Management Accounting for Decision Makers Revision Notes PDF

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Management Accounting for Decision Makers Revision Notes Lecture 1: The Meaning of Cost Who uses financial information? Customers, Owners, Managers, Competitors, Government, Suppliers, Lenders (banks), Employees Managers take management accounting information from accountings and use it to: - Make better decisions - Implement actions - Monitor and evaluate consequences - Learn from outcomes… Management Accounting - Provides info for internal use – to help plan, control and cost management

Information itself has a cost-benefit trade of

As the cost of providing information increases with each additional piece… The optimal level is where the gap between cost and value is greatest.

For management accounting is a service. For information to be useful – we must know who it is for and for what purpose. As shown in the diagram, information generated must be: - Material, - Reliable, - Comparable - Understandable Financial information should only be produced if the cost of providing the information is less than the benefits gained. Cost

Full Cost Full cost of any particular job is the sum of the costs specifically allocated to the job (direct costs) And The share of costs that allow production to take place, but do not specifically relate to any particular job (indirect costs)

Fixed and Variable costs The cost of a ‘job’ is: Sum of the costs that remain the same irrespective of the level of activity (Fixed cost) And Costs that vary according to the level of activity (variable cost)

Marginal Cost The variable cost of making one more unit Variable Cost Behaviour

Fixed Cost Behaviour

Variable costs per unit do NOT remain constant – they may fall on a rate per unit basis if activity increases and they may rise on a cost per unit basis if activity decreases. - You may buy from a supplier in batches, with consequential higher or lower per unit. How do you find the Fixed and Variable costs when only the Total Cost is shown? Take the months with the highest and lowest outputs. Example 1

Example 2

There are lots of diferent costs Example of relevant costs

Usually we would use this method…

But this is very wrong!!!

Existing Staff is left out because it hasn’t changed – the guy was already working. Existing equipment is a sunk cost – it was bought anyway and was not specific to the project… Consultants bill was agreed 3-months ago… so left out!!

So, Costs may be constructed and expressed as reported costs, used in cost reporting. Costs may be constructed and expressed as relevant costs, used in decision making

Lecture 2: Full Costing When calculating full cost, it accounts for: Direct costs - Direct Labour - Direct Materials Usually accurate Indirect Costs (overheads) -

Charging in overheads is called ‘overhead absorption costing’ or ‘overhead recovery costing’

There are a number of ways of charging in oveheads

Example: Basic Basin Per unit Direct Materials (DM) = £10 Direct Labour (DL) = £10 One unit takes 1 hr to produce Total Direct Cost = £20 Budgeted Overheads = £100 Budgeted Production Units for the period is 50 units. Budgeted DL hours is 50 hours. Budgeted Machine Hours is 25 hours (each basin takes 30 minutes to make) One way to charge overheads is Direct Labour Hour Rate Total Budgeted Overheads / Total Budgeted Labour Hours = £100 / 50 Hours This gives us an overhead absorption rate (charge) of £2 for each labour hour Remember, each unit only needs 1 labour hour, Therefore, the overhead charge is 1 hour * £2 = £2 for each labour hour. So overall,

Machine Hour Rate

This gives us an overhead recovery/absorption rate (charge) of £4 for each machine hour. The overhead charge for one unit is £2 because Each basin takes 30 minutes of machine hours, multiplied by £4 = £2

Let’s compare both:

When there is a single output, the overhead charge is the same, irrespective of the method used to absorb the overheads… Where multiple output exist, the choice of method is important as different overhead are charges can result from different approaches.

Example 2, Warm Glow Warm glow makes two types of electrical heater: Warm Glow and Hot Heat.

Total Budgeted Labour Hours = 125 hours Total Budgeted Machine Hours = 37.5 hours. If machine hours were used for charging in overheads, the overhead charge to each product to each product would be the same… But would this be right? Hot Heat’s DL hours are double and takes double the production time to make…

Warm Glow and Hot Heat Direct Labour Hour Rate

£4 overhead charge for each DL hour. Warm Glow Direct Labour Absorption Rate Each unit of Warm Glow uses 0.5 DL hours So, the overhead charge for 1 unit is £2 (0.5 DL hr * £4 overhead charge)

Hot Heat Direct Labour Absorption Rate Each unit of Hot Heat uses 1 DL hour Overhead charge is still £4, so the DL Overhead Absorption rate is £4 per unit

Overall, The overhead charges for the products differ, showing there are differences in the products…

Direct Costs: - Direct Materials

- Direct Labour Indirect Costs (Overheads) - Rent - Salary - Power/Energy costs - Insurance - Cleaner’s wages Example 1 Cost of one table using Unit of Output rate

Example 2: Wrekit Limited

Monthly Planned/Budgeted Fixed Overheads: £10,000 Monthly Planned/Budgeted Direct Labour Hours: 1000 hours Each £12 DL wage per hour One repair used - DM of £15 - DL of 3 hours Overheads are charged on a DL hour basis What was the full cost of the repair?

Example 3 – Non-Identical Outputs Jacob Land Ltd Fixed Overheads = (Per Month)

£20,000

Direct Labour Hours

1,600 hrs

Machine hours

1,000 hrs

Information on the jobs

Calculate the overhead charge to each job

Selecting an ‘appropriate’ approach to charging overheads into costs units depends on the circumstances and judgement of the managers.

Charging overheads across more than one cost centre Some companies split their processes up into different ‘cost centres’. Each cost centre has its own: - Direct costs - Sometimes indirect costs for their activities Overall, there will also be overheads costs for the whole business. -

Should there be one overhead for the whole business or individual overhead recovery rates for each cost centre?

In reality, the job ‘gathers costs’ as it makes its way through each cost centre.

Example 1

Stardust LTD – Budget for Current Year

For our scenario, we are going to use this to find the absorption costs for 300 units: Units Produced = Direct Materials = Direct Labour =

300 units £3,300 £4,500

The following time was spent on the batch:

Task calculate the unit production cost and total production cost for the batch: 1) Individual cost centre overhead absorption rates on Machine Hour basis

NB: do not use the batch hour rates, use the original data from the first table… The question asks for the total production and unit production. The above is used to find the rate for from the total production per 1 unit. This can then be applied to the 300 units used below: To find the unit overhead, using the machine hour rate for every cost centre:

NB – now we use the time information from the second table to find the overheads for the 300 units. 2) Individual cost centre overhead absorption rates on Direct Labour Hour basis

Again, for the above, use the total production cost to find 1 unit overheads and then apply it to the 300 unit scenario using the calculation’s below:

3) Cutting Cost Centre on Machine Hour basis, and Assembly and Finishing on Direct Labour hour Basis

So batch costing is done as follows: - Calculate the total cost of the batch using full costing (between cost centres if asked) - Divide by the number of units in the batch to give the cost per unit

Non-Manufacturing Overheads May be included as part of the full cost but must be excluded for external reporting purposes.

Variable Costing Only variable costs are charged to the cost of production. Fixed costs (overheads) are charged for the total financial period Example SALES = Fixed OHD Production =

£900 £300 100 units

Price Per Unit £10 Units Sold £90

Full Costing basis Fixed Overhead per Unit Variable Cost Per Unit TOTAL PRODUCTION COST

= £3 (£300 / 100 units) = £5 = £8

The unsold 100 units in the warehouse will be valued at £800 full cost Profit Statement Sales £900 Full Cost (£720) (90 units at £8) Profit £180 Closing Inventory £80. (10 units at £8)

Variable Costing Variable Cost = £5 and therefore total production variable cost is £500 for all 100 units Profit Statement Sales VC FC Profit

£900 £450 (90 units * £5) £300 £150

Closing Inventory = £50 (10 units at £5 each)

Look at Seminar 2

Lecture 3, Contribution and CVP Analysis Marginal Costing (Variable Costing)

Assigns only the ‘marginal’ costs (costs which vary with level of production) to the products.

The main difference between Marginal Costing and Absorption Costing was how Indirect Manufacturing costs are treated. Absorption – apportion/absorb the Indirect Manufacturing costs into the product to total production costs. Marginal - Indirect Manufacturing costs are treated as ‘period’ costs, not as part of the product costs. They will be treated as ‘Other Expenses’ and will not be charged to the product to form part of the Costs of Goods Sold - Manufacturing overheard are written-off each year as period costs - Only takes into account PRIME COSTS as the PRODUCTION COSTS Prime Costs are all directly traceable to each unit of product. Each time there is a change in the level of production – direct costs will change.

Example

Absorption Costing Approach

Prime Costs and Indirect Manufacturing Costs Prime Costs

- Direct Materials - Direct Labour - Other Variable Costs Indirect Manufacturing Costs - Fixed Manufacturing Costs

£1 £1 £0.5

Marginal Costing Approach

Contribution Margin Contribution is the excess of sales revenue over the variable costs It can be thought of as the contribution towards paying for the fixed costs -

Once the fixed costs have been covered, the rest of the contribution is profit! If your Fixed Costs (Overhead) remain constant, the more contribution you make, the higher the profit!

If we close down project 4, we save £2m (pretend) of fixed overheads, BUT we lose £3m of contribution. This is not a good way to do business!

The Contribution Margin Ratio Contribution Margin / Sales price Example 1

This shows the amount of contribution generated per £1 e.g. Project 1 generates £0.73 contribution per £1 of sales. Example 1 continued

You can also do specific analysis – say that labour is scarce and wages command premium, it would make sense to establish how much contribution is generated per £1 Wages / Contribution gives the following: Shows the contribution for every £1 spent on wages. Example – Lecture

What if a factor was to change, like Fixed Costs? Unit Sale Price = Variable Cost = Fixed Costs Output

£10 £4 £150,000 50,000 units

What would happen if Fixed Cost increased by £15,000?

The BEP has changed

¿ Cost Contribution per Unit

=

£ 165,000 6

= 27,500 units

What if Variable Costs Change? Unit Sale Price = Variable Cost = Fixed Costs Output

£10 £4 £150,000 50,000 units

Raw materials increase by 10% £4 * 10% increase = new Variable Cost of £4.4 per unit New Contribution Margin of £10-£4.4 = £5.6

The new break-even point is:

¿ Cost Contribution per Unit

=

£ 150,000 £ 5.6

= 26,786 units

What if the Selling Price changes? Increase in selling price by 10% (£11) led to a 10% fall in sales volume (Sales in Units).

The new BEP

¿ Cost Contribution per Unit

=

£ 150,000 £7

= 21,429 units

Firms can use the BEP to helps change existing sales mixes by selling more of the product with the highest contribution margin!

Cost Volume Profit (CVP) Analysis CVP analysis looks at the relationships between Fixed Cost, Variable Costs, Sales and Profit at varying levels of activity. - FC and VC need to be separated so volume and VC can be manipulated to show changes in profit Example Your sales team tell you that their research shows if you reduce your sales price by 25%, annual sales volume will double. Currently: Annual sales volume = 3,000 units Unit sales price = £10 Unit VC = £6 Annual Fixed Costs = £8,000 VC and Fixed Costs remain unchanged Revenue = Fixed Costs = Variable Costs = Profit =

£30,000 - (3,000 * £10) (£8,000) (£18,000) - (3000 * £6) £4,000

Contribution

£12,000 (8,000 + 4,000)

Proposed New Position Revenue = Fixed Costs = Variable Costs = Profit =

£45,000 - (6,000 * £7.5) (£8,000) (£36,000) - (6000 * £6) £1,000

Contribution

£9,000

(8,000 + 1000)

NB the 6000 is the annual sales volume doubled for the new scenario and £7.5 represents a 25% drop in the unit sales price…

So, we had a situation where the headline looks good but in reality, it sucks. Contribution is really good here - Fixed costs remain constant and contribution falls – then profit falls. Limitations of CVP Analysis Relationship between Sales Revenue and Sales Volume (units sold) may not be linear Relationship between Total Cost and Output (quantity produced) may not be linear Businesses with multiple products may have multiple BEP for different sales mixes

Break-Even Analysis Calculating Break Even Point (BEP)

Example Fixed Costs =

£50,000

Per Unit Selling Price = £1000 Variable Cost = £500 Contribution per Unit = £500 (£1000 - £500 VC) Therefore, £50,000 / £500 (contribution) = 100 units (BEP) Example 2: Fixed Costs =

£30,000

Per Unit Selling Price = £2000 Variable Cost = £500

Contribution per Unit = £1500 (21000 - £500 VC) Therefore, £30,000 / £1500 (contribution) = 20 units (BEP)

Example 3 Unit Sale Price = Variable Cost per unit Fixed Cost = Units Produced Potential Units produced

£10 £4 £150,000 40,000 50,000

Contribution Per Unit = Unit Sales Price – Variable Cost Per Unit

BEP=

¿ Cost Contribution per Unit

break even

Example 4

=

£ 150,000 £ 10− £ 4

=

£ 150,000 £6

= 25,000 units must be sold to

Equation Method

Sales Mix

Margin of Safety Budgeted Target Sales = 200 units

Break Even Point of 100 units (example 1) The margin of safety is 200 – 100 = 100 units MOS The greater the MOS, the higher degree things can go in the wrong direction without causing too much concern e.g. if we only sold 195. Ideally, we want a low BEP.

Margin of Safety Example (MOS) Cottage Industries Makes baskets (target 500 a month) Selling Price per basket £14 Fixed Costs (Month)

£500

Direct Materials (Per basket)

£2

Direct Labour (Per Hour)

£5

Direct Labour Hours

2 hours

What is the BEP? Selling Price DL DM VC

£14 £10 (5 *2) £2 (£12)

14-12 = £2 Contribution per Unit 500 / £2 = 250 BEP What is the Margin of Safety? Target sales is 500 units Target sales – BEP = MOS = 500 – 250 = 250 units

BEP SALES =

£3,500 (14*250 BEP)

MOS SALES =

£3,500 (14*250 MOS)

Cottage Industries Example 2 Considers renting a machine Makes baskets (target 500 a month) Selling Price per basket £14 Fixed Costs (Month)

£3000

Direct Materials (Per basket)

£2

Direct Labour (Per Hour)

£5

Direct Labour Hours

1 hours

What is the BEP? £14- £7 = £ Contribution per unit £3000 / £7 = £429 (BEP) MOS = 500 – 429 = 71 MOS So the machine should not be bought.

BEP SALES = £6,006 (429 * 14) MOS SALES = £994 (71*14)

Target Profit Business and managers want to know how many units they would have to sell in order to achieve a target profit.

¿ Costs+Target Profit Contribution per Unit

If cottage industries wishes to make £4,000 profit each month – how many units would they need to sell? Without Machine

£ 500+ £ 4000 = 2250 units to be sold (per month) £2 to achieve £4,000 monthly profit

With Machine

£ 3000+ £ 4000 £7

= 1,000 units to be sold (per month)

to achieve £4000 monthly profit Lecture Material - Operating Gearing Proportion between variable and fixed costs within total cost For a frim with high fixed costs, a fall in sales could lead to a bigger loss and when sales are rising, profits would rise even more. Not usually as linear as below tho…

Close down or continue operating? Fixed Costs cannot be eliminated in the Short Term If you stop selling a product that’s making a loss, that means fixed costs are less covered by contribution and the loss would be greater than before… Only close down if fixed costs ‘saved’ are greater than contribution lost.

Limiting Factor A factor in short supply that stops the organisation from expanding its activities. e.g. - machine supply - Skilled Labour

- Raw Materials Rule: in response – maximise the contribution per limiting factor! Example

Determine the profit maximising production plan

Sub-Contract or do it in-house? Compare the Variable Cost (Marginal Cost) of manufacturing with the cost of buying the good/service from an outside supplier. Other considerations include: -

Reliability of Supply quality of manufacturing future price changes

Example

Lecture 4: Relevant Costs for Decision Making Looking at ‘apparent’ costs. Grouping costs which have an impact on the cash consequences of going ahead with the decision and those which do not. -

Sunk Costs Committed Costs Opportunity Costs Saved/Avoided Costs

It should take account of the ‘cash consequences’

Similar to the above, a relevant value is one which represents, as a result of going ahead with the proposal: - An additional cash inflow - An additional cash outflow - An existing cash inflow lost - An existing or potential cash outflow saved/avoided

Cash costs are the most relevant in decision-making An opportunity cost is the cost of the next best alternative course of action Fixed Overheads are not relevant in the decision to close down something like e.g. a factory The basis for the price of a company should charge for a one-off order A company working at full capacity should charge opportunity cost + marginal costs for a one-off order In a make vs buy decision, fixed production costs are irrelevant The most important factor in a product mixed decision, to maximise profit, contribution per unit of a scarce resource used to make the product

Example

Example 2...