufficiently high saleable value to merit recognition as a main product
Your syllabus requires you to understand only general principles of joint and by-products. You will not be required to perform any computations
Characteristics of joint products KK K K
In the manufacturing of blood products, the process produces red cells, platelets and plasma (which requires further processing) The output from oil refining is the various grades of petrol, diesel, paraffin, and so on
K
K
K
Examples of joint products Accounted for separately as far as possible Products become individually recognisable at separation point or split-off point Costs incurred before separation point ¼ joint costs, common costs or pre-separation costs Common costs are apportioned to joint products mainly for stock valuation May require further processing after separation 51 ——————————————————————————————————————————
Continuous Operation Costing
Joint product and by-products Accounting for joint products
K K
Weight or volume of output of each product at separation point. Not suitable if products in different form, e.g., solid, liquid, gas Sales value at separation point. Produces same apparent gross margin for each product, but some products may not be saleable at separation point. In this case use the third method Final sales value, net of the cost of any further processing beyond the separation point
Apparent gross margin
K
The most common bases of apportioning pre-separation point costs to joint products are as follows:
Note reference to ‘apparent’ gross margin. Apportionment of common costs results in arbitrary cost for each joint product. Result is of limited use for decision making. Decisions should focus on what happens to products after separation, e.g., incur further processing costs?
52 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––––– Continuous Operation Costing
Joint products and by-products
Definition
Example of by-product Sawdust produced when timber is processed
Characteristics of by-products
None of the costs of the main process are attributed to the by-product. The value of the by-product is usually used to reduce the net costs of the main process, i.e., credit by-product value to main process account. It is usually valued at its sales value, less any further processing costs required to put it into a saleable state
Value is small and incidental compared with that of main product or products Do not absorb any process costs
Accounting for by-products
K
K
By-product – output of some value produced incidentally in manufacturing something else (main product)
Point to notice Notice that a by-product is effectively treated in the same way as a normal loss, which has a scrap value
53 ——————————————————————————————————————————
Bookkeeping Systems Integrated and non-integrated accounting systems
Topics Key study system questions 33 35 36 37
Integrated accounts Integrated Integrated Integrated
and interlocking accounts accounts accounting system
. . . . . .
Integrated and interlocking systems Accounting for materials Accounting for wages Accounting for production overhead Other accounts Interlocking accounts 55
Bookkeeping Systems
Integrated and interlocking systems
Interlocking system – a system in which the cost accounts are distinct from the financial accounts, the two sets of accounts being kept continuously in agreement by the use of control accounts or reconciled by other means Main disadvantage of integrated system is that a single system has to provide information for both external and internal reporting. However, the information needs of each are very different
K KK
Avoids duplication of effort involved in keeping two separate ledgers No need for periodic reconciliations Avoids confusion that can arise by using two different sets of accounts
Advantages of interlocking systems K
Integrated accounts – a set of accounting records which provides both financial and cost accounts, using a common input of data for all accounting, purposes
Advantages of integrated systems
K
Definitions
Management attention can be focused on operational aspects of business Cost accounts can analyse information to be useful to managers, without need to conform to statutory requirements
56 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––––––––– Bookkeeping Systems
Accounting for materials (i) (ii)
(iii)
(iv)
Purchase of raw materials on credit Dr: Materials control; Cr: Creditors control Issue of direct materials to production Dr: Work in progress (WIP) control; Cr: Materials control Issue of indirect materials to production Dr: Production overhead control; Cr: Materials control Return of unused direct materials to stores Dr: Materials control; Cr: Work in progress (WIP) control (i.e., the reverse of entry (ii) above)
Material control account Balance b/d xx (i) Creditors xx (iv) WIP – returns from prodn. xx xx
(ii) WIP – direct (iii) Prodn. o/h-indirect Balance c/d
xx xx xx xx
57 ——————————————————————————————————————————
Bookkeeping Systems
Accounting for wages (i)
Payment of net wages Dr: Wages control; Cr: Bank
(ii)
Account for PAYE/NI Dr: Wages control; Cr: PAYE/NI creditor
(iii)
Transfer gross direct wages to WIP Dr: Work in progress control; Cr: Wages control
(iv)
Transfer gross indirect production wages to production overhead control Dr: Production overhead control; Cr: Wages control
The gross wages ((i) þ (ii)) are collected in the wages control account before they are transferred to work in progress, or to production overhead control, according to whether they are direct wages or indirect wages. The gross wages are made up of two parts: the net wages that are paid from the bank, plus the PAYE/NI deductions. Wages control account (i) Bank – net wages xx (ii) PAYE/NI creditor xx xx
(iii) WIP – direct (iv) Prodn. o/h – indirect
xx xx xx
58 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––––––––– Bookkeeping Systems
Accounting for production overhead (i)
(ii) (iii) (iv) (v)
Issue of indirect materials to production Dr: Production overhead control; Cr: Materials control Transfer of gross indirect production wages Dr: Production overhead control; Cr: Wages control Payment of other production overhead costs Dr: Production overhead control; Cr: Bank/creditors Absorb production overhead cost Dr: WIP control; Cr: Production o/head control Transfer under/over absorbed balance to P & L Under-absorbed: Dr: P & L; Cr: Prodn. o/head control Over-absorbed: Dr: Prodn. o/head control; Cr: P & L
All production overheads are collected in the production overhead control account before they are absorbed into work in progress, using a pre-determined overhead absorption rate Production overhead control account (i) Materials control (ii) Wages control (iii) Bank/creditors
xx xx xx xx
(iv) WIP control xx (v) Under-absorbed to P&L* xx xx
*Over-absorbed overhead would be debited in the overhead control account and credited to the profit and loss account
59 ——————————————————————————————————————————
Bookkeeping Systems
Other accounts (i)
(ii) (iii)
(iv) (v)
Expenses for selling/distribution/ administration Dr: Selling/distn./admin. o/head control; Cr: Creditors Transfer of cost of completed production Dr: Finished goods control; Cr: WIP control Transfer of cost of goods sold Dr: Cost of sales account; Cr: Finished goods control Sale of goods on credit Dr: Debtors control; Cr: Sales account Complete summary profit and loss account Dr: P & L account; Cr: Cost of sales account Dr: P & L account; Cr: Selling/distn./admin. o/head control Dr: Sales account; Cr: P & L account
Work in progress control account Balance b/d Materials control Wages control Prodn. o/h control
xx xx xx xx xx
(ii) Finished goods Balance c/d
xx xx
xx
Profit and loss account (v) Cost of sales xx (v) Selling o/h control xx (v) Distn. o/h control xx (v) Admin. o/h controlxx Under-absorbed o/h* xx xx Profit for period xx
(v)
Sales
xx
xx
*Over-absorbed overhead is credited to P & L account 60 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––––––––––––– Bookkeeping Systems
Interlocking accounts
K K
K
Used to record all information which is passed to and from financial ledger Records entries for which there is no account in cost ledger
Some items affect financial accounts profit but not included in cost accounts. Examples: interest, loss on sale of fixed assets Some items affect cost accounts profit but not included in financial accounts. Examples: notional charges for rent or interest Some items treated differently in two ledgers. Examples: stock value, depreciation
K
Cost ledger control account
K
The need to reconcile cost ledger and financial ledger profits
Interlocking accounting systems maintain two separate ledgers: one for financial accounts and one for cost accounts. Cost ledger operates in same way as integrated system (i.e., materials control, work in progress control, etc.) but no accounts in cost ledger for financial items (debtors, creditors, fixed assets, dividends, etc.)
Cost ledger control account may also be called general ledger control account or financial ledger control account
61 ——————————————————————————————————————————
Absorption Costing and Marginal Costing The principles of absorption costing and marginal costing
Topics Key study system questions 39 40
Marginal and absorption costing Marginal costing
. . . .
Marginal costing and contribution Preparing profit statements Reconciling the profit figures Marginal costing or absorption costing? 63
Absorption Costing and Marginal Costing
Marginal costing and contribution Marginal costing and absorption costing
Definition
Absorption costing values all stock items at full production cost, including absorbed fixed production overhead costs. Marginal costing values all stock items at variable or marginal production cost only. Fixed costs are treated as period costs and written off in full against the profit for period
Marginal cost – the part of the cost of one unit of product or service which would be avoided if that unit were not produced, or which would increase if one extra unit were produced
Contribution
Remember this! The difference between the two systems is in their treatment of fixed production overheads only. Both systems treat other types of fixed overhead as period costs
Contribution is so called because it literally does contribute towards fixed cost and profit. Contribution is calculated as: Sales value variable/marginal* costs *The terms marginal cost and variable cost tend to be used interchangeably
64 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Absorption Costing and Marginal Costing
Preparing profit statements Example data Data concerning product X are as follows: Selling price per unit Variable production cost per unit Variable selling cost per unit
£ 35
Fixed production overhead Other fixed overhead Budgeted production and sales
£ 30,000 per month £ 12,000 per month
Opening stock for June Production in June Sales for June
1,200 units 2,800 units 2,600 units
£ 14 £2
3,000 units per month
Marginal costing profit statement for June £ Sales revenue (2,600 £ 35) Opening stock (1,200 £ 14) 16,800 Variable prodn. cost (2,800 £ 14) 39,200 56,000 19,600 Closing stock (1,400 £ 14) 36,400 Variable selling costs (2,600 £ 2) 5,200 Variable cost of sales Contribution Less fixed overhead: Fixed production overhead 30,000 12,000 Other fixed overhead Profit
£ 91,000
41,600 49,400
42,000 7,400
65 ——————————————————————————————————————————
Absorption Costing and Marginal Costing
Preparing profit statements Absorption costing profit statement for June £ Sales revenue Opening stock (1,200 £ 24) 28,800 67,200 Full prodn. cost (2,800 £ 24) 96,000 33,600 Closing stock (1,400 £ 24) 62,400 2,000 Under-absorbed o/head Full production cost of sales Gross profit Less other overhead: Variable selling cost 5,200 12,000 Other fixed overhead Profit
£ 91,000
Notes 1.
Fixed production overhead per unit ¼ £ 30,000/3,000 ¼ £ 10 per unit Full production cost per unit ¼ £ 14 þ £ 10 ¼ £ 24
2. 64,400 26,600
Fixed production overhead absorbed ¼ 2,800 units produced £ 10 £ 28,000
Fixed production overhead incurred Under-absorbed production overhead
17,200 9,400
£ 30,000 £ 2,000
This amount is added to the cost of sales for the month. If the overhead had been over absorbed the amount would have been deducted
66 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Absorption Costing and Marginal Costing
Reconciling the profit figures
K
K
K
Profit differences Difference arises between profit reported under marginal costing and under absorption costing only if stock volume changes during period If stocks increase, absorption costing profit is greater than marginal costing profit, because some fixed production overhead is carried forward in stock to later periods If stocks reduce, absorption costing profit is lower than marginal costing profit, because some fixed production overhead that had been carried forward is now released from stock to be charged against sales for the period
Example Using the data from the previous example, stocks increased during the period, therefore absorption costing will report a higher profit than marginal costing, because of the extra fixed production overhead carried forward in stock Marginal costing profit Add: fixed production overhead carried forward in stock increase (200 units £ 10) Absorption costing profit
£ 7,400
£ 2,000 £ 9,400
67 ——————————————————————————————————————————
Absorption Costing and Marginal Costing
Reconciling the profit figures
K
K
K
K
Summary Profit difference ¼ change in stock units fixed production overhead cost per unit If stocks increase, absorption costing profit > marginal costing profit If stocks reduce, absorption costing profit < marginal costing profit If stocks do not alter, absorption costing profit ¼ marginal costing profit
Study tip This type of reconciliation lends itself well to an objective testing situation and has been a favourite topic in the multiple choice questions on past papers. Learn these four rules and ensure you can apply them quickly in an assessment situation
68 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Absorption Costing and Marginal Costing
K
K
K
Fixed production overheads are a necessary cost of production and therefore should be included in unit valuation Accounting standards require the use of absorption costing for external reporting If stocks are accumulated for future sale, then absorption costing smooths profits by carrying forward in stock the fixed production overheads, to be matched against sales when they are made
K
Arguments in favour of marginal costing
K
Arguments in favour of absorption costing K
Marginal costing or absorption costing?
Provides better information for short-term decision-making Focuses management attention on the more controllable measure of contribution Absorption of fixed production overhead done on arbitrary basis and result can be misleading for decision-making
69 ——————————————————————————————————————————
Breakeven Analysis and Decision-Making Using cost information to make decisions
Key study system questions 41 42 47 48 50 52
Breakeven analysis Breakeven analysis Breakeven analysis Cost behaviour/breakeven chart Relevant costs Limiting factor decision-making
Topics
. . . . .
Breakeven analysis Breakeven charts Limitations of breakeven analysis Relevant costs Limiting factor decision-making 71
Breakeven Analysis and Decision-Making
Breakeven analysis Contribution per unit is usually assumed to be constant. As sales volumes increase, the total contribution increases in a linear fashion until it just covers fixed costs. This is the breakeven point, where neither profits nor losses are made Breakeven point in units ¼
fixed costs contribution per unit
Example Data for a product for one month are as follows: £ per unit £ per unit Selling price 65 Direct material 22 Direct labour 12 Variable overhead 8 15 57 Fixed overhead* 8 Profit per unit *Based on budgeted production and sales of 2,300 units
Study tip No breakeven formulae will be provided in the assessment. Therefore you will need to learn all of the formulae in this chapter
Solution Total fixed overhead ¼ 2,300 units £ 15 ¼ £ 34,500 Contribution per unit ¼ £ 65 £ (22 þ 12 þ 8) ¼ £ 23 Breakeven point ¼
£ 34;500 ¼ 1;500 units per month £ 23
72 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Breakeven Analysis and Decision-Making
Breakeven analysis
Definition
Example Using the data from the previous example:
Margin of safety – the difference between the projected level of sales and the breakeven point
Margin of safety ¼ projected sales breakeven point The larger the margin of safety (MOS) the more likely it is that a profit will be made. MOS should be expressed as a percentage of projected sales to put it in perspective Forecast profit ¼ MOS contribution per unit
MOS ¼ (2,300 1,500) units ¼ 800 units per month ¼ (800/2,300) 100% ¼ 35% of projected sales Projected profit ¼ 800 units £ 23 contribution per unit ¼ £ 18,400 The projected profit can also be calculated as follows: Projected contribution ¼ 2,300 units £ 23 ¼ £ 52,900 Projected profit ¼ contribution fixed costs ¼ £ (52,900 34,500) ¼ £ 18,400
73 ——————————————————————————————————————————
Breakeven Analysis and Decision-Making
Breakeven analysis Contribution to sales ratio ðC=S ratioÞ ¼
contribution per unit 100% selling price per unit
Usually expressed as a percentage. Also referred to as P/V (profit/volume) ratio. With higher C/S ratio the profits grow more quickly as sales increase Breakeven point in sales value ¼
fixed costs C/S ratio
Example Using the data from the previous example: C/S ratio ¼ £ 23/£ 65 ¼ 35.4% £ 34;500 0:354 ¼ £ 97;458
Breakeven point in sales value ¼
(check: 1,500 units £ 65 ¼ £ 97,500)
74 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Breakeven Analysis and Decision-Making
Breakeven analysis To achieve a given level of profit the total contribution must cover the fixed overhead and leave sufficient contribution to earn the required profit Required sales for target profit fixed overhead þ target profit ¼ contribution per unit
Solution £ 34;500 þ £ 25;300 £ 23 ¼ 2; 600 units
ðaÞ
Required sales ¼
(b)
Revised contribution per unit ¼ £ (23 1 2) ¼ £ 20
Example Using the data from the previous example:
Revised C/S ratio ¼ 20/64 100% ¼ 31.25%
(a)
Required monthly sales to break even ¼
(b)
Calculate the number of units to be sold to achieve a monthly profit of £ 25,300 If the selling price reduces to £ 64 per unit and the direct material cost increases to £ 24 per unit, calculate the revised sales revenue to break even each month
fixed costs C=S ratio 34;500 ¼ 0:3125 ¼ £ 110;400
75 ——————————————————————————————————————————
Breakeven Analysis and Decision-Making
Breakeven charts
K
K
K
K
K
K
Traditional breakeven chart Vertical axis ¼ costs and revenues; horizontal axis ¼ level of activity Includes straight lines for sales revenue, fixed cost and total cost Fixed cost line cuts vertical axis at cost at zero activity ¼ total fixed cost ¼ £ 20,000 in example Total cost line cuts vertical axis at fixed cost level. Increases in straight line to total cost at maximum activity Sales revenue line passes through origin and increases in straight line to total revenue at maximum activity Breakeven is where total cost ¼ sales revenue
76 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Breakeven Analysis and Decision-Making
Breakeven charts
K
K
K
K
KK
Contribution breakeven chart Axes ¼ same as for traditional/basic chart Includes straight lines for sales revenue, variable cost and total cost Total cost and revenue lines are same as for traditional/basic breakeven chart Variable cost line begins from origin and increases in straight line to total variable cost at maximum activity Contribution can be read as difference between sales revenue line and variable cost line Breakeven is where total cost ¼ sales revenue
The advantage of the contribution breakeven chart is that contribution can be read directly from the chart, because the variable cost line is substituted for the fixed cost line
77 ——————————————————————————————————————————
Breakeven Analysis and Decision-Making
Breakeven charts
K
K
K
K
K
Profit-volume chart Vertical axis ¼ profit or loss; horizontal axis ¼ level of activity Horizontal axis is drawn at zero profit/loss on vertical axis Straight line shows profit or loss for relevant range of activity Profit line cuts vertical axis at loss at zero activity ¼ fixed costs ¼ £ 20,000 in example. Increases in straight line to total profit at maximum activity Breakeven point ¼ where profit line cuts horizontal axis
The main advantage of the profit volume chart is that it can depict clearly the effect on profit and breakeven point of any changes in the variables
78 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Breakeven Analysis and Decision-Making
Limitations of breakeven analysis
K
KK
KK
K
Limitations stem mostly from the assumptions made Assumes variable costs are linear, i.e., constant variable cost per unit Assumes fixed costs are constant in total Assumes sales revenue is linear, i.e., constant sales revenue per unit Assumes no changes in stocks Assumes that activity is the only factor affecting costs Assumes a constant product mix, or a single product only
Remember this! It is unreliable to assume that cost and revenue behaviour patterns are relevant across a wide range of activity. Managers must ensure that they work within the relevant range of activity, i.e., within the range over which the identified cost and revenue relationships are reliable
79 ——————————————————————————————————————————
Breakeven Analysis and Decision-Making
Relevant costs
KK
K
Examples of non-relevant costs Sunk or past costs. For example, the cost of market research that has already been undertaken Absorbed fixed overhead Committed costs. For example, the cost of staff salaries where there is a policy of no redundancies
Remember this! Relevant costs and revenues are represented by future cash flows, whose magnitude will vary depending upon the outcome of the management decision made
A relevant cost is one which will be affected by the decision being taken. If a cost will not alter as a result of the decision then it is a non-relevant cost
Study tip In an assessment you should assume that fixed overheads are non-relevant costs, unless you are given information to indicate that they will alter; for example, if there is a step in fixed costs at a specified activity level.
80 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Breakeven Analysis and Decision-Making
Relevant costs
Definition Opportunity cost – the value of the benefit sacrificed when one course of action is chosen, in preference to an alternative. The opportunity cost is represented by the foregone potential benefit from the best rejected course of action Opportunity costs and notional costs Are very similar in concept. A notional rent charge could be made against an owned factory, to aid comparability with the costs incurred in a rented factory. In effect, the notional rent represents the foregone opportunity to rent the factory to a third party, i.e., it represents the opportunity cost of occupying the factory for the company’s own use
Example Contract X is being considered, which requires 25 hours of skilled labour. The skilled employees are paid £ 18 per hour and are currently working on product B, which earns a contribution of £ 14 per hour. If Contract X is undertaken the sales of product B would be foregone. Solution Relevant cost of skilled labour: Hourly rate Opportunity cost: foregone contribution from product B
£ per hour 18 14 32
Total relevant skilled labour cost of Contract X ¼ £ 32 25 hours ¼ £ 800
81 ——————————————————————————————————————————
Breakeven Analysis and Decision-Making
Relevant costs
K
K
K
Relevant cost of materials in stock If used regularly: relevant cost ¼ replacement cost If no other use: relevant cost ¼ zero or scrap value If alternative use possible: relevant cost ¼ opportunity cost, i.e., value of next best alternative use
The relevant cost of materials that are not yet in stock will always be the current replacement price of the material
Example A contract requires 100 kg of material X and 50 kg of material Y 75 kg of material X are in stock, but have no other use. The stock was originally purchased for £ 5 per kg. It could be sold for £ 5.50 per kg and the current replacement price is £ 6 per kg Material Y is used regularly and 45 kg are in stock, which were originally purchased for £ 3 per kg. The current market price of material Y is £ 3.50 per kg Solution Relevant cost of material X ¼ (75 kg £ 5.50) þ (25 kg £ 6) ¼ £ 562.50 Relevant cost of material Y ¼ 50 kg £ 3.50 ¼ £ 175
82 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Breakeven Analysis and Decision-Making
Relevant costs
Definitions
Differential/incremental cost – the difference in total cost between alternatives; calculated to assist in decision-making
Avoidable costs – the specific costs of an activity or sector of a business which would be avoided if that activity or sector did not exist
Example of avoidable cost The salaries of canteen staff if the canteen is to be closed and vending machines installed instead
Study tip Differential costs are particularly useful for highlighting the effect of sequential steps in a decision, e.g., the incremental cost of employing one supervisor, two supervisors, etc.
Always remember to consider the potential non-financial impact of a decision; for example, the effect of department closure on labour morale or the potential loss of customer goodwill if a decision is made to withdraw a product which is unprofitable in the short term.
83 ——————————————————————————————————————————
Breakeven Analysis and Decision-Making
Limiting factor decision-making Definition
Remember this!
Limiting factor – any factor which is in scarce supply and which stops the organisation from expanding its activities further
Examples: machine capacity, labour hours If an organisation is faced with a single limiting factor, e.g., machine capacity, the production plan must maximise the profit from the available capacity. Assuming that total fixed costs remain constant, this can be achieved by maximising the contribution from the limiting factor. Machine capacity must be allocated to products which earn the highest contribution per machine hour
The decision rule with a single limiting factor is to maximise the contribution per unit of limiting factor Example Product A Product B Product C per unit per unit per unit £ 34 £ 23 £ 31 £5 £ 11 £ 14
Selling price Variable cost Fixed overhead £ 19 £5 £7 cost £ 10 £7 £ 10 Profit Kg of material 3 2 5 Hours of labour 0.5 1 2 Monthly demand (units) 400 350 540 Maximum material available ¼ 4,300 kg Maximum labour hours available ¼ 1,700 hours
84 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Breakeven Analysis and Decision-Making
Limiting factor decision-making First step: check for Product A Demand (units) 400 Material required 1,200 kg Labour required 200 hr
a limiting factor Product B Product C Total 350
540
700 kg
2,700 kg
4,600 kg
350 hr
1,080 hr
1,630 hr
Labour supply is sufficient but the availability of material is a limiting factor
Second step: Rank products in order of contribution per kg of material Product A Product B Product C £ per unit £ per unit £ per unit Selling price 34 23 31 5 11 14 Variable cost 29 12 17 Contribution Kg of material 3 2 5 Contribution per kg £ 9.67 £ 6.00 £ 3.40 Ranking 1 2 3
85 ——————————————————————————————————————————
Breakeven Analysis and Decision-Making
Limiting factor decision-making Third step: allocate available material according to ranking Product Recommended production (units) A 400 B 350 C 480
to products Material utilised (kg) 1,200 700 2,400 (bal.) 4,300
Supply of product C will fall short of demand by 60 units
Fourth step (if required): calculate profit resulting from recommended plan Assumption: unit fixed overhead costs are based on the monthly demand for each product Monthly fixed overhead cost ¼ (£ 19 400) þ (£ 5 350) þ (£ 7 540) ¼ £ 13,130 Product Units A 400 (£ 29) B 350 (£ 12) C 480 (£ 17) Fixed overhead cost Profit
Contribution £11,600 £ 4,200 £ 8,160
Total
£ 23,960 £ 13,130 £ 10,830
86 ——————————————————————————————————————————
Budgetary Planning and Control Preparing and using budgets
Key study system questions
Topics
58 61 62 63
. . . .
Functional budgets Functional budgets Cash budget Flexible budgets
The purposes of budgeting The planning process Preparing budgets Budgetary control 87
Budgetary Planning and Control
The purposes of budgeting Definition
Budget – a quantified plan of action relating to a given period of time
To be useful the budget must be quantified
K K
Delegate authority to budget holders Communicate targets and responsibilities to individual managers Coordinate activities of all parts of organisation
K
Provide a basis for monitoring current performance
Plan activities of all parts of organisation
KK
The purposes of budgeting Planning process forces managers to think ahead Comparing actual results with budget enables control action to be taken if necessary Budget holders may incur expenditure on behalf of their part of the organisation Managers will appreciate how their activities relate to those of other managers
88 ——————————————————————————————————————————
––––––––––––––––––––––––––––––––––––––– Budgetary Planning and Control
The planning process
Definitions Budget period – the period for which a budget is prepared and used, which may then be subdivided into control periods Budget centre – a section of an entity for which control may be exercised and budgets prepared
The budget period can be any length to suit management purposes, but is usually one year. Each separate control period may also be any length, depending on the level of control to be exercised, but is usually one month
Strategic planning Preparing long-term action plans to achieve the organisation’s objectives. Also known as corporate planning, or long-range planning
Budgetary planning Preparing short to medium term plans. Carried out within the framework of the strategic plan. Each annual budget is an interim step towards achievement of the strategic plan
Operational planning Planning on a day-to-day basis. Carried out within the framework of the budgetary plan. Also known as tactical planning
89 ——————————————————————————————————————————
Budgetary Planning and Control
The planning process
Definition
KK
K
K
Typical contents of budget manual
Participative budgeting – a budgeting system in which all budget holders are given the opportunity to participate in setting their own budgets
KKK
Budget committee coordinates budgetary planning and control process. Includes representative from every part of organisation. Responsible for preparation of budget manual, which is a collection of documents containing key information for those involved in planning process
Introductory explanation of budgetary planning and control process and budgetary objective Organisation chart to show responsibility for each budget and how they are interrelated Timetable for budget preparation Copies and explanations of all forms to be completed by budget holders Details of organisation’s account codes Key planning assumptions, e.g., inflation rate Name of budget officer to be consulted with any problems or queries
Participative budgeting also called ‘bottom-up budgeting’, to contrast with a system of imposed or top-down budgets, where budget holder does not participate in the planning process
90 ——————————————————————————————————————————
––––––––––––––––––––––––––––––––––––––– Budgetary Planning and Control
Advantages of computerised budgeting systems
Principal budget factor – a factor which will limit the activities of an undertaking and which is often the starting point in budget preparation
Point to note The PBF, and the limiting factor discussed in the last chapter, are effectively the same thing
Computers can easily handle and store the large volume of data involved Processes data more rapidly and accurately Data can be quickly and accurately manipulated and adjusted; for example, in carrying out ‘what-if?’ analysis
Early identification of principal budget factor (PBF) indicates which budget should be prepared first, e.g., if sales volume is PBF then sales budget must be prepared first and all other budgets coordinated to this
KK
Definition
K
The planning process
‘What-if?’ analysis involves adjusting the forecast variables to assess the effect on the final outcome
Computerised budgetary planning and control systems have a number of advantages over a manual system 91 ——————————————————————————————————————————
Budgetary Planning and Control
Preparing budgets Assuming that sales volume is the PBF, the order of budget preparation will usually be as follows:
8
5 6 7
Sales budget (units and value) Finished goods stock budget Production budget (units) Production resource budgets, e.g., direct labour, machine hours, material usage budget Material stock budget Material purchases budget (units and value) Other functional budgets, e.g., production overheads, selling and administration costs Cash budget and budgeted profit and loss account and balance sheet
1 2 3 4
Production volume is not necessarily equal to sales volume because of budgeted changes in stock. Production ¼ sales þ closing stock opening stock Purchases ¼ usage þ closing stock opening stock These three budgets comprise the master budget, which is presented to senior management for approval
92 ——————————————————————————————————————————
––––––––––––––––––––––––––––––––––––––– Budgetary Planning and Control
Preparing budgets Example
Solution
A company manufactures and sells a single product. Extracts from the company’s budgetary planning data:
(a) Production budget Sales volume Closing stock
Sales
2,000 units Opening stocks Closing stocks Finished product 300 units 250 units Raw material 170 kg 155 kg Material usage per unit 3 kg @ £ 4 per kg Prepare the following budgets: (a) (b)
Production budget Material purchases budget
Units 2,000 250 2,250 300 1,950
Less opening stock Budgeted production (b) Material purchases budget Budgeted material usage (1,950 units 3 kg) Closing stock Less opening stock Budgeted material purchases Value @ £ 4 per kg
kg 5,850 155 6,005 170 5,835 £ 23,340
93 ——————————————————————————————————————————
Budgetary Planning and Control
Preparing budgets Cash budget shows cash effect of all decisions taken in budgetary planning process. Decisions such as supplier payment periods and stockholding policy affect cash flow. Managers need to be forewarned whether there will be cash deficits or surpluses and for how long the surpluses or deficits will last
Study tips Things to watch out for in preparing cash budgets: Depreciation is not a cash flow. Exclude from any figures before inclusion in a cash budget Bad and doubtful debts must be excluded before calculating cash receipts from sales.
Example Extracts from a company’s budgetary planning data: Budgeted sales value
May £ 3,200
June £ 4,000
July £ 3,800
50% of sales are for cash. Of the remaining customers, 40% pay during the month after sale and receive a 2% discount; the remainder pay two months after the sale. Calculate the budgeted cash receipts from sales in July
Solution Receipts from cash customers £ 3,800 50% Receipts from credit customers: June sales £ 4,000 50% 40% 98% May sales £ 3,200 50% 60%
£ 1,900 £ 784 £ 960 £ 3,644
94 ——————————————————————————————————————————
––––––––––––––––––––––––––––––––––––––– Budgetary Planning and Control
Preparing budgets Cash budgets are often prepared on a rolling basis
Example Definition
A rolling budget might be prepared every three months
A system of rolling budgets is also known as continuous budgeting
Year 1: budget prepared in detail for January to March and in less detail for April to December End of March Year 1: budget for first three months deleted and further three months added for January to March Year 2. Budget for remaining nine months of Year 1 updated, adding more detail for April to June Year 1
Advantages of rolling budgets KKK
Note
Rolling budget – a budget continuously updated by adding a further accounting period (month or quarter) when the earliest accounting period has expired. Its use is particularly beneficial where future costs and/or activities cannot be forecast accurately
A full year’s budget is always available Managers forced to continually plan ahead Budget can adapt to changing circumstances
95 ——————————————————————————————————————————
Budgetary Planning and Control
Preparing budgets Definition
Problem
Incremental budgeting – a method of budget setting in which the prior period budget is used as a base for the current budget, which is set by adjusting the prior period budget to take account of any anticipated changes
Definition
Zero-based budgeting – a method of budgeting which requires each cost element to be specifically justified, as though the activities to which the budget relates were being undertaken for the first time. Without approval, the budget allowance is zero
Incremental approach tends to perpetuate inefficient practices. Unnecessary expenditure built into the budget (budget slack) will not be detected and eliminated
One possible solution to this problem Zero-based budgeting developed as an alternative to the incremental approach. Each budget is prepared from scratch instead of using the previous year as a base 96
——————————————————————————————————————————
––––––––––––––––––––––––––––––––––––––– Budgetary Planning and Control
K K K
K K K
A specific manager is responsible for managing each budget centre and controlling the budget for the centre Budgetary control achieved by comparing actual results with budget, flexed if necessary to actual level of activity Actual budget ¼ variance. Action taken to correct variances if appropriate Costs higher than budget, revenues lower than budget ¼ adverse variance Costs lower than budget, revenues higher than budget ¼ favourable variance
K
Features of useful budget reports
K
Budgetary control information K
Budgetary control
Timely. Corrective action must be taken as soon as possible after the event Sufficiently accurate. May be a conflict between timeliness and accuracy Relevant. Ideally based on exception principle and separating controllable and non-controllable items Communicated to appropriate manager. Individual budget holders’ responsibilities must be clearly defined
97 ——————————————————————————————————————————
Budgetary Planning and Control
Budgetary control Definitions
K
Cost behaviour patterns are important in preparing flexible budgets
K
Fixed budget – a budget which is normally set prior to the start of an accounting period, and which is not changed in response to subsequent changes in activity or costs/revenues. Fixed budgets are generally used for planning purposes
Study tip
K
Flexible budget – a budget which, by recognising different cost behaviour patterns, is designed to change as volume of activity changes
Flexible budgets are appropriate where activity levels fluctuate and variable costs are significant. In this situation, a comparison of actual results with the original fixed budget will not produce useful control information
A fixed cost is easily identified by looking at the absolute amounts Identify variable or semi-variable costs by dividing each cost by the activity level Constant unit rate ¼ variable cost; changing unit rate ¼ semi-variable cost Analyse semi-variable costs using the high-low method
Flexible budget cost allowance ¼ budgeted fixed cost þ (variable cost per unit no. of units)
98 ——————————————————————————————————————————
––––––––––––––––––––––––––––––––––––––– Budgetary Planning and Control
Budgetary control Actual results for latest period:
Example: flexible budget Summary budgets for two activity levels are as follows: Units Direct costs Production overhead Other overhead
7,000 £ 2,100 8,900 3,480 14,480
9,000 £ 2,700 9,300 3,480 15,480
Study tip
Units Direct costs Production overhead Other overhead
8,500 £ 2,580 9,109 3,611 15,300
Assuming that the fixed budget activity level is 9,000 units, prepare a budgetary control report for the period and identify the volume variance and expenditure variances
Although direct costs are usually variable costs, you must check this by testing the cost behaviour pattern. It is possible that the cost will be semi-variable 99 ——————————————————————————————————————————
Budgetary Planning and Control
Budgetary control Solution Direct cost: variable Cost per unit ¼ £ 2,100/7,000 ¼ £ 0.30 Budget cost allowance ¼ £ 0.30 8,500 ¼ £ 2,550 Production overhead: semi-variable Variable cost per unit ¼ £ (9,300 8,900)/ (9,000 7,000)¼ £ 0.20 Fixed cost ¼ £ 9,300 (£ 0.20 9,000) ¼ £ 7,500 Budget cost allowance ¼ £ 7,500 þ (£ 0.20 8,500) ¼ £ 9,200 Other overhead cost: fixed Budget cost allowance ¼ £ 3,480
Budgetary control report Variances in brackets are adverse Fixed Flexible budget budget £ £ Direct costs 2,700 2,550 Prod’n o/h 9,300 9,200 Other o/h 3,480 3,480 15,480 15,230
Actual results £ 2,580 9,109 3,611 15,300
Expenditure variances £ (30) 91 (131) (70)
Volume variance ¼ £ 15,480 £ 15,230 ¼ *£ 250 favourable Total variance ¼ £ 15,480 £ 15,300 ¼ £ 180 favourable ¼ £ 70 adverse þ £ 250 favourable *Volume variance ¼ 500 fewer units variable cost per unit ¼ 500 £ (0.30 þ 0.20) ¼ £ 250 favourable 100
——————————————————————————————————————————
Standard Costing and Variance Analysis Using standard costs to plan and control unit costs
Key study system questions 66, 67, 68 71 72 73 75
Variance analysis Fixed overhead variances Variance analysis Profit reconciliation Standard cost bookkeeping
Topics
. . . . . .
Standard costing Setting standard costs Standard costing in today’s environment Variance analysis Interpreting variances Standard cost bookkeeping 101
Standard Costing and Variance Analysis
Standard costing Definitions Standard costing – a control technique which compares standard costs and revenues with actual results, to obtain variances which are used to stimulate improved performance Standard cost – the planned unit cost of the product, components or services produced in a period
Standard costs used in performance measurement, control, stock valuation and establishing selling prices. Standard costs and prices provide the basic unit information for valuing cost and revenue budgets
Example: standard cost card for product 456 Direct material: standard quantity standard price Direct labour: standard hours standard rate Standard prime cost Variable prod’n o/h: standard hours standard rate Standard variable production cost Fixed prod’n o/h: standard hours standard rate Standard total production cost Other overhead Standard total cost
£ xx xx xx xx xx xx xx xx xx
For every production cost the standard amount and standard price of resource is detailed. Standard selling price might also be shown. Detail provides information for variance analysis, as long as actual results are recorded in same detail 102
——————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Standard Costing and Variance Analysis
Standard material cost
KK
potential suppliers: quotations, discounts, delivery charges, etc. historical trend in material prices quality specifications
Standard material usage KK
K K
Ideal standard. Assumes ideal operating conditions. Makes no allowance for losses, waste, machine downtime, etc. Highlights cost of inefficiencies, but can be demotivating Attainable standard. Assumes efficient operating conditions. Includes allowances for normal loss, waste, machine downtime, etc. Current standard. Based on current operating conditions. Does not encourage improvement from current levels of efficiency Basic standard. Kept unchanged and used for basis of preparing up-to-date standards
K
Sources of information
K
Performance levels K
Setting standard costs
performance level: allowance for losses? technical specifications
103 ——————————————————————————————————————————
Standard Costing and Variance Analysis
Setting standard costs Sources of information
The predetermined overhead absorption rate (OAR) provides the standard rate for production overhead:
Standard labour rate KK
OAR ¼ personnel department bonus scheme details
KKK
Standard labour times performance level: allowance for downtime? technical specifications results of work study exercises
budgeted production overhead budgeted standard hours
Standard hour is a useful way of measuring output when dissimilar items are manufactured. It must always be used as an absorption base in standard costing systems, unless a single product is manufactured, in which case a rate per unit is suitable Example: standard Product A B
hour Units output 1,000 1,800
Std hrs per unit 2 5
Std hrs of output ¼ (1,000 2) þ (1,800 5) ¼ 11,000
104 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Standard Costing and Variance Analysis
Standard costing in today’s environment
K K
Developed when products and services were more standardised. Nowadays need to respond to individual customer requirements
K
K
Emphasis on labour variances not appropriate with more automated production methods
K
K K
Performance to standard used to be acceptable. Nowadays should strive for continuous improvement to compete effectively
Addressing the criticisms
Developed when business environment was stable. Not appropriate for control purposes in today’s dynamic environment
K
Criticisms of standard costing
Standards can be updated regularly to ensure they reflect current operating conditions and remain useful for control purposes Use of demanding performance levels and ideal standards encourages continuous improvement Standards can be developed for machine times and hourly machine operating costs Possible to identify a number of standard components and activities for which standards can be set and used for control
105 ——————————————————————————————————————————
Standard Costing and Variance Analysis
Variance analysis Example data
Direct material price variance
Standard material cost per unit ¼ 4 kg @ £ 8 per kg ¼ £ 32 Actual material cost for 500 units ¼ 2,100 kg £ 7 per kg ¼ £ 14,700
Measures how much of the total material variance was due to paying a different price per kg of material.
Direct material total variance
2,100 kg should have cost ( £ 8) But did cost Direct material price variance
500 units should cost ( £ 32) But did cost Direct material total variance
Direct material usage variance
Direct material price variance þ Direct material usage variance ¼ Direct material total variance
£ 16,000 £ 14,700 £ 1,300 favourable £ 2,100 fav £ 800 adv £ 1,300 fav
£ 16,800 £ 14,700 £ 2,100 favourable
Measures how much of the total material variance was due to using a different quantity of material than the standard for the output achieved 500 units should have used ( 4 kg) 2,000 kg 2,100 kg But did use Variance in kg 100 kg adverse Direct material usage variance ( £ 8 std) £ 800 adverse
106 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Standard Costing and Variance Analysis
Variance analysis Example data
Direct labour rate variance
Standard labour cost per unit ¼ 3 hr @ £ 9 per hr ¼ £ 27 Actual labour cost for 500 units ¼ 1,550 hr £ 8 per hr *150 of these hours were recorded as idle time
Measures how much of the total labour variance was due to paying a different rate per hour of labour
Direct labour total variance 500 units should cost ( £ 27) But did cost (1,550 £ 8) Direct labour total variance
£ 13,500 £ 12,400 £ 1,100 favourable
Idle time variance ¼ 150 hrs £ 9 std ¼ £ 1,350 adv Direct labour rate variance þ Direct labour efficiency variance þ Idle time variance ¼ Direct labour total variance
£ 1,550 £ 900 £ 1,350 £ 1,100
fav fav adv fav
1,550 hr should have cost ( £ 9) But did cost Direct labour rate variance
£ 13,950 £ 12,400 £ 1,550 favourable
Direct labour efficiency variance Measures how much of the total labour variance was due to using a different number of active labour hours than the standard for the output achieved 500 units should have used ( 3 hr) 1,500 hr 1,400 hr But did use (active hours only) Variance in hr 100 hr fav Direct labour efficiency variance ( £ 9 std) £ 900 fav
107 ——————————————————————————————————————————
Standard Costing and Variance Analysis
Variance analysis Example data
Variable overhead expenditure variance
Std variable o/h cost per unit ¼ 3 hr @ £ 2 per hr ¼ £ 6 Actual variable o/h cost for 500 units ¼ £3,500. Labour hours as on previous card
Measures how much of the total variable overhead variance was due to paying a different rate per active hour
Variable overhead total variance 500 units should cost ( £ 6) But did cost Variable overhead total variance
£ 3,000 £ 3,500 £ 500 adverse
Variable o/h expenditure variance þ Variable o/h efficiency variance ¼ Variable o/h total variance
£ 700 adverse £ 200 favourable £ 500 adverse
1,400 active hrs should have cost ( £ 2) £ 2,800 £ 3,500 But did cost Variable overhead expenditure variance £ 700 adverse
Variable overhead efficiency variance Measures how much of the total variable overhead variance was due to using a different number of active labour hours than the standard for the output achieved. 500 units should have used ( 3 hr) 1,500 hr 1,400 hr But did use (active hours only) Variance in hr 100 hr fav Variable o/h efficiency variance ( £ 2 std) £ 200 fav 108
——————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Standard Costing and Variance Analysis
Variance analysis
Remember this!
Fixed production overhead total variance
The total fixed production overhead variance is equal to the under- or over-absorbed fixed production overhead for the period
Overhead absorbed ¼ 1,340 std hr £ 6 ¼ £ 8,040 £ 7,370 Actual overhead incurred £ 670 fav Fixed production o/head total variance
Budget 1,230 £ 7,380
Actual 1,340 £ 7,370
Predetermined o/head absorption rate ¼ £ 7,380/1,230 ¼ £ 6 per std hr
Reasons for under/over absorption K
Output (standard hours) Fixed production overhead
Overhead over absorbed ¼ favourable total variance Overhead under absorbed ¼ adverse total variance
K
Example data
Overhead expenditure different from budget (overhead expenditure variance) Output different from budget (overhead volume variance)
Production is measured in standard hours. The approach would be the same if output was measured in units 109 ——————————————————————————————————————————
Standard Costing and Variance Analysis
Variance analysis Fixed production overhead expenditure variance
Check: Fixed production overhead: expenditure variance volume variance
Measures the under/over absorption caused by the overhead expenditure being different from budget Budgeted expenditure Actual expenditure Fixed prodn. o/h expenditure variance
£ 7,380 £ 7,370 £ 10 fav
£10 favourable £660 favourable
Fixed production overhead total variance £ 670 favourable
Fixed production overhead volume variance
Remember this! Always indicate whether a calculated variance is adverse or favourable
Measures the under/over absorption caused by the output being different from budget 1,340 standard hours 1,230 standard hours 110 standard hours
x overhead absorption rate (£ 6) Fixed prodn. o/h volume variance
Actual output Budget output Difference
Favourable variance because output greater than budget ¼ potential over absorption of fixed production overhead
£ 660 fav 110
——————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Standard Costing and Variance Analysis
Example Sales and production units Unit selling price Total unit cost
K
Total sales margin variance K
Variance analysis
Measures difference between actual margin at standard costs and budgeted margin Since analysis of cost variances explains differences caused by cost changes from standard, sales margin variance is based on standard cost, not on actual cost
Total sales margin variance ¼ actual margin (based on standard unit costs) budgeted margin ¼ (actual sales value less standard cost of sales) (budgeted sales value less budgeted cost of sales)
Budget 7,240 £ 27 £ 20
Actual 7,460 £ 25 £ 19
Solution Actual margin (based on standard unit costs) Actual sales value (7,460 £ 25) £ 186,500 £ 149,200 £ 37,300 Std. cost of sales (7,460 £ 20) Budgeted margin Budget sales value (7,240 £ 27) Budget cost of sales (7,240 £ 20) Total sales margin variance
£ 195,480 £ 144,800 £ 50,680 £ 13,380 adv
111 ——————————————————————————————————————————
Standard Costing and Variance Analysis
Variance analysis A profit reconciliation statement summarises the calculated variances, to demonstrate how they contribute to the difference between budgeted and actual gross profit
Favourable variances are added to budgeted profit Adverse variances are deducted from budgeted profit Good practice to give a key. Alternatively, could use ‘A’ for adverse; ‘F’ for favourable
Profit reconciliation statement for latest period £ £ Original budgeted profit xx xx Total sales margin variance xx Cost variances Direct material: price (xx) xx xx usage Direct labour: rate xx (xx) efficiency (xx) Variable overhead: expenditure xx xx efficiency (xx) Fixed overhead: expenditure xx xx xx volume xx Actual gross profit Note: variances in brackets are adverse
112 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Standard Costing and Variance Analysis
Variance analysis
K K K
Remember this!
Compared with absorption costing variances, differences only arise where fixed production overhead features Only one variance for fixed production overhead ¼ fixed production overhead expenditure variance No variance for fixed production overhead volume variance Total sales contribution variance replaces total sales margin variance: contribution is used instead of margin; standard variable unit cost is used instead of standard total unit cost
K
Standard marginal costing
In a standard absorption costing system and in a standard marginal costing system, all ‘quantity’ variances (material usage, labour efficiency, variable overhead efficiency) are valued at the standard rate per kg, per hour, etc.
In a marginal costing system, under/over absorption of fixed overheads does not arise due to volume changes
Study tip Be prepared for assessment questions which require you to work backwards from variance information to derive the data for actual costs 113
——————————————————————————————————————————
Standard Costing and Variance Analysis
Interpreting variances Variance Direct material price Direct material usage Direct labour rate Direct labour and variable overhead efficiency
Possible cause of favourable variance Lower quality material Standard usage too high
Possible cause of adverse variance
Less skilled employees used More skilled employees used
Standard rate too low Ideal performance standard
Idle time
Standard price too low High level of waste
Machine breakdown
Variable overhead expenditure
Standard hourly rate too high
Higher variable power costs
Fixed overhead expenditure Fixed overhead volume
Lower cost for rent, salaries Increased demand for output
Budgeted expenditure too low Budgeted volume too high
114 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Standard Costing and Variance Analysis
Interpreting variances
For example higher quality material ¼ adverse price variance but favourable usage variance
Ideal performance standard tends to produce adverse variances
K
K
A variance which exceeds, say, 5% of standard, might be investigated
The significance of variances
KK
On the last card we gave a single possible cause for each type of variance. Many other causes are possible. In the assessment you should study the information available and select a cause which is consistent with an adverse or favourable variance.
It is probably not worth investigating every variance. Factors which may be considered before conducting an investigation include the following
K
Study tip
Size of variance. Standards cannot be 100% accurate and costs will tend to fluctuate Likelihood of variance being controllable. For example, labour rate variances may be caused by uncontrollable market forces Possible interrelationship of variances Likely cost of investigation. Cost of investigation might outweigh saving from correction of variance Type of standard set 115
——————————————————————————————————————————
Standard Costing and Variance Analysis
Standard cost bookkeeping
K K K K K KK
Note These are general rules. Variations do exist
Record the actual variances as a debit (adverse variance) or a credit (favourable variance) in a separate variance account. Entries described in the list opposite ¼ ‘other side’ of each variance entry
Record all variances at the point at which they arise Materials price variance in materials control stock account Labour rate variance in wages control account stock ‘Quantity’ variances (material usage, efficiency variances) in work in progress account Overhead variances in production overhead control account Sales values recorded at actual amounts. No accounts are kept for sales variances Finished goods stock held at standard cost. Transfer to cost of sales and to P & L made at standard cost
K
Recording variances – general rules
At period end, transfer all variance account balances to P & L to offset against standard cost of sales. Adverse ¼ debit to P & L; favourable ¼ credit to P & L
116 ——————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Standard Costing and Variance Analysis
Standard cost bookkeeping Material control account Balance b/d Creditors Price variance*
xx xx xx xx
WIP (actual usage std. price) Balance c/d
Wages control account Bank net wages
xx
PAYE/NI creditor
xx xx
xx xx xx
*This example shows a favourable price variance, which is credited to the material price variance account for later transfer to P & L. For an adverse variance, the material control account would be credited and the material price variance account would be debited
WIP (actual hours std. rate) Labour rate variance#
xx xx xx
#This example shows an adverse rate variance, which is debited to the labour rate variance account for later transfer to P & L. For a favourable variance, the wages control account would be debited and the labour rate variance account would be credited
117 ——————————————————————————————————————————
Standard Costing and Variance Analysis
Standard cost bookkeeping Production overhead control account Expense creditors Depreciation provn. Expenditure variance*
Work in Progress control account
xx xx
WIP (standard hours std. rate) xx
xx xx
Volume variance#
xx xx
*Favourable variance is credited to overhead expenditure variance account. Entry reversed if variance is adverse # Adverse variance is debited to overhead volume variance account. Entry reversed if variance is favourable
Balance b/d Material usage at std. price Labour hrs at std. rate Prodn. o/h at std. rate Efficiency variance*
xx Finished goods (actual production std. cost) xx Usage variance#
xx xx
xx xx xx Balance c/d xx
xx xx
*Favourable labour efficiency variance is credited to variance account for later transfer to P & L # Adverse material usage variance is debited to variance account for later transfer to P & L
118 ——————————————————————————————————————————
