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AAT Level 3 Diploma in Accounting Costs and Revenues

Association of Accounting Technicians

Costs and Revenues

Level 3

Published by: Home Learning College 1 Hammersmith Broadway London W6 9DL © Home Learning College Ltd 2013 Version 2.0 aat3_cstr_v3_master_201016

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Costs and Revenues Contents Introduction to Costs and Revenues

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Lesson 1 - Introduction to Cost Accounting Introduction

4

Accounting personnel

4

Financial accounting and management accounting

5

Cost allocation

9

Cost unit

10

Cost centres

10

Profit centres

11

Investment centres

11

Responsibility centres

11

Lesson 2 - Cost Classification Introduction

14

Departmental costs

14

Classifying costs by element

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Classifying costs by nature

17

Classifying costs by function

19

Classifying costs by behaviour

21

Variable costs

22

Fixed costs

23

Stepped costs

24

Semi variable costs

25

Using cost classifications

29

Product cost

29

Total cost statement

31

Calculating cost using cost behaviour

32

Calculating unit cost at different levels of output

35

Lesson 3 – Costing for Materials Introduction

38

Purchasing materials

38

Purchasing system

39

Planning and controlling materials

41

Reorder level

42

Economic Order Quantity (EOQ)

44

Inventory

47

Valuing inventories

48

Methods of valuing inventories

48

First In First Out (FIFO)

50

Last In First Out (LIFO)

55

Weighted average cost (AVCO)

60

Impact on profit

63

Other valuation methods

65

Standard cost

65

Replacement cost

65

Finished goods and work in progress

66

Inventory-taking

66

Bookkeeping for materials

67

Lesson 4 – Costing for Labour Introduction

72

Setting pay rates

72

Direct labour costs

73

Clock cards

73

Timesheets

73

Job cards or job sheet

75

Swipe cards

75

Signing in book

75

Calculating gross pay

75

Time rate

75

Piecework rate

81

Bonuses

85

Idle time

87

Comparing gross pay methods

87

Bookkeeping for labour costs

89

Lesson 5 – Costing for Expenses Introduction

94

Capital and revenue expenses

94

Depreciation

96

Straight line method depreciation

96

Reducing balance method depreciation

97

Machine hour method depreciation

99

Bookkeeping for expenses

100

Lesson 6 - Absorption Costing Introduction

104

Overheads

104

Absorption costing

105

Allocation

105

Apportionment

105

Service departments

115

Direct apportionment

116

Step down method

120

Overhead absorption

123

Direct labour hour overhead absorption rate

124

Machine hour overhead absorption rate

126

Direct labour % overhead absorption rate

127

Selecting a suitable absorption base

128

Over or under absorption

129

Advantages of absorption costing

131

Bookkeeping for overheads

131

Lesson 7 - Marginal Costing Introduction

134

Marginal costing

134

Advantages of marginal costing

137

Absorption costing and marginal costing and changing inventory levels

138

Lesson 8 - Further Aspects of Costing Introduction

144

Unit costing

144

Job costing

150

Batch costing

152

Contract costing

152

Activity Based Costing

153

Service costing

156

Process costing

156

Losses

161

Two processes

166

How to approach an assessment task on process costing

168

Process costing and work in progress

169

Bookkeeping for process costing

172

Lesson 9 – Break-even and Limiting Factors Introduction

176

Decision making

176

Break-even analysis

178

Margin of safety

180

Break-even chart

181

Limitations of break-even

183

Target profit

183

Profit-volume ratio

184

Limiting factors

185

Lesson 10 – Variances Introduction

192

Budgets

192

The purpose of budgets

193

Variances

194

Fixed budgets

198

Flexible budgets

199

Significant variances

206

Reporting variances

210

Causes of variances

212

Poor budgeting

212

Recording or measurement errors

212

Operational factors

213

Random factors

215

Control action for variances

215

Investigating variances

215

Materiality

216

Controllability

216

Trend

217

Lesson 11 – Investment Appraisal Introduction

220

Capital investment

220

Other considerations

221

Payback

223

Discounted cash flow

226

Internal Rate of Return (IRR)

233

Glossary

238

Costs and Revenues

Introduction to Costs and Revenues The AAT Level 3 Certificate in Accounting consists of six separate units which should be completed in the following order: 1. Accounts Preparation (ACPR) 2. Prepare Final Accounts for Sole Traders and Partnerships (FSTP) 3. Costs and Revenues (CSTR) 4. Indirect Tax (ITAX) 5. Spreadsheet Software (SDST) 6. Professional Ethics (PETH) This is the Costs and Revenues unit and is therefore the third unit for you to study. It is written to AAT’s AQ2013 syllabus specifications and is designed to be used in conjunction with Home Learning College’s Virtual Learning Community (VLC). This unit will help you understand why cost accounting is important to an organisation. You will learn how to recognise and use different approaches and make reasoned judgements to inform management on the most effective costing techniques to aid decision making. You will be able to gather, analyse and report information about income and expenditure to support decision-making, planning and control. Throughout the unit you will find the icons shown below. These highlight important items, reinforce essential points and provide helpful examtaking hints. Example – this is an illustration of a learning point in the context of a real-life scenario.

Key Learning Points – the main items to learn and understand in a particular lesson. Exam Tip – these call attention to information about potential pitfalls and essential information regarding the AAT assessment.

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Costs and Revenues

LESSON 1 Introduction to Cost Accounting On completing this lesson you should be able to:  Explain the purpose of internal reporting and providing accurate information to management  Explain the relationship between the various costing systems within an organisation  Define cost centres, profit centres, investment centres and responsibility centres

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Introduction Accounting is the system by which businesses are able to keep track of their money. This is important because a business that does not make a profit, or that has insufficient cash to operate, will go bankrupt. There are a number of different ways that businesses can record and monitor their activities and accounting is the term that covers the systems of recording, preparing and interpreting business transactions. Thus accounting is a primary source of information for owners and managers to enable them to plan and control the activities of the business and make decisions. This lesson examines the essential features of two strands of accounting: financial accounting and management accounting. It explains the relationship between the various accounting and costing systems within an organisation and identifies the nature of responsibility, cost, profit and investment centres.

Accounting Personnel The number of people involved in accounting in a business will depend on the nature and size of the business. Many small businesses are run by just one or two people who are both the owners and the managers. In larger businesses there will be a specific chain of command and different accounting functions will be undertaken by different departments. Medium-sized business – Typical accounting chain of personnel

Finance Director

4

Financial Accountant

Management Accountant

Bookkeeper

Cost Accountant

Costs and Revenues

In larger businesses the managers are responsible for decision making and controlling activities on a day-to-day basis. The owners may not be involved at all in running the business but rather see the business as an investment opportunity. An example of this type of situation is a large limited company where the owners are the shareholders; those people who have bought shares in the company and are hoping to receive dividends and make a profit when they sell their shares. Although the shareholders may attend a general meeting of shareholders once or twice a year, they are not involved in the day-to-day running of the company. Shareholders of large companies entrust the running of the company to directors who manage its resources and report regularly on its progress. The directors have overall responsibility but rely on departmental managers to provide them with sufficient useful information to enable them to make good decisions for the company’s profitability and financial stability. The accounting systems provide financial information to managers and directors so that they can make business decisions. Accounting can be described as the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information (as defined by the American Accounting Association).

Financial Accounting and Management Accounting It is important to recognise that there are a number of differences between financial accounting and management accounting. Financial accounting is concerned with how monetary amounts are divided into different categories and recorded in accounting records. It is also concerned with how that financial information is presented. It is important that the treatment and presentation of information is consistent from period to period so that the financial performance of the business can be assessed over time. Financial information can be presented in a number of different ways but the two main financial statements are the Statement of Profit or Loss (also known as an Income Statement) and the Statement of Financial Position.

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The Statement of Profit or Loss is a statement that summarises the income earned by the organisation and the expenses incurred in making that income. It identifies the amount of profit or loss that the organisation has made during a specific period of time. If more income has been earned than expenses incurred then the organisation has made a profit. If more expenses have been incurred than income earned then the organisation has made a loss. A Statement of Profit or Loss is prepared for a specific period of time. For financial accounting purposes this is usually a year, however, some organisations choose to prepare financial statements monthly or quarterly as well as annually. The Statement of Financial Position lists the assets and liabilities of an organisation at a specific date in time. Students who have studied the Basic Accounting units will already be familiar with assets and liabilities. Assets are items of value to an organisation and represent items owned such as plant and machinery or items owed to the organisation such as customers who owe money for goods that have been supplied to them on credit. Liabilities are financial obligations of an organisation to persons or other organisations. These financial statements are prepared using historical information and their format is prescribed by statutory legislation. This means that all organisations will prepare statements of profit or loss and statements of financial position in the same way and using the same terminology. This enables comparison between organisations and consistency of presentation and measurement over time. The financial statements are prepared from the double entry bookkeeping system. This is the mechanistic process of recording business transactions in books of account so that income, expenses, assets and liabilities can be tracked and summarised. This allows owners and managers to identify how well the organisation is performing and keep control over its finances. Financial statements are not only used by the owners and managers of an organisation but by other users outside the organisation itself. These other users include investors, lenders, debtors, creditors and government agencies.

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Costs and Revenues

Management accounting is concerned with providing information for management so that it can carry out its functions of planning, control and decision making. Planning for the future This involves both short-term and long-term budgets and forecasts. Planning should highlight any shortages of resources, bottlenecks in production and limitations affecting the organisation. Controlling expenditure This involves comparing actual results with the budgeted plans to enable corrective action to be taken if appropriate. Decision making There are numerous decisions that need to be taken to maintain an organisation as a viable and profitable unit. Knowing the cost of a product or service will enable effective sales prices to be set. Information on the profitability and demand of products will be needed where there is a shortage of resources to ensure that an organisation can maximise its profits. To ensure that investment in capital equipment will generate a return for the organisation, information is required about the costs to be incurred and savings that will be generated. The information and techniques used to make these and other decisions will be explained during this unit. So, management accounting includes identifying, measuring, accumulating, analysing, preparing, interpreting and communicating information to management so that they can plan and control the organisation to ensure that resources are being used appropriately. They are not concerned with the everyday recording of financial transactions for use in preparing statutory financial statements. Management accountants may undertake a vast range of different work that could include: •

Applying a range of different methods and techniques to enable them to ascertain costs.

•

Analysing savings or inefficiencies and comparing these with previous experience or standards.

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Operating specific costing systems as a basis for identifying how profitable a product will be, the value of inventory held by the organisation, analysing labour costs, controlling general production costs and determining appropriate selling prices.

•

Establishing budgets, calculating the standard (expected) cost of a product, identifying the actual costs of processes, activities or products and calculating and analysing differences occurring between expected costs and actual costs.

•

Creating a reporting system that enables managers to take corrective action where necessary to control costs and provide information for decision making.

Management accounting is also referred to as cost accounting because it deals with questions such as ‘How much does it cost to…’ … mine a tonne of tin? … treat a patient for a day? … make 1,000 dresses? … build a factory? Management accountants will work with historical data and use this to make estimates or forecasts of future data. The result is that management accountants may be called upon to produce a variety of types of information in a number of different formats. The key is that the information provided must be accurate, useful, relevant and timely to enable management to carry out their roles of planning, control and decision making. Management accounting reports do not have any set format and are not required by legislation. This means that an organisation is free to prepare repo...