RECP 674 Advanced Management Accounting (CTA LEVEL)

MANAGEMENT ACCOUNTINGPART 2

STUDY GUIDE FOR

RECP 674 VEC*RECP674VEC*

SCHOOL OF ACCOUNTINGVAAL TRIANGLE CAMPUS

Study guide compiled by:

Prof SS Visser, Mr RJJ Barnard & Mrs EM Venter

Edited nn.

+Page layout by Elsabé Botha, Graphikos.

Printing arrangements and distribution by Department Logistics (Distribution Centre).

Printed by Ivyline Technologies 018 293 0715/6.

Copyright 2013 edition. Date of revision 2013.

North-West University, Potchefstroom Campus.

No part of this book may be reproduced in any form or by any means without written permission from the publisher.

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MODULE CONTENTSWelcome...................................................................................................................................iv

Lecturer.................................................................................................................................... iv

Prescribed books......................................................................................................................iv

Supplementary study material (for library use).........................................................................iv

Aims of the course....................................................................................................................iv

Study programme......................................................................................................................v

Method of work..........................................................................................................................v

Assessment..............................................................................................................................vi

Compilation of the semester mark............................................................................................vi

Warning against plagiarism.....................................................................................................viii

Study unit 1 Introduction to strategic management accounting........................1

Study unit 2 Introduction to management accounting and profit planning..............................................................................................9

Study unit 3 Direct and absorption costing and cost classification................27

Study unit 4 Cost-volume-profit analysis............................................................43

Study unit 5 Profit planning..................................................................................53

Study unit 6 Flexible budgets...............................................................................63

Study unit 7 Standard costing..............................................................................71

Study unit 8 Job costing and activity-based costing.........................................93

Study unit 9 Process costing, hybrid costing and rework..............................105

Study unit 10 Joint product costing....................................................................125

Study unit 11 Relevant costs and decision making...........................................137

Study unit 12 Risk and uncertainty......................................................................149

Study unit 13 Linear programming, shadow prices and sensitivity analysis...........................................................................................159

Study unit 14 Transfer pricing and service departments..................................169

Study unit 15 Performance measurement...........................................................183

Study unit 16 Decentralisation.............................................................................193

Study unit 17 An improved and changed manufacturing environment and a changed business environment................................................197

Study unit 18 Cost management and the theory of constraints.......................205

iii

WELCOME

Welcome to the management accounting part of RECP 674! I hope that 2011 is a special one for you and that your insight into management accounting improves. I hope, too, that this subject will give you just as much pleasure as it has given me in my career. I wish you all success.

LECTURER

NAME OFFICE TELEPHONE

PRESCRIBED BOOKS

Vigario, F. 2007. Managerial accounting. Fourth edition. Durban: LexisNexis (referred to as V in this study guide).

Vigario, F. 2010. Questions in managerial accounting and finance. Sixth edition. Durban: LexisNexis.

Drury, C. 2011. Management and cost accounting. London: Thomson (referred to as D in this study guide).

The page and chapter references of the older editions are given in brackets.

SUPPLEMENTARY STUDY MATERIAL (FOR LIBRARY USE)

Garrison, R.H. & Noreen, E.W. 2006. Managerial accounting. New York: McGraw-Hill/Irwin (referred to as G in this study guide).

Redelinghuis, A., Julyan, F.W., Steyn, B.L. & Benade, F.J.C. 2000. Kwantitatiewe metodes in bestuursbesluitneming. Durban: Butterworths (referred to as R in this study guide).

Horngren, C.T., Datar, S.M., Foster, G., Rajan, M. & Ittner, C. 2008. Cost accounting: A managerial emphasis. Thirteenth edition. Upper Saddle River: Prentice-Hall (referred to as H in this study guide).

Relevant recent articles from journals.

AIMS OF THE COURSEThe highest-order teaching objectives, namely analysis, synthesis and evaluation, will make up the most part of student assessment of this course.

God, the Creator, Owner and Keeper of the entire earth, has made us stewards of His property. Stewardship requires accountability. Planning, control and decision making are the three main tasks of the managerial accountant and these tasks require accountability. A considerable amount of caution is needed for profit planning and budgetary control because the end result of planning must be the maximum utilisation of the available resources; at the same time the consumer’s needs must be met. Control is needed to ensure that the objectives formulated in the planning process have been achieved and planning will be useless if there is no control.

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Decision making entails deliberately choosing between two or more alternatives. To make decisions, information is needed and can be obtained by means of cost and management accounting.

Management accounting involves creating methods, systems and techniques to obtain useable information in order to achieve the three most important aims: decision making, planning and control.

STUDY PROGRAMME

This programme involves mainly the following:

You must be familiar with the subject terminology and acquire theoretical knowledge.

You must be able to solve cost and management accounting problems, as well as problems integrated with related subjects, using theoretical knowledge.

You will have to complete assignments that require you to make full use of subject literature, including recent journals in the library.

METHOD OF WORK

Theoretical knowledge

In each study unit the lecturer will briefly provide and explain the following:

Overview of the study unit

How the contents of the study unit link with existing knowledge

Main points and problem areas

You are responsible for supplementing the given framework from the prescribed books and the library.

Problems

When you start this course you will be given a work scheme of scheduled assignments, case studies and problems. While working through the study units, you must solve the scheduled problems and case studies relating to the study unit being discussed after doing the necessary reading. Prescribed problems and case studies will be selected in order to test all learning outcome levels, namely knowledge, insight, application, analysis, synthesis and evaluation.

Suggested solutions to the above problems will be discussed and may be required to be submitted without warning for marking.

Library

Assignments indicated on the work scheme can be done by using the library.

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ASSESSMENTAssessment will take place through:

Practicums

Two simulated qualifying exams

Two examinations

Consult the integrated roster of the accounting programme supplied for the individual dates.

COMPILATION OF THE SEMESTER MARKThe semester mark is compiled as indicated on the programme.

GLOSSARY OF TERMSLearning

ObjectiveVerbs Used Definition

Lev

el 1 Knowledge

What you are expected to know.

List

State

Define

Make a list of

Express, fully or clearly, the details/facts of

Give the exact meaning of

Lev

el 2

Comprehension

What you are expected to understand.

Describe

Distinguish

Explain Identify Illustrate

Communicate the key features of

Highlight the differences between Make clear or intelligible/State the meaning or purpose of

Recognise, establish or select after consideration

Lev

el 3 Application

How you are expected to apply your knowledge.

Apply

Calculate

Demonstrate

Prepare

Reconcile

Solve

Tabulate

Put to practical use

Ascertain or reckon mathematically

Prove with certainty or exhibit by practical means

Make or get ready for use

Make or prove consistent/compatible

Find an answer to

Arrange in a table

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Lev

el 4

Analysis

How you are expected to analyse the detail of what you have learned.

AnalyseCategoriseDemonstratePrepareReconcileSolveTabulate

Examine in detail the structure of

Place into a defined class or division

Show the similarities and/or differences between

Build up or compile

Examine in detail by argument

Translate into intelligible or familiar terms

Place in order of priority or sequence for action

Create or bring into existence

Lev

el 5

Evaluation

How you are expected to use your learning to evaluate, make decisions or recommendations.

Advise

Evaluate

Recommend

Counsel, inform or notify

Appraise or assess the value of

Propose a course of action

CIMA – Verb hierarchy, 2010

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WARNING AGAINST PLAGIARISM

ASSIGNMENTS ARE INDIVIDUAL TASKS AND NOT GROUP ACTIVITIES. (UNLESS EXPLICITLY INDICATED AS GROUP ACTIVITIES)

Copying of text from other learners or from other sources (for instance the study guide, prescribed material or directly from the internet) is not allowed – only brief quotations are allowed and then only if indicated as such.

You should reformulate existing text and use your own words to explain what you have read. It is not acceptable to retype existing text and just acknowledge the source in a footnote – you should be able to relate the idea or concept, without repeating the original author to the letter.

The aim of the assignments is not the reproduction of existing material, but to ascertain whether you have the ability to integrate existing texts, add your own interpretation and/or critique of the texts and offer a creative solution to existing problems.

Be warned: students who submit copied text will obtain a mark of zero for the assignment and disciplinary steps may be taken by the Faculty and/or University. It is also unacceptable to do somebody else’s work, to lend your work to them or to make your work available to them to copy – be careful and do not make your work available to anyone!

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Study unit 1

1 INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING

It will take approximately 10 hours to master this study unit.

Study material: Drury - Chapter 22

Supplemental reference material: [CIMA BBP Learning Media – Enterprise Strategy 3]

LEARNING OUTCOMES

After completing this study unit, you should be able to:

Give a definition of:

Strategy

Vision and mission

Entity values

Stakeholders

External environment

Internal environment

Explain and give examples of:

Strategic planning processes

Goals and objectives of strategy development

Components of a strategic plan

Identify and discuss the key stakeholders of an entity and their roles.

Discuss the external influences on an entity’s strategic development.

Explain corporate culture.

Illustrate and explain the following analytical models:

Porter’s 5 forces

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Study unit 1

Strengths, Weaknesses, Opportunities and Threats (SWOT) analysis

1. Introduction and overview

The three roles of a Management Accountant are:

Planning – Planning are key to the success of any business, enterprise or project. Tools used to do planning include master budgets and cash budgets.

Control – Control over actual activities provide a Management Accountant of valuable information regarding performance and the achievement of objectives. Measures to ensure control includes standard cost systems and the calculation of variances.

Decision-making – Every Management Accountant are faced with decisions based on the performance of an entity or project.

Strategic Management Accounting is a “form of management accounting in which emphasis is placed on information which relates to factors external to the entity, as well as non-financial information and internally generated information”. (CIMA official terminology)

Businesses will have different strategic positions, leading to different types of planning, control measures and decisions. It is the role of the Management Accountant to know, understand and apply the strategy chosen by a company to its planning, control and decision-making processes.

2. Generic Strategies D572

Porter has suggested that there are three basic generic strategies followed by organizations:

Cost leadership

A cost leadership generic strategy is demonstrated in South Africa’s low cost airlines, where services delivered as well as quality of services are similar, but their competitiveness is based on the cost they charge the customer.

Differentiation

Organisations that use differentiation as selling point include clothing stores with selected brands or food shops with organic produce. They seek to offer products and services to the customer that is superior and unique in relation to their competitors with less emphasis on cost.

Focus

These organizations are trading in segments that are exclusive or narrow, with the delivery of special services or products, such as for example custom built cars. They can generate competitive advantage either through cost leadership or product differentiation in the segment they operate.

3. Strategic management accounting terms Strategy: specifies how an organization matches its own capabilities with the

opportunities in the marketplace to accomplish its objectives.

Vision and mission: The vision of a company is where it is aiming to go in the future, while the mission is the reason for a company to exist; it defines what the organization is all about.

Entity values: the measure of a company’s value

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Study unit 1

Stakeholders: all parties involved in and connected to the organization directly or indirectly.

External environment: all factors outside of the control of the entity.

Internal environment: the environment that can be managed by the organization to its benefit.

4. Strategic planning processes

A Strategic Plan is a “statement of long term goals along with a definition of the strategies and policies which will ensure achievement of these goals”. (CIMA official terminology)

The rational model is generally applied to strategic planning, and consists of the following aspects:

Strategic analysis – understanding the current strategic position of a company

Strategic choice – generation of options available to the company and evaluating the suitability, feasibility and acceptability of each strategic option

Strategy implementation – the conversion of the strategy to the operational units through resource, operations and organizational planning

5. Goals and objectives of strategy development

The goal of the development of a strategy for an organization are derived from the organization’s mission and vision and extends generally over the long term.

Objectives set during the development of a strategy for an organization should be “SMART”:

S – Specific

M - Measurable

A – Achievable

R – Realistic / Relevant

T – Time-related

Often a critical success factor approach is required to ensure performance in a number of small areas, will result in satisfactory competitive performance overall and the achievement of goals and objectives.

Critical success factors (CSF’s) are “Elements of the organizational activity which are central to its future success. Critical success factors may change over time, and may include items such as product quality, employee attitudes, manufacturing flexibility and brand awareness”. (CIMA official terminology)

6. Components of a strategic plan

The components of a strategic plan can include, but are not limited to, the following:

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Study unit 1

Determining the vision of an organization

Compiling a formal mission statement for an organization

Analysing the stakeholders of the organization

Setting goals for the organization within limited timeframes and utilizing available resources

Documenting and updating all in a strategic plan for the organization

Criticisms of mission statements:

Compilation for the eye of the reader rather than the actual values of the company

The mission statements are often to general

The implementation strategy often do not link up to the mission statement

The mission statement becomes obsolete if it does not grow with the organization and its changing environment

The balanced scorecard is a performance measurement tool that links mission and strategy into objectives and measures combining both financial and non-financial aspects.

7. Stakeholder analysis

Various methods of accepted stakeholder analysis tools can be found. The basic analysis is as follows:

Step 1: Identify all stakeholders important to the company.

Step 2: Group all stakeholders into different dimensions of importance.

Dimensions include:

Power (high / low)

Support (positive / negative)

Influence (high impact / low impact)

Need (strong / weak)

Step 3: Incorporate the results of the stakeholder analysis into the strategic plan of the organisation.

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Study unit 1

8. External influences on Strategy development Organisations can no longer focus on profitability for the shareholders only, but need to consider external influences and stakeholders such as:

Government

Local and International Legislation

Treaty obligations

Consumers

Employers

Pressure groups

9. Corporate culture Based on its assumptions, attitudes, values and rituals, each organization has its own corporate culture.

Corporate social accounting is the “reporting of the social and environmental impact of an entity’s activities upon those who are directly associated with the entity (for instance employees, customers, suppliers) or those who are in any way affected by the activities of the entity, as well as the assessment of the cost of compliance with relevant regulations in this area”. (CIMA Official terminology)

10. Analytical models:

A SWOT analysis is a tool to analyse the internal and external environment to the organization. Strengths and weaknesses are usually internal to the organisation, while opportunities and threats are usually external.

Example of a SWOT analysis diagram:

Strengths

• What does your organisation do better than others?

Opportunities

• What new innovation could your organisation bring to the market?

Weakness

• What do other organisations do better than you?

Threats

• What is your competition doing that could negatively impact you?

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Study unit 1

Porter’s five forces

Porter's five forces of competitive position analysis were developed in 1979 by Michael E. Porter of Harvard Business School as a simple framework for assessing and evaluating the competitive strength and position of a business organisation.

Strategic analysts often use Porter’s five forces to understand whether new products or services are potentially profitable.

The five forces are:

1. Supplier power. Can suppliers force prices up?

2. Buyer power. Can customers force prices down?

3. Competitive rivalry. How many competitors and how capable are they?

4. Threat of substitution. What is the likelihood of customers switching to substitute products?

5. Threat of new entry. How strong are the barriers to keep competitors in a profitable market limited?

Class exercise:

Read the following case study:

A leading manufacturer of personal computers has set up its manufacturing operation in a region of the country which has seen a decline of its traditional industries, lower prosperity and higher unemployment than the rest of the country. Its decision was seen as a success for the Regional Development Agency, which had been hoping to attract such companies to the region.

Required:

1. Which generic strategy would you expect a manufacturer of personal computers to follow?

2. What would you expect the vision and mission of a manufacturer of personal computers to be?

3. Name one method to measure the value of a company that manufactures personal computers.

4. Name five (5) stakeholders to a manufacturer of personal computers.

5. Discuss the positive and negative potential impact the external environment can have on a manufacturer of personal computers.

6. Name three (3) risks faced by a manufacturer of personal computers in its internal environment.

7. Perform a basic strategic analysis of the company discussed in the case study.

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Study unit 1

8. Which strategic choices might have been available to the company, considering the industry?

9. Which performance measures would the company apply to assess the success of the implementation of its strategic plan?

10. Name three (3) critical success factors to a manufacturer of personal computers.

Suggested solution will be discussed in the contact session.

Complete 22.20 in Drury and compare your solution to the suggested solution below:

Suggested Solution Drury IM 22.6

(a) Financial statement for the year ended 31 May:

Medical (£000)

Dietery (£000)

Fitness (£000)

Total (£000)

Client fees 450.0 600.0 450.0 1500.0

Healthfood mark-up (cost × 110%)

120.0 120.0

Salaries (240.0) (336.0) (225.0) (801.0)Budget gross margin 210.0 384.0 225.0 819.0Variances: Fee income – favourable/(adverse))

(37.5) (100.0 275.0 137.5

Healthfood mark-up loss)

(30.0 (30.0)

Salaries increase (15.0) (75.0) (90.0)Extra fitness equipment

______ ______ (80.0) (80.0)

Actual gross margin 157.5 254.0 345.0 756.5Less: company costs: Enquiry costs – budget

(240.0)

– variance (60.0)

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Study unit 1

General fixed costs (300.0)Software systems cost

(50.0)

Actual net profit 106.5Budget margin per consultation (£)

35.00 32.00 25.00

Actual margin per consultation (£)

28.64 25.40 23.79

(b) Competitiveness

Compared with the budget new business enquiries have increased by 60% and the existing business enquiries have declined by 33%.

The uptake from enquiries was:

New business – Budget (30%) and Actual (25%)

Repeat business – Budget (40%) and Actual (50%)

Repeat business represents a measure of customer loyalty and the figures are encouraging whereas there has been a decline in the take up rate for new business.

Even though there has been a decline in the uptake from new enquiries the increased number of enquiries has resulted in new business exceeding budget by 5000 consultations in absolute terms. However, repeat business consultations are 2000 below budget arising from a decline in the number of client enquiries.

Medical and dietary consultations are below budget by approximately 8% and 16% respectively and fitness has exceeded budget by approximately 60%.

Ideally, competitiveness should also be measured against external benchmarks rather than the budget.

Flexibility

Flexibility relates to the responsiveness to customer enquiries. For example, the ability to cope with changes in volume, delivery speed and the employment of staff who are able to meet changing customer demands.

Outside medical specialists have been employed thus providing greater flexibility on the type of advice offered and additional fitness staff has been appointed to cope with the increasing volume. The measure of the uptake of new enquiries (see competitiveness above) can also provide an indication of the responsiveness to customer enquiries. It could be argued that the organization has failed to respond to a change in demand, given that dietary consultations have declined by 16%, but staff numbers have remained unchanged. The organization may, however, be anticipating an upsurge in future demand.

ASSIGNMENTS

Consult the work scheme.

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Study unit 2

2 INTRODUCTION TO MANAGEMENT ACCOUNTING AND PROFIT PLANNING


Study material: Horngren - Chapter 1 (1) Vigario - Chapter 1 (1)[Drury - Chapter 1]

LEARNING OUTCOMES


Distinguish between management accounting, financial accounting and cost accounting and explain the purpose of each.

Discuss the tasks of a management accountant.

Discuss the ethical code of conduct and the characteristics (of the Chartered Institute of Management Accountants (CIMA)) of a management accountant.

Discuss the key management accounting guidelines.

Discuss the value chain of business functions.

Discuss strategic decisions of a management accountant and provide information for competing resources and benefits.

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Study unit 2

1. INTRODUCTION H29, V1, 4, D5

Distinguish between management accounting, financial accounting and cost accounting.

The main purposes of accounting systems are:

i) Routine internal reporting for those decisions of managers that are made regularly, e.g. determining prices and cost control.

ii) Non-routine internal reporting for those decisions of managers that are made on each occasion but not regularly.

iii) External reporting to investors, the government and other external parties.

The purpose of cost accounting is to gather and provide information for internal and external purposes.

The purpose of financial accounting is to provide information to external users, such as creditors and the Receiver of Revenue.

The purpose of management accounting is to provide financial and non-financial information to management for their planning, control and decision making within the business.

Cost management entails the activities of managers to control costs in the short and long term.

2. TASKS OF A MANAGEMENT ACCOUNTANT V4, D8-12

The main tasks of a management accountant are:

Planning by means of budgets

Evaluating performance by means of flexible budgets, standard costing, ratios, etc.

Making decisions based on relevant costs, marginal costs, quantitative management techniques, etc.

See the discussion in Horngren p. 37 on planning and control.

3. THE MANAGEMENT ACCOUNTANT’S ROLE IN IMPLEMENTING STRATEGY H31

3.1 Value chain

Planning and control refer to one or more business functions in which managers and management accountants play an important role. The value chain is the sequence of business functions that can add value to the products or services in an organisation. Management accountants support managers in each of the following six business functions:

Value chain analysis

Research and development (R&D)

Design of products, services or processes

Production

Marketing

Distribution

Customer service

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Study unit 2

3.2 Supplier chain analysis

What is the supplier chain? It is the flow of goods, services and information from the original sources of material and services to the delivery of products to customers, regardless of whether the activities occur in the same organisation or different ones.

4. ENHANCING THE VALUE OF MANAGEMENT ACCOUNTING SYSTEMS H32

Customer focus: The success of an organisation is determined by the service to the customers.

Key success factors: Cost, quality, time and innovation.

Continuous improvement: This applies to the process, the product and overall performance of the organisation.

Value chain analysis: Two related aspects here are: (i) deal with each business function as an essential and valuable contribution and (ii) integrate and coordinate the efforts of all business functions.

5. KEY MANAGEMENT ACCOUNTING GUIDELINES H37

Cost-benefit approach: A principle applied in all decisions. The costs must be justified by the benefit that could realise.

Behavioural and technical considerations: A management accounting system must help managers make wise economic decisions and motivate both managers and employees to pursue the firm’s objective.

Different costs for different purposes: A cost concept used for external purposes may differ from that used for internal purposes, e.g. compare an absorption costing approach with a marginal costing (direct costing) approach.

6. ORGANISATION STRUCTURE AND THE MANAGEMENT ACCOUNTANT H39

Distinguish between line and staff management.

Line management is directly responsible for pursuing the objectives of the organisation, e.g. managers of manufacturing divisions may have specific levels of budgeted operating income and certain levels of product quality, safety etc.

Staff management, e.g. management accountants give advice and support to line management.

The responsibilities of the chief financial officer (CFO) or financial director are:

i. Controllership

ii. Finance

iii. Risk management

iv. Tax

v. Internal audit

7. ETHICS OF THE MANAGEMENT ACCOUNTANT H40

The ethical codes of CIMA and the Institute of Management Accountants (IMA) for management accountants involve competence, confidentiality, integrity and objectivity. What characteristics can you add and how would you apply them?

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Study unit 2

8. STRATEGIC DECISIONS AND THE MANAGEMENT ACCOUNTANT H31

Do 1.29 in Horngren as practice and compare your answer with the suggested solution below.

H + F + D 1.291. Possible motivation could be:

a) Management incentives: Possibly a bonus scheme based on performance for the year

b) Promotional opportunities and job certaintyc) Maintenance of division/section autonomy

2. a) Acceptable: Cannot do much more

b) Unacceptable: Fiscal year-end 31/12

c) Unacceptable: Changing the dates is falsification

d) Acceptable: Can do little about it

e) Acceptable: No record of falsification

f) Unacceptable: Advertisements billed to current year

g) Acceptable: Transaction appears to be ethical

3. If Malonson believes that Patterson is involving her in unethical behaviour, she will speak directly to Patterson about it. If Patterson is unwilling to change his request, Malonson will direct her concern to the corporate controller of Nations Appliance. Malonson could also ask for a transfer. The extreme action would be to resign if the corporate culture of Nations Appliance is to reward divisions where managers perform only at the end.

ASSIGNMENTS


APPENDIX TO STUDY UNIT 1

Study Unit 1 emphasises the fact that cost management is important for a management accountant. Cost management is the activity of managers to manage cost over the short and long term. This includes analysis of cost, and therefore also inventory valuation.

1. DISTINCTION BETWEEN DIRECT AND ABSORPTION COST SYSTEM

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Study unit 2

It is important for you to distinguish between a direct and an absorption cost system.

What is an absorption cost system?

Fixed AND variable manufacturing costs are included in inventory value.

What is a direct cost system?

Only variable manufacturing costs are included in inventory value.

The difference therefore lies with inventory valuation.

The absorption cost system is used by the financial accountant.

Why?

Required by IAS 2.

Fixed manufacturing overhead, e.g. rent of factory, is needed to make inventory available for sale. Without it the products or services could not exist. Therefore, it is necessary to take those costs in account to determine the value of inventory.

Additional to the above, the value of the fixed manufacturing cost included in inventory, is needed for insurance purposes, otherwise the inventory will be underinsured.

The direct cost system is used by the management accountant.

Why?

Fixed overheads take place in a specific period. If fixed overhead is included in closing inventory, one effectively defers the cost to a following period.

It is important for you to realise that decisions cannot be made in an absorption cost environment.

See the examples below for illustration:

EXAMPLE 1:Given: Accept the following information:

Units

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Study unit 2

Sales 1 000

Opening inventory 100

Production 1 200

Closing inventory 300

Per unit

Sales 12

Material 4

Variable labour 2

Fixed cost 4

Profit 2

Required: Prepare an income statement on both the direct and absorption cost system.

SOLUTION:

Income Statement (Direct)

Sales 12 000

Cost of sales 10 000

Opening inventory 600°

Production cost 11 200²

Material 4 800

Labour 2 400

Fixed cost 4 000

Closing inventory 1 800³

Profit 2 000

° Inventory value includes variable costs ONLY, therefore:4 (material) + 2 (variable labor) = 6 per unit x 100 units = 600² Total production cost as calculated for each component separately (amount x price)³ Include ONLY variable cost in inventory valuation, therefore: 6 x 300 units = 1 800

Income Statement (Absorption)

Sales 12 000

Cost of sales 9 200

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Study unit 2

Opening inventory 1 000°

Production cost 11,200

Material 4 800

Labour 2 400

Fixed cost 4 000

Closing inventory 3 000²

Profit 2 800

° Now fixed cost is allocated at a rate of R4 per unit. Therefore the value of beginning inventory: R4 + R2 + R4 = R10 x 100 units² Fixed overhead is also included, therefore R10 x 300 units

It is clear that profit differs. The difference in profit is because of:

Direct Absorption Difference

Opening inventory value 600 1 000 (400) Decrease in profit

Closing inventory value 1 800 3 000 1 200 Increase in profit

800 Difference

This is exactly the difference in profit.

On the absorption cost system, profit can therefore be manipulated. If management wants to achieve a higher profit this year, they can see to it that inventory levels are higher. Therefore, decisions can’t be made on an absorption cost basis.

2. IN A DIRECT REPORTING ENVIRONMENT

2.1. WHAT AFFECTS PROFIT?

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Study unit 2

Production quantity has no effect on profit in a direct reporting environment.

Sales is the only volume alteration that has an effect on profit (equal to the amount in sales volume x contribution).

See the following example as illustration:

EXAMPLE 2:

Required: Assume the following information:

Sales 1 000


Per unit

Sales 12

Material 4

Variable labour 2

Fixed cost 4

Profit 2

Required: Prepare 2 variable cost income statements:(i) The first statement for production of 1 200 units(ii) The second statement for production of 2 000 units

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Study unit 2

SOLUTION:

(i) Income statement

Sales 12 000



Production cost 11 200

Material 4 800

Labour 2 400

Fixed cost 4 000

Closing inventory 1 800

Profit 2 000

(ii) Income statement

Sales 12 000




Material 8 000

Labour 4 000

Fixed cost 4 000


Profit 2 000

As one can see, profit remains the same, regardless of change in production volumes.

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Study unit 2

2.2. WHAT IS CONTRIBUTION?

Contribution = Sales – all variable costs

However, other variable costs does not form part of inventory valuation (in other words, non-manufacturing costs, such as sales costs, does not form part of inventory valuation).


EXAMPLE 3:

Given: Assume the following information:

Per product A Rand

Sales price 100

Material 15

Labour 20

Variable factory rent 5

Variable audit cost 2

Variable sales cost 5

Fixed factory rent 2 000

Fixed administration cost 1 500

Required:(i) What is the contribution of a product A?(ii) What is the value of a product A on a direct cost basis?

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Study unit 2

SOLUTION:

(i) The contribution will be as follows:

Sales price 100

Less ALL variable costs:

Material (15)

Labour (20)

Variable factory rent (5)

Variable audit cost (2)

Variable sales cost (5)

Contribution of Product 53

(ii) The value of 1 Product A is as follows:

Material 15

Labour 20

Variable factory rent 5

Inventory value 40

3. FORMATS

The format of the income statement does not determine the reporting method.

As mentioned above, the difference between a direct and absorption cost system is only the inventory value (opening and closing inventory).

Do the following examples and take your answer to class where the solution will be handed over to you:

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Study unit 2

EXAMPLE 4:


Units

Sales 1 000


Production 2 000

Budgeted costs for total production:

Rand

Material 10 000

Variable labour 20 000

Variable sales cost 4 000

Fixed labour 25 000

Fixed admin cost 15 000

Budgeted sales price:Selling price per unit 100

Required: Calculate the budgeted profit:

1 In a contribution format income statement(i) For a direct cost system(ii) For an absorption cost system

2 On a traditional basis(i) For a direct cost system(ii) For an absorption cost system

Your answer must be as follows:

For both the direct cost system budgets = R41 000

For both the absorption cost system budgets = R53 750

The complete answer will be handed out during the contact session.

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Study unit 2

4. ABSORPTION COST SYSTEM

The following has an impact on profit in an absorption cost system:- A change in sales (also equal to contribution x volume difference)- A change in inventory (with the fixed overhead allocated component)

Refer to example 1:

EXAMPLE 5:

Given: Assume the same information as in example 1:

Income statement (Absorption)

Sales 12 000

Cost of sales 9 200

Opening inventory 1,000


Material 4 800

Labour 2 400

Fixed cost 4 000


Profit 2 800

Required: What will happen if production increases with 100 units? Closing inventory will automatically also increase with 100 units, as sales remain the same.

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Study unit 2

SOLUTION:

Income statement (Absorption)

Sales 12 000

Cost of sales 9 200

Opening inventory 1 000°


Material 5 200²

Labour 2 600³

Fixed cost 4 000*

Closing inventory 4 000º

Profit 8 200

° This will still be 100 x R10² 1300 x R4³ 1300 x R2* Fixed regardless of volumeº This will now be 400 x R10

It is clear that profit changes with a change in inventory volume.

A change in sales will also have an effect on profit, exactly the same as explained above.

4.1. FIXED OVERHEAD

Regardless of the method of valuation, the amount of fixed cost in the income statement is always the ACTUAL amount. Over/under allocated overheads does NOT have an effect on profit!

What is over/under allocated overhead?This is the difference between the actual overhead and the allocated overhead.

How is it calculated?

Budgeted fixed overhead = Standard fixed overhead allocation rate (SFOR)

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Study unit 2

Budgeted production

The allocated fixed overhead will then be = SFOR x actual production

The difference between the allocated and the actual overhead is the under or over allocated overhead.

Over/under allocated overhead exists because of a volume and/or price variance. This arises as the allocation rate is incorrect.


EXAMPLE 6:


Budgeted volume:


Production 500

Sales 400

Therefore, closing inventory 200

Budgeted costs: (Total) = standard cost Therefore, per production unit

Material 10 000 20

Labour 5 000 10

Fixed overhead 10 000 20

Sales price per unit 100

What is the standard fixed overhead rate?10,000/500 = R20

The company follows a standard cost system.

a) What is an overhead variance because of a volume difference?

Actual volume:


Production 450

Sales 420


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Study unit 2

Actual costs: (Total) Therefore, per production unit

Material 9 000 18

Labour 5 200 10,4

Fixed overhead 10 000 22,22


Income statement

Sales (420 x 110) 46 200

Less: Cost of sales -21 700

Opening inventory (100 x (20+10+20))° 5 000

Production costs:

Material* 9 000

Labour* 5 200

Fixed overhead (450 X 20) 9 000

Closing inventory (130 x (20+10+20)) -6 500

Gross profit 24 500

Under allocated overhead -1 000

Profit 23 500

° Keep the costs at standard cost as given in the example.* Actual.

b) What is an overhead variance because of a budget difference?

Actual volume:


Production 500

Sales 420



Material 9 000 18

Labour 5 200 10,4



Income statement

Sales (420 x 110) 46 200

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Study unit 2


Opening inventory (100 x (20+10+20)) 5 000

Production costs:

Material 9 000

Labour 5 200



Gross profit 27 000


Profit 26 000

c) What is a overhead variance because of both a volume and rate variance?

Actual volume:


Production 450

Sales 420



Material 9 000 18

Labour 5 200 10,4



Income statement

Sales (420 x 110) 46 200


Opening inventory (100 x (20+10+20)) 5 000

Production costs::

Material 9 000

Labour 5 200



Gross profit 24 500


Profit 22 500

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Study unit 2

It is clear that fixed overhead in the income statement stays equal to the ACTUAL overhead incurred. Over/under allocated overhead does not have an effect on profit.

26

Study unit 2

27

Study unit 3

3 DIRECT AND ABSORPTION COSTING AND COST CLASSIFICATION


Study material: Horngren - Chapters 9 and 10 Vigario - Chapters 4 and 6[Drury - Chapters 7 and 23][Garrison - Chapters 5 and 7]

LEARNING OUTCOMES


Classify costs according to the:

* High-low method

* Graph method

* Least squares method to separate mixed costs into fixed and variable components

Discuss and apply the principles of direct costing by calculating net operating income according to this method in firms where actual costs are used and in firms where standard costs are used.

Discuss and apply the principles of absorption costing by calculating net operating income according to these methods in firms where actual costs are used and in firms where standard costs are used.

Do a profit reconciliation between the net operating income calculated as per the direct costing method and as per the absorption costing method.

Do a profit reconciliation between the net operating income where actual costs are used and where standard costs are used in each of the direct costing and absorption costing methods.

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Study unit 3

Give reasons for differences and congruences in profit between direct cost statements and absorption cost statements, and prove by means of figures these differences and congruences.

Determine the breakeven point and make decisions if absorption costing is used.

Convert an income statement prepared according to the direct costing method to one prepared according to the absorption costing method and vice versa.

Evaluate the direct and absorption costing methods as reporting methods.

Divide cost variances and the adjustments on a pro rata basis.

Convert from actual costs to standard costs and vice versa in absorption costing as well as direct costing.

Implement throughput costing and reconcile the profit with that calculated as per the direct and absorption costing methods.

Determine the influence of the learning curve on cost, profit and breakeven point.

Determine the effect of a JIT approach on the reporting methods.

1. OVERVIEW AND INTRODUCTION D141, H324+, V121

Absorption costing is also known as full costing.

Direct costing is also known as marginal costing or variable costing.

The name depends on which costs are included in inventory.

Influences inventory valuation and reporting (profit realisation).

Better planning and control because costs are divided into fixed and variable.

Direct costs: Direct in the sense of directly variable.

Product absorbs variable costs.

Absorption costs: Product absorbs the total cost of acquisition.

Reporting: (i) Internal Direct costing

(ii) External Absorption costing

Direct and absorption costing can be used in actual costs and standard costs.

Distinguish between product costs and period costs.

2. METHODS OF COST CLASSIFICATION, H368+, D597, V207

2.1 Industrial engineering method – Not mathematical: Work study methods and sampling

2.2 Account analysis method: Surface distinction

2.3 High-low method V207, H372 e.g.

b = Change in costs Change in activity

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Study unit 3

EXAMPLE

X Y1. 1 500 R800 b = 1 350 – 8002. 2 000 1 000 3 000 – 1 5003. 3 000 1 350 = 5504. 2 500 1 250 1 5005. 1 500 800 = .366

.367Substitute in y = a + bx

a = 1 350 - .367 x (3 000) = 1 350 – 1 101 = 249

y = a + bx y = 249 + .367 x Test at lowest level

2.4 Graph G204 (255)

Y 1 400 -

- 1 200 -

- 1 000 -

- Rand -

- 600 -

a = ± 200-

b =

1 350 − 7003 000

400 -

= .38333-

200 --

500 1 000 1 500 2 000 2 500 3 000

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Study unit 3

2.5 Least squares V212, H374

xy = ax + bx²y = na + bx

X Y XY X²1 500 800 1 200 000 2 250 0002 000 1 000 2 000 000 4 000 0003 000 1 350 4 050 000 9 000 0002 500 1 250 3 125 000 6 250 0001 500 800 1 200 000 2 250 000

10 500 5 200 11 575 000 23 750 000

11 575 000 = 10 500a + 23 750 000b … 5 200 = 5a + 10 500b …

x 2 100: 10 920 000 = 10 500a + 22 050 000b - 655 000 = 1 700 000b b = .385

Substitute in a = 5 200 – 10 500 (.385) 5

= 231.5Computer a = 230.88

b = .385 …

2.6 Variance of average method

1. Average X : 10 500 = 2 1005

2. Average Y : 5 200 = 1 0405

3. 4 columns I: Difference between actual and average X II: Square of IIII: Difference between actual and average YIV: I x III

4. b = IV II

5. a = y – bx

I II III IV-600 360 000 -240 144 000-100 10 000 -40 4 000 b = 655 000+900 810 000 +310 279 000 1 700 000+400 160 000 +210 84 000 = .385 -600 360 000 -240 144 000 a = 1 040 – 2 100

- 1 700 000 - 655 000 (.385) = 231.5

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Study unit 3

3. CONTRIBUTION MARGIN AND GROSS PROFIT H105

Contribution margin: Sales less ALL variable costs

Gross profit: Sales less ALL costs of acquisition (VC + FC)

Contribution margin Gross profit

4. ACTUAL AND STANDARD COSTS H335+

Actual: Direct

Absorption costs

Standard costs: Direct – VC variances

All – VC + FC variances

Normal costs: Direct and absorption costs

5. PRINCIPLES (CHARACTERISTICS) OF DIRECT COSTING D144, H326, V123

VC as product costs (all VC at product but only production costs are in inventory)

FC as period costs (all FC).

Actual costs

Actual DM, DL, FC but variable overheads at predetermined rate, therefore adjust variable overheads overallocated or underallocated.

Standard costs

DM, DL and variable overheads at standard, therefore adjust all variable cost variances, FC at actual.

Net profit: Sales – VC = Contribution margin - FC = Net profit

Example of income statement G283 (329), D232, H328 (297)

6. PRINCIPLES (CHARACTERISTICS) OF ABSORPTION COSTING, H327, V124, D144

All costs of acquisition are product costs (VC + FC).

All costs after acquisition are period costs (VC + FC).

Actual costs: Actual DM and DL and manufacturing overheads (FC + VC) at a predetermined rate, therefore adjusted variable and fixed overheads overallocated or underallocated.

Standard costs: DM, DL and manufacturing overheads (FC + VC) at standard; therefore adjust ALL variances.

Net profit: Sales – Cost of sales = Gross profit – Selling and administrative expenses = Net profit.

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Study unit 3

7. INCOME STATEMENT: EXAMPLE D143, H330, V128

8. PROFIT RECONCILIATION D146, H329, V139

When will profits be the same?

Production = Sales, no inventory difference.

When will profits differ?

Production Sales, there is an inventory difference inventory increase or decrease.

Production > Sales: inventory increase, absorption cost highest profit

Production < Sales: inventory decrease, direct cost highest profit

Example

9. EXTERNAL AND INTERNAL REPORTING D148, H344

Direct costing: Internal, important for decision making, planning and control

Absorption costing: External

Which form of reporting?

10. PRO RATA DIVISION OF VARIANCES

11. CRITICAL EVALUATION OF DIRECT COSTING AND ABSORPTION COSTING AND REPORTING METHODS D148, V122

DIRECT COSTING

ADVANTAGES

Provides more useable information for decision making.

Inventory difference in direct costing is not reflected in profit; therefore an increase in sales causes an increase in profit.

Direct costing does not include FC in inventory; therefore not necessary to allocate FC.

Fictitious profits are not possible.

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Study unit 3

DISADVANTAGES

FC overallocated or underallocated are important figures and are not shown.

Inventory valuation excludes FC, which easily leads to being underinsured; this affects earnings per share, current ratio and liquidity ratio.

ABSORPTION COSTING

ADVANTAGES

Emphasises the importance of FC.

Fictitious losses cannot occur.

Theoretically more correct for reporting, externally acceptable (FC + VC were necessary for production and have to be included).

Pricing.

AC 108 (IAS 2): Paragraphs 1, 7, 10, 30. IAS 2 V111(V61).

DISADVANTAGES

FC are allocated arbitrarily – choosing a level of activity is difficult.

Pricing – don’t forget selling and administrative expenses.

12. BREAKEVEN POINT AND ABSORPTION COSTING REPORTING H350

CVP (U) = FC + [SFOR (CVP (U) – Units produced)]

Contribution margin/U

13. CONVERTING INCOME STATEMENTS TO ANOTHER METHOD

From absorption costing to direct costing. Example attached (study guide BRK 311)

From direct costing to absorption costing. Example attached (study guide BRK 311)

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Study unit 3

13.1 Converting from absorption costing to direct costing

Experimental Ltd uses standard absorption costing. Management intends converting to direct costing and expects you to convert the following income statement to the direct costing method.

Income statement– absorption costing method (R) (R)

Sales (5 000 units @ R50/u) 250 000Less: Cost of sales 151 600

Opening inventory 30 000Plus: Production costs 171 000Min: Closing inventory 51 000Cost of sales at standard cost 150 000Plus/less: Variances: Variable 5 000

Fixed ( 3 400)Cost of sales at actual 151 600

Gross profit 98 400Less: Other costs 70 000

Selling and admin. expensesVariable 25 000Fixed 45 000

Net profit 28 400

Additional information:

The budgeted fixed production costs for the year amounted to R60 000 for a normal volume of 5 000 units.

There was no opening or closing work-in-process inventory.

Inventory is valued at standard cost.

Variances are adjusted to cost of sales where appropriate.

The actual fixed production cost was R65 000.

REQUIRED:

1) By means of an income statement, determine the net profit according to the direct costing method.

2) If there is a difference in net profit according to the given income statement and the one you prepared in (1) above, do a reconciliation.

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Study unit 3

Suggested solution

(1) Direct costing income statement

Income statement– direct costing method (R) (R)

Sales (5 000 units @ R50/u) 250 000Less: Variable cost of sales 95 000

Opening inventory 18 000Plus: Production costs 102 600Less: Closing inventory 30 600Cost of sales at standard cost 90 000Plus/less: Variances: Variable 5 000Variable cost of sales at actual 95 000

Less: Other variable costsSelling and admin. expenses 25 000

Contribution margin 130 000Less: Fixed costs 110 000

Production costs 65 000Selling and admin. expenses 45 000

Net profit 20 000

Calculations:

Total cost per unit = R150 000/5 000 units = R30,00 per unit

Fixed costs per unit = R60 000/5 000 units = R12 per unit

Variable costs per unit = R30 – R12 per unit = R18 per unit

Opening inventory units = R30 000/R30 per unit = 1 000 units

Closing inventory units = R51 000/R30 per unit = 1 700 units

Production units = R 171 000/5 000 units = 5 700 units

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Study unit 3

(2) Profit reconciliation: Direct costing method profit = R20 000 Absorption costing method profit = R28 400 Difference in profit = R8 400

Inventory: Opening inventory: D/C + R18 000 A/C + R30 000Closing inventory: D/C - R30 600 A/C - R51 000Cost reduction - R12 600 - R21 000

Inventory difference R8 400

Direct costing: Highest cost Absorption costing: Lowest costTherefore Lowest profit Therefore Highest profit

The costs of the direct costing method will be R8 400 higher than the absorption costing method owing to a difference in inventory valuation – this leads to a R8 400 lower profit in the direct costing method (as indicated above). The costs of the absorption costing method will be R8 400 lower than in the direct costing method owing to a difference in inventory valuation – this leads to a R8 400 higher profit in the absorption costing method (as indicated above).

13.2 Conversion from direct costing to absorption costing

AB Limited uses a direct costing system for internal reporting and gives you the following information on the past third quarter:

Income statement – direct costing method (R) (R)

Sales (5 500 units @ R45/u) 247 500Less: Variable cost of sales 70 000

Opening inventory 36 000Plus: Production costs 72 000Less: Closing inventory 42 000Cost of sales at standard cost 66 000Plus/less: Variances: Variable 4 000Variable cost of sales at actual 70 000

Less: Other variable costsSelling and admin. expenses 12 375

Contribution margin 165 125Less: Fixed costs 125 000

Production costs 80 000Selling and admin. expenses 45 000

Net profit 40 125

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Study unit 3

Additional information: Inventory is valued at standard cost.

There was no opening or closing work-in-process inventory.

The budgeted fixed manufacturing overheads for this quarter are R75 000 for a normal volume of 5 000 units or 10 000 direct labour hours.

REQUIRED:

1) Prepare an income statement according to the absorption costing method where you use standard rates.

2) Does the given net profit differ from that given in (1) above? Substantiate your answer with the necessary figures.

Suggested solution

Income statement – absorption costing method (R) (R)

Sales (5 500 units @ R45/u) 247 500Less: Cost of sales 142 500

Opening inventory 81 000Plus: Production costs 162 000Less: Closing inventory 94 500Cost of sales at standard costs 148 500Plus/less: Variances: Variable 4 000

Fixed ( 10 000)Cost of sales at actual 142 500

Gross profit 105 000Less: Other costs 57 375

Selling and admin. expensesVariable 12 375Fixed 45 000

Net profit 47 625

Calculations:

Variable costs per unit = R66 000/5 500 units= R12 per unit

Opening inventory units = R36 000/R12 per unit = 3 000 units

Closing inventory units = R42 000/R12 per unit = 3 500 units

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Study unit 3

Production units = R72 000/R12 per unit = 6 000 units

Fixed costs per unit = R75 000/5 000 units = R15 per unit

Fixed costs variance = Actual - Allocated = R80 000 – (6 000 x 15) = R10 000 overallocated

(2) Profit reconciliation: Direct costing method profit: R40 125 Absorption costing method profit: 47 625 Difference in profit R7 500

Inventory Opening inventory: D/C + R36 000 A/C +R81 000Closing inventory: D/C -R42 000 A/C -R94 500Cost reduction - R 6 000 -R13 500

Inventory difference R7 500

Direct costing: Highest cost Absorption costing: Lowest costTherefore Lowest profit Therefore Highest profit

The costs of the direct costing method will be R7 500 higher than the absorption costing method owing to a difference in inventory valuation – this leads to a R7 500 lower profit in the direct costing method (as indicated above). The costs of the absorption costing method will be R7 500 lower than in the direct costing method owing to a difference in inventory valuation – this leads to a R7 500 higher profit in the absorption costing method (as indicated above).

14. INFLUENCE OF JIT ON THE REPORTING METHODS

Profits differ because production sales.

In JIT: The aim is no inventory.

Therefore production = sales profits are closer to each other.

15. THROUGHPUT COSTING H335

Supervariable costs

Only materials costs in inventory

16. ALTERNATIVE VOLUMES D150, H339

Theoretical capacity

Practical capacity

Normal utilisation

Master budget utilisation

What is the effect of each on the volume variance?

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Study unit 3

17. LEARNING CURVES H379, V217

A function showing how labour hours per U can decrease if production U increase because workers learn and improve in their work. Efficiency improves and unit costs are lower.

Experience curve: A broader application of the learning curve which shows how the full production costs per U (manufacturing, marketing and distribution) decrease as output increases.

Distinguish between the cumulative average time learning model and the incremental unit time learning model.

See example 10.10 - 10.13 H382 for an explanation.

Example: Assume it takes 40 hours to carry out a task and it has been determined that an 80% learning curve is appropriate for the task when production doubles. Determine the average unit time and the marginal unit time for the production of 16 tasks V217.

Marginal

Production Cumul. Prod. Ave. time Total time Total time Ave. time

1 1 40 40 40 40

1 2 32 64 24 24

2 4 25.6 102.4 38.4 19.2

4 8 20.48 163.84 61.44 15.4

8 16 16.384 262.14 98.3 12.3

Ave. time = Average of past x 80%

Total time = Average time x Cumulative production

Marginal total time = Current total time – Previous total time

Marginal average unit time = Marginal total time ÷ Production

Graph

Ave. hours/U

of cumul. prod.

Cumul. quantity in U

Example:

Determine the learning curve % from the following:

First batch production takes 70 hours to manufacture

Second batch production takes 28 hours to manufacture

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Study unit 3

Cumulative Marginal Total Ave.

1 70 70 70

2 28 98 49

Therefore the average is based on a 70% learning curve.

Do 9.18 and 9.19 in Horngren as self-assessment exercises and compare your answers with the suggested solutions below.

H + F + D 9.18

1a INCOME STATEMENT – DIRECT COSTING

JAN. FEB. MAR.

Sales R1 750 000 R2 000 000 R3 750 000

- VC: Of sales (@ R900) 630 000 720 000 1 350 000

Selling + adm. 420 000 480 000 900 000

= Contribution margin R700 000 R800 000 R1 500 000

- FC: Production 400 000 400 000 400 000

Selling + adm. 140 000 140 000 140 000

= Net operating income R160 000 R260 000 R960 000

**(900 + 400, 900 + 500, 900 + 320)

1b.

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Study unit 3

INCOME STATEMENT – ABSORPTION COSTING

JAN. FEB. MAR.

Sales R1 750 000 R2 000 000 R3 750 000

- Cost of sales (@ R1 300**) 910 000 *1 120 000 *1 850 000

= Gross profit R840 000 R880 000 R1 900 000

- Selling + adm.: VC 420 000 480 000 900 000

FC 140 000 140 000 140 000

= Net operating income R280 000 R260 000 R860 000

**VC = R 900, FC = R 400 (R400 000 ÷ 1 000 units), total costs/U = R1 300

*Volume variance = (AOV – NV) SFOR

Jan. = (1 000 – 1 000) R400 = R0 so COS 700U x R1 300 = R910 000

Feb. = ( 800 – 1 000) R400 = (R80 000) [ 800U x R1 300 ] + R80 000

Mar. = (1 250 - 1 000) R400 = R100 000 [1 500 x R1 300] - R100 000

2. Difference in operating income: Jan. = R120 000, Feb. = R0, Mar. = R100 000

Difference in inventory: Direct costing: January February March

+O/I : 0 R270 000 R270 000

- C/I : R270 000 270 000 45 000

-R270 000 - + R225 000

Difference in inventory: Absorption costing:

+O/I: 0 R390 000 R390 000

- C/I: R390 000 390 000 65 000

-R390 000 -R 0 +R325 000

Difference in inventory in the two above methods:

Jan: R270 000 - (-R390 000) = R120 000, compared with difference in operating income.

Feb: 0 -(0) = R0, compared with difference in operating income.

Mar: R225 000 - (R325 000) = R100 000, compared with difference in operating income.

Inventory increase in January: Absorption costing - the highest profit

Inventory decrease in March: Direct costing – the highest profit

H + F + D 9.19 (refer to 9.18 for the direct costing and absorption costing statements)

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Study unit 3

1. INCOME STATEMENT FOR 2007 JAN. FEB. MAR.

Sales R1 750 000 R2 000 000 R3 750 000

O/I - 150 000 150 000

- Direct materials production cost 500 000 400 000 625 000

C/I (150 000) (150 000) (25 000)

= Throughput contribution margin R1 400 000 R1 600 000 R3 000 000

- Direct labour 100 000 80 000 125 000

- Overheads: Manufacturing: VC 300 000 240 000 375 000

FC 400 000 400 000 400 000

Sales: VC (@ R600) 420 000 480 000 900 000

FC 140 000 140 000 140 000

= Net operating income R40 000 R260 000 R1 060 000

Compare the operating income from above three income statements: class discussion. Make sure you do each month separately.

*: O/I + Production – C/I = R390 000 + 1 120 000 – 420 000 = R1 090 000

: = R420 000 + 1 525 000 – 61 000 = R1 884 000

2. Net operating income:

Jan Feb Mar

Absorption costing

Direct costing

Throughput costing

R280 000

160 000

40 000

R260 000

260 000

260 000

R860 000

960 000

1 060 000

Throughput costing places more emphasis on sales as a source for providing net income than direct costing and absorption costing do.

3. Throughput costing penalises production when sales and production are not synchronised in the same period. Other costs (except for materials) that are variable are recorded when they are incurred, in contrast to direct costing where they are capitalised in the inventory.

ASSIGNMENTS


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Study unit 4

4 COST-VOLUME-PROFIT ANALYSIS


Study material: Horngren - Chapter 3Vigario - Chapter 7[Drury - Chapter 8][Garrison - Chapter 6]

LEARNING OUTCOMES

After completing this study unit, you should be able to: Apply the cost-volume-profit technique to make decisions on:

* Utilising capacity

* Profitability of products or product lines

* Turnover to realise a certain percentage of return on capital

* Maximum increase in fixed or variable costs allowed in order to realise a certain profit

* The percentage by which sales can drop before a loss occurs

* The most profitable sales mix

* Pricing

Determine, with the aid of cost-volume-profit analysis, the effect of a change in the assumptions (sensitivity analysis) on the profit, contribution margin, contribution ratio and return on capital.

Determine, in businesses selling more than one type of product, the effect of the sales mix on the breakeven point, margin of safety and margin of safety ratio.

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Study unit 4

1. INTRODUCTION H86, D165, V243

Also known as breakeven analysis or CVP analysis.

Ideal for solving problems dealing with selling price, profit maximisation, utilisation of capacity, etc.:

i. Determine selling price to realise a particular profit.

ii. Determine turnover units to realise a particular profit.

iii. Which products to focus on to realise the highest profit.

iv. Which selling price or units to realise a particular % return on capital.

v. Influence of a change in selling price or cost or volume on the profit of the business.

Breakeven point is the point at which no profit or loss can be made or the point at which the cost and the income of a certain volume are equal.

Very suitable for manufacturing enterprises, trade enterprises and service enterprises.

2. TERMINOLOGY H110, V245

Contribution margin: Also called marginal income. Calculated from sales less all variable costs; it is the amount available for settling fixed costs and realising a profit.

Contribution margin ratio (%): Contribution margin expressed in terms of sales. A valuable figure for assessing a product’s profitability.

Breakeven point: See paragraph 1; the point where contribution margin is equal to fixed costs.

Margin of safety: The amount or volume by which sales can drop before a loss occurs. These are the “safe” sales and are calculated by sales less sales at breakeven point, and can be expressed in units or rands.

Margin of safety ratio (%): The percentage of sales that produces a profit, i.e. the % by which sales can drop before a loss occurs.

Sales mix: The combination of products sold.

3. ASSUMPTIONS H91

SP/U is constant.

VC/U are constant and FC in total are constant.

Sales mix is constant.

Production and sales are synchronised, so there is no inventory difference.

Productivity and efficiency remain the same.

Costs can be divided into fixed and variable costs.

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Study unit 4

4. DETERMINING CVP H90, D166

i. Equation method

Sales = Variable costs + Fixed costs + Profit

However, the profit is zero and so the equation is:

Sales = Variable costs + Fixed costs

ii. Contribution margin method

Breakeven point = Fixed costs

(U) Contribution margin/UOR

Breakeven point = Fixed costs

(R) Contribution margin %

iii. Graph method

Not a very accurate method, but study H90 (64).

Traditional CVP graph H91, D168 Contribution margin graph D175

Profit-volume graph H94, V262, D176

5. MARGIN OF SAFETY V245, D173

Calculated from sales less breakeven sales, therefore the sales (U or rands) that produce a profit.

Margin of safety % is the margin of safety divided by sales (U or rands).

A service enterprise, i.e. a laboratory taking only one type of blood test, has asked for your help in providing the following missing information:

Income per blood test: R40

Variable cost per blood test: Fixed cost per month: Salaries R10 000

Materials R8,00 Rent R5 000

Commission R5,00

Overheads R2,00

800 blood tests were taken during July.

REQUIRED:

Using the above information, calculate the:

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Study unit 4

i) Contribution margin %

ii) Margin of safety %

i. Contribution margin % = 62.5% ii. Margin of safety % = 25%

6. TARGET PROFIT H94

If a particular profit is the objective, use the principle of CVP, but add profit into the formula.

So: Sales = Variable costs + Fixed costs + Profit

or Turnover = Fixed costs + Profit

(U) Contribution margin/U

Turnover = Fixed costs + Profit

(R) Contribution margin %

7. INCOME TAX AND CVP H94

No cost, only an appropriation of profit

Note which profit is targeted: before or after tax

Profit before tax = Profit after tax

l – tax rate

8. CHANGES IN ASSUMPTIONS H97, D180

Use sensitivity analysis

Sensitivity analysis: What-if technique which measures how the expected values will be affected by a change in the assumptions.

Illustration

9. OTHER FORMULAE

i. Net profit = Sales – VC - FC

or = Margin of safety x Contribution margin %

or = Sales x Contribution margin % - FC

ii. Sales = FC + Profit + VC

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Study unit 4

or = Contribution margin

Contribution margin %

or = Variable cost

Variable cost %

or = Margin of safety

Margin of safety %

iii. Fixed costs = Sales - VC - Profit

or = Sales x Contribution margin % - Profit

or = CVP x Contribution margin %

iv. Variable costs = Sales – Contribution margin

or = Sales – Fixed costs - Profit

or = (l – Contribution margin %) x Sales

v. Margin of safety = Sales – CVP

or = Profit ÷ Contribution margin %

vi. Margin of safety % =Sales – CVP

Sales

or = Net profit

Contribution margin

10. CRITICISM OF CVP

Not all the assumptions are realisable and each assumption is a constraint.

11. DECISION-MAKING MODELS AND UNCERTAINTY H95

Role of a decision-making model

Quantitative analysis:

i. Identify a selection criterion: Quantify an objective.

ii. Identify the set of alternatives to consider.

iii. Identify the set of events that may occur.

iv. Determine a possibility for each event.

v. Identify the set of possible outcomes.

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Study unit 4

12. SALES OF MORE THAN ONE TYPE OF PRODUCT H101, V262, D176

Aim for the combination that will increase the overall net profit of the firm.

Limiting factors such as DLH, materials, capacity, etc. may affect the product mix. By considering the contribution margin of each limiting factor, the most profitable combination can be selected.

The CVP principles as applied for single products remain exactly the same. Take note of the following important information:

i. CONTRIBUTION MARGIN per unit is replaced by AVERAGE contribution margin per unit.

ii. CONTRIBUTION MARGIN % is replaced by AVERAGE CONTRIBUTION MARGIN % and the formulae principles remain the same.

Average contribution margin: Calculated from the total contribution margin of the sales mix divided by the number of units in the sales mix.

Average contribution margin %: Calculated from the average contribution margin per unit divided by the average selling price per unit.

Test yourself by doing the following exercise and compare your answer with the suggested solution.

PQR Ltd produces three products P, Q and R with the following price and cost information:

PRODUCT P PRODUCT Q PRODUCT R

Selling price R12 R20 R25 R

Variable cost 6 8 10

The monthly fixed cost is R108 000.

An income tax rate of 45% is applicable.

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Study unit 4

REQUIRED:

Consider each of the following (a, b and c) situations individually and calculate the sales of each individual product as required in the sales mix:

a. With a sales mix in units of 4P: 2Q: 4R, determine the:- Breakeven point in units and rands.- Turnover (in units) to realise a net profit of R23 760 after tax per month.

b. With a sales mix in rands of 30% P: 40% Q: 30% R, determine the:- Breakeven point in units if an increase of R6 000 in fixed cost occurs.- Turnover (in units) to realise a net profit of R20 900 per month after tax

and the fixed cost increase of R6 000 is still applicable.

c. With a sales mix in units of 4P: 2Q: 4R consider the following situation: An additional sales commission of 10% is applicable to P and R for all sales higher than breakeven point. What number of sales units must be achieved to realise a profit of R37 280 before income tax?

a. *4 000P, 2 000Q, 4 000R or P = R48 000, Q = R40 000, = R10 000

*5 600P, 2 800Q, 5 600R

b. *5 000P, 4 000Q, 2 400R*6 667P, 5 333Q, 3 200R

c. *5 600P, 2 800Q, 5 600R

13. CVP ANALYSIS FOR DECISION MAKING H95

Sensitivity analysis and uncertainty

Contribution margin

14. COST PLANNING AND CVP H98

Profit-volume graph for different options

Contribution margin

Operating leverage

Influence of the time horizon

Do the self-assessment exercise 7.4 in Vigario and compare your answer with the suggested solution below.

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Study unit 4

Vigario 7.4

Income statement for 19x5 R’000 R’000 /U

Sales 9 million x R20 R180 000 R20

- VC: DM 10 000

Other mat. 26 000

DL *19 800

Overheads - 55 800 6.20

= Contribution margin R124 200 R13.80

- FC: DL 13 200

Overheads 80 000

Selling + admin. 27 000 120 200

= Net operating income R4 000

- Tax: 42% 1 680

= Net operating income after tax R2 320

* R33 000 000 x .6 % = VC Var. DL = R19 800 000

Fixed DL = R13 200 000

1. 19x6: Costs + 6% (In thousands) 2. 19x6: Cost and SP + 6%

FC

CVP = Contrib. marg./U

R127 412

CVP = 20 + 6% - 6.572

= R120 200 + 6%

R20 – (6.2+6%)

= R127 412

20 – 6.572/U

= R127 412

21.20 – 6.572

= 9 488.53 U x 1000 = 8 710.14 U x 1 000

= 9 488 530 U = 8 710 140 U

or R189 770 x 1000 of R184 655 x 1 000

= R189 770 600 = R184 655 000

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Study unit 4

Let SP =

3. Turnover = FC + VC + Profit

9 450 x = 127 412 + (6.572 x 9 450) + 4 000

x = 193 517.4

9 450

x = R20.478/U selling price

4. R20.478

20 = 102.39% is the SP in 19x6 versus 19x5

Sales U: 9 000 – 2.39% = 8 784.9U

Sales 8 784.9 x R20.478 = R179 897

- VC 8 784.9 x 6.572 57 734.36

= Contribution margin R122 163

- FC 127 412

= Net profit (loss) (R5 249) x 1000 = R5 249 000

Loss 2.9177 % of turnover

5. (i) Advertising costs + R15 000 000 Units 15%

(ii) Advertising costs + R20 000 000 Units 22.5%

(iii) Advertising costs + R25 000 000 Units 30%

Contribution margin = FC + Profit + Increase in advertising

In thousands (i) (ii) (iii)

FC R127 412 R127 412 R127 412

+ Profit 4 000 4 000 4 000

+ Advertising costs 15 000 20 000 25 000

= Contribution margin R146 412 R151 412 R156 412

÷ Contribution margin/U (20.478 – 6.572)

13.906 13.906 13.906

Units required 10 528.693 10 888.24 968 11 247.8 067

Increase in units:

8 784 + 15% + 22.5% + 30% 10 101.6 10 760.4 11 419.2

Margin of safety - - 171.39 U

Alternative (iii) seems promising

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Study unit 4

ASSIGNMENTS


53

Study unit 6

5 PROFIT PLANNING


Study material: Horngren - Chapter 6 Vigario - Chapter 8 (10)[Drury - Chapters 15, 16][Garrison Chapter 9]

LEARNING OUTCOMES


Do short-term planning for manufacturing and trade enterprises by means of a master budget.

Discuss and implement zero-based budgeting.

Implement kaizen budgeting in a business.

Implement activity-based budgeting in a business.

Evaluate the use of budgets for planning and control.

Indicate how responsibility accounting affects budgets.

Implement the just-in-time approach in budgeting and discuss its effect on budgeting.

Apply the learning curve to budgeting.

Discuss the effect of uncertainty by applying sensitivity analysis to budgets.

1. INTRODUCTION AND MOTIVATION H206, V285, D351

Short-term planning: The environment of today, physical, human and financial resources currently available.

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Study unit 5

Long-term planning: Strategic or corporate planning, e.g. profit maximisation, increasing market share.

Budgeting: Plan of action for future periods to coordinate activities within the business or quantify the objectives in an accounting plan to provide a basis for control and performance evaluation.

A quantitative expression of a plan of action for a specific future period.

Budgets reflect the firm’s policy.

Master budget: Coordination of all the financial projections in the organisation.

Purpose of budgeting: Planning and control

Planning Fixed budget

Control Flexible budget

Personal budgets

Strategic analysis Short-term planning Short-term budgets

2. STEPS IN THE PLANNING PROCESS D352

i) Identify objectives: Formulate mission, firm’s objectives/goals and division objectives/goals, e.g. what type of enterprise? Which market will be served? Profit objective? Growth rate?

ii) Identify potential strategies, e.g. in the development of a new market, new product, or both.

iii) Evaluate strategic options: Criteria, e.g. suitability, possibility and acceptability.

iv) Select the alternative possibilities of actions: Choose the activities with the greatest potential.

v) Implement the long-term plans: The annual budget is prepared from this.

vi) Monitor the actual results.

vii) Respond to deviations from the plan.

3. WHY BUDGETING? D355, H209, V286

The aims of budgeting become advantages if they are achieved.

Planning and strategy: Forces management to plan.

Coordination: Cooperation between divisions.

Communication: Various divisional heads must communicate and iron out problems in good time.

Motivation: Employees are motivated because they know what is expected of them.

Raises awareness of costs.

Control: Framework for comparing the budgeted and actual.

Performance evaluation: Evaluation on the basis of deviations prevented –benchmark.

4. BUDGET PERIOD D357, H211

Period for which budget applies.

Period determines the name, e.g. short-term is one year and long-term is five years.

Rolling budget.

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Study unit 6

5. ADMINISTRATION OF BUDGETS D357, H209

Budget committee: High-level representatives of various segments (divisions).

Budget officer coordinates the budgets of the different segments.

Accounting staff assist.

Budget manual.

Participatory budgets.

6. STEPS IN THE BUDGETING PROCESS D358

Communicate the details of the budgeting policy.

Determine limiting factors, e.g. sales.

Prepare the sales budget.

Initial preparation of budgets.

Negotiate with budget representatives.

Coordinate and revise budgets.

Final approval.

7. MASTER BUDGET D361, H211, V290

Diagram in Horngren on p. 213

7.1 Operating budget with budgeted income statement as the goal

i) Sales budget D364, H215, V291

Starting point or cornerstone if sales is the bottleneck.

Sales manager’s responsibility.

Prepare in units (U), prices, per product, sales territory, period.

ii) Production budget D364, H215, V291

Production manager’s responsibility to convert the sales plan into activities.

Indicate per product, in units, per period.

Production = Sales + Closing inventory (C/I) – Opening inventory (O/I)

iii) Closing inventory budget H218

What inventory must be held to support sales?

Which remains constant: inventory or production? Show units, costs and value of raw material, work-in-process and finished goods.

iv) Production cost budget

Raw material

a) Materials usage budget D364, H216

- Usage = Production units x Raw material needed per unit

- Indicate type, quantity, per department, time, cost.

- MRP, JIT, EOQ

b) Materials purchases budget D365, H216

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Study unit 5

- Which purchases should be provided for usage and kept in stock?

- Indicate type, quantity, price and time.

- Strive for an optimal balance between purchases, inventory and usage.

- Purchases = Usage + C/I – O/I

- Check quantity shortages, storage capacity, delivery time

Direct labour budget D365, H216, V292

- How many labourers? Which labourers? At what rates? When? Where necessary? As per the requirements of the production budget

- Standard times established from time and motion studies, estimates and past data.

Manufacturing overheads budget D366, H218

- Distinguish between fixed (non-controllable) and variable (controllable) overheads, each item separately.

- Distinguish between production and service departments.

- Establish link between cost and activity.

v) Cost of sales budget

How is cost of sales determined? (Production costs plus/less Work-in-process inventory difference plus/less Finished goods inventory difference).

The cost of sales budget can form part of the income statement or is composed of (ii) to (iv).

vi) Selling expenses budget D367, H219

Sales manager’s responsibility.

What sales expenses must be incurred to make the intended sales?

Distinguish between fixed and variable, each item separately.

vii) Administrative expenses budget H219

Chief administrative officer’s responsibility.

Cost of management, administration and venues.

Distinguish between fixed and variable.

All expenses except for production, sales, distribution and R&D expenses.

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Study unit 6

viii) Distribution cost budget

Based on sales, not production

Consists of storage and transport costs

Essential for the product to reach the consumer

Distribution manager’s responsibility

Distinguish between fixed and variable, may include advertising costs

ix) Budgeted income statement D368, H220

Summary of the above budgets

7.2 Financial budget with budgeted balance sheet as the goal D369, H229

i) Cash budget D6369, H229

Purpose is to ensure that sufficient cash is available and not to leave too much unproductive cash in the business

Short periods, e.g. monthly

Cash receipts:

- Sales (cash and credit), note discount, collection and bad debts. Rent, interest received, disposal of non-current assets, profit on alienation?

Cash payments:

- Materials purchases (note discount and payment terms), direct labour, operating expenses (note in arrears and prepaid), non-current assets, dividends, loans, etc.

What about depreciation and loss on alienation?

Closing balance: Opening balance + Receipts – Payments

If a minimum balance is required: financing will be needed

Note the comprehensive examples in each of the prescribed books.

ii) Budgeted cash flow statementIAS 7

Every change in a balance sheet item

a) - Cash generated

- Cash utilised

b) - Operations

- Investment activities

- Financing activities

Refer to Financial Accounting

iii) Budgeted balance sheet H230, D368

Each item is projected as per the business plan, as reflected in the above budgets.

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Study unit 5

8. ZERO-BASED BUDGETING (ZBB) D375, V305

Background: Does not use traditional annual budgeting as the basis, but is rather based on priorities.

Also known as priority-based budgeting.

How to implement ZBB V306, nine steps summarised briefly:

i. Describe each activity in a decision package.

ii. Evaluate the package and place it in order of preference.

iii. Allocate the resources.

(Note: Vigario on page 305 gives a detailed discussion on the implementation of ZBB, as well as the advantages and disadvantages.)

Advantages over the other budgets (See specifically Vigario, who identifies nine)

i. The process has to be reviewed each time and resources allocated according to need

ii. Requires a questioning attitude

iii. Focuses the attention on output in terms of value for money

iv. Leads to increased staff involvement and improved motivation

Disadvantage: Very time-consuming. (See Vigario’s ten disadvantages)

9. EVALUATING THE USE OF BUDGETS H209

Advantages: Refer to the aims, paragraph 3

Disadvantages:

i. Based on forecasts

ii. High administration costs

iii. Does not replace management

iv. Responsibilities may overlap and this may cause conflict

10. EFFECT OF A JUST-IN-TIME (JIT) APPROACH TO BUDGETING

Distinguish between JIT purchases and JIT production

JIT production occurs only in manufacturing enterprises

JIT purchases occur in manufacturing and trade enterprises

Principles of JIT purchases (5)

Principles of a JIT approach

i. Saves cost of keeping inventory

ii. Quality purchases

iii. Number of suppliers limited

iv. Long-term agreements with suppliers

v. Saves administrative expenses

Effect on short-term budgets

i. JIT production: Production production costs, inventory, cash, balance sheet, etc.

ii. JIT purchases: Materials purchases, purchase of inventory, trading stock, cash, balance sheet, etc.

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Study unit 6

JIT purchases and the economic order quantity.

11. RESPONSIBILITY ACCOUNTING AND BUDGETING H223

A system measuring the plans (budgets) and actions (actual results) of each responsibility centre.

Principle: A person is responsible for the department, segment or centre.

Responsibility centres:

i. Cost centre: Control over costs

ii. Income centre: Control over income

iii. Profit centre: Control over income and expenses

iv. Investment centre: Control over investment and return (profit)

Controllability: The effect (control) of a specific manager over expenses, income and other items.

12. KAIZEN BUDGETING H221

Kaizen is derived from the Japanese word kaizen meaning continuous improvement.

Continuous improvement results in continuous adjustments to the budget.

13. ACTIVITY-BASED BUDGETING D371, H217

Activity-based costing (ABC) leads to activity-based budgeting (ABB).

An activity-based budget is prepared on the basis of activity-based costs.

Steps for preparing an activity-based budget:

i. Determine the budgeted costs for each unit in each activity.

ii. Determine the demand for each activity based on production, new product development, etc.

iii. Determine the cost of realising each activity.

iv. Prepare the budget to realise the costs of each activity (rather than past information).

14. LEARNING CURVE APPLICABLE TO BUDGETS V300

Efficiency increases as a result of the learning curve.

Make provision in the direct labour budget for the increase in efficiency.

15. SENSITIVITY ANALYSIS AND CASH FLOW H233

This helps managers to anticipate outcomes and take steps to minimise the effect of expected cash flow reductions in the industry.

16. COMPUTER-BASED FINANCIAL PLANNING MODELS H220, D370

17. RESPONSIBILITY AND CONTROLLABILITY H223

Controllability

Controllable expenses

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Study unit 5

18. HUMAN ASPECTS OF BUDGETING H225

Budgetary slack

19. BUDGETING IN MULTINATIONAL COMPANIES H227

Do IM 15.9 and IM 15.11 in Drury as practice and compare your answer with the suggested solution below.

Solution IM 15.9a) (i) Sales budget in quantity and value

July August September TotalSales units 400 300 600 1 300Sales value (R) 100 000 75 000 150 000 325 000

(ii) Production budget in units

Sales 1300Closing stock 225

1525Opening stock (200)Good output required 1325Normal loss (1325 x 1/9) 147Production required 1472

(iii) Raw material usage budget

(iv) Raw material purchases budget

A B C Total(kgs) (kgs) (kgs)

Kgs used 4416 2944 5888Stock increase (20%) 200 80 120Purchases in kgs 4616 3024 6008Unit cost R3.50 R5.00 R4.50Purchases cost R16 156 R15 120 R27 036 R58 312

Production (units) 1472(kg)

Material A (at 3kg per unit) 4416Material B (at 2kg per unit) 2944Material C (at 4kg per unit) 5888

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(v) Labour requirements budget

Production in units 1472Unit labour hours 10Total hours 14 720Cost per hour R8.00Total cost R117 760

b) The principal budget factor (also known as the limiting factor) is the factor that constrains or limits the activities of the organization during a budget period. During the budget process, the principal budget factor is the foundation upon which all of the budgets must be based and which constrains activity from being expanded. For example, if machine hours are the principal budget factor, the production budget, sales budget and all of the remaining budgets will be restricted to the maximum output from the available machine hours. Prior to the preparation of the budgets it is necessary for management to identify the principal budget factor, since this factor will determine the point at which the annual budgeting process should begin.

Solution IM 15.11

a) Cash budgetWeek

1 2 3 4 5 6(R000) (R000) (R000) (R000) (R000

)(R000)

Cash receipts from sales* 80 80 75 70 70 80Cash payments: Materials** 27 46 12 - - - Direct labour and variable overhead***

41 41 16 16 16 16

Fixed overhead**** 16 16 12 12 12 1284 103 40 28 28 28

Weekly surplus / (deficit) (4) (23) 35 42 42 52Opening cash balance (39) (43) (66) (31) 11 53Closing cash balance (43) (66) (31) 11 53 105

Week*Cash Receipts

1 2 3 4 5 6(R000) (R000) (R000) (R000) (R000) (R000)

Opening debtors 80 40Week 1 sales 40 402 35 353 35 354 35 35

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Study unit 5

5 __ __ __ __ __ 4580 80 75 70 70 80

The above sales can be achieved because opening stocks of finished goods (2800 units) + production in weeks 1 and 2 (2400 units) are greater than sales in weeks 1–5 (3800 units) by 1400 units.

**Purchase of MaterialsWeek 1 Week 2

(R) (R)Closing stock 40 000 10 000+ Production (1200xR35) 42 000 42 000- Opening stock (36 000) (40 000)= Purchases 46 000 12 000 (paid for 1 week later)

*** Direct labour and variable overhead; fixed overhead

(R)Weeks 1 and 2 = 1200 x R30 = 36 000

+ 5 000 ( overtime premium)41 000

Weeks 3-6 = 800 x R20 = 16 000**** Weeks 1 and 2 = 800 x R25 = 20 000

- 4 000 ( depreciation)16 000

Weeks 3-6 = R16 000 - R4 000 = 12 000

b) The matters which should be drawn to the attention of the management are:(i) The overdraft limit will be exceeded in week 2, and arrangements should be made to

increase this limit.(ii) Excess funds will be available from weeks 4 to 6 and plans should be made to invest

these funds on a short-term basis.(iii) Funds will be required as soon as production recommences in order to re-establish

stocks of raw materials and finished goods.

ASSIGNMENTS

Consult work scheme.

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Study unit 6

6 FLEXIBLE BUDGETS


Study material : Horngren - Chapters 7 and 8 Vigario - Chapter 8 (10)[Drury - Chapter 17, 18][Garrison - Chapter 11]

LEARNING OUTCOMES


Distinguish between a flexible and a fixed (static) budget.

Prepare a variable budget using three methods:

* Formula method

* Table method (multi-activity level)

* Graph method

Compile a performance report in which an analysis of variance is given at levels 0, 1, 2 and 3.

Calculate and interpret budget variances and divide them into various causes, i.e. spending and efficiency causes, and make recommendations for corrective action.

Analyse and interpret sales volume variances.

Critically evaluate the use of flexible budgets in a business.

Discuss benchmarking and re-engineering, apply benchmarking to motivate performance measurement and make recommendations for improving performance.

Discuss the use of activity-based costing in flexible budgets.

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Study unit 6

1. INTRODUCTION D417, H251, V303

Distinguish between monitoring and control D451, V303, H251

Control is the process of ensuring that a business’s activities are in line with the planning and objectives. It requires planning, comparison and activity. It takes place at the end of an activity, i.e. periodically.

Monitoring takes place continually, e.g. materials inventory control.

Distinguish between fixed and flexible budgets H252

Fixed budget: For one specific level of activity, therefore for planning.

Flexible budget: For more than one level of activity, therefore for control.

Static (fixed) budget: Identify sales volume variance.

Static budget variance: Level 1 and divided into:

i. Flexible budget variance and

ii. Sales volume variance, distinguished at level 2

Uses of flexible budgets:

1. To estimate annual manufacturing overheads.

2. To evaluate performance of departmental managers.

3. Adjust automatically to actual activity’s budgeted costs; therefore effective for control.

Proviso: It must be possible to separate costs into fixed and variable.

2. METHODS FOR PREPARING A FLEXIBLE BUDGET H254

2.1 Formula method: allowance: based on output

Before period begins:

i. Budget for usual activity level.

ii. Separate into fixed and variable.

iii. Determine variable rate per activity unit and construct the formula.

End of the period:

i. Determine actual activity.

ii. Budget for actual activity.

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Study unit 6

i. Information given: 5 000U

ii.

Fixed Variable /U

Separate:

IM

- R7 000 1.4

IL - R8 000 1.6

Electr. 2 500 R5 000 1.

Maint. 3 000 R9 000 1.8

Rent 11 250 -

Depr. 6 250 -

23 000 29 000 ÷ 5 000U

= R5.8/U

÷ 6 250/mh

= R4.64/mh

y = 23 000 + 5.8X where X = Units

Budget for 6 000U : 23 000 + 5.8 (6 000)

= R57 800

End of the period: (i) 7 200U

(ii) 41 760

y = 23 000 + 5.8 (7 200)

= R64 760

2.2 Table method (multi-activity level method)

Budget Interpolate: 7 200 =

7 000 + 20% of difference

7 200U 5 000U 6 000U 7 000U 8 000U

IM (1.4) R10 080 R7 000 R8 400 R9 800 11 200 9 800 + 20% x 1 400) = 10 080

IL (1.6) 11 520 8 000 9 600 11 200 12 800 11 200 + ( x 1 600) = 11 520

Electr. (2 500 + 1) 9 700 7 500 8 500 9 500 10 500 9 500 + ( x 1 000) = 9 700

Maint. (3 000 + 1.8) 15 960 12 000 13 800 15 600 17 400 15 600 ( x 1 800) = 15 960

Rent (11 250) 11 250 11 250 11 250 11 250 11 250 11 250

Depr. (6 250) 6 250 6 250 6 250 6 250 6 250 6 250

R64 760 R52 000 R57 800 R63 600 R69 400 R64 760

Y = 23 000 + 5.8 (7 000) = R63 600

Test Y = 23 000 + 5.8 (8 000) = R69 400

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2.3 Graph method

On a graph draw the flexible budget line by plotting the costs of different activities.

Vertical: cost; horizontal: activity

3. STEPS IN DEVELOPING A FLEXIBLE BUDGET H254

i) Determine the budgeted selling prices, budgeted variable costs per unit and the budgeted fixed costs. Determine the income of the actual activities.

ii) Determine the income as per the flexible budget. Determine the actual activity of the cost driver.

iii) Prepare the flexible budget for costs based on the actual activity.

These steps lead to a level 2 variance analysis.

4. ANALYSES: LEVELS 0 TO 3 H254-257

(Work through the detailed example in Horngren p. 254+, which illustrates the analysis of levels 0-2.)

Level 0: Compare actual operating income with budgeted operating income. The difference is the static budget variance H252.

Level 1: Compare the actual results (units sold, sales income, variable costs and fixed costs) with the static budget in contribution margin format. The difference is the static budget variance in detail. (Analysis of level 1 is simply more detailed than level 0) H253.

Level 2: The static budget variance calculated at level 1 is divided into a flexible budget variance and a sales volume variance as follows H254:

i. Flexible budget variance = Difference between the actual results and the flexible budget (budgeted for the actual). Take careful note of everything, i.e. units sold, sales income, variable costs, contribution margin, fixed costs and operating income.

ii. Sales volume variance = Difference between the flexible budget and the static budget. Take careful note of everything in detail: the income statement in contribution margin format, therefore sales units, sales income, variable costs and fixed costs.

Level 3: Divide the flexible budget variance into a price variance and an efficiency variance H257 as follows:

i. Price (spending/rate) variance = Difference between the actual price and budgeted price x Actual input quantity.

ii. Efficiency variance = Difference between the actual quantity (input) and the budgeted (standard) quantity allowed for the actual output x Budgeted price.

[Note: See the illustration of analysis level 3 in the next paragraph and H262. There is also a detailed example of analysis levels 0 to 3 in H272.]

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Study unit 6

5. COST VARIANCES D457, H250

A cost variance occurs if the actual and allowed (budgeted) costs differ.

Budget variance: Actual less budgeted actual output (from level 2)

Spending variance + Efficiency variance (from level 3)

Spending variance: Budgeted actual input less actual input

Efficiency variance: Budgeted actual input less budget for standard input (actual output)

EXAMPLE: Flexible budgeting using the table method with a performance report

Control Ltd provides the following information about a product being produced.

Budgeted information:

5 000 units or 6 250 machine hours are regarded as the normal monthly volume. The cost for this volume is:

FIXED COSTS BUDGETED AMOUNT FOR NORMAL VOLUME

Indirect materials - R7 000

Indirect labour - 8 000

Electricity 2 500 7 500

Maintenance 3 000 12 000

Rent 11 250 11 250

Depreciation 6 250 6 250

Intended (budgeted) production for October: 6 000 units.

Actual activity for October: 7 200 units and 10 000 machine hours.

ACTUAL COSTS FOR OCTOBER

Indirect materials R10 400

Indirect labour 11 450

Electricity 9 900

Maintenance 16 000

Rent 11 800

Depreciation 6 250

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Study unit 6

REQUIRED:

1. Prepare a budget for October.

2. Compile a performance report for October in which you analyse as many variances as possible for each cost item.

Solution

1. Budget for October

BUDGET

OCTOBER

6 000U RATES/U RATE PER MACHINE

HOURS

Indirect materials R8 400 R1.4 R1.12

Indirect labour 9 600 1.6 1.28

Electricity 8 500 1 + R2 500 .8 + R2 500

Maintenance 13 800 1.8 + R3 000 1.44 + R3 000

Rent 11 250 11 250 11 250

Depreciation 6 250 6 250 6 250

R57 800

2. Performance report

7 200 x 1.25

Budgeted Budget Budgeted Budgeted Effic.

/mh 7 200U Actual variance 10 000mh Spend. 9 000mh

1.12 IM R10 080 R10 400 (R320) R11 200 R800+ R10 080 (R1 120)

1.28 IL 11 520 11 450 70+ 12 800 1 350+ 11 520 (1 280

.80 Elect. 9 700 9 900 (200) 10 500 600+ 9 700 (800)

1.44 Maint. 15 960 16 000 (40) 17 400 1 400+ 15 960 (1 440)

Rent 11 250 11 800 (550) 11 250 550(-) 11 250 -

Depr. 6 250 6 250 - 6 250 - 6 250 -

R64 760 R65 800 (R1 040) R69 400 R3 600+ R64 760 (R4 640)

Distinguish between efficiency and effectiveness H267.

6. COST CLASSIFICATION D463

Controllability depends on two factors

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Study unit 6

i. Level of management authorisation

ii. Duration (activity) allowed

For the enterprise as a whole, all costs are controllable.

Controllable costs: Costs which a person, e.g. production manager, can control, such as indirect labour, indirect materials, electricity, etc.

Non-controllable costs: Costs which a person cannot control, e.g. depreciation.

The question is: should all costs be included in a flexible budget? If the purpose of the flexible budget is only cost control, non-controllable costs can be left out, but if the purpose is also for product costs, all costs should be included in the flexible budget.

Traceable costs: Costs of a service department which can be allocated to a production department.

7. CAUSES OF VARIANCES H266

To eliminate problems, the causes should be established.

Spending variance: Mainly as a result of price or rate.

Efficiency variance: As a result of more or less time taken and only for controllable costs.

8. ADVANTAGES OF FLEXIBLE BUDGETING H266

Provides a dynamic foundation for assessment.

Adaptable to actual activity.

The causes of variances are highlighted.

Useful in cost estimates.

9. ACTIVITY-BASED COST (ABC) CALCULATIONS AND FLEXIBLE BUDGETS H266

ABC works well together with flexible budgets.

Difference between traditional cost systems and ABC systems is the QUANTITY.

ABC: For each activity centre there is a separate flexible budget.

Example: G493 (481), H269

Advantage: A number of flexible budgets ensures accuracy.

10. PERFORMANCE MEASUREMENT: BENCHMARKING AND RE-ENGINEERING H266

Benchmarking: Key activities are compared with the world’s best. The purpose is to determine how existing activities can be improved and to ensure that they are implemented.

Business process re-engineering (BPR): The business processes are examined to make them more streamlined and eliminate activities or reduce those that do not add value.

Purpose of the re-engineering: To improve key processes by focusing on simplifying, reducing costs and improving quality and customer satisfaction, e.g. changing from a traditional layout to a just-in-time system, for instance.

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Do IM 17.1 in Drury as practice and compare your answer with the suggested solution below.

Solution IM 17.1

a) i) Flexed budget for month 6

Original budget Flexed budget Actual cost Total variance

Units of J 20 000 18 500 18 500

(R) (R) (R) (R)

Direct materials 480 000 444 000 442 650 1 350 F

Direct labour 140 000 129 500 129 940 440 A

Variable overhead 60 000 55 500 58 800 3 300 A

Fixed overhead 100 000 100 000 104 000 4 000 A

780 000 729 000 735 390 6 390 A

Material price variance = (standard price - actual price) x actual quantity= (AQ x SP) - (AQ x AP)= (113 500 x R4) - R442 650 actual cost = R11 350F

Material usage variance = (standard quantity - actual quantity) x standard price= ((18 500 x 6) - 113 500) x R4 = R10 000A

Wage rate variance = (standard rate - actual rate) x actual hours= (SR x AH) - (AR x AH)= (R7 x 17 800) - R129 940 = R5340A

Labour efficiency variance = (standard hours - actual hours) x standard rate= (18 500 x 1 hr - 17 800) x R7 = R4900F

ASSIGNMENTS

Consult work scheme.

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Study unit 7

7 STANDARD COSTING


Study material: Horngren - Chapters 7, 8 and 14 Vigario - Chapter 9 [Drury - Chapters 17, 18][Garrison - Chapters 10 and 11]

LEARNING OUTCOMES


Discuss standard costing under the following headings:

* Purpose

* Distinction between standard costing and budgeting

* Price and quantity standards

* Advantages and disadvantages of using standard costing for budgetary control

Do a detailed analysis of the static budget variance, i.e. explain why the budgeted profit and actual profit differ by pointing out the causes relating to:

a) Flexible budget variance

i) Spending variance

ii) Efficiency variance, divided into mix and yield variances for materials, labour and overheads

b) Sales volume variance

i) Sales mix variance

ii) Sales volume variance, divided into market size variance and market share variance

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Calculate the standard costing variances for:

a) Materials regarding materials price and materials quantity, as well as the division of the price variance into pure price variance and pure efficiency variance.

b) Labour in terms of labour rate variance and labour efficiency variance.

c) Overheads where the normal volume is based on inputs:

i) Spending

ii) Efficiency

iii) Volume, divided into efficiency variance and pure volume variance

d) Overheads where the normal volume is based on outputs:

i) Budgeted

ii) Volume

e) Overheads if the overheads rate is combined:

i) Spending

ii) Efficiency

iii) Volume

Discuss the causes of standard cost variances as analysed under learning outcomes 2 and 3, and make recommendations on eliminating variances.

Do a graphical analysis of cost variances for materials, labour and overheads.

Reconstruct a journal using standard costing, open accounts for each variance and show the inventory accounts where:

i) all inventory accounts are at standard cost

ii) not all inventory accounts are at standard cost

Critically evaluate the use of standard costing.

Discuss productivity measurement and calculate partial and total factor productivity.

1. INTRODUCTION D451, H286, H250

Responsibility reporting requires that costs and income information be collected and variances pointed out to responsible people.

Standard costs: Predetermined or target costs that will be incurred under efficient circumstances (benchmark).

Standard costing is the cornerstone of budgets, i.e. the planned cost per unit, and a budget is the cost plan for a certain period.

Benchmark: Point from which comparisons can be made. An ongoing process of measuring products, services and activities at the best performance levels.

Performance gap: Difference between actual and benchmark.

Variance: Difference between actual and budgeted (allowed).

Purposes of standard costing

i) Preparing budgets and performance evaluation

ii) Exercising control

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iii) Forecasts

iv) Inventory valuation

v) Prepare a challenging goal and motivate individuals

vi) Pricing

Costs consist of price and quantity

(Standard cost = Price standard x Quantity standard)

Mechanised environment?

Added value costs and non-added-value costs

2. COST STANDARDS

2.1 Price standards D420

Materials price standard (MPS): The price for a specific material under the most favourable and economic circumstances. Freight + Quantity discount are taken into account D729

Labour price standard (LPS): The price that should be paid for an efficient labourer D729

2.2 Quantity standards D730

Materials quantity standard (MQS): The quantity of materials needed to manufacture one unit, determined as per essential input-output ratios.

Labour quantity standard (LQS): Number of hours needed by an efficient labourer to manufacture one unit of product, determined as per essential input-output ratios.

3. TYPES OF STANDARDS D423, V328

Basic cost standard: Remains constant over a longer period. Provides a basis for quantities but not suitable for price standards.

Theoretical or ideal standard: Includes minimum costs that are recoverable under the most efficient circumstances. No provision for normal or abnormal spoilage or lost hours.

Currently attainable standard: Can be achieved under efficient circumstances. Provides for normal spoilage or lost time; meaningful evaluation of performance.

4. REVISION OF STANDARDS

At least annually, price standards can be revised more often.

5. HOW A STANDARD COSTING SYSTEM WORKS D423, V328

Especially suitable for enterprises with a series of repetitive processes.

Can also be used in non-manufacturing enterprises that have repetitive activities.

Proviso: It must be possible to set price and quantity standards.

Variances must be allocated to responsibility centres.

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6. STANDARD COST CARD D426

Direct materials : 2 kg @ R5 = R10

Direct labour : 3 hours @ R10 = R30

Overheads: Variable : 4 mh @ R3 = R12

Fixed : 4 mh @ R5 = R20

R72

7. COST VARIANCES D425

Favourable variance = Actual costs < allowed costs

Unfavourable variance = Actual costs > allowed costs

Controllable variance: Within a person’s control, usually variable cost variances.

Non-controllable variance: Not normally within a person’s control or responsibility and relates more to fixed costs.

7.1 Materials cost variances H259, D425, V342 Materials cost variance = Price variance and quantity variance V346

Reasons for: Price and quantity variances

Mix variances: Discussed later in detail

MPV = (SP - AP) AQ bought, purchasing department D429, V345

MQV = (SQ - AQ) SP, production department D428, V347

7.2 Labour cost variances H260, D430, V350 Labour cost variance = Rate variance and efficiency variance V350

Reasons for: Rate and efficiency variances V355

LCV = (SC - AC) AQ worked or actual time used D430, V351

LEV = (SR - AH) SR D430

7.3 Overheads variances D432, H289, V356 More difficult than the previous because:

Overheads are fixed and variable.

Overheads are indirect and occur as a whole. An allocation basis must be found to match costs and product.

Predetermined rate = Budgeted overheads Normal volume

Where the normal volume input can be, for example, hours or costs in terms of output, e.g. units produced

Allocated (allowed) overheads = Rate x Actual output or its equivalent, i.e. standard input volume (SIV) depending on whether normal volume is input or output

Overallocated or underallocated overheads = Total of all the overhead variances.

Volumes

i) Normal volume (NV) = Budgeted capacity aimed at, e.g. input or output denominator activity

ii) Actual output volume (AOV) = Units produced

iii) Actual input volume (AIV) = Actual hours worked or any input volume, e.g. direct labour costs actually incurred

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iv) Standard input volume (SIV) = Input allowed for actual production

7.3.1 Overheads variances (normal volume = input, 3 plan)

Overheads spending variance - (see flexible budgeting) D432, H291, V356, 359

Calculated from budgeted overheads for AIV less actual overheads.

Fixed overheads = Budgeted normal volume less actual fixed overheads

Variable overheads = Budgeted AIV less actual variable overheads

= SVOR x AIV – Actual VC

Overheads efficiency variance H290, D433, V358

Calculated from the difference between budgeted variable overheads for AIV less budgeted variable overheads for SIV

= (SIV - AIV) standard variable overhead rate

Overheads volume variance H295, V360

Calculated from difference between allocated fixed overheads and budgeted fixed overheads

= (SIV – NV) standard fixed overhead rate

This variance can also be divided into:

i. Volume efficiency variance = (SIV - AIV) SFOR

ii. Volume capacity variance = (AIV - NV) SFOR

7.3.2 Overheads variances (normal volume = output, 2 plan)

Overheads budget variance calculated from the difference between budgeted AOV and actual overheads.

Fixed overheads = Budgeted normal volume less actual fixed overheads

= Same as spending variance

Variable overheads = Budgeted AOV less actual variable overheads

= SVOR x AOV – Actual VC

Overheads volume variance calculated from the difference between allocated fixed overheads and budgeted fixed overheads

= (AOV - NV) standard fixed overhead rate

Note that budget variance = spending variance plus efficiency variance

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Do 8.29 and 8.32 in Horngren as practice and compare your answers with the suggested solutions below.

H + F + D 8.29

Actual FC R350 208 Budgeted AOV: FC R348 096 (NV)

VC 76 608 VC 76 800

Allocated FC R376 200 NV = 888 U or 1 776 mh

VC 76 800 AIV = 1 824 mh

Budgeted VC (NV) R71 040

a) 888 x 2 mh = 1 776 mh

b) SFOR =

Budgeted FCNV

=

R348 0961 776

= R196/mh

c) SVOR =

R 71 0401 776 mh

= R40/mh

d) SIV = Input allowed for actual production

= R76 800 ÷ 40/mh

= 1 920 mh

e) 1 920 mh ÷ 2 mh/U

= 960 units

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f) Actual mh/U: = AIV ÷ Actual units

= 1 824 mh ÷ 960

= 1.9 mh/U

H + F + D 8.32 (8.32) (Case A)

All figures with * were given

CASE A:

Actual cost

Actual input

× Budgeted rate

Flexible budget:

Budgeted input

for actual output

× Budgeted rate

Allocated:

Budgeted input for actual output

× Budgeted rate

Case A:

Variable manufac-turing overheads R15 000*

(1,325 × R15)

R19 875

(1,250* × R15)

R18 750*

(1,250* × R15)

R18 750*

Therefore spending variance = 4 875

Efficiency variance = 1 125

There will never be a variance between the flexible budget and the allocated.

Fixed overheads

R26 500* R25 000*

R25 000*

(1,250 × R20a)

R25 000*

Spending variance = 1 500

There will never be a variance between actual input at budgeted rate and budgeted input.

Production volume variance = 25 000 – 25 000

= 0

This is the difference between the budgeted input and allocated.

Total budgeted overheads = 18 750 + 25 000= 43 750

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CASE B:

Variable overheads R13 813

(1,625 R8,50*)

R13 813

(1,625* R8,50*)

R13 813

(1,625* R8,50*)

R13 813

Spending variance = 13 813 – 13 813 = 0

Efficiency variance = 13 813 – 13 813 = 0

There will never be a variance between flexible budget and allocated.

Fixed overheads

R16 750 R17 500b R17 500b(1,625* R10)

R16 250

Spending variance = 16 750 – 17 500 = 750 F

There will never be a variance between actual input at budgeted rate and flexible budget.

Production volume variance = 17 500 – 16 250 = 1 250 U

Denominator = Budgeted fixed overheads ÷ Budgeted fixed overheads allocated rate

= R17,500 ÷ R10 = 1,750 hours

CASE C:

Variable overheads

R15 500

(2,925 R5,00*)

R14 625

(2,875 R5,00*)

R14 375c

(2,875 R5,00*)

R14 375c

Spending variance = 15 500 – 14 625 = 725 U

Efficiency variance = 14 625 – 14 375 = 250 F

There will never be a variance between flexible budget and allocated.

Fixed overheads R30 000* R27 500* R27 500* R28 750d

Spending variance = 30 000 – 27 500 = 2 500 U

There will never be a variance between actual input at budgeted rate and flexible budget.

Production volume variance = 1 250 F

Total budgeted overheads = R14,375 + R27,500 = R41,875

aBudgeted fixed overheads allocated rate = Budgeted fixed overheads ÷ Budgeted activity

= R25 000 ÷ 1,250 = R20

b = +

R31 313* = BFMOH + (1,625 R8,50)

BFMOH = R17 500

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Budgeted hours allowed for actual output must be derived from the output volume variance or, since the fixed overheads allocated rate is R27 500 ÷ 2 750 = R10, and the allocated amount is R28 750, the budgeted hours of output needed are 2 875 (R28 750 R10).

d2 875 (R27 500* ÷ 2 750*) = R28 750

8. VARIANCES DETERMINED IN GRAPHS

Price and quantity variances Overheads budget variance

(materials and labour)

Actual

Budgeted Budget var. Flex. budget line

AC LCV

SR

R

LEV

Rate/

Price

SH AH AOV or SIV

Time/Quantity Volume

Overheads volume variance

Alloc. FC

BVV (+)

Cost Budgeted FC

BVV(-)

NV (volume)

9. ACCOUNTING ENTRIES D452, H263

Debit unfavourable variances.

Credit favourable variances

Inventory accounts must be kept at standard costs in the general ledger (there are variations in method).

Transactions:

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i. Materials purchases:

Materials inventory control (AQ x SP) Dr

MPV Dr

Creditors (AQ x AP) Cr

ii. Materials usage:

WIPC (SQ x SP) Dr

MQV Dr

Materials inventory control (AQ x SP) Cr

iii. Direct labour costs incurred:

W/SR (AH x AC) Dr

Credit Wages (AH x AC) Cr

iv. Direct labour costs imputed:

WIPC (SH x SR) Dr

LCV Dr

LEV Dr

W/SR (AH x AC) Cr

v. Overheads incurred:

Overheads control VC Dr

FC Dr

Creditors/Bank Cr

vi. Overheads allocated:

WIPC (AOV or SIV x SOH) Dr

Unallocated overheads Dr

Overheads control Cr

vii. Overheads variances (e.g. all unfavourable)

BOHV - FC Dr

- VC Dr

BEV Dr

BVV Dr

Over/underallocated overheads Cr

viii. Finished goods:

FGC (Finished x S/Ke/U) Dr

WIPC Cr

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ix. a) Cost of sales:

COS (Sales x S/Ke/U) Dr

FGC Cr

b) Selling price: Debtors Dr

Sales (Sales x Selling price/U) Cr

10. WHEN TO INVESTIGATE VARIANCES H266 Rules that apply, e.g. a certain percentage variance on standard costs.

Statistical models that don’t consider the costs and benefits of the investigation.

Statistical decision-making models that do consider the costs and benefits of the investigation.

Management by exception (MBE).

11. CAUSES OF COST VARIANCES H266, D461 Measurement errors, e.g. in the distinction between direct labour and indirect labour.

Standards that are not up to date: Prices and rates change easily or labourers may take less time to complete production as a result of the learning curve.

Activities beyond control: Inefficient activities as a result of faulty machinery or human error.

Uncontrollable factors: The same instruction given to the same labourer under the same conditions at a different time is performed differently – uncontrollable factors.

12. WHAT HAPPENS TO BALANCES IN VARIANCE ACCOUNTS? D456 Written off at cost of sales

Adjustment to profit

Pro rata allocation and adjustment to WIPC, FGC and COS

13. CRITICAL EVALUATION OF USE OF STANDARD COSTING Advantages:

Management by exception (MBE)

Cash and inventory planning

Establishes efficiency

Easier to determine income

Supports responsibility accounting

Assists in planning, control and performance measurement

Disadvantages:

Which variances must receive attention?

Emphasis is on variances, but what about trends?

Implementation requires high administrative expenses

MBE principle has a negative effect on supervisor morale

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14. VARIANCE ANALYSIS IN A MECHANISED MANUFACTURING ENVIRONMENT

Standard costing and mechanisation: Direct labour is more fixed and less valuable. Objective of higher quality.

New performance measures: JIT, flexible manufacturing systems (FMS) lead to quality control, materials control, inventory control, machine performance and delivery performance.

Quality control measures: Guarantee claims, customer complaints, defective units.

Materials control measures: Emphasis on high quality, waste control, shorter waiting periods.

Inventory control measures: Inventory turnover higher because there is less inventory.

Machine performance measures: Use as a percentage of available capacity to control bottlenecks.

Delivery performance measures: Speed just as important as quality. Percentage of on-time delivery (strive for 100%). Depends on factors such as delivery cycle time and throughput time.

Note financial and non-financial performance measures H305.

15. PLANNING VARIANCES D429

Purchases planning variance

Purchases efficiency variance

16. PROFIT RECONCILIATION V328-341

Production > sales

Production < sales

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17. VARIANCE ANALYSIS – MORE THAN JUST ONE TYPE OF PRODUCT OR INPUT MIX H542-547, D457-459, V348

17.1 Introduction and mix variances: Analysis levels 2, 3 and 4 H262, 547 (233, 513)

Note the diagram H547 (513)

Level 1: Static budget variance

Level 2: Flexible budget variance Sales volume variance

Level 3: Spending variance Effic. var. Sales mix var. Sales quantity var.

Mix Yield

variance var. Market size Market share

Level 4: var. var.

So far we have dealt with production cost variances.

Sales of more than one type of product: A variance in the sales mix also can also cause a variance in the yield.

Analyse sales volume variance in: Sales mix variance and sales yield variance.

The latter is analysed in market size and market share variances.

17.2 Sales of more than one type of product

Sales volume variance (as analysed at level 2) is calculated from H543, D459-461:

The difference between the actual and budgeted quantity of units sold multiplied by the budgeted selling price per unit.

So: = (Actual sales quantity – Budgeted sales quantity) x Budgeted selling price per unit, but if VC is known, use contribution margin instead of SP.

If the actual variable costs per unit differ from the budgeted variable costs per unit, the budgeted contribution margin per unit can be used in the formula instead of the budgeted selling price.

Remember: Actual sales quantity (U) = Flexible budget quantity (U)

and

Budgeted sales quantity (U) = Static budget quantity (U)

The sales volume variance can be analysed in a sales quantity variance (yield variance) and the sales mix variance, which are calculated as follows:

i. Sales quantity variance (yield variance) D461, H545, V295: Calculated from the difference between the total units actually sold and the total budgeted units sold multiplied by the sales mix % multiplied by the budgeted selling price. The formula looks like this:

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= (Actual total U sold – Budgeted total U sold) Budgeted mix % x Budgeted SP/U

ii. Sales mix variance H543, D 459 – 460, V362:

Calculated from the difference between the actual mix % and the budgeted mix % multiplied by the actual units sold in total multiplied by the budgeted selling price per unit. The formula looks like this:

= (AM% - BM%) A total sales U x Budgeted SP/U

Note the signs of whether the variances are favourable or unfavourable. Remember, you are working with sales and not expenses. If the actual mix % > budgeted mix %, then the variance is favourable. The reverse is also true.

The sales quantity variance in (i) above can be further divided into a market size and market share variance, which indicate how the organisation has performed in the industry. These variances are calculated like this:

a) Market size variance H546

Calculated from the difference between the actual market size in units and the budgeted market size in units multiplied by the budgeted market share multiplied by the budgeted average selling price per unit. The formula looks like this:

=(A market size U – Budgeted market size U) x Budgeted market share x Budgeted average SP/U

(A market size > Budgeted market size = Favourable variance. The reverse is also true.)

b) Market share variance H545

Calculated from the difference between the actual market share and the budgeted market share multiplied by the actual market size in units multiplied by the budgeted average selling price per unit. The formula looks like this:

= (A market share – Budgeted market share) x A market size U x Budgeted ave. SP/U

(A market share > Budgeted market share = Favourable variance. The reverse is also true.)

- Horngren p. 547 contains a detailed example.

Do 14.34 and 14.35 in Horngren as practice and compare your answers with the suggested solutions below.

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H + F + D 14.34

1. Sales volume variance: (AU - BU)Contribution margin/U

CC = (57 600 - 45 000) R2 = R25 200(+)

OR = (18 000 - 25 000) 2.30 = R16 100(-)

C = ( 9 600 - 10 000) 2.60 = R 1 040(-)

WC = (13 200 - 5 000) 3 = R24 600(+)

MN = (21 600 - 15 000) 3.10 = R20 460(+)

R53 120(+)

2. Sales yield variance (TAU - TBU) x BM% x Contribution margin/U

CC = (120 000 - 100 000) x .45 x 2 = R18 000(+)

OR = (120 000 - 100 000) x .25 x 2.3 = R11 500(+)

C = (120 000 - 100 000) x .10 x 2.6 = R5 200(+)

WC = (120 000 - 100 000) x .05 x 3 = R3 000(+)

MN = (120 000 - 100 000) x .15 x 3.10 = R9 300(+)

R47 000(+)

3. Sales mix variance: (AM% - BM%) x TAU x Contribution margin/U

576

CC = (1 200 - .45) x 120 000 x 2 = R 7 200(+)

18

OR = ( 120 - .25) x 120 000 x 2.3 = (R27 600)

96

C = (1 200 - .10) x 120 000 x 2.6 = (R 6 240)

132

WC = (1 200 - .05) x 120 000 x 3 = R 21 600(+)

216

MN = (1 200 - .15) x 120 000 x 3.10 = R 11 160(+)

R 6 120(+)

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4. Actual sales were more than budgeted sales, which causes a favourable volume variance. More of the more profitable products (those with the highest individual contribution margin) were sold, namely WC and MN. This further improves the situation. The budgeted average contribution margin per unit is R2,35 [(2 x 45 000 + 2.3 x 25 000 + 2.6 x 10 000 + 3 x 5 000 + 3.l0 x 15 000) ÷ 100 000U]

∴ The sales of more profitable products caused a volume variance of R53 120; this is better than (20 000U x R2,35) = R47 000

H +F + D 14.35

Market size variance = (Actual market size – Budgeted market size) x BM/share x Budgeted ave.e contribution margin

= (960 000 - 1 000 000) x 10% x *2.35

= R9 400(-)

*Ave.e contribution margin/U: [(2 x 45 000) + (2.30 x 25 000) + (2.6 x 10 000) + (3 x 5 000)

+ (3.10 x 15 000)] ÷ 100 000U

= 2.35/U

Market share variance = (Actual market share – Budgeted market share) Actual market size x Avee contribution margin/U

120 000

= (960 000-10%) 960 000 x 2.35

= R56 400(+)

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Comments:Actually increasing the market share from 10%, which was budgeted, to 12.5%

120 000

(960 000) resulted in a market share variance of R56 400(+). The market size variance of R9 400(-) was caused by the Chicago market which was 40 000 kg less than the budgeted market of 1 000 000 kg.

Sales volume variance

R53 120(+)

Sales yield variance Sales mix variance

R47 000(+) R6 120(+)

Market size variance Market share variance

R9 400(-) R56 400(+)

17.3 Production with inputs in a fixed ratio H550-553

Production mix variances occur when more than one type of raw material, direct labour or overhead is needed in a specific ratio (mix or %) to manufacture a product.

Refer to the introductory paragraph 17.1 of this lecture.

Level 2: Flexible budget variance

Level 3: Spending var. Effic. var.

Level 4: Mix var. Yield var.

For materials, labour and overheads

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Direct materials

- Materials price (spending) variance: The same formula as discussed previously.

- Materials quantity (efficiency) variance: The same formula as discussed previously, except that in calculating the standard quantity, the input:output ratio must be taken into account. For example H551 (517):

Input of 1.6 tons (consisting of 50% L, 30% C and 20% F) produces 1 ton of output. A production of 4 000 tons of output needs a standard input of (4 000 x 1.6) x 5L, 3C and 2F, which sets a standard input of 3 200 tons L, 1 920 tons C and 1 280 tons F.

The materials quantity variance can be analysed in a materials mix variance (variance in the input) and a materials yield variance (variance in the output).

These variances are calculated as follows:

i. Materials yield variance H552, D458, V347

Calculated from the difference between the total actual quantity of materials used less the total budgeted quantity allowed for actual production (SQ) multiplied by the budgeted materials mix % multiplied by the standard price or budgeted price of materials. The formula is as follows:

= (Total AQ - Total SQ) x Budgeted input mix % x SP (Budgeted price)

Example H(869) 593

If the AQ > SQ, the variance is unfavourable. The reverse is also true.

ii. Materials mix variance H552, D457, V347

Calculated from the difference between the budgeted cost of actual materials input mix and the budgeted cost provided the budgeted materials input mix has not changed. The formula is as follows:

=(A Mat. input mix % - Budgeted mat. input mix %)

x A total quantity mat. used x SP (Budgeted price)

If the A mix > budgeted mix, the variance is unfavourable. The reverse is also true.


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H + F + D 14.37

MPV = (SP - AP)AQ bought MQV = (SQ - AQ)SP

O = ($6.10 – $6.00) × 23,180 = $2,318 U

O = (23,180 – 24,000) × $6.00 = $4,920 F

P = ($1.80 – $2.00) × 37,820 = 7,564 F

P = (37,820 – 36,000) × $2.00 = 3,640 U

Total $5,246 F Total $1,280 F

2. MMV = (AM% - BM%) x ATQ x SP

Oak = (0.38 – 0.40) × 61,000 × $6.00 = 0.02 × 61,000 × $6.00 = $7,320 FPine = (0.62 – 0.60) × 61,000 × $2.00 = – 0.02 × 61,000 × $2.00 = 2,440 UTotal variance $4,880 F

-

MYV = (SQ - AQ) x Budgeted input mix x SP

Oak = (61,000 – 60,000) × 0.40 × $6.00 = 1,000 × 0.40 × $6.00 = $2,400 Pine = (61,000 – 60,000) × 0.60 × $2.00 = 1,000 × 0.60 × $2.00 = 1,200 F

$3,600 F

3.

Actual input Actual mixBudgeted quantity input for actual output

Budgeted mix

Oak 23,180 b.f. 38% 8 b.f. × 3,000 u = 24,000 b.f. 40%

Pine 37,820 b.f. 62% 12 b.f. × 3,000 u = 36,000 b.f. 60%

Total 61,000 b.f. 100% 60,000 b.f. 100%

Direct labour V350

Exactly the same principles and formulae as in direct materials, except that the names of the variances differ, e.g. price variance becomes rate variance and quantity variance becomes efficiency variance.

Overheads

Exactly the same principles and formulae as in materials.

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17.4 Measuring productivity H515-518

- Partial productivity: This compares the quantity of output produced with the quantity of a single input used, e.g. output units ÷ labour hours or materials inputs or machine hours, etc. The formula looks like this:

Partial productivity = Quantity of output units produced

* Quantity of input used

* May be direct labour hours, materials quantity or machine hours.

In this way, the partial productivity of one year can be compared with that of a previous year and trends can be determined.

- Total factor productivity (TFP): This is also known as total productivity and it is a technique to measure productivity that measures inputs simultaneously, i.e. the ratio of the quantity of outputs produced to the cost of all inputs used where the inputs are combined on the basis of current prices. The formula looks like this:

Total factor productivity = Quantity of output units produced

Cost of all inputs used

The advantage of this method of measurement is that it measures the productivity of the combination of all inputs.

18. BENCHMARKING AND VARIANCE ANALYSIS H270

19. VARIANCE ANALYSIS AND ABC H268, 306

20. STANDARD COSTING AND THE BALANCED SCORECARD

ASSIGNMENTS


APPENDIX TO STUDY UNIT 6

Fixed overheads:There are 2 types of overhead variances:1. Budget / spending variance2. Volume variance

1. Budget variance: This is the easiest variance to calculate. It is the difference between the budgeted and the actual fixed overheads. (The total amount budgeted and the total amount actually incurred). This variance tells us that our budget was incorrect and we paid more or less overheads than we thought we would.

In a direct cost environment, (inventory carried at variable production costs), this will be the only fixed overhead variance you will find.

2. Volume variance This variance is only in an absorption environment. (In an absorption cost environment, you will therefore have a budget variance AS WELL AS a volume variance).

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The volume variance identifies the part of the overhead as a result of the actual production being different from the budgeted production. If we knew, from the beginning, that production will differ, the allocation rate would have been different.

Therefore, this is the difference between actual production (AP) and budgeted production (BP) multiplied by the standard fixed overhead allocation rate (SR).(AP-BP) x SR

The volume variance is further divided into:a. Volume efficiency varianceb. Volume capacity varianceThese two variances try to identify the reason for the volume variance. a. Volume efficiency variance This variance asks how efficient production was. If we always use 10 units of input to get 8 units of output, and in actuality we only get 8 units of output from 10 units of input, we are unproductive. The “unit” we refer to, is the allocation activity (machine hours, labour hours, etc.)

Therefore, this is the difference between the standard hours of output (SH) and the actual hours of input (AH) for the period, multiplied by the standard fixed overhead allocation rate (SR).(SH-AH) x SR

b. Volume capacity variance This variance asks why actual production is different from budgeted production. If the budget aims to use 10 000 hours of input and in actuality only uses 9 000 hours, it will be clear that the entity failed to use the budgeted capacity to the full.

Therefore, this is the difference between the actual hours of input (AH) and the budgeted hours of input (BH) multiplied by the standard fixed overhead rate. SR).(AH – BH) x SR

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See the next example to illustrate the above:Given information:Budgeted production 100 000 unitsBudgeted machine hours 200 000 hoursBudgeted total fixed overhead R500 000

Actual production 120 000 unitsActual machine hours 180 000 hoursActual total fixed overhead R600 000

Fixed overhead is allocated on the basis of machine hours.

Required: Analyze the fixed overhead variances in as much detail as possible.

Solution:Initially the plan was to use 2 machine hours (input) to produce 1 unit of output.200 000 hours / 100 000 units

The budgeted fixed overhead allocation rate: R500 000 / 200 000 = R2,50 per machine hour (this is technically more correct).Or R500 000 / 100 000 = R5,00 per unit

Spending variance:R600 000 – R500 000 = R100 000We paid more than we budgeted, so this variance is negative.

Volume variance(120 000 – 100 000) x R2,50 x 2h/u = R100 000We produced more units than planned. We were more productive than planned, so this will be a positive variance. Here we are working in units, so it will be necessary to use the allocation rate in a “per unit” form rather than a “per hour” form.

The total spending variance and volume variance is the under- or over allocated fixed overhead in the income statement. In this expample it will be R0 and it is therefore neither under- or over absorped. If this amount is positive, the amount in the income statement will be an over allocated fixed overhead (more was allocated than planned, so the overhead must be reduced, so the expense is reduced and therefore it is like income. Vice versa.The volume variance is further divided:

Volume efficiency variance:Standard hours input: We produced 120 000 units. If we worked at the efficiency rate that we planned, we would have needed 240 000 hours (120 000 x 2h/u) to produce this output.

(240 000-180 000) x R2,50 = R150 000We can see that we were much more efficient with the units input we used. Thus, this is a positive variance.

Volume capacity variance(180 000 – 200 000) x R2,50 = R50 000We can see that we did not use all the capacity. Therefore, this is a negative variance.

The total volume capacity- and volume efficiency variance is equal to the total volume variance:

R150 000 – R50 000 = R100 000 (positive)

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8 JOB COSTING AND ACTIVITY-BASED COSTING


Study material: Horngren - Chapters 4 and 5 Vigario - Chapters 2 and 5 [Drury - Chapters 4 and 10][Garrison - Chapters 3 and 8]

LEARNING OUTCOMES


Implement a job costing system in a service enterprise and a manufacturing enterprise.

Reconstruct a general ledger with an integrated operating ledger and financial ledger.

Allocate over- / under allocated overheads using the following methods:

Total over- / under allocated overheads to cost of sales per IAS 2

In proportion to different inventory accounts

Identify circumstances in an enterprise in which a costing system would be implemented.

Define activity-based costing (ABC) and name the differences between this system and the traditional costing system.

Incorporate ABC in job costing and process costing.

Apply ABC in service enterprises.

Evaluate ABC as a method of improving or weakening costing systems in enterprises.

Define and provide examples of the following concepts, among others:

a) Cost driver

b) Activity centre

1. INTRODUCTION H122, D79

Costing systems: Job costing and process costing.

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Job costs: Each product or service is individual and meets particular needs of a specific consumer.

Process costs: Mass production of the same product or service.

Activity-based costing (ABC): Costs are allocated accurately to different jobs or processes.

2. SOURCE DOCUMENTS H128, D80

Job cost record: Contains materials, labour and overheads

Materials: Materials requisition H129

Labour: Time ticket or clock card

Overheads: Predetermined rates, e.g. Rate = Budgeted overheads

Budgeted volumei.e. direct labour hours, machine hours, direct labour rate, units

or post-determined rates, e.g. Rate = Actual overheads

Actual volume

3. RECORDING TRANSACTIONS IN SUBSIDIARY JOURNALS AND THE GENERAL LEDGER H136, D82-95, V48

The same as in MACC 211 and MACC 311 (the format for standard costs)

Materials purchases

Materials issues

Labour costs incurred on wage statement

Wage analysis

Overheads incurred

Overheads allocated

Overheads overallocated/underallocated

Jobs completed

Jobs sold: costs

Selling price

Note the example in Horngren pp. 137-141 illustrating the general ledger and subsidiary ledgers, as well as T-accounts and journal entries.

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4. COST AND INCOME STATEMENTS

- Cost of sales statement is prepared as follows by manufacturing enterprises:

Direct materials usage (O/I + Purchases – C/I)

+ Direct labour

= Primary costs

+ Allocated overheads

= Manufacturing costs

± WIP inventory difference + O/I

- C/I

= Cost of finished goods

± FG inventory difference + O/I

- C/I

= Cost of sales (at normal)

± Underallocated or overallocated overheads

= Cost of sales at actual

- Income statement (as per the traditional or absorption costing method)

Sales

- Cost of sales (fixed + variable)

= Gross profit

- Selling and administration expenses

Fixed

Variable

= Net operating income

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- Income statement (as per the contribution margin method)

Sales

-Variable costs: of sales

Selling and admin.

= Contribution margin/marginal income

-Fixed costs: production

Selling and admin.

= Net operating income

5. WHEN TO USE JOB COSTING H123

Costs are recorded on a job cost sheet, i.e. materials, labour and overheads.

The cost of each job is individual because the composition differs.

Produced for a specific consumer.

Costs are known once the job has been completed.

Denominator is small.

Examples: Manufacturing – furniture, contracts, aeroplanes, etc.

Service - doctors, lawyers, auditors

Trade - catalogues distributed, special promotions

6. JOB COSTING IN SERVICE ENTERPRISES H146

Steps taken by service enterprises, e.g. public accounting practice. The general approach to job costing can be applied in this type of enterprise according to the following seven steps:

i. Identify the job selected as the cost object.

ii. Identify the direct costs of the job.

iii. Identify the indirect cost pools associated with the job.

iv. Select the cost allocation base for allocating indirect costs to the job.

v. Determine the cost allocation rate.

vi. Determine the indirect costs of the job.

vii. Determine the total costs of the job: direct and indirect.

7. PRORATION OF UNDERALLOCATED OR OVERALLOCATED OVERHEADS H142

Method 1: The pro rata portion is based on the total amount of overheads (before proration) included in the closing inventory of WIP, finished goods and cost of sales [Example H143].

Method 2: The pro rata portion is based on the total closing balances (before proration) of WIP, finished goods and cost of sales.

Method 3: All overallocated or underallocated overheads are written off to cost of sales.

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8. JOB COSTING IN MANUFACTURING ENTERPRISES H135

The steps are the same as discussed in (6) above for service enterprises, except that the cost items in step (vi) consist of direct materials and direct labour instead of only professional labour. The indirect costs consist of manufacturing overheads and not indirect support services.


Solution IM 4.2

a) See the comparison between management accounting and financial accounting in Chapter 1 for the answer to this question.

b) Note that the job ledger control account shown in the question is equivalent to the work in progress control account described in Chapter 4.

Stores ledger control account

(R000) (R000)

Opening balance 176.0 Job ledger control A/c

(64 500kg x R3.20)

206.4

Financial ledger control A/c 224.2 Production o/head control A/c (Balancing figure)

24.3

____ Closing balance 169.5

400.2 400.2

Production wages control account

(R000) (R000)

Financial ledger control A/c 196.0 Job ledger control A/c (75%) 147.0

____ Production o/head control A/c (25%) 49.0

196.0 196.0

Production overhead control account

(R000) (R000)

Financial ledger control A/c 119.3 Job ledger control A/c* 191.1

Stores ledger control A/c 24.3 Under-absorbed overhead (Balance to 1.5

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profit and loss A/c)

Production wages control A/c 49.0 ____

192.6 192.6

* Direct labour hours = Direct labour wages (R147 000) / Direct labour wage rate (R5) = 29 400 hours.

Overhead charged to production = 29 400 direct labour hours x direct labour rate (R6.50) = R191 100.

Job ledger control account

(R000) (R000)

Opening balance 114.9 Cost of sales A/c (balancing figure) 506.4

Store ledger control A/c 206.4 Closing balance 153.0

Production wages control A/c 147.0

Production o/head control A/c 191.1 ____

659.4 659.4

CLASS DISCUSSION

9. MOTIVATION FOR ABC D222, H162, V172

ABC: Accurate pricing helps in cost management decisions by improving processes and product designs.

Product cost cross-subsidisation: As a result of inaccurate cost allocation caused by a broad average allocation (peanut-butter costing).

Traditional product costing was designed when a small range of products was produced, and materials and labour costs formed the majority of the production costs.

Variable manufacturing environment: Makes traditional product costing and cost allocation obsolete.

Competition in the global market requires accurate costs and prices.

A refined costing system uses ABC.

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10. DEFINITION H170, D221, V172

ABC systems refine costing systems by focusing on individual activities as the fundamental cost objects. An activity is an event, job or unit of work with a specific purpose, e.g. designing a product, setting up a machine, distributing products.

ABC systems calculate the costs of individual activities and impute costs to cost objects like products and services on the basis of the activities carried out for each product or service.

11. COMPARATIVE ANALYSIS OF ABC AND TRADITIONAL COSTING D223, H178, V189

In ABC costs are imputed to activities according to the products’ demands for activities. Work through the example in V178-180.

12. HOW ABC WORKS D228, H174, V187

Drury identifies the following four steps for designing ABC systems:

Identify the major activities in an organisation.

Impute costs to the activity cost centres.

Determine the cost driver and the cost driver rate for each major activity.

Impute the costs of the activities to the products as per the product’s demand for activities.

Vigario 172 discusses the process in five steps, which correspond with Drury’s four we mentioned above.

Horngren expands these steps more clearly:

i. Identify the cost objects, e.g. products.

ii. Identify the direct costs of the products.

iii. Select a cost allocation base for allocating indirect costs to the products.

iv. Identify the indirect costs associated with each cost allocation base.

v. Determine the allocation rate.

vi. Determine the indirect costs imputed to the products.

vii. Determine the total costs from the direct and indirect costs of each product.

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Work through the example in Horngren p. 176.

Note the cost hierarchy in Horngren p. 173, D230 and the levels of activity that cause costs:

Output unit-level costs

Batch-level costs

Product-sustaining costs

Facility-sustaining costs

13. EVALUATION OF THE USE OF ABC D235, V188

Advantages

i. More accurate costs as a result of a larger number of cost pools, the change of the allocation base and change in management’s perception.

ii. Because the costs are more accurate, more effective and efficient decisions can be made.

iii. More efficient cost control.iv. More efficient planning.

Disadvantages/limitations

i. Arbitrary cost allocation.ii. High costs of measurement.iii. ABC is based on absorption costing techniques, which are only valid at one historical

level of production.iv. Selecting cost drivers is difficult and in some instances has little relevance for activities.

14. ABC AND SERVICE ENTERPRISES D236, H183

This system works very well in these enterprises. Simply replace products with services. However, there are two common problems that make implementation difficult: a larger portion of the costs in service enterprises are facility-level costs and it is more difficult to establish activities in a service enterprise.

15. USING ABC TO IMPROVE COST MANAGEMENT AND PROFITABILITY H178

Pricing and product mix decisions

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Cost reduction and process improvement

Design decisions

Planning and managing activities

ABC leads to activity-based management, activity-based cost management and activity-based management accounting.

16. INTERNATIONAL USES

John Deere (USA), Europe, particularly Germany and Northern Europe. South Africa?

17. KEY TERMS H189

See especially: ABC, batch-level activities, unit-level activities, facility-level activities, product-level activities, NVA**please give English equivalent** activities, process value analysis.

18. ABC AND STRATEGIC DECISIONS V190

Traditional: Absorption costing is used for product costs and then in decision making.

ABC is more sophisticated. Work through the example in Vigario.

Decision making: Marginal costing is more effective.

Compare the Western and Eastern style of management. The Japanese use target costing for pricing.

Bhimani & Bromwich


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H + F + D 5.39

1. Sold.: R942 000 ÷ 1 570 000 = R0.60 / sold.p.

Shipm: 860 000 ÷ 20 000 = 43. / shipment

Qual. contr.: 1 240 000 ÷ 77 500 = 16 / inspection

Purch. orders = 5 / order

Machine power = .3 / mh

Machine setups = 25 / setups

M R

DM: (R208 584) R208 R584

DL: 18 42

Mach. costs 144 72

Direct costs (total) R370 R698

Indirect costs:

Solder. (.60 x 1 185 000, 385 000) R711 000 R231 000

Shipm. 696 600 163 400

Qual. contr. 899 200 340 800

Purch. orders 400 500 549 900

Mach. power 52 800 4 800

Mach. setup 400 000 350 000

R3 160 100 R1 639 900

Income R19 800 000 R4 560 000

- Cost: Direct (22 000 x 370, 4 000 x 698) 8 140 000 2 792 000

Indirect 3 160 100 1 639 900

= Gross profit R8 499 900 R128 100∴ GP/U R386.36 R32.025

GP % 42.93% 2.8%

2. The existing system allocates manufacturing overheads differently than machine costs on the basis of machine hours. M uses twice as many machine hours as R and the costs are therefore double. ABC uses various cost drivers and more accurate costs could have been realised. M would then be more profitable than R.

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3. Duval’s comments on ABC implementation are valid. When designing and implementing ABC, management and the management accountants must play costs and benefits off against one another. More activities added result in higher costs for implementation, but increase the accuracy of cost information, which may lead to more effective decisions.

4. ABC is the use of the information to make improvements to the organisation, e.g. products can be revised on the basis of revised cost information. For the long term, ABC management can help to make decisions on the viability of product lines, distribution channels, marketing strategies, etc. ABC emphasises improvements such as eliminating activities that don’t add value, selecting lower cost activities, etc. It focuses on long- and short-term strategies and tactics.

5. Faulty reporting to M and to maintain R is unethical.

What about the ethical code of management accountants?

Competence

Integrity

Objectivity

ASSIGNMENTS


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Study unit 9

9 PROCESS COSTING, HYBRID COSTING AND REWORK


Study material: Horngren - Chapters 17 and 18 Vigario - Chapter 3 [Drury - Chapter 5][Garrison - Chapter 4]

LEARNING OUTCOMES


Identify when to implement a process costing system.

Determine the closing inventory value for finished goods and work-in-process units if:

* An addition of materials to Dept I causes an increase in units.

* Units are spoilt in all the production departments that can be attributed to avoidable and unavoidable causes at different inspection points, e.g. at the beginning, during or end of the process.

There are unfinished units at the beginning of the period.

Determine the closing inventory value of finished and work-in-process units if:

* A weighted average method and

* A first-in-first-out method is applicable to the opening work-in-process inventory.

Compile a cost report and quantity schedule for any production department.

Make accounting entries in the general ledger from the cost report and quantity schedule.

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Determine the closing inventory value for finished and work-in-process units if standard costs are used.

Determine the variances between actual and allowed costs.

Determine the operating income for an enterprise after taking all the above objectives into account.

Discuss the influence of activity-based costs in process costing.

Define important terms and determine the value of finished goods and work-in-process if any of the following occur during the production process:

* Rework

* Normal spoilage

* Abnormal spoilage

* Hybrid costing

* Scrap units

1. INTRODUCTION H123, 626, D99, V65

Process costing is a system used in enterprises that produce homogeneous products or services.

Mass production, therefore not for a specific consumer; a continuous flow.

Equivalent units: Equivalent of the finished units.

2. WHEN PROCESS COSTING IS USED H123, 626

Mass production: For inventory and not a specific consumer.

Continuous flow: Therefore costs are recorded per period and not per job.

Denominator large: In contrast to job costs, which have a small denominator.

Homogeneous products: Total costs divided by the units produced; therefore an average unit price.

Costs are recorded per cost centre, per period; work-in-process therefore occurs and equivalent units become relevant.

Examples:

Production: Chemical industry, canning industry, mining companies, rubber and steel

Service: Mail sorting at post office, premiums at insurance companies, banks

Trade: Marketing corn, processing new magazine subscriptions

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3. BASIC STEPS H630

i. Determine physical flow: From where to where?

Opening inventory + Added = Finished + WIP

ii. Determine equivalent units: note the instruction, i.e. weighted average or first-in-first-out (FIFO) method.

Remember: With the weighted average the equivalent units are made up of finished units + work-in-process units X% completed by the end.

In FIFO the equivalent units are made up of units that could absorb costs during the period concerned, i.e. WIP – Opening inventory X% to complete + Units started and finished + WIP closing inventory X% completed.

iii. Determine unit costs: Weighted ave.: = Opening balance + Cost for period

Equiv. U as in (ii)

FIFO = Cost for period

Equiv. U as in (ii)

iv. Set out the total costs and determine the value of finished goods and work-in-process.

4. PROBLEMS TO AVOID H649

Remember that any department after the first one has the costs from the preceding department.

In FIFO: Units completed and transferred out include opening WIP inventory that was completed during the period.

Unit costs can fluctuate from one period to the next.

Units may be measured differently in different departments, e.g. in kg in one department and in litres in another.

5. PRODUCTION COST REPORT H649

Groups costs according to department or segment

Groups costs as per time, e.g. daily, weekly, monthly

Quantity schedule for each department

Determine unit prices according to cost elements

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6. SPOILAGE IN THE FIRST PRODUCTION DEPARTMENT AND THEREAFTER D101, H664-678, V74-80

6.1 Uncontrollable spoilage

Costs are carried by the good units. This spoilage is through normal causes, such as evaporation, shrinkage etc.

Dept I: Influences only the unit costs of the first department.

After Dept I: Influences the unit costs of the department concerned as well as those of the preceding department (adjust the unit price of the costs of the preceding department).

6.2 Controllable spoilage

Costs of the spoilage are carried by assigning a value to spoilage and imputing them as a loss in the income statement. This spoilage is through spillage or negligence.

In paragraph 13 H664-678 spoilage, reworked units and inspection points are discussed in detail.

7. ADDITION OF MATERIAL TO DEPT 1

The appearance changes, but not the units themselves, e.g. paint on toys, cars. The additional material changes the character only, but not the quantity – it is therefore only an additional cost element, i.e. materials.

The additional material causes an increase in the units, e.g. liquids – this is the opposite of spoilage.

Cost in current department: Only an additional cost element.

Cost from preceding department: Carried by more units, therefore a new lower unit price.

8. WORK-IN-PROCESS AT THE START OF THE PERIOD D106, H628+

8.1 Weighted average method H634, D110

Equivalent units: As discussed in paragraph 3 above.

Total costs: (Opening inventory plus cost for the period) divided by the total units (opening inventory plus addition).

Unit costs: Total costs divided by equivalent units.

Work through the example on pp. 71 to 78.

8.2 FIFO method and modified FIFO method H636, D168

Equivalent units: As discussed in paragraph 3 above.

Unit costs: Costs for the period divided by the equivalent units as determined in paragraph 3 above for the current department. For the preceding department the same method for determining unit costs is used as for the weighted average.

Work through the example with two departments for two months (as practice and compare your answer with the suggested solution below) on pp. 71 to 78 of this study guide. You will not find this type of situation in any prescribed book.

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(i) Note the values of the closing WIP inventory from July, which becomes the opening WIP inventory value for August and, most importantly, WHERE the amounts are indicated in the cost report and quantity schedule

(ii) Also note the values of the finished goods transferred out of department 1 to department 2 and, very important, WHERE the amounts are indicated in the cost report and quantity schedule.

Below are the instructions for an exercise of one department for only one month. Do this exercise below first before you work through the example on pp. 71 to 78.

Do 17.30 and 17.32 in Horngren as practice and compare your answers with the suggested

solutions below.

H + F + D 17.30

1. Physical flow: 5 000 + 20 000 = 22 500 + 2 500

2. Equiv. U: Materials: 22 500 + 2 500 = 25 000u

A + B: 22 500 +1 750 = 24 250u

3. Unit costs:

Materials: 1 250 000 + 4 500 000/25 000u= R 230

A + B: 402 750 + 2 337 500/24 250u= R 113

4. Completed and transferred out:

5 000u (230 + 113) = R1 715 000

17 500u (230 + 113) = R 6 002 500

Total = R 7 717 500

C/I WIP:

2 500u x (230 X 100%) = 575 000

2 500u x (113 x 70%) = 197 750

Total = 772 750

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H + F + D 17.32

1. Physical flow: 5 000 + 20 000 = 22 500 + 2 500

2. Equiv. U: M A + B

WIP – O/I to complete - 2 000

Started and completed 17 500 17 500

WIP – C/I x % 2 500 1 750

20 000 21 250

3. U/price:

Mat: 4 500 000/20 000u= R225/U

A + B: 2 337 500/21 250u= R110/U

4. Value: WIP: Mat: 2 500 x 100% x R225 = R562 500

A + b: 2 500 x 70% x R 110 = R192 500

R755 000

FG: WIP – O/I: R1 250 000 + 402 750 = R1 652 750

5 000 x 40% x 110 = 220 000

Started + completed: 17 500 x (225 + 110) = R5 862 500

R7 735 750

Difference:

a) Cost per equivalent unit: WA FIFO

Mat. R230 225

A + B 113 110

(Differences in unit costs are caused by the fact that in FIFO only the costs for the current period are divided by the units that could absorb costs for the current period)

b) Work-in-process: WA FIFO

Mat. 575 000 R562 500

A + B 197 750 R192 500

R772 750 R755 000

Difference R17 750

c) Finished goods R 7 717 500 R7 735 750

Difference 18 250

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9. ACCOUNTING ENTRIES FOR PROCESS COSTING H643

The top part of the cost report and quantity schedule is the debit side of the WIP control account of the department concerned.

The bottom part of the cost report and quantity schedule is the credit side of the WIP control account of the department concerned.

For each department, a work-in-process control account is opened.

From the last department, the work is transferred out to the finished goods and then cost of sales.

The procedure for recording this in the books is the same as for job costing.

10. STANDARD COSTING AND PROCESS COSTING H641

Easy to apply: Homogeneous products, and use price and quantity standards.

Also calculate price and quantity variances.

Example: The following information relates to business A. A standard costing system is used together with the first-in-first-out method for inventory valuation. Determine the cost variances per cost element for the period concerned.

Standard direct material/U R74, standard conversion costs/U R54

Actual costs: DM R19 800 Conversion costs R16 380

Quantity schedule: WIP – O/I 225 U (100% completed in terms of DM and 60% converted)

Added 275U

Completed and transferred out 400U

WIP – C/I 100U (100% completed in terms of DM and 50% converted)

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Suggested solution (according to the four basic steps as discussed in paragraph 3)

1. Physical flow: 225 + 275 = 400 + 100

2. Equiv. U: DM Conversion

WIP - O/I......... - 90

Started + completed 175 175

WIP - C/I x % 100 50

275 315

3. U/price: DM = R74, conversion R54 (given)

4. Finished goods: 400U x (74 + 54) = R51 200

Work-in-process: DM 100 x 100% x 74 = R7 400

Conversion 100 x 50% x 54 = R2 700

Variances: DM Conversion

Actual costs R19 800 R16 380

Allowed: (275 x 74) R20 350

(315 x 54) R17 010

R550(+) R630(+)

Both variances are favourable and thus credited.

11. ACTIVITY-BASED COSTING AND PROCESS COSTING

Applicable in allocating overheads.

12. PROCESS COSTING FOR DECISION MAKING AND COST CONTROL

For decision making: Costs must be divided into fixed and variable components, but in process costing with a unit price this has not yet been done. Refinement will have to take place.

Cost control: It is important to compare costs in the current period to apply cost control and not costs that have been carried over from a previous period. See paragraph 10 above.

13. SPOILAGE AND INSPECTION POINTS H674, V74

IAS 2 paragraph 14:

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Examples of costs excluded from the costs of inventory and dealt with as expenses in the period in which they were incurred:

(a) Abnormal contribution margins for scrap material, labour and other production costs

(b) Storage costs unless they were necessary for the production process before a further production phase

(c) Administrative overheads unrelated to generating inventory...

(d) Selling expenses

The most common methods for valuing inventory are LIFO, FIFO and weighted average. LIFO is used to reflect a profit determined from current income and expenses and therefore it is suitable for internal reporting. For external reporting: IAS 2 – Inventory must be shown at FIFO or weighted average.

- Distinguish:

Spoilage: Unacceptable production units, e.g. defective units that may be partially complete or can be completed, and classified as unacceptable upon inspection.

Rework: Unacceptable production units which are subsequently repaired to be sold as acceptable units, e.g. computer hard drives.

Scrap: A product with minimal sales value compared to the other products, e.g. offcuts of material and leather, where the pattern for the main product has been cut out.

Normal spoilage: Spoilage under efficient circumstances, e.g. evaporation or shrinkage.

Abnormal spoilage: Spoilage not expected to arise under efficient circumstances – it is not part of the process, but arises through avoidable causes and is therefore controllable. Abnormal spoilage costs are written off in the period in which they are incurred.

Work through example H668+

Note example 2 H668 where the inspection point is at the end and normal spoilage is 10% of the good units; the rest are abnormal.

..10% x 7 000 = 700 of the units are normal spoilage and 300 (1 000 - 700) are abnormal spoilage. The cost of the abnormal spoilage is written off in the income statement (R5 925) as a loss and the cost of the normal spoilage (R13 825) is added to the cost of finished goods because the inspection took place after completion. Work-in-process at the end was 50% complete in respect of labour and overheads and therefore does not form part of the costs of normal spoilage.

The inspection point therefore plays a very important role in imputing the costs of normal spoilage.

The same principle is applied in the illustration of this example according to the weighted average, FIFO and standard costing method.

The principle in imputing costs of normal spoilage is that these costs will go to all good units that are past the inspection point.

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14. IMPORTANT TERMS H656

Hybrid costing systems H650: This system has characteristics of both job and process costing. Job and process costing have extreme characteristics and hybrid costing is a combination of the two. Job costing deals with heterogeneous products or services with individual compositions, whereas process costing deals with homogeneous products or services, mass production and a continuous flow in the production process.

A hybrid costing system is applied when there is a combination of production for a specific consumer but also mass production, e.g. at Ford Motor Company where there is continuous flow, but a special combination of engine, transmission, radio etc.

Modified FIFO: In practice, it is not possible to apply the FIFO principle or pure IFO principle in process costing after the first department, and it therefore becomes an adapted or modified FIFO.

Modified FIFO means that:

i. The costs of the preceding department are dealt with as the weighted average for determining the unit price because it is not possible to determine practically which units increased and which units were spoilt.

ii. Costs of the current department are dealt with as FIFO in determining equivalent units and unit price.

15. COST OF ABNORMAL SPOILAGE V79

Abnormal spoilage: The costs must be carried by the products themselves, so a value must be allocated to record it in the income statement.

Equivalent units?

Unit price? Higher or lower than when there is normal spoilage.

What happens with weighted average and FIFO?

Do 18.30 and 18.31 in Horngren as practice and compare your answers with the suggested solutions below. Note that the information between the two editions of Horngren differs slightly.

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H + F + D 18.30

Cleaning dept – Mat. added at beginning of process.

O/I = 80%, C/I = 25% completed Normal spoilage = 10% x Good units

1. Physical flow: 1 000 + 9 000 = 7 400 + 740 + 260 + [1 600]

2. Equiv. U: Mat: 7 400 + 740 + 260 + 1 600 = 10 000U

A + B: 7 400 + 740 + 260 + (1 600 x .25) = 8 800U

R1 000 + 9 000

3. U/price: M: 10 000U = R1/U

R 800 + 8 000

A + B: 8 800U = R1/U

4. Value: FG: 7 400U x R2 = R14 800

+ Cost of normal spoilage: (740 x 2) = 1 480 R16 280

WIP: Mat: 1 600 x 100% x R1 = R1 600, A + B: 1 600 x .25 x 1 = R400

Abnormal spoilage: 260U x R2 = R520

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H + F + D 18.31

1. Physical flow: 1 000 + 9 000 = 7 400 + 740 + 260 + [1 600]

2. Equiv. U: Mat A + B

O/I – WIP… - 200

+ Started + completed 6 400 6 400

+ WIP – C/I x % 1 600 400

+Normal spoil. (100% completed) 740 740

+Abn. spoilage (100% completed) 260 260

9 000 8 000

R9 000 R8 000

3. U/price: Mat: 9 000U = R1/U, A + B: 8 000U = R1/U

6 400 x R2 = R12 800

R1 800 2 000

4. Value: FG: 7 400U

1 000 (200 x 1) R14 800

+ Cost of normal spoilage: 740 x 2 = R1 480

TOTAL R16 280

WIP: M: 600 x 100% x R1 = R1 600, A + B: 1 600 x .25 x 1 = R400

Abnormal spoilage: 260 x R2 = R520

Coincidentally, the U/prices, FG and WIP of 18.30 + 18.31 are the same. Why?

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16. LAST-IN-FIRST-OUT METHOD (LIFO) V81This method has limited applicability in process costing. Note that it can be applied in valuing work-in-process inventory.

17. JOB COSTING AND SPOILAGE H674

18. EXAMPLE: TWO PRODUCTION DEPARTMENTS FOR TWO MONTHS ACCORDING TO THE WEIGHTED AVERAGE AND FIFO METHODCompany A manufactures a product that moves through two production departments. The production and cost information for two months is given to you to determine the closing inventory values of WIP and finished goods at the end of each period if:

The weighted average cost method is used.

The FIFO method is used.

Production and cost information

July: Dept I

There is no opening WIP inventory. During the month 1 000 units are placed into production, of which 75% are completed, 20% have a closing WIP inventory (50% conversion costs) and 5% are spoilt.

Production costs: Direct materials R9 500

Conversion costs 8 500

Dept II

There is no opening WIP inventory. A materials addition of R7 500 in this department increases the units by 100 and at the end of the month 600 units are completed and transferred out to storage. 150 units have not been completed (⅓ completed in terms of conversion costs).

Conversion costs for the month amount to R9 750.

August Dept I

800 units are placed into production at a cost of R7 225 and are processed with R6 056 conversion costs. During the period 600 units are completed and there are 300 work-in-process units (40% completed in respect of conversion costs) at the end of the month.

Dept II

The materials addition at a cost of R6 375 causes the units to increase by 50 and conversion costs of R9 132,50 are incurred during the month. At the end of the month 550 units are completed and there are 200 work-in-process units 60% completed in respect of conversion costs.

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Notes: (i) All materials are added at the beginning of the process in both production departments.

(ii) All spoilage is attributed to normal causes.

(iii) Unit costs to three decimal points.

COST REPORT AND QUANTITY SCHEDULE (WEIGHTED AVERAGE COST)

JULY

I II

QUANTITY VALUE U/PRICE


Costs of preceding dept

WIP – O/I

+ Added

= Average price 750 15 000 20

+ Increased U 100

= New price 850 15 000 17.647

+ Additional costs

= Adjusted price 20.

Costs of current dept:

WIP – O/I:

DM

Conversion costs

Month: DM 1 000 9 500 10 7 500 10

Conversion costs 8 500 10 9 750 15

1 000 18 000 20 850 32 250 45

Completed + transf. 750 15 000 20 600 27 000 45

WIP: Preceding dept 200 150 3 000

DM 2 000 1 500

Conversion costs 1 000 750

Spoilage 50 100

1 000 18 000 20. 850 32 250 45

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COST REPORT AND QUANTITY SCHEDULE (WEIGHTED AVERAGE COST)

AUGUST

I II



Costs of preceding deptWIP – O/I 150 3 000+ Added 600 12 030= Average price 750 15 030 20.04+ Increased U 50= New price 800 15 030 18.788+ Additional cost= Adjusted price 20.04Costs of current dept:WIP – O/I:

DM 200 2 000 1 500Conversion costs 1 000 750

Month: DM 800 7 225 10.25 6 375 10.5Conversion costs 6 056 9.8 9 132.5 14.75

1 000 16 281 20.05 800 32 787.5 45.29Completed + transf. 600 12 030 20.05 550 24 909.5 45.29WIP: Preceding dept 300 200 4 008

DM 3 075 2 100Conversion costs 1 176 1 770

Spoilage 100 501 000 16 281 20.05 800 32 787.5 45.29

Calculations: Basic steps, H 669

1. Physical flow:

JulyDept I : 1 000 = 750 + 200 + 50

II : 750 + 100 = 600 + 150 + ? 100 (spoilage)

AugustDept I : 200 + 800 = 600 + 300 + ? 100 (spoilage)

II : 150 + 600 + 50 = 550 + 200 + ? 50 (spoilage)

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2. Equivalent units:

July

Dept I : Materials: 750 + (200 x 100%) = 950U

Conversion costs: 750 + (200 x 50%) = 850U

II : Materials: 600 + (150 x 100%) = 750U

Conversion costs: 600 + (150 x ⅓) = 650U

August

Dept I : Materials: 600 + (300 x 100%) = 900UConversion costs: 600 + (300 x 40%) = 720U

II : Materials: 550 + (200 x 100%) = 750UConversion costs: 550 + (200 x 60%) = 670U

3. Total costs (see report)

4. Unit costs Materials Conversion costs

July - Dept I:

R 9 500950U = R10

R 8 500850U = R10

Dept II:

R7 500750U = R10

R 9 750650U = R15

August - Dept I:

2 000 + 7 225900U = 10.25

1 000 + 6 056720U = 9.8

Dept II:

1 500 + 6 375750U = 10.50

750 + 9 132 . 5670U = 14.75

5. Value of closing inventory: Finished goods

July - Dept I: 750 x 20 = R15 000Dept II:600 x 45 = R27 000

Aug. - Dept I 600 x 20.05 = R12 030Dept II:550 x 45.29 = R24 909,50

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Work-in-process

July - Dept I: 200U x R10 = R2 000 200U x 50% x R10 = R1 000

Dept II:150U x R20 = R3 000 150U x R10 = R1 500

150U x ⅓ x 15 = R750

August - Dept I: 300U x 10.25 = 3 075 300U x 40% x 9.8 = R1 176

Dept II:200U x 20.04 = R4 008 200U x 10.5 = R2 100

200U x 60% x 14.75 = R1 770

COST REPORT AND QUANTITY SCHEDULE (FIFO)JULY

I II

QUANTITY VALUE U/PRICE QUANTITY VALUE U/PRICE

Costs of preceding dept:WIP – O/I+ Added= Average price 750 15 000 20+ Increased U 100= New price 850 15 000 17.647+ Additional cost= Adjusted price 20.Costs of current dept:WIP – O/I:

DMConversion costs

Month: DM 1 000 9 500 10 7 500 10Conversion costs 8 500 10 9 750 15

1 000 18 000 20 850 32 250 45Completed + transf. 750 15 000 20 600 27 000 45WIP: Preceding dept 200 150 3 000

DM 2 000 1 500Conversion costs 1 000 750

Spoilage 50 1001 000 18 000 20. 850 32 250 45

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AUGUST

I II

QUANTITY VALUE U/PRICE QUANTITY VALUE U/PRICE

Costs of preceding dept:WIP – O/I 150 3 000+ Added 600 12 012.54= Average price 750 15 012.54+ Increased U 50= New price 800 15 012.54 18.766+ Additional cost= Adjusted price 20.017Costs of current dept:WIP – O/I:

DM 200 2 000 1 500Conversion costs 1 000 750

Month: DM 800 7 225 10.321 6 375 10.625Conversion costs 6 056 9.768 9 132.5 14 730

1 000 16 281 800 32 770.04Completed + transf. 600 12 012.54 550 24 874.04WIP: Preceding dept 300 200 4 003.4

DM 3 096.3 2 125Conversion costs 1 172.16 1 767.6

Spoilage 100 501 000 16 281 800 32 770.04

Calculations: Basic steps H630

1. Physical flow: The same as for weighted average method.

2. Equivalent units

July – Dept I and II: The same as for the weighted average method because there is no opening work-in-process inventory.

DEPT I

August Materials Conversion costs

WIP – O/I to complete - 100+ Units started + completed 400 400+ WIP – C/I x % completed 300 120

700 620

DEPT II

August Materials Conversion costs

WIP – O/I to complete - 100+ Units started + completed 400 400+ WIP – C/I x % completed 200 120

600 620

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3. Total costs (report)

4. Unit prices:July: The same as for the weighted average method because there is no

opening work-in-process inventory.

August: Materials Conversion costs

Dept I

R7 225700U = R10.321

R 6 056620U = R9.768

Dept II

R 6 375600U = R10.625

R 9 132 .5620U = 14.730

5. Closing inventory valueWork-in-process:

July: The same as for weighted average method.

August: Dept I: 300U x 10.321 = R3 096.3, 300 x 40% x 9.768 =

R1 172.16.

Dept II: 200U x 20.1 071 = R4 003.4, 200 x 10.625 =R2 125

200 x 60% x 14.730 = R1 767.6

Finished goods:

July: The same as for the weighted average method.

August:

Dept I: R16 281 less WIP = R12 012.54200U: 2 000 + 1 000 = 3 000

x 50% x 9.768 = 976.8

Test: 600U

400U x (10.321 + 9.768) n = 8 035.6 R12 012.4

-Dept II: R32 770.04 less WIP = R24 874.04

150:U 1 500 + 750 + (150 x 20.017) = R 5 252.55x 2/3 x 14.730 = 1 473

Test: 550U

400U x (20.017 + 10.625 + 14.73) = R18 148.8 R24 874.35

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ASSIGNMENTS


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10 JOINT PRODUCT COSTING


Study material: Horngren - Chapter 16 (16)Vigario - Chapter 3 (3)[Drury - Chapter 6]


Clearly define the following concepts and provide examples of them:

* Main products, joint products, co-products, by-products and waste

* Technically common costs

* Separable costs

* Net realisable value

* Opportunity costs

Allocate technically common costs to joint products by:

* Physical units

* Sales value

* Relative sales value

* Constant gross profit percentage

Deal with by-products and technically common costs according to various methods including:

* By-product income regarded as other income

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* By-product sales regarded as other sales

* By-product income to reduce costs in a variety of applicable methods

Apply IAS 2, paragraph 14 to by-product costs.

Determine the closing inventory values and operating income for joint products and by-products in all the methods mentioned in learning outcomes 2 and 3.

Do the accounting entries for allocating common costs to joint products and by-products.

Make decisions and recommendations to management regarding the further processing of products and utilisation of products as raw material for other products using two methods:

* Differential income and cost

* Opportunity cost

Solve integrated problems covering several topics, such as process costs, technically common costs, standard costs, budgets and relevant costs.

1. INTRODUCTION H598, D125, V92

Technically common costs (TCC): These are the costs of a single process that produces more than one type of product simultaneously but unavoidably.

Products differ in value and some are classified as main products, joint products or by-products.

Cost allocation: Arbitrary, no method is 100% accurate.

Cost allocation is important: To determine costs accurately for:

i. Inventory valuation

ii. Profit determination

Examples: Oil refinery, meat packers, canning factory, mining companies, farms, chemical industry, etc.

2. TERMINOLOGY H599, D126, V92

Split-off point: The point at which products can be identified individually.

TCC: Costs relating to more than one type of product which are produced simultaneously; also known as pre-separation costs.

Separable costs: All costs after split-off relating to specific products.

Joint products: When two or more products are manufactured simultaneously and neither one can be identified as the main product, e.g. meat packing**this example is very cryptic – I’d suggest expanding a bit more to explain exactly which products in a meat packing plant could be considered joint products**. All the products are economically equally important for the business and have a relatively high sales value.

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Co-products: Products that are manufactured at the same time, but not necessarily with the same raw material or the same processes, e.g. tree felling **this example is very cryptic – I’d suggest expanding a bit more to explain exactly which products in tree felling could be considered co-products**.

By-product: Manufactured under the same circumstances as the previous two types of products, but is not the main (primary) objective of the business and has a smaller sales value. In economic terms, therefore, it is not as important as a joint or main product. The measure is that by-product income is less than 10% of the total sales value of the business’s production.

Main product: This is the most important product in the business and the primary purpose of the business, e.g. gold in a gold mine, fuel at SASOL.

Waste: Products with little, if any, sales value.

3. COST ALLOCATION

3.1 Joint products H601, D126, V93

i. Physical measure: All the products must be measurable with the same measure, e.g. kg, litres, metres.

The TCC are allocated on the basis of the physical units of each product released.

Disadvantage: Sales value is ignored.

ii. Sales value method: The total value of each product, i.e. production units multiplied by the selling price, is used to allocate the TCC to products. This method is used if products don’t require further processing.

iii. Net realisable value (NRV) method: The NRV is obtained by reducing the final sales value (Production units x Selling price) by the post-separation costs. It can then be used to allocate the TCC to the different products.

iv. Constant gross profit %: In this method the same gross profit % is obtained for all the products by doing the following:

Determine the business’s gross profit and gross profit % from total sales less total manufacturing costs.

Use the overall gross profit % and deduct the gross profit for each product from sales to calculate the cost of production.

Deduct the post-separation cost from production cost to obtain the TCC portion of each product.

Example: Use the information in Horngren question 16.28 (16.28) on page 623 (589) which illustrates the above four methods (question 1). Question 2 of 16.28 requires comparative income statements in which the four methods of overheads allocation are done. You will be able to do question 3 of 16.28 once you have studied paragraph 5. The solution appears below.

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16.281a) Sales value at split-off: **this solution contains a mixture of gallons and grams. I’d recommend using one or the other system, preferably gallons, since the question uses US measures. I’d then also recommend changing R to $. If you do the latter, then you’d probably need to do it for all the exercises, or else insert a sentence at the beginning saying that even though the exercise in the Horngren textbook uses dollars, you will use rands**

CPL (600 g x 21) CP: 6 000 kg x R4

Beans

15 000 kg MCL (900 g x 26) MC: 10 200 kg x R5

(R30 000)

CPL: 600 gall. x 21 = R12 600

1260036000 x 30 000 = R10 500

MCL: 900 gall. x 26 = R23 400

2340036000 x 30 000 = R19 500

1b) Physical measure:

CPL: 600 gall.

615 x 30 000 = R12 000

MCL: 900 gall.

915 x 30 000 = R18 000

1c) NRV:

CPL: (6 000 x 4) – 12 750 = R11 250

1125036000 x 30 000 = R9 375

MCL: (10 200 x 5) – 26 250 = R24 750

24750R36000 x 30 000 = R20 625

1d) Constant gross profit %:

Sales (6 000 x 4) + (10 200 x 5) R75 000

- Cost (30 000 + 12 750 + 26 250) 69 000

=Total gross profit R6 000 % =

600075000 = 8%

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CPL MCL

Final sales value:

(6 000 x 4) (10 200 x 5) R24 000 R51 000

Less: Gross profit 8% 1 920 4 080

= Cost of sales R22 080 R46 920

Less: Separable costs 12 750 26 250

= Common costs allocated R9 330 R20 670

2.

CPL MCL

a) Sales R24 000 R51 000

-TCC 10 500 19 500

-Separable costs 12 750 26 250

=Gross profit R750 R5 250

Gross profit % 3.125% 10.294%

b) Sales R24 000 R51 000

-TCC 12 000 18 000


=Gross profit (R750) R6 750

Gross profit % (3.125%) 13.23

c) Sales R24 000 R51 000

-TCC 9 375 20 625


=Gross profit R1 875 R4 125

Gross profit % 7.81% 8.088%

d) Sales R24 000 R51 000

-TCC 9 330 20 670


=Gross profit R1 920 R4 080

Gross profit % 8% 8%

3. Further processing?

CPL: Incr. income:

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(6 000 x 4) – (600 x 21) = R11 400

Less: Incr. costs 12 750

Disadvantage to process (R1 350)

MCL: Incr. income:

(10 200 x 5) – (900 x 26) = R27 600

Less: Incr. costs 26 250

Advantage to process R1 350

Do the following self-assessment question and compare your answer with the suggested solution below.

A firm manufactures three products, namely X, Y and Z with a TCC of R140 000.

The production and selling prices are: X: 4 000 units @ R12/U Y: 8 000 units @ R20/U after R50 000

separable costs have been spent Z: 2 000 units @ R25/U after R20 000

separable costs have been spent.

REQUIRED:

Allocate the TCC according to four methods and calculate the gross profit % of each product in each of the methods you have chosen.

(i) Physical measure:TCC allocated: X R40 000 GP% 17%

Y 80 000 19%*Z 20 000 20%*

*Remember the post-separation costs throughout

(ii) Sales value method:TCC allocated X R26 047 GP% 46%

Y R86 822 14%Z R27 131 6%

(iii) Net realisable value:TCC allocated X R35 745 GP% 26%

Y 81 915 18%Z 22 340 15%

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(iv) Constant gross profit %:TCC allocated X R39 072 GP% 18.6%

Y R80 240 18.6%Z R20 688 18.6%

1.1 Cost allocation – by-products H610+, D133, V96

i. When by-products are recognised in the general ledger At production: As cost reduction or other incomeAt sales: As cost reduction or other income

ii. When by-products are recorded in the income statementAs a cost reduction of the main or joint productAs a separate item, i.e. additional income

IAS 2 par 14: In joint products and by-products where conversion costs cannot be identified separately in products, they must be allocated on a rational basis, e.g. relative sales value at split-off point or upon completion of production. Most by-products are not as important and are valued at net realisable value, which is deductible from the cost of the main product.

Work through the example on pp. 611-613 of Horngren.

Note the important points that the example highlights.

The alternatives for question (i) above are illustrated in income statements in Horngren 611. They can be summarised briefly as follows:A: Record the by-product in the general ledger at production. The income is used from

production of the by-product to reduce the TCC. Note the by-product closing inventory (valued at SP).

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B: Record the by-product at sales. The income from sales of the by-product is recorded as other income and the by-product’s closing inventory is shown at its zero value.

By-products can be dealt with in a variety of ways. The two most common ways are:i. The cost of sales of the main product is reduced by the income from sales of the

by-product.ii. The TCC of the main products are reduced by the net realisable value of the by-

product.

When should you use which method?

Note the instruction you are given in the question. If no instruction is given, the most common methods can be used.

Do 16.25 in Horngren as practice and compare your answer with the suggested solution below. Note that the information in the old and new editions differs slightly.

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16.25

1. SP (R40 000) 20 000 kg @ R10

(R320 000) RP 120 000 kg @ R2

240 000 kg

PB (R20 000) 40 000 kg @ R3 10% profit, 25% sales

20 000 kg SP

240 000 kg raw material given 120 000 kg RP

40 000 kg PB

NRV: SP: (20 000 x R10) – 40 000 = R160 000 (

1640 )

RP: 120 000 x 2 = 240 000 (

2440 )

PB: 40 000 x R3 – 20 000 – 10% - 25% = R58 000 TCC

SP:

1640 = R104 800

∴ TCC: R320 000 – 58 000 = R262 000

RP:

2440 = R157 200

Unit costs: SP: (R104 800 + 40 000) ÷ 20 000 = R7,24/kg

RP: R157 200 ÷ 120 000 = R1,31/kg

PB: (R58 000 + 20 000) ÷ 40 000 = R1,95/kg for invent. valuation

2. SP: R160 000 (NRV) ∴

160470 x 320 000 = R108 936

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RP: R240 000

240470 x 320 000 = 163 404

PB: 120 000 – 20 000 = R70 000

70470 x 320 000 = 47 660

R470 000

∴ Unit costs: SP: (R108 936 + 40 000) ÷ 20 000 = R7,45 /kg

RP 163 404 ÷ 120 000 = 1,36 /kg

PB: (R47 660 + 20 000) ÷ 40 000 = 1,69 /kg

4. ACCOUNTING ENTRIES H611

5. DECISION MAKING H608, V95, D131

Relevant costs: Expected future costs that differ between alternative actions

Differential income: Difference in income between two alternatives

Incremental income: Increase in income resulting from an alternative

Sunk costs: Costs that have already been incurred and can make no difference to the decision to be made currently

Differential costs: Costs that arise as a result of an alternative

Opportunity costs: Forfeited income, i.e. sacrificing an opportunity to earn income

5.1 Further processing

Decision to process further if the differential income exceeds the differential cost.

Decision to process further if the opportunity cost plus differential (separable) costs are less than the sales value after processing.

TCC are sunk costs and have no effect on the decision to process further.

Refer to paragraph 2 on p. 83 of this study guide. Question 16.28 in Horngren contains an illustration of decision making.

Illustration: Lecture.

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5.2 Using a product as raw material

The same principles as discussed in paragraph 5.1 apply.

ASSIGNMENTS


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Study unit 11

11 RELEVANT COSTS AND DECISION MAKING


Study material: Horngren - Chapter 11 Vigario - Chapter 11 [Drury - Chapters 9[Garrison - Chapter 13]


Clearly formulate the following concepts and apply each in internal decision making:

* Relevant and irrelevant costs

* Avoidable and unavoidable costs

* Opportunity costs

* Differential costs and income

* Qualitative and quantitative factors

* Traceable costs

* Replacement costs

* Imputed costs

* Sunk costs

* Deferred costs

Discuss decision making as part of the primary task of management.

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Make the following decisions with the aid of cost information:

Dropping a product/department

Short-term and long-term pricing

Acceptance of special orders at a lower price than the normal selling price

Temporarily and permanently dropping activities

Make or buy

Expanding capacity

Product mixes

Replacing means of production

Profitability of products

Identify the influence of risk and uncertainty in internal decision making and suggest a solution to overcome this factor.

Discuss the effect of activity-based costing on relevant costs in decision making.

1. INTRODUCTION D191, H412, V441 Decision making requires a choice between alternatives.

Cost information is very important for making decisions.

Contribution theory is very valuable.

Main problem: To determine in advance what the impact of the decision will be in the long term.

Relevant information: Relates to the future and differs according to alternatives.

Qualitative and quantitative factors. Examples.

2. DECISION MAKING AND LIMITING FACTORS D197, H426, V449 Limiting factor/constraint: A scarce factor, e.g. machinery, direct labour hours, materials,

preventing an enterprise from expanding without limitation.

If there is a scarce factor, the best decision is the alternative with the highest contribution margin per limiting factor.

e.g. Product A B C

Cont. marg./U R12 R10 R6

Production time 3 hours 2 hours 1 hour

If there is no limit: Order of preference A, B, C

If there is a limit: Order of preference C, B, A

Decision model H426, D198, AT29-34

Obtain information, make forecasts, select an alternative, implement the decision and evaluate the performance.

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3. TERMINOLOGY AT85, H439, V442, D213

Relevant cash flow: Relates to the future and differs according to alternatives.

Relevant costs: The same characteristics as relevant cash flow.

Irrelevant costs: Costs that have already been incurred and are the same among the alternatives.

Quantitative factors: Expressed in monetary terms, e.g. expenses, income

Qualitative factors: Not expressed in monetary terms, e.g. reliability of suppliers, employee morale, product quality.

Differential or incremental cash flow: Difference in cash flow between two alternatives.

Differential or incremental costs: Difference in costs as a result of an alternative.

Avoidable costs: Costs that will not be incurred if another activity is undertaken or when a product or service is dropped.

Unavoidable costs: Costs that will still be incurred even if a product or service is dropped.

Traceable costs: Costs that can be directly imputed to a job, product or cost centre.

Replacement costs: Cost of replacing a product or asset, thus the current or future market price.

Opportunity costs: Forfeited income or contribution margin or the costs that arise as a result of an opportunity to earn income being sacrificed.

Imputed costs: The amount to use any productive service.

Sunk costs: Costs that have already been incurred and cannot affect the decision.

Deferred cost: Costs that can be shifted to the future with more or less no effect on the efficiency of current production.

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Example

40 kg (R200) 45 kg @ R25/kg Hamburgers

@ R20

Permanent labourers @ R1 000 per week

(R4 000)

Carcass

Calculate the:

Relevant costs

Irrelevant costs

Differential cash flow

Differential costs

Opportunity costs

Avoidable costs

Sunk costs

Unavoidable costs

Traceable costs

4. DECISIONS

4.1 Dropping a product/department D205, V443, H430

Loss? Look at contribution margin.

If the product/department is still making a contribution, don’t drop it but consider the avoidable and unavoidable costs.

Contribution margin > Avoidable costs = Continue. The reverse is also true.

Take limiting factors into account.

The limiting factor is the availability of the capacity.

Note the cash breakeven point where the cash inflow and the cash expenses can be plotted on a graph. This is only a short-term solution.

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4.2 Short- and long-term pricing D193-197, V447

Price can be set on a cost basis.

Pricing: Keeps record of customers, competitors and costs.

Short-term: A price higher than the variable costs is acceptable, provided there is spare capacity.

Contribution theory works well for pricing.

If there is no capacity, set the price at VC + Cost of capacity, i.e. FC.

If absorption costing is used, remember selling and administrative expenses and be sure to deal with FC as unit costs because volume is an important factor in allocating FC.

4.3 Pricing for special orders H416, D193, V444

A special order must not affect normal sales, but is an additional order.

Is there capacity for production?

If there is capacity: Any price higher than the variable cost is acceptable because it can make a contribution to paying the enterprise’s FC.

If there is no capacity: Price must then be set at variable cost plus cost of capacity, e.g. overtime, double shifts, additional FC, or the contribution margin on existing products lost when production has to be sacrificed.

Proviso: Special orders at special prices may not decrease normal sales.


11.18

1. NormalSP = R10

VC = 4.5 ∴ Contribution margin of R5.5/pair

FC = 1.5

Special order: 20 000 x (R6 – 4.50) = R30 000

Additional contribution margin and income

b) R30 000 increase

2. Reno currently: VC: R48

R9 avoidable

FC: 16

R64 7 unavoidable

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Purchase price R60/U + R7/U unavoidable

If made, the unit cost is R64

If bought, the unit cost is R67

Difference R3/U x 20 000 U

= R60 000, but Reno wants to save at least R25 000

So: Essential relevant cost that must be saved is

R60 000 + 25 000 = R85 000

Therefore: 2(b)

4.4 Temporarily or permanently dropping activities

Temporary: Contribution margin? Loss? Cost of reopening.

Permanent: VKV**Please insert English equivalent** analysis.

4.5 Make or buy decision H419, D201, V443

Capacity?

i. If there is capacity, compare the cost that will change (VC) if the decision to make is made to the purchase price.

ii. If there is no capacity, compare VC + FC of production with the purchase price.

When a buy decision causes an idle loss, recover the capacity costs from the purchase price.

Volume is important in make or buy decisions.

Example: Production costs R20/U plus R51 000 fixed

Purchase price R50/U

>1 700 U: rather make; < 1 700 U: rather buy

Distinguish between avoidable and unavoidable costs

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Graph

Buy

Make

Cost (R)

1 700

Volume (U)

Qualitative factors: Quality of the product, long-term relationship with suppliers, technological changes

Outsourcing and insourcing


Solution IM 9.6

a)

C D

(R) (R)

Selling price 127 161

Variable costs 66 87

Contribution 61 74

The drilling and grinding hours required to meet the production requirements for the period are calculated as follows:

A B C D Total

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Hours per unit: Drilling 2 1 3 4

Grinding 2 4 1 3

Units of output 50 100 250 500

Drilling hours required 100 100 750 2000 2950

Grinding hours required 100 400 250 1500 2250

Drilling hours are the limiting factor (1650 hours are available). The contributions per drilling hour are R20.33 for product C (R61/3 hours) and R18.50 (R74/4 hours) for product D. Therefore the maximum demand of product C should be met, resulting in 950 drilling hours being utilized (750 for product C and 200 hours for components A and B). The remaining capacity of 700 hours can be used to produce 175 units of product D. It is assumed that the internal demand for components A and B must have priority over meeting the demand for product D. The estimated profit per week is:

(R)Contribution from product C (250 units at R61) 15 250Contribution from product D (175 units at R74) 12 950 Total contribution 28 200Allocated fixed overheads (250xR23)+(175xR39) 12 575

15 625

b) i) Components A and B are not used to produce either of the finished products but if they are purchased drilling time can be freed up to expand production of product D. The variable costs of components A and B are R32 and R78 respectively and the outside purchasing costs are R50 and R96. Thus variable costs will increase by R18 per unit for both components but the contribution per drilling hour from producing product D is R18.50. Purchase of componentA releases 2 drilling hours (yielding R37 additional product D contribution) and purchase of component B releases 1 drilling hour (yielding R18.50 additional contribution). Thus components A and B should be purchased from outside and this will free up 200 drilling hours (50 components x 2 hours for component A plus 100 x 1 hour for component B). This will enable output of product D to be expanded by 50 units (200 hours/4 hours per unit). The increase in contribution is calculated as follows:

(R) (R)

Additional contribution from product D (50xR74) 3 700

Less additional purchasing costs:

Component A (50xR18) 900

Component B (100xR18) 1 800 2 700

Additional contribution 1 000

b) ii) For the answer to this question see ‘Single-resource constraints’ and ‘Tworesource constraints’ in Chapter 25.

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4.6 Expanding capacity or product lines

Consider advertising, incremental marketing, commission and incremental administrative costs. Also consider working capital regarding inventory and debtors.

Opportunity costs: Whether income of any current production must be sacrificed.

Capacity? The same principles apply as in paragraph 4.2.

4.7 Replacing means of production H431, D199

Refer to investment decisions in RECP 674 (Financial Management).

Book value of old machine (asset): Relevant? Cash flow?

Current sales value of old asset: Relevant? Cash flow?

Profit or loss through alienation: Relevant? Cash flow?

Purchase price of new asset: Relevant? Cash flow?

4.8 Product mix decisions H426

Limited capacity: Product mix with the highest contribution margin per constraint.

5. MANAGING CONSTRAINTS H426, V449

Careful planning is needed to make the best use of facilities.

Opportunity costs come to the fore.

Product mix at capacity limits: Linear programming (Study unit 13).

Outsourcing.

6. RISK AND UNCERTAINTY IN DECISION MAKING: STUDY UNIT 11

7. CUSTOMER PROFITABILITY, ABC AND RELEVANT COSTS H427

Decisions on whether to add or drop a product line/branch/segment – similarly, the product line/segment can be a customer.

Decision: Add or drop a customer.

Principle of relevant costs and relevant income where the customer is the cost object rather than the product.

Examples 11.8 and 11.9 H428 [393] explain this.

These examples also contain the ABC principle for allocating overheads.

Note the information that must be provided relating to the bases used for allocating costs. Why?

Customer profitability analysis for Allied West

Customer

Vogel Brenner Wisk TotalRevenues R500 000 R300 000 R400 000 R1 200 000

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Cost of sales 370 000 220 000 330 000 920 000Furniture-handling labour 41 000 18 000 33 000 92 000Furniture-handling equipment cost written off as depreciation

12 000 4 000 9 000 25 000

Rent 14 000 8 000 14 000 36 000Marketing support 11 000 9 000 10 000 30 000Sales-order and delivery processing 13 000 7 000 12 000 32 000General administration 20 000 12 000 16 000 48 000Allocated corporate-office costs 10 000 6 000 8 000 24 000

Total costs 491 000 284 000 432 000 1 207 000

Operating income R9 000 R16 000 R(32 000) R(7 000)

REQUIRED:

1. Should Wisk be dropped?

2. Should Loral be added instead of Wisk? (Loral needs the same as Wisk plus R9 000 equipment).

Loss in revenues and savings in costs from

dropping Wisk account

Incremental revenues and

incremental costs from adding Loral

account(1) (2)

Revenues R(400 000) R400 000Cost of sales 330 000 (330 000)Furniture-handling labour 33 000 (33 000)Furniture-handling equipment cost written off as depreciation

0 (9 000)

Rent 0 0

Marketing support 10 000 (10 000)

Sales-order and delivery processing 12 000 (12 000)

General administration 0 0

Corporate-office costs 0 0

Total costs 385 000 (394 000)

Effect on operating income (loss) R(15 000) R6 000

Relevant revenue and relevant cost analysis for dropping Wisk and adding Loral

Do Drury IM 9.9 as practice and compare your answer with the suggested solution below.

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Suggested solution IM 9.9

(a) The relevant costs of the contract are as follows:

(R) (R)Salary of G. Harrison 2 000Supervision cost * 10 000Cost of craftsmen * 16 000Cost of equipment ** 3 000Material costs: ***A (100 x R3) + (900 x R3) 3 000B (1000 x R0.90) 900C (100 x R6) 600D (100 x R2) + (100 x R3) 500E (5000 x R0.20) 1 000F (1000 x R1) + (2000 x R2) 5 000 11 000Other direct expenses 6 500Owner’s opportunity cost ^ 3 000

51 500Less savings on maintenance work ^^ (1 500)Minimum contract price 50 000

Notes:* The costs given in the question include apportioned fixed overheads which are not a relevant cost. Therefore R1000 has been deducted from the supervision cost (10% x R10 000) and R800 from each of the craftsmen’s costs.

** The historical cost of the equipment is a sunk cost. It is assumed that the existing equipment would have been sold if the contract were not accepted. Therefore the relevant cost of using the equipment is the reduction in the scrap value over the duration of the contract.

*** Material A: It is assumed that the usage of the 100 units in stock will be replaced in the coming year and be used on property maintenance. This is more profitable than the alternative of selling the materials for R2 and replacing them at a later date at R3. The remaining quantities will be replaced at the current purchase price. Material B: It is assumed that the 1000 units issued from stock for the contract will be replaced at R0.90 per unit. This material is used regularly in the business.Material C: This material is purchased specially for the contract.Materials D and F: The stocks of these materials have no alternative use within the business and will be sold if not used on the contract. Hence the sale price represents the opportunity cost of using these materials. The remainder of the materials will be purchased at current prices.Material E: It is assumed that the material taken from stock for this contract will be replaced at the current purchase price. This material is used regularly in the business.

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^ It is assumed that the alternative is for Johnson to pay out R12 000 to maintain the existing business while he earns R15 000 on the one year appointment. If the contract is undertaken then Johnson will lose R3000.

^^ It is assumed that the contract could be completed and maintenance programme carried out during the period in which the supervisor and craftsmen are employed (one year). It is also assumed that the supervision and craftsmen will be employed for one year only. A further assumption is that the lowest quotation will be accepted. Other assumptions: The lease of the yard would have to be paid even if the contract were not accepted.

(b) (i) What is the likelihood that Johnson will obtain other contract work during the year? If there is a possibility then any lost contribution should be covered in the minimum contract price.(ii) Given that the profit was R12 000 last year, Johnson should consider closing operations and obtaining a permanent salary of R15 000 per annum. (iii) Do any alternative uses for the accommodation of the yard exist? If so then appropriate opportunity cost should be added.(iv) The contract price represents a minimum price. Johnson should aim to earn a surplus on the contract.(v) Will the loss of one-quarter of Johnson’s time to the existing business result in a reduction in profit? If this is the case then the lost profits should be included as an opportunity cost.

ASSIGNMENTS


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Study unit 12

12 RISK AND UNCERTAINTY


Study material: Vigario - Chapter 10[Drury - Chapter 12][Redelinghuis - Chapter 4]

LEARNING OUTCOMES


Discuss and calculate expected values.

Distinguish between certainty, uncertainty and risk.

Draw a decision tree and evaluated expected values.

Define the following terms:

* Objective probability

* Marginal probability

* Mutually exclusive events

* Collectively exhaustive events

* Expected monetary value

* Statistical dependence and independence

* Maximin

* Maximax

* Minimax

Make decisions by using the maximin, maximax and minimax decision criteria.

Make decisions based on risk by using the following methods:

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* Expected monetary value

* Expected value of perfect information

* Expected opportunity loss

1. INTRODUCTION R127

Information for decision making contains both quantitative and qualitative characteristics.

Decisions are made on future events because historical events are irrelevant for current decisions.

No one can predict the future with certainty.

Risk and uncertainty deal with future events.

Risk: Situations have several possible outcomes and there is material statistical evidence for this. The decision maker is therefore able to assign a probability to the outcome of the various events.

Uncertainty: There are various possible outcomes, but little statistical evidence to support the decision maker in their forecast. This limited information therefore does not enable the decision maker to assign a probability to the outcome of an event.

2. TERMINOLOGY V409, R160

Subjective probabilities: The decision maker has no basis from past experience to support the probabilities. Probabilities are therefore assigned according to individual judgement, which differs from one person to the next.

Objective probabilities: Based on historical evidence or experience.

Marginal probabilities: The outcome of any event is not influenced or caused by a preceding event.

Mutually exclusive events: Only one event occurs at a time. The probabilities of events that are mutually exclusive can be added and must always total 1.

Collectively exhaustive events: List of all the possibilities or probabilities of a given action. Events can be mutually exclusive and collectively exclusive, but the sum of probabilities must be 1.

Statistical independence: The occurrence of one event will not affect the occurrence of a second event.

Statistical dependence: One event is affected by or dependent on the occurrence of another.

Decision trees: Diagrammatical representation of a decision-making problem.

Decision node: Point on a decision tree, represented by a box, where a choice has to be made between different alternatives.

Decision table: A table showing all the outcomes of the various events for each alternative action.

Event note: Point on a decision tree, represented by a circle, from which the various possible events that may arise branch out.

Maximax: Optimistic decision-making criterion in decision making based on uncertainty which maximises the maximum outcome.

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Minimax: Decision-making criterion in decision making based on uncertainty which is based on opportunity loss.

Expected monetary value: The expected average result if the same decision were to be taken repeatedly over a long period.

Maximin: Pessimistic decision-making criterion in decision making based on uncertainty which is based on maximising the minimum outcome.

3. DECISION MAKING BASED ON UNCERTAINTY R127, V417

In these circumstances, the decision maker has no information that would enable them to assign a probability to the outcome of an event. If the manufacturer produces a new product without the opportunity of doing market research, the decision is based on uncertainty. The following criteria can be used in these types of decisions: maximax, maximin, minimax and the criterion of realism (lies between maximax and maximin values). To explain this, we use the example from Vigario 417.

Company A plans to market one of the following products X, Y or Z. Only one can be marketed and there is no statistical evidence as to the probable success of the products.

Product X is considered to be a high-risk, high-return product.

Product Y is considered to be of average risk and return.

Product Z is a low-risk, low return product.

Consumer attitude towards general buying power could be high, static, low or highly depressed. A estimates that the potential profits, given one of the four economic states for each of the products, is as follows:

Profit given in R’000 States

1 2 3 4____

Product X 50 Mama 25 4 -10

Product Y 30 20 15 0

Product Z 10 8 6 6 Maximin

REQUIRED:

Show how you would arrive at a decision on product choice using the maximin, maximax and minimax decision criteria.

Suggested solution

Maximin decision (pessimistic criterion)

According to this criterion, the worst state is 4 and the product that will make the highest profit there is Z, i.e. R6 000. Therefore Z will be selected.

Maximax decision

This is the opposite of the maximin decision and takes the most optimistic view of the best outcome. The product with the highest risk profile will be chosen, i.e. X with a maximum profit of R50 000.

Minimax decision (minimise the maximum regret)

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This decision considers the opportunity cost of making the wrong decision. We could ask: What is the opportunity cost of making the wrong decision or by how much would the decision maker regret not having made the correct decision? For example, in state 1 if product X is chosen, the profit will maximise and there will be no opportunity cost. If product Y is chosen, the maximum opportunity cost or regret is R20 000 (R50 000 - R30 000). For product Z the maximum regret will be R40 000 (R50 000 – 10 000). The final choice is the product that minimises the opportunity cost or maximum regret. Apply the method as follows:

Step 1: For state 1, select the highest profit, i.e. X and deduct the profit of all other products in state 1.

Step 2: Do the same for states 2, 3 and 4.

Step 3: Select the maximum values for each product row.

Step 4: Select the product with the smallest (lows) of the maximum values under step 3.

Minimax table State

1 2 3 4

Product X 0 0 11 16

Product Y 20 5 0 6

Product Z 40 17 9 0

The highest value for each row is:

X 16

Y 20

Z 40

Selection: Product X which minimises the maximum regret or opportunity cost.

4. DECISION MAKING BASED ON RISK R131

Risk in decision making arises from the possibility that the actual result of a particular event may deviate from the expected result. This problem can be overcome by assigning a probability to each outcome of an event. The degree of risk will depend on the confidence in the probability. Probabilities may be determined from past experience, market research, pilot studies, etc. If past information is not available, the decision maker must rely on the probabilities, which are assigned subjectively and therefore there is a lower confidence level in them.

Methods used to make decisions based on risk are:

- Selecting the alternative with the highest expected monetary value

- Expected value of perfect information

- Expected opportunity loss

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4.1 Expected monetary value R131

The formula for calculating the expected value is:

E(×) = n ×iP(×i) Where E = Expected value

× = Outcome ×i

i = 1 P(×i)= Probability ×i

Example: R131 - 136

A market buys highly perishable products at R3 a box and sells them for R5 a box. If the box is not sold within one day, it must be destroyed at 25 cents per box. How many boxes must be ordered to meet the next day’s demand?

Sales records for the past 150 days are as follows:

Boxes sold per day Number of days on which that quantity was sold

100 15

200 45

300 60

400 30

Examples of combinations:

i. If 100 boxes are ordered and sold, the income is R200 (100 x 5 - 3).

ii. If 100 boxes are ordered and the demand is for 200, 300 or 400 boxes, the sales are lost and the provisional value remains R200.

iii. If 200 boxes are ordered and demand is only for 100 boxes, the remaining 100 boxes have to be destroyed at 25 cents each and the provisional value is then -R125 (200 x 3 + 100 x .25 expense as opposed to income of 100 x 5).

Decision table

Alternative actions

Number of boxes

Demand 100 200 300 400

R R R R

100 200 (125) (450) (775)

200 200 400 75 (250)

300 200 400 600 275

400 200 400 600 800

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The probability distribution is:

Daily

sales

Number

of days

Probability (P)

100 15 0,1 (15/150)

200 45 0,3 (45/150)

300 60 0,4 (60/150)

400 30 0,2 (30/150)

150 1,0

The expected monetary value using the above formula is:

U (order 100 boxes) = * 200 (.1) + 200(.3) + 200(.4) + 200(.2)

= 200

*Income from 100 boxes = 100(5 - 3) = R200

U (order 400 boxes) = -775(.1) - 250(.3) + 275(.4) + 800(.2)

= 117.5

Expected monetary values:

Demand P Alternative actions

Number of boxes ordered

100 200 300 400

R R R R

100 .1 20 (12.5) (45) (77.5)

200 .3 60 120 22.5 (75)

300 .4 80 160 240 110

400 .2 40 80 120 160

Expected value 200 347.5 337.5 117.5

The best solution would therefore be to order 200 boxes. Note that the expected monetary value is not the income that will be realised on one particular day, but the expected average over a long period.

4.2 Expected value of perfect information

Perfect information refers to complete and accurate information. The expected value of perfect information is the expected income that will be realised if the optimal number can be bought every day and is calculated in the table below. The provisional values are the maximum possible income for each sales volume.

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Expected value of perfect information

Demand P Provisional income based Expected

(boxes) on certainty value

100 .1 R200 R20

200 .3 R400 120

300 .4 R600 240

400 .2 R800 160

Expected value of perfect information R540

The value of additional information is:

Expected value of perfect information R540

Expected value based on risk (p6) 347.5

Value of additional information R192.50

The purchasing manager of the market must therefore not pay more than R192,50 for a market researcher.

Do IM12.5 in Drury as practice and compare your answer with the suggested solution below.

Suggested solution IM 12.5

There are two possible selling prices and three possible direct material costs for each selling price. The contributions per unit before deducting direct material costs are R12 (R15 - R3) for a R15 selling price and R17 for a R20 selling price. The purchase costs per unit of output are R9 (3 kg x R3), R8.25 (3 kg x R2.75) and R7.50. Where the firm contracts to purchase a minimum quantity, any surplus materials are sold at R1 per kg.

Statement of outcomesSales

quantitiesGross

contributionNet

purchase cost

Fixed cost Profit / (loss)

Probability Expected value

(000) (R000) (R000) (R000) (R000) (R000)

R15 selling price (R3 purchase price)36 432 324 65 43 0.3 12.928 336 252 65 19 0.5 9.518 216 162 65 (11) 0.2 (2.2)

20.2

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R15 selling price (R2.75 purchase price)36 432 297 65 70 0.3 21.028 336 231 65 40 0.5 20.018 216 148.5 65 2.5 0.2 0.5

41.5

R15 selling price (R2.50 purchase price)36 432 270 65 97 0.3 29.128 336 210 65 61 0.5 30.518 216 159* 65 (8) 0.2 (1.6)

58.0

R20 selling price (R3 purchase price)

28 476 252 136 88 0.3 26.4

23 391 207 136 48 0.5 24.0

13 221 117 136 (32) 0.2 (6.4)

44.0

R20 selling price (R2.75 purchase price)

28 476 231 136 109 0.3 32.7

23 391 189.75 136 65.25 0.5 32.625

13 221 126.5** 136 (41.5) 0.2 (8.3)

57.025

R20 selling price (R2.50 purchase price)

28 476 210 136 130 0.3 39.0

23 391 174*** 136 81 0.5 40.5

13 221 144**** 136 (59) 0.2 (11.8)

67.7

Notes:

* 170 000 kg minimum purchases at R2.50 per kg less 16 000 kg [70 000 - (3 kg x 18 000) at R1 per kg].** 50 000 kg minimum purchases at R2.75 per kg less 11 000 kg [50 000 - (3 kg x 13 000) at R1 per kg].*** 70 000 kg minimum purchases at R2.50 per kg less 1000 kg [70 000 - (3 kg x 23 000) at R1 per kg].**** 70 000 kg minimum purchases at R2.50 per kg less 31 000 kg [70 000 - (3 kg x 13 000) at R1 per kg].

If the objective is to maximize expected profits then the R20 selling price combined with purchasing option (iii) is recommended. On the other hand, if the maximin criterion is adopted then the R15 selling price combined with purchasing option (ii) is recommended. An alternative approach is to examine the probability distributions (final column of the statement) and adopt a combination which best satisfies the decision-maker’s risk/return preferences.

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(b) If demand is predicted to be optimistic, the highest payoff of R130 000 (R20 selling price and R2.50 purchase price) for the most optimistic demand level would be chosen. If the most likely demand is predicted, the highest payoff is R81 000 (R20 selling price and R2.50 purchase price). If the pessimistic demand level is predicted, the highest payoff is R2500. The expected value of profits assuming it is possible to obtain perfect information is:

RR130 000 x 0.3 = 39 000

R81 000 x 0.5 = 40 500R2 500 x 0.2 = 500

80 000

The highest expected profit without perfect information in (a) is R67 700. Therefore the maximum price payable for perfect information is R12 300 (R80 000 - R67 700).

5. DECISION TREES R139

Refer to RECP 674 (Financial Management)

ASSIGNMENT


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159

Study unit 13

13 LINEAR PROGRAMMING, SHADOW PRICES AND SENSITIVITY ANALYSIS


Study material: Horngren - Chapter 11

Vigario - Chapter 12

[Drury - Chapter 25]

LEARNING OUTCOMES


Use linear programming to find the optimal solution to a problem with multiple constraints.

Formulate linear programming equations and find solutions in graph form to maximise profit or minimise cost.

Apply the concept of shadow prices.

Evaluate linear programming as a technique to make decisions where there are multiple constraints concerning:

* Utilisation of capacity.

* Profitability of product lines.

* The desirability of additional marketing efforts.

* Limitation in capacity, direct labour or materials.

* Utilisation of storage space, etc.

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1. INTRODUCTION R215

Decision making thus far: One constraint – use contribution margin per limiting factor.

What if there is more than one constraint? Linear programming (LP).

Examples of problems that can be solved with LP:

i. Rationing scarce resources, e.g. capacity, raw material, direct labour hours.

ii. The combination of products to sell.

iii. Fixing transfer prices.

iv. Establishing transport routes.

The purpose: Maximum profit or minimum costs.

LP: A mathematical technique that can be used by management to determine how limited resources can be used optimally.

2. ASSUMPTIONS AND LIMITATIONS OF LP V478, R220

It is assumed that the coefficients (i.e. the values, costs, production requirements, etc.) in the objective function and constraint equations can be determined with certainty and will not change during the period.

A linear relationship is assumed in the objective function and constraints.

Divisibility: It is assumed that the decision-making variables in the optimal solution need not be whole numbers, but may be fractions.

Product independence: The assumption is that the demand for one product will not affect the demand for another. If products are complementary, however, it could affect demand.

Accuracy of information: The final solution is as accurate as the information for the model.

3. TERMINOLOGY R241

Algebraic method: Once the determining constraints have been identified by means of a graph, the optimal solution can be calculated by solving two equations algebraically.

Constraints: Resources that are available in limited quantities and are formulated in the linear programming model as mathematical equations.

Upper bound: Indicates that the use of a resource must be less than or equal to (<) a particular quantity.

Objective function: Mathematical expression of a target or objective, e.g. maximising profit or minimising costs.

Duality: An alternative way of approaching a linear programming problem.

Linear programming model: A decision model consisting of linear objective functions and linear constraints.

Non-negativity constraint: A constraint that prevents decision variables from assuming negative values. All decision variables must be greater than or equal to zero, e.g. ≥ 0.

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Lower bound: Indicates that the use of a resource must be greater than or equal to (>) a particular quantity.

Shadow prices: The value of one additional unit of a resource that is already fully utilised.

Feasible region: The area on a graph in which any feasible solution must fall. It has lower bounds below and left and upper bounds above and right.

Profit line (cost line) method: The optimal solution is determined by plotting profit lines arbitrarily on the graph. The optimal solution of a maximisation problem occurs before the point that is the furthest away from the origin where the profit line intercepts the feasible region (in minimising, this is the point closest to the origin).

4. USE OF LP R238

In production: Production planning, product composition and mix composition.

In marketing: Advertising and distribution, e.g. develop a system with LP to minimise the transport costs to the various marketing territories.

In human resources: Staff planning and composition.

In financing: LP can be used in determining the optimal combination of sources of financing and in investment portfolios to decide on shares and stocks.

5. STEPS IN LP H437, V467

i. Determine the objective function: Maximise profit or minimise costs.

ii. Identify the constraints: Examples: capacity, direct labour hours, materials.

iii. Determine the optimal solution with the aid of trial-and-error graphs.

Work through the example in Horngren 392 carefully, where all the steps are explained clearly. Make sure you are very familiar with the algebraic and graph methods of determining the optimal combination.

6. SENSITIVITY ANALYSIS H439, V474

Uncertainty in the LP model means that a change in the coefficients affects the slope of the objective function or the area of feasible solutions, e.g. a change in the contribution margins of the products will affect the optimal solution.

7. DUALITY AND SHADOW PRICES V469, R235

A shadow price is the value of an additional unit of a particular resource added to the existing quantity (or the value of a unit that is removed). It is therefore the marginal change in the objective function if a resource increases or decreases by one unit. The equation for the shadow price is sometimes known as the dual problem.

If the primary objective function equation entails the maximisation of profit, the purpose of the dual equation will be to minimise costs. The upper bounds (<) will be converted to lower bounds (>) and vice versa. For management the most useable information that is obtained by solving the dual is the shadow prices.

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Assume the following in an example:

XYZ Limited manufactures two products: A and B with the following production requirements:

Product A Product B

Selling price R60 R65

Variable cost:

Materials: 8 kg x R2 = R16 4 kg x R2 = R8

Labour: 6 hours x 4 = 24 8 hours x 4 = 32

Overheads: 4mh x 1 = 4 6mh x 1 = 6

Constraints: 2 880 direct labour hours, 3 440 kg direct materials

REQUIRED:

Using the algebraic method, determine what the optimal composition of the products must be, taking the constraints into account.

- Objective function: 16A + 19B

- Equations: 8A + 4B < 3 440------- Only A A = 430, Only B B = 860

6A + 8B < 2 880------- Only A A = 480, Only B B = 360

A > 0 ; B > 0

Optimal composition A = 400, B = 60

x 2 : 16A + 8 B ≤ 6 880 - -

- 10A = 4 000 Substitute A = 400 in

A = 400 B =

3 440 − 8( 400)4 = 60

If machine hours are also a constraint, e.g. 2 760, the solution can be determined in a graph by adding the equation 4A + 6B < 2 760 to the above two. Only A A = 690, Only B B = 460. If the problem is solved in a graph and the vertex method is used to substitute the different alternatives for the composition of the products in the equation 16A + 19B, the optimal composition is A = 400 and B = 60 as the highest contribution margin [400 (16) + 60 (19) = R 7 540].

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Shadow prices can be used to do a sensitivity analysis on the availability of the constraint.

For 400 of A and 60 of B the two constraints, i.e. 2 880 direct labour hours and 3 440 kg direct material, are fully utilised. By the way, this was the intersection of these two equations.

Here is an example to illustrate the shadow price concept. Assume that 10 direct labour hours are lost and only 2 870 direct labour hours are available.

The new optimal product mix will still be at the intersection of:

8A + 4B < 3 440

6A + 8B < 2 870

Solve simultaneously A = 401 and B = 58

The new contribution margin is 16 (401) + 19 (58) = R7 518. Compare this with the previous contribution margin of R7 540. This indicates a drop in contribution margin of R22 caused by the 10 lost direct labour hours the shadow price per hour is R22 ÷ 10 = R2,20.

Do the same for materials and work out that the shadow price for materials is R0,35/kg.

8. SIMPLEX METHOD V476, R255-279

So far the application of LP has been limited to problems with two decision variables and it was possible to find solutions using a two-dimensional graph.

Problems often have many, sometimes even hundreds of, variables and the scope of the problems is too big for a two-dimensional graph.

The simplex method can be used to solve LP problems with several variables.

The simplex method is an algebraic procedure of systematic iteration. The principle is simple and similar to the graph vertex method. Because of the many different levels and dimensions it is not possible to draw the feasible region on a graph, but the optimal solution will still be at the vertex.

The simplex method evaluates each vertex by starting at a certain vertex and systematically and iteratively (i.e. by repeating the same procedure each time) moving to the next vertex until the optimal solution has been found. The starting point is an initial feasible solution that is systematically adjusted in a way that improves the objective function with each iteration. Each iteration is therefore closer to the optimal solution.

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The repetitive nature of this procedure makes it extremely suitable for solving by computer.

EXAMPLE: THREE CONSTRAINTS (add the following to the example in paragraph 7)

Suppose there is a constraint of machine hours, i.e. 2 760. Now the optimal composition can be indicated in a graph as below.

The equation for the constraint of machine hours is:

4A + 6B ≤ 2 760 ONLY A A = 690, ONLY B B = 460

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Products A and B will be plotted on the x- and y-axis, respectively, as follows (DLH in black, MH in blue, materials in red):

B

9

8

7

6

5

4

3 Q

2

1

E

(00) P 1 2 3 4 5 6 7 8

(00) Units

Do 12.5 in Vigario as practice and compare your answer with the suggested solution below.

Polygon: P Q R S Objective function 16A + 19B

(feasible region)

P: 16(0) + 19(0) = 0

Q: 16(0) + 19(360) = R6 840

*R: 16(400) + 19(60) = 7 540 Optimal

S: 16(430) + 19(0) = 6 880

*Determined algebraically in paragraph 7.

For a contribution margin of R6 080 the profit line (in green) can be plotted.

(A =

R 6 08016 = 380)

(B =

R 608019 = 320)

More contribution margin lines could be included (arbitrarily)

A

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Vigario 12.5

a)

Gamma Delta

Contribution margin

Contribution margin/blending hour

R4 000/kg

R4 000/100 blending hours

= R40/blending hour

R8 000/kg

R8 000/250 blending hours

R32/blending hour

Contribution margin R4 000 x 10.5 kg = R42 000

- FC 36 000

Income R6 000

This point is the optimal, since Gamma earns R40 per blending hour and Delta only R32 per hour. This is true because blending hours are the only constraint and any potential loss if Delta is not sold is not taken into account – the reason being that it is not relevant.

b) Objective function = 4 000G + 8 000D

Constraints: G: D 0 400G + 120D 1 200

100G + 90D 450

100G + 250D 1 050

Vertices:

A: 4 000 (3) + 8 000 (0) = R12 000

B: 4 000 (2.25) + 8 000 (2.5) = R29 000

C: 4 000 (1.125) + 8 000 (3.75) = R34 500 (optimal)

D: 4 000 (0) + 8 000 (4.2) = R33 600

Profit = R34 500 – 36 000 = (R1 500) loss

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c) Implications:

Question 2 implies a loss of R1 500 for the three months, so the following must be considered:

Are there other more profitable products to produce with the limited capacity?

Is it possible to expand capacity, e.g. through overtime, outsourcing?

Are the fixed costs unavoidable or what would happen if other products were produced?

How will demand for the products in the future change?

Can Gamma or Delta be bought externally or only made internally?

Can selling prices be raised or is there any other way of saving costs?

Can unrefined Gamma or Delta be sold to overcome a temporary production shortage?

d) Blending:

100G + 90D 450

100G + 250D 1 051

D 3.75625

G 1.119375

4 000 (1.119375) + 8 000 (3.75625) = R34 527.50

Compared to R34 500 (of 2)

Management will not pay more than R27,50 for the additional blending hour.

Refining:

100G + 90D 451

100G + 250D 1 050

D 3.74375

G 1.140625

4 000 (1.140625) + 8 000 (3.74375) = R34 512.5

Compared to R34 500 (of 2)

Management will not pay more than R12,50 for an additional refining hour.

This information can be used in the following ways:

Usine will pay up to R12,50 more than the normal rate for an extra refining hour.

Other uses of the refining time is that at least R12,50 per hour must be recovered and shadow prices can be used to determine rates for new products when they have to be evaluated.

The limitation of shadow prices is the same as for linear programming, with one other important issue, namely that shadow prices will only be relevant for a particular range. If more refining hours become available, the constraint on the graph will move further right and the composition changes for determining the most profitable combination.

Other limitations:

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Are the objective function and constraints linear functions?

Reliability of estimates?

Are there no other constraints?

Qualitative factors?

Interdependence, e.g. the sales volume of one product may affect the sales of other products.

ASSIGNMENTS


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14 TRANSFER PRICING AND SERVICE DEPARTMENTS


Study material: Horngren - Chapters 15 and 22

Vigario - Chapter 13

[Drury - Chapter 20]

[Garrison - Chapters 12 and 16]

LEARNING OUTCOMES


Discuss the objectives of transfer pricing.

Discuss the objectives and method of target pricing.

Discuss transfer pricing when the transferring division sells to the external market and when it sells only to an internal division.

Explain why cost-plus transfer prices will not maximise group profits.

Discuss multinational transfer prices and tax considerations.

Discuss and prepare life cycle budgets.

Discuss departmentalisation and allocate costs in service departments and production departments.

Discuss and apply four methods of determining transfer prices.

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1. INTRODUCTION H794

Pricing decisions not only involves those decisions made by management about the price of a product or service, but also include decisions about the profitability of products.

Costs must be known in order to set prices. Unfortunately there is no single method to determine costs for pricing because the pricing may be for different purposes. For example, a price for a special order is based on variable costs and a price for the long term is based on total costs (FC + VC).

Three important factors that can influence a price are customers, competitors and cost (the 3C’s).

An internal focus, i.e. continuous improvement, is key to keeping costs low.

2. MANAGEMENT CONTROL SYSTEMS H795

A management control system is a means of gathering and using information to coordinate planning and control decisions throughout the organisation.

Levels of management control systems:

i) Total organisational level: For example, inventory price, net income, return on investment, total employment.

ii) Customer/market level: For example, customer satisfaction, time taken to respond to customer requests for products and cost of competitors’ products.

iii) Individual-facility level: For example, materials costs, labour costs, absenteeism rates and accidents in various divisions of business functions, i.e. R&D, production and distribution.

iv) Individual-activity level: For example, time taken and costs incurred for receiving, storage, assembly and distribution.

Financial and non-financial information is gathered.

3. CONSIDERATIONS OTHER THAN COST IN PRICING DECISIONS

Target price: This is an important form of market-based price. It is the estimated price of a product or service that potential customers will be prepared to pay.

Target profit: This is the income (profit) that a business wants to earn on a product or service.

Target costs: These are the estimated long-term costs per unit (product or service) if it is sold for the target price.

Costs that are relevant for target costing: FC + VC.

Target costs are used by Ford, General Motors, Mercedes, Toyota, Panasonic, Sharp, Compaq and Toshiba.

Implementation of target costing.

Pricing with target costing works opposite to cost-based pricing. The steps are as follows:

i. Develop a product that satisfies the needs of potential customers.

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ii. Choose a target price that will be acceptable to potential customers.

iii. Subtract the target profit from the target price to obtain the target cost.

iv. Design and develop the product at the target cost (note that re-planning, value-chain analysis and valuation are allowed to come off the target costs).

Target costing is customer oriented because it starts with the selling price.

Distinguish between price discrimination and peak load pricing.

4. DEPARTMENTALISATION H572

Cost allocation: Costs relating to more than one department or activity can be allocated in various ways, e.g. between production departments and also to service departments.

Cost allocation and service departments: Refer to MACC221.

i. Direct allocation method: This is the most common method where the costs of the service departments are allocated directly to the production departments, e.g. by means of a measure such as maintenance hours, cafeteria workers etc.

ii. Step-down allocation method: Service department costs are allocated in a particular sequence.

iii. Reciprocal allocation method: The mutual services of service departments to one another are taken into account, which means that a service department may receive costs after its own have been allocated.

5. RESPONSIBILITY CENTRES H799

To measure the performance of subunits (departments) in centralised and decentralised organisations, management can use one or a combination of four types of responsibility centres:

i. Cost centre: Control over costs.

ii. Income centre: Control over income only.

iii. Profit centre: Control over income and expenses.

iv. Investment centre: Control over investment, income and expenses.

6. TRANSFER PRICING H799+, D503, V505

Transfer price: The price at which a product or service is transferred from one segment/department to another within the organisation.

Methods of determining transfer prices:

i. Market-based transfer prices: This represents the price of a similar product or service external to the organisation.

ii. Cost-based transfer price: This cost base may be a marginal cost (variable cost) or an absorption cost (total cost) base, depending on capacity. It may be an actual or budgeted cost.

iii. Negotiated transfer price: This price is set after negotiation between the departments concerned or price negotiations could be held with external parties.

Work through the example in Horngren H766+ (767) and the explanation of the theory H767+ (768+).

iv. Target profit: V290. Vigario adds a fourth method, i.e. target profit, which is also based on cost but with the addition of a fixed percentage for profit. This

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method is used when a market price is not available or when the above methods produce unsatisfactory results.

7. GENERAL GUIDELINES FOR TRANSFER PRICING D512, H808, V507

The minimum transfer price must be based on variable costs plus opportunity costs (forfeited contribution margin on existing products of the supplying department).

If there is no capacity: Minimum transfer price = VC or incremental costs + Opportunity costs.

If there is capacity: Minimum transfer price = VC or incremental costs.

8. TRANSFER PRICING AND SELLING MARKETS V509

Transferring department.

Receiving department.

Transfer price.

Goal congruence.

Perfect and imperfect markets.

Study Vigario 505 to 523 and work through the examples. Note when there is an external market for the product and when not and also when there is a market for the transferring department and for the receiving department.

Do Drury IM 20.5 and Horngren 22.21 as practice and compare your answer with the suggested solutions below.

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Solution IM 20.5

The report should include an estimate of divisional profits and return on investment (ROI) based on current demand:

Division A Division B(R000) (R000)

Contribution from outside sales 1500 250Contribution from internal transfers 375 ___Total contribution 1875 250Fixed costs 500 225Profit 1375 25Investment 6625 1250ROI 20.8% 2%

Assuming there is a single market price of R30, the current system is motivating correct decisions since both managers are encouraged to expand output. However, the current transfer pricing system is causing motivational problems because it under estimates the contribution which division B makes to overall company profits. In other words, the current system results in an inadequate measure of divisional performance. Division A has 30 000 units capacity available to meet the demand of Division B. Therefore Division A can meet the demand of Division B without forgoing any sales to outside customers. Consequently the relevant cost of the transfers is R15 per unit variable cost. A transfer price of R15 per unit would be unfair to Division A, since internal transfers would not provide any contribution to fixed costs. A possible solution is to set the transfer price at R15 per unit, and Division B should also pay Division A an annual lump sum contribution to cover the fixed costs of Division A. Total output of Division A is 125 000 units, consisting of 100 000 units outside sales and 25 000 units internal transfers. Therefore 20% of Division A’s capacity is devoted to Division B, and thus the lump sum payment should be R100 000 (20% of R500 000 fixed costs). If in any year it is anticipated that demand in the external market will be in excess of Division A’s capacity, the transfer price should be set at the prevailing market price. It is assumed that additional sales of 5 000 units of product J can only be obtained if a new branch is opened. The incremental costs to the company are R175 000 (R125 000 variable cost + R50 000 establishment costs) and the incremental revenues are R250 000. Therefore total company profits will increase by R75 000 if the new branch is opened. However, with the present transfer pricing system Division B will regard the transfer price as an incremental cost. Consequently contribution will be R10 per unit and the annual establishment costs of R50 000 will equal Division B’s total contribution of R50 000. Therefore Division B profits will remain unchanged and the manager will not be motivated to open the new branch. If the new branch is opened then, with the present transfer pricing system, the R75 000 additional profit will be allocated to Division A.

A transfer price system consisting of R15 variable cost plus a lump sum payment is recommended. The revised transfer pricing system will motivate the manager of division B to open the new branch. The divisional profit calculations (without the new branch) based on the proposed transfer pricing system are as follows:

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Division A Division B(R000) (R000)

Contribution from outside sales 1500 625Contribution from internal transfers - -Lump sum payment 100 (100)Fixed costs (500) (225)Profit 1100 300Investment 6625 1250ROI 16.6% 24%

H 22.21

Transfer price

@ MP

Transfer price @

110% x man. cost

1.

Mining Division:

Income: 400 000 x R90, 60 x 110% R36 000 000 R26 400 000

Less: Costs:

VC: 400 000 x (12 + 16 + 24) 20 800 000 20 800 000

FC: 400 000 x 8 3 200 000 3 200 000

Division operating income R12 000 000 R2 400 000

Metals Division:

Income: 400 000 x R150 R60 000 000 R60 000 000

Less: Costs:

Transfer costs of preceding department

400 000 x R90, 60 x 110% 36 000 000 26 400 000

Division VC: (6 + 20 + 10) x 400 000 14 400 000 14 400 000

Division FC: 15 x 400 000 6 000 000 6 000 000

Division operating income R3 600 000 R13 200 000

2.

Bonus:

Mining Division (1%) R120 000 R24 000

Metals Division (1%) 36 000 132 000

The Mining Division manager would prefer the transfer price @ MP and the Metals Division manager would prefer the transfer price @ 110% x manufacturing costs. Give figures.

3. Class discussion. Jones would prefer the market price to the transfer price because it yields the highest bonus and competition exists that makes the market price relevant. This leads to goal achievement.

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9. MULTINATIONAL TRANSFER PRICES AND TAX CONSIDERATIONSD517, H810

Work through the example in Horngren H813.

10. LIFE CYCLE BUDGETING AND COSTING

Product life cycle: This spans the time from the development of the product until it reaches the customer.

Life cycle budgeting: These budgets contain the income and expenses of a product or entity from research and development until customer service.

Life cycle costs: These consist of all the actual costs of each product from the cradle to the grave.

Life cycle budgeting can be used in pricing.

Do 13.3 in Vigario as practice and compare your answer with the suggested solution below.

VIGARIO 13.3

a) Contribution margin/U (1 000u) (2 000u) (3 000u) Govt contract

SP R170 R150 R120 R125

70 70 70 70

-VC 16 16 16 16

= Contr margin 84 64 34 39

Number U 1 000 2 000 3 000 1 000

=Total contribution R84 000 R128 000 R102 000 R39 000

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Income statement for 19x1

Contribution margin: 1 000U x R39 (Govt contract) = R 39 000

2 000U x 64 128 000

Total contribution margin R167 000

-FC: Manuf. overheads R24 x 3 000U = R72 000:

Avoidable = 50% 36 000

Depr. = 30% 21 600

Head office = 20% 14 400

Net operating income R72 000

b) 1 000U x (R170 – 86) = R84 000

2 000U x ( 150 – 86) = 128 000

3 000U x ( 120 – 86) = 102 000

R161 - VC(86) = R75 x 2 000U = R150 000

151 - 86 = 65 x 3 000U = 195 000 desired demand

111 - 86 = 25 x 4 000U = 100 000

Income statement for 19x2

Contribution margin: Open market: 2 000 x 64 R128 000

* Internal division: 3 000 x 22.50** 67 500

Total contribution margin R195 500

-FC: Avoidable: (36 000 + 30%) 46 800

Depr. 21 600

Head office 14 400

Net operating income R112 700

*The maximum group profit will be realised if 2 000 units are sold on the open market (the highest contribution margin) and the rest based on transfer prices to the receiving division.

Lowest transfer price:

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1 000U x R125 (Govt contract)

Rest 2 000U x R86 variable costs

Highest transfer price:

If 2 000U produced, contribution margin is R150 000.

If 3 000U produced, contribution margin is R195 000.

Therefore for 1 000U extra, contribution margin increases to R45 000, which yields a

contribution margin/U of R45.

The highest transfer price will therefore be:

VC + Contribution margin

= R86 + R45

= R131/U

The “mid” transfer price:

For the 3 000U = (86 + 131) ÷ 2 = 108.50

Contribution margin: 3 000U x (R108.50 – 86) = R22.50**

c) Performance evaluation can be in the long or short term. For the long term, capital invested must also be taken into account. Then measures (criteria) such as return on investment (ROI), return on sales (ROS), residual income (RI), and economic value added (EVA) will be relevant.

For the short term performance evaluation can take place to determine bonuses of divisional managers. The issue of ethics is involved here and it is important to note the overall performance of the organisation, otherwise strong competition between divisions may derail the pursuit of the organisation objective to the long-term benefit of the organisation as a whole. Performance criteria of the whole organisation may include increase in sales volume, market share of product sales, manufacturing efficiency, product quality and customer satisfaction, new products and employee relations.

ASSIGNMENTS


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SUPPLEMENTARY TO TRANSFER PRICING (D501-526, CIMA 436-452)

1. Aims and aspects

Any transfer pricing system must aim at the following:

To ensure that resources are allocated optimally.

To provide information to make good economic decisions.

To be useful in evaluating division performance.

To shift profits between divisions.

To ensure that divisional autonomy is not undermined.

To promote goal congruence.

To motivate divisional managers.

To facilitate management performance.

The overall aims must be simple calculations and implementation, and not frequent adjustments.

2. General rules for implementing transfer pricing

Minimum: The minimum price will always be the variable costs plus consideration of circumstances such as capacity and how it is to be obtained, e.g. overtime, sacrificing other products, acquiring additional assets. Factors such as the market price of products of the supplying department’s external sales also make things difficult, but the minimum remains the margin cost plus circumstances.

Maximum: The lowest market price at which the purchasing department obtains the goods or services externally less any internal cost savings in packaging and delivery.

This is because:

(a) the transferring department will not agree to transfer units if the price is lower than the marginal cost plus opportunity costs and

(b) the receiving department will not accept internal products if the internal price is higher than the price at which the product can be bought externally

3. Methods for setting transfer prices

3.1 Cost-based prices

These include marginal costs, absorption costs, standard costs and marginal costs plus a two-part tariff. Actual costs can vary with volume, season and other factors, and if actual costs are used as the basis for the transfer price, any inefficiency in the production department will be transferred to the receiving department. For this reason, standard costs are recommended instead of actual costs so that the transferring department’s efficiencies and inefficiencies are carried by that department itself.

i. Marginal costs: Be careful about using marginal cost alone if you are not sure of the related circumstances as discussed in paragraph 2. Remember the concept of

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opportunity cost which arises if the transferring department already has an external market for the product being transferred.

ii. Absorption costs: If this method is used to set the transfer price, the variable and fixed costs must be included. The principles are the same as for relevant costs, but you must consider here that two departments are involved and the organisation as a whole cannot be placed at a disadvantage.

iii. Standard costs: The transferring department may not transfer its inefficiencies to the receiving department and standard costs will eliminate this risk, except that the volume for the allocation of fixed costs must be selected carefully.

iv. Two-part tariff: In this method the transferring department will ask a price equal to the marginal cost (including the opportunity cost) plus a fixed annual fee for the privilege of receiving the product or service at that price.

3.2 Market-based prices

For decision-making and performance evaluation purposes, it is optimal to set the transfer price at competitive market prices and this will be used when there is a perfectly competitive market.

A perfectly competitive market exists when all products are homogeneous and no buyer or seller can affect the prices.

With this pricing strategy, the income of each division will be the same as if they were separate organisations.

In a perfectly competitive market, the transferring department will have to produce as much as the receiving department requires (at the current market price) for as long as the incremental costs are lower than the market price. If the quantity is insufficient for the receiving department, additional units must be obtained by buying externally at the current market price.

The transferring department may give the buying department discount on the variable selling expenses that are saved if the product is sold internally.

The market price for the intermediary product (the product transferred between departments or divisions) is suitable only when the quality, delivery, discount and support services are the same.

(Consult Vigario 505 to 523 for the circumstances in which an external market exists for the product and when not for the transferring and receiving departments.)

3.3 Marginal cost

This method may be to the disadvantage of the transferring department because the product must be produced at a price lower than the cost. This in essence means that this department is subsidising the receiving department. The following economic theory applies: For an imperfect market the marginal cost will be the correct price to use if the group’s income is optimised.

The motivation and morale of the transferring department may suffer because there is risk in recovering the fixed costs. The marginal cost base may be adjusted with a mark-up to overcome this problem.

The principle, as with relevant costs, is:

If there is spare capacity, products/services are transferred at variable cost.

If there is no spare capacity, transfer is at variable cost plus lost contribution margin.

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Example

Situation 1

The capacity of division A is to manufacture 20 000 units. It currently only manufactures 15 000 which it produces for the market. The variable cost is R100 per unit. Division B needs 3 000 units in its production cycle. The transfer price is therefore R100.

Situation 2

The capacity of division C is 20 000 units. It currently only manufactures 19 000 which it produces for the market. The variable cost is R100 per unit and the selling price is R200. Division D needs 3 000 units in its production cycle.

Contribution margin per unit: R100 demand capacity

Lost sales (19 000 + 3 000 = 22 000 – 20 000 = 2 000 units lost)

Variable costs: R100 x 3 000 = R300 000

Opportunity costs: R100 x 2 000 = R200 000

Contribution margin lost

Total cost R500 000

Units 3 000

Cost per unit R167

Study the example from Drury 509-512 after paragraph 3.5.

In the absence of a perfect market for intermediary products, none of the transfer pricing methods can achieve both the objectives of decision making and performance measurement perfectly, and divisional autonomy is also undermined.

Intervention by head office may be necessary to instruct the selling division to transfer products at marginal cost, thus undermining autonomy.

A better option is to transfer at marginal cost plus a fixed lump sum (e.g. R100 per unit and R10 000), or dual prices, where different prices are set for different quantities.

3.4 Dual prices

This method is used to overcome the problems of marginal costing, such as keeping the morale of the transferring department high and motivating them to maximise the group profit. The dual pricing method means that two prices are used:

The transferring department is credited with a price equal to cost plus mark-up.

The receiving department is debited with the marginal cost.

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The transferring department is therefore also permitted to realise a profit and the receiving department has the right information to make the right sales decision to maximise the group profit. The difference between the two prices is debited to the group’s account, i.e. Transfer price adjustment account, and is taken into account at the end of the year to calculate the group’s profit.

Dual prices can also be used with the market price instead of the marginal cost for the receiving department. They are not used often because they are complicated to administer, include head office’s involvement in accounting and the other methods we have discussed are more practical.

3.5 Negotiated price

As mentioned, it is important for divisional managers to have equal bargaining power.

Unequal bargaining power may occur if one division is small and all its products or services are sold to another very large division, and the purchases constitute a small part of the large division’s total purchases.

Sometimes it is necessary and essential for top management to intervene if divisions cannot reach a compromise.

Negotiated transfer prices are therefore more suitable if there is an imperfect market.

Problems

Because the price agreed upon depends on the negotiating skills and bargaining power of the divisional heads, this may lead to:

Suboptimal decisions for the company as a whole

Unfair performance measurement

This may lead to conflict between divisions which may necessitate management intervention.

This is very time consuming for management and may mean that they have less time to spend on other management responsibilities.

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Study unit 15

15 PERFORMANCE MEASUREMENT


Study material: Horngren - Chapter 23 Vigario - Chapter 14 [Drury - Chapter 19][Garrison - Chapter 12]

LEARNING OUTCOMES


Distinguish between financial and non-financial performance measures.

Discuss the balanced scorecard according to:

* Four perspectives.

* Elements of a well-balanced scorecard.

* Implementation problems.

Describe the following performance measures and evaluate the performance of an enterprise or division in an enterprise:

* ROI and compare it with the Du Pont method

* Residual income (RI)

* Economic value added (EVA)

* Return on sales (ROS)

Discuss the alternative definitions for performance measures.

Discuss performance measurement in multinational companies.

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Discuss the ethical responsibilities involved in performance measurement.

1. INTRODUCTION H824

So far we discussed performance management in a particular context, but in this study unit the design, implementation and uses of performance measurement are more general.

Performance measurement and evaluation and reward are key elements for motivating employees.

Measuring the performance of an organisation’s subunits (departments) is essential for allocating resources within the organisation.

Performance measurement of managers is used in decisions about their salaries, bonuses, future tasks etc.

2. FINANCIAL AND NON-FINANCIAL PERFORMANCE MEASURES H825

Most performance measures, e.g. operating income, rely on internal financial and accounting information. In addition, external financial information can be used, such as share prices, internal non-financial information (e.g. waiting time in manufacturing) and external non-financial information (e.g. customer satisfaction). Businesses can compare their financial and non-financial performance measures with others through benchmarking.

Businesses can show their financial and non-financial performance measures of all the subunits (department) in a single report, i.e. the balanced scorecard.

3. BALANCED SCORECARD D576, H492-499

The management accountant’s role to implement a strategy, e.g. the balanced scorecard.

Balanced scorecard: Rewriting the enterprise’s mission and strategy in a comprehensive set of performance measures that provide a framework for implementing its strategy. It contains financial and non-financial goals of the organisation.

Performance evaluation from four perspectives:

* Financial

* Customer

* Internal business process

* Learning and growth

Purpose of a balanced scorecard: Balance financial and non-financial performance measures to evaluate short- and long-term performance in a single report.

Re-engineering: Fundamental reconsideration and redesign of the business process to make improvements to critical measures of performance such as cost, quality, service, speed and customer satisfaction.

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3.1 Four perspectives of the balanced scorecard D576-583, H493

Financial: Evaluate the profitability of the strategy, e.g. which part of operating income and return on capital was affected by reducing costs or increasing sales.

Customer: This perspective identifies the target market segments and measures the company’s success in these segments.

Internal business process: Focus on internal activities, i.e. three sub processes such as innovation, operations and after-sales service.

Learning and growth: Identify the ability of the organisation to distinguish itself from competitors by pursuing superior internal processes that can be of value to customers and shareholders.

Information on the balanced scorecard:

i. Profitability measures: Operating income, income growth, ROI and EVA.

ii. Customer satisfaction measures: Market share, customer response time, on-time performance, product reliability and customer complaints.

iii. Efficiency, quality and time measures: Direct materials efficiency, overheads spending variance and return on defects as a % of production.

iv. Innovation measures: Number of new patents, number of new products introduced, new product development time and spending on research and development.

3.2 Elements of a good balanced scorecard H497

i) It tells a story about the organisation’s strategy (cause-and-effect relationships).

ii) It helps to communicate the strategy to all members of the organisation.

iii) Places strong emphasis on financial objectives and measurement.

iv) Limits the number of measures to the most critical.

v) Emphasises management’s error of not dealing with operational and financial measures together.

3.3 Problems in implementing the balanced scorecard H498

i) Don’t assume the cause-and-effect link is precise.

ii) Don’t constantly look for improvements in the measures.

iii) Don’t only use objective measures in the balanced scorecard.

iv) Consider costs and benefits.

v) Don’t ignore non-financial measures in evaluating managers and employees.

vi) Don’t use too many measures.

4. DESIGN OF AN ACCOUNTING-BASED PERFORMANCE MEASURE H826

Take the following steps:

i) Choose the performance measures that represent top management’s financial goals, e.g. operating income, return on assets or income (paragraph 4).

ii) Choose the time horizon of each performance measure in step (i) (paragraph 5).

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iii) Choose definitions of the terms included in each performance measure in step 1 (paragraph 6).

iv) Choose measurement alternatives for each performance measure in step 1 (paragraph 7).

v) Choose a target level of performance, e.g. should all divisions (departments) have the same rate of return on assets as their goal? (paragraph 8).

vi) Choose the timing of feedback, e.g. should performance reports be sent daily, weekly or monthly to top management? (paragraph 9).

5. PERFORMANCE MEASURES H826

Step 1

5.1 Return on investment (ROI) D482, V545, H827

Calculated from Operating income

Investment

Also known as accounting rate of return. Businesses differ on the denominator and the numerator and take net income instead of operating income or total assets instead of total assets less current liabilities as the denominator.

Du Pont’s method of profitability analysis contains two parts for profit: the use of assets to earn more income and increase income in rands. See the example in Horngren p. 824+ for the explanation of the Du Pont method.

IncomeTotal assets x

Operating incomeIncome =

Operating incomeTotal assets

5.2 Residual income D483, H829, V552, 557+

This is calculated from income less the required ROI. The required ROI is also known as imputed costs.

Work through the example in Horngren on p. 483.

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5.3 Economic value added D484, H830, V552

EVA is equal to the after-tax operating income less the after-tax weighted average cost of capital multiplied by total assets less current liabilities.

EVA = After-tax operating income - [WACC x (Total assets – Current liabilities)]


5.4 Return on sales H831

ROS is one component of return on investment in the Du Pont method of profitability analysis.

ROS = Operating income ÷ Sales


6. CHOICE OF TIME HORIZON H832

Step 2

The ROI, RI, EVA and ROS calculations all represent the results for a single period.

Subunits, e.g. divisions within a business, can be evaluated by the above performance measures over a number of years. For comparison purposes the performance over a number of years is very valuable.

7. ALTERNATIVE DEFINITIONS FOR PERFORMANCE MEASURES H833

Step 3

i) Total assets available: Include all assets regardless of their specific purpose.

ii) Total assets employed: All available assets less the sum of all unutilised assets and assets bought for future expansion.

iii) Total assets employed less current liabilities: This definition excludes part of total assets employed that are financed by short-term creditors.

iv) Shareholders equity

8. CHOICE OF MEASUREMENT ALTERNATIVES FOR PERFORMANCE MEASURES H833

Step 4

Current costs

Longer term assets: Gross or net book value. Note example H833.

9. CHOICE OF TARGET LEVELS OF PERFORMANCE H836

Step 5

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These target levels entail setting targets (goals) to compare the actuals. A popular method is to set targets that continuously improve.

10. CHOICE OF TIMING OF FEEDBACK H836

Step 6

The timing of the feedback depends largely on how critical the information is for the success of the organisation, the specific level of management receiving the feedback and the sophistication of the organisation’s information technology.


Solution IM 19.7

Return on investment

A B C D

Profit (Rm) 4.0 1.1 1.2 0.5

Net assets (Rm) 23.5 9.5 4.0 1.8

Return on investment 17.02% 11.58% 30% 27.78%

Residual income

Profit (Rm) 4.0 1.1 1.2 0.5

Interest charge (16% on net assets) (Rm) 3.76 1.52 0.64 0.29

Residual income (Rm) 0.24 (0.42) 0.56 0.21

AssumptionsThe divisions are investment centres, and it is therefore appropriate to charge

managers an imputed interest charge on divisional assets. The interest/cost of capital charge is based on the average cost of capital for the company (0.4 *10% + 0.6 *20% = 16%). It is assumed that the risk attaching to the activities of each division is equivalent to the average overall risk on the company’s assets. If risk varies from division to division, a different percentage cost of capital/interest charge should be applied to each division. The higher the risk, the higher should be the interest charge. The group interest charge has been ignored, since it is a purely notional charge which bears no relation to the company’s cost of capital. The above calculations are after taking into account the exchange gain by division A. It is assumed that managers are accountable for foreign exchange management where overseas transactions occur. However, the exceptional charge to division C has not been included in the above calculations, since it is assumed to be an exceptional item and results from a decision taken at head office level. The profits are after charging depreciation, since this

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reflects a charge for the use of divisional assets. It would be preferable to base the depreciation charge on replacement cost rather than historical cost. For a detailed discussion of the usefulness of residual income (RI) and return of investment (ROI) see Chapter 19. The answer should stress that ROI is a relative measure which gives an approximate indication of the return on a division’s investment. This can be compared with an appropriate cost of capital and thus signify whether or not divisional investments are obtaining adequate returns. The measure highlights those divisions where economic viability may need to be reviewed using appropriate relevant economic cost and revenue estimates. ROI can also be used for comparing the returns between divisions of different sizes. It is also widely used by financial analysts for making intercompany comparisons. RI is an absolute measure which in the long-run takes into account the opportunity cost of an investment and is equivalent to NPV. By making a risk-adjusted cost of capital charge, risk is incorporated into the performance measure. RI also encourages managers to invest in projects whose returns are in excess ofthe cost of capital. Possible standards for comparison include budgeted/target ROI or RI, comparisons with other divisions within the group, comparisons with previous periods and comparisons with similar companies operating outside the group. However, care must be taken to ensure that one is ‘comparing like with like’ and that the measurements are consistent and based on the same asset valuation and profit measurement principles.

(b) It is unclear whether the question relates to the evaluation of the division as an economic entity or the evaluation of the performance of the divisional managers. Where the economic performance of a division is being evaluated, all head office costs should be allocated to divisions. Allocations should be based on benefits received (e.g. sales values for the credit control department) using appropriate cost allocation bases. Alternatively a transfer pricing system can be established for those head office services where divisional usage can be measured. Head office costs are joint costs, and it is inevitable that arbitrary allocations will be used to trace some costs to divisions. Care should therefore be taken when interpreting the economic performance of a division, and the performance measures should be seen as a monitoring system which can be used to trigger off an economic investigation of the viability of a division. For evaluating managerial performance, only controllable head office expenses should be charged to divisional managers. For the answer to this part of the question see ‘Alternative divisional profit measures’ in Chapter 19. Arbitrary allocations should be avoided. It is preferable to use transfer prices based on divisional usage when charging head office costs to divisional managers.

(c) The main problems are:(i) The initial high investment together with long paybacks may result in a low ROI or negative RI in the early years of a project’s life.(ii) The cash flows are more uncertain in high-tech industries, and it is therefore difficult to set budgets against which to monitor actual performance.(iii) Many of the benefits are of a qualitative nature and not easy to quantify.(iv) It is difficult to establish an appropriate cost of capital which takes into account risk when calculating RI. If ROI is used, the ROI should be higher to compensate for the increased risk. However, it is extremely difficult to determine the additional return which is required to justify the additional risk.(v) The RI and ROI measures are overstated if written down values are used in the calculations. Managers will be reluctant to replace old assets with new assets, because this will lead to a large increase in the investment base and an accompanying decline in ROI and RI.

The following actions should be taken to improve these measures:

(i) Value assets at replacement cost instead of historical cost. Depreciation charges should also be based on replacement costs (see ‘The impact of depreciation’ in Chapter 19).

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(ii) Use other performance measures in addition to ROI and RI so that some of the dysfunctional consequences which arise from placing too much emphasis on single financial measures can be avoided (see ‘Addressing the dysfunctional consequences of short-term financial measures’ in Chapter 19).

(iii) Set realistic budgets and accept that cash flows may decline in the short term. Compare actual results with realistic budgets and avoid placing too much emphasis on short-term results.

(iv) Use risk-adjusted imputed interest charges using the capital asset pricing model (see Chapter 14). For a more detailed discussion of the conflict between short-run and long-run performance measures and alternative depreciation methods see Learning Note 19.1 on the open access website.

11. PERFORMANCE MEASUREMENT IN MULTINATIONAL COMPANIES H837

Comparing the performance of divisions of a multinational company is difficult because:

i) The difference in economic, legal, political, social and cultural environments,

ii) Control over selling price,

iii) Availability of materials and skilled labour as well as the cost of materials, labour and infrastructure and

iv) Different currencies.

12. DISTINCTION BETWEEN MANAGERS AND ORGANISATIONAL UNITSH839

Incentives regarding risk.

Intensity of incentives and financial and non-financial measures.

Benchmarking and relative performance evaluation.

13. PERFORMANCE MEASURES AT INDIVIDUAL ACTIVITY LEVEL H841

Multiple tasks.

Team-based compensation arrangements.

14. EXECUTIVE PERFORMANCE MEASURES AND COMPENSATIONH842

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15. ENVIRONMENT AND ETHICAL RESPONSIBILITIES

ASSIGNMENTS


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16 DECENTRALISATION


Study material: Horngren - Chapter 22 Vigario - Chapter 14

LEARNING OUTCOMES


Discuss the reasons for decentralisation.

Discuss the factors to consider in measuring and evaluating the performance of management and divisions.

Distinguish between functional and divisional structures.

Evaluate decentralisation as a method or attempt to analyse performance.

Compare interdepartmental performance and discuss problems.

Discuss responsibility centres and distinguish between four such centres.

1. INTRODUCTION H794, V539

Decentralisation: Freedom for managers at lower levels to make decisions.

Autonomy: Refers to the degree of freedom for decision making.

Subunit: Any part of an organisation, e.g. division, Chevrolet at General Motors.

Total decentralisation: Minimum restrictions and maximum freedom for lower levels of managers to make decisions.

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Total centralisation: Maximum restrictions and minimum freedom for lower level managers.

Measurement of division performance: Divisional net profit, divisional controllable net profit, ROI.

Degree of autonomy: Determine whether the division is a cost, income or investment centre.

2. STRUCTURE OF DIVISION V542

2.1 Functional structure

i) Divisions have no profit responsibility.

ii) Decision making is done at head office level.

iii) Divisions are responsible for buying good quality materials at minimum cost, producing at minimum cost and good quality and meeting delivery dates, marketing.

iv) Decisions on pricing, product mixes etc. are made by central management.

2.2 Divisional structure

i) Decentralised decision making – requires greater responsibility and independence.

ii) Management sets selling prices, selects suppliers, makes production decisions, markets their own products.

3. ADVANTAGES OF DECENTRALISATION H797, V543

i) Improves the quality of decision making and management,

ii) Business units are more responsible,

iii) Business problems can be solved quicker,

iv) Management is free to do long-term planning,

v) Management is better motivated,

vi) Divisional managers can act more as entrepreneurs and take the initiative,

vii) Participatory decision making leads to team building,

viii) Unprofitable activities can be identified and eliminated.

4. DISADVANTAGES OF DECENTRALISATION H798, V544

i) Activities are duplicated, e.g. purchasing departments and computer systems,

ii) Decisions of divisional managers are not necessarily to the benefit of the company,

iii) Difficult to design performance criteria where divisions are interdependent,

iv) Conflict may occur through competition,

v) Inexperienced managers may make mistakes,

vi) Greater staff numbers,

vii) Reduces loyalty to the organisation as a whole,

viii) Increases the cost of gathering information.

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5. RESPONSIBILITY CENTRES H799, V544

Cost centres: Control over/responsible for costs

Income centres: Control over/responsible for income

Profit centres: Control over/responsible for cost and income

Investment centres: Control over/responsible for investment

6. PERFORMANCE EVALUATION OF DIVISIONS V544

Short- and long-term performance evaluation

LT: Long-term return on capital, future cash flow at targeted weighted average cost of capital

ST: Evaluate personal performance of management:

i. Increase in sales volume

ii. Market share of product sales

iii. Manufacturing efficiency

iv. Product quality and customer satisfaction

v. New products

vi. Employee relations

Comparing the performance of different divisions is good, but may be meaningless if:

i. The age of assets is different

ii. One division is labour intensive and the other capital intensive

iii. One division owns its building and the other leases it

iv. Products are sold in different markets with different pricing strategies

v. There are different inventory valuation methods

7. MANAGERIAL PERFORMANCE EVALUATION

Refer to chapter 23 in Horngren and the rest of chapter 14 of Vigario in Study unit 18 on performance evaluation.

ASSIGNMENT


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Study unit 17

17 AN IMPROVED AND CHANGED MANUFACTURING ENVIRONMENT AND A CHANGED BUSINESS ENVIRONMENT


Study material: Horngren - Chapters 12, 13 and 20[Drury - Chapter 22]

LEARNING OUTCOMES


Apply the different pricing methods.

Define the following concepts and apply and implement the principles of each:

* Activity-based cost management.

* Activity-based management.

* Activity-based management accounting.

* Activity-based budgeting.

* Just-in-time approach.

* Cost of quality.

* Backflush costing.

* Throughput accounting.

* Balanced scorecard.

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Distinguish between partial and total factor productivity.

Discuss inventory management in the implementation of JIT system.

Discuss the main elements of a JIT system.

Discuss the JIT approach and evaluate it as a development in managing costs.

Discuss backflush costing as a development in managing costs.

1. INTRODUCTION D569

Mechanisation has brought about a number of changes in the production process and consequently the management of costs.

Developments through mechanisation: ABC, ABCM, ABM, activity-based management accounting (ABMA), activity-based budgeting (ABB), JIT, cost of quality (COQ), backflush costing, throughput accounting, balanced scorecard.

Changed manufacturing circumstances lead to developments in cost allocation, cost recovery and consequently also pricing.

A highly competitive market, especially globally, requires sophisticated cost allocation and pricing to be implemented for survival.

The changed business environment is caused by global competition, which means that customers are far more demanding and organisations must perform to make their product or service highly competitive.

A protected competitive environment no longer exists, mainly because of deregulation, government subsidies, the diversity of products and intense competition from overseas markets.

The changed manufacturing and business environments make new demands of management accounting regarding cost management, quality, eliminating activities that do not add value and new developments to determine costs accurately.

2. PRICING H455

Pricing: Discussed under relevant costs and transfer pricing.

Main influences on price: Customers, competitors and costs (CCC).

Time horizon: Affects price in the long or short term.

Target costs as a basis for target pricing – four steps.

Distinguish: Costs of activities that add value and those that do not.

Locked-in cost: Costs that have not yet been incurred but have already been included in the decision.

Cost-plus prices: Includes an objective for return on capital in the mark-up.

Advantages of including fixed costs in prices H437.

Life cycle budgets and costs: Also include R&D costs, design, marketing, customer service, etc.

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Considerations other than cost for pricing: Price discrimination and peak loaded pricing.

3. COSTING AND PRICING H456

Short and long term: Principles of relevant costs.

Alternative pricing approach: Market based (target price) and cost based.

Implementing target prices and target costs H416 (4 steps).

Two strategies: Product differentiation and cost leadership.

4. EVALUATION OF THE SUCCESS OF A STRATEGY H499

Analyse changes in operating income to evaluate strategies.

5. STRATEGIC ANALYSIS OF OPERATING INCOME H500

Example H500.

Which part of the growth in operating income is caused by:

i) Growth component: Increase in number of units sold (the same as the sales volume variance).

ii) Price recovery component: Change in prices of inputs and outputs, e.g. selling price variance and price or spending variances for materials, labour and overheads.

iii) Productivity component: Measures the change in cost of inputs used for the respective years.

a) Partial productivity

= Output units

Quantity of inputs

Calculated for materials quantities, labour hours, etc.

The higher the rate, the higher the productivity.

b) Total factor productivity

= Output units

*Cost of inputs

*Materials + labour + overheads, quantities x prices

6. INVENTORY MANAGEMENT AND MRP H736

MRP requires: (i) Demand forecast of the final product,

(ii) Requisition for material and

(iii) Amount of raw material required for end-products.

Inventory management is a key challenge for an MRP system.

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Key aspect of MRP: Push-through system rather than the just-in-time demand-pull system.

7. INVENTORY MANAGEMENT AND JIT H732

Five main aspects of JIT.

See paragraphs 10 and 17.

8. INVENTORY MANAGEMENT IN RETAIL ORGANISATIONS H725

Costs associated with cost of sales:

i) Purchasing costs: Cost of goods acquired from suppliers, freight included.

ii) Ordering costs: Preparation and issue of and payment for purchase orders plus receipt and inspection costs.

iii) Stockout costs: Problem when there is a demand for the product but the inventory is zero.

iv) Cost of quality: Four categories, i.e. prevention costs, appraisal costs, internal failure costs and external failure costs.

9. SAFETY STOCK H729

10. THEORY OF CONSTRAINTS AND THROUGHPUT CONTRIBUTION H706-707

Theory of constraints: Methods of maximising operating income when there are bottlenecks and when there are no bottlenecks. Three important measures in the theory of constraints are:

i) Throughput contribution: Sales less direct materials.

ii) Investment: Total of inventory (materials, work-in-process and finished goods) plus R&D costs plus equipment and buildings.

iii) Operating expenses: All operating expenses except materials.

An organisation manufactures four products, i.e. P, Q, R and S. The products use a range of different machines, but there is one machine that is essential for all the products, i.e. X, which has caused a bottleneck. The standard selling prices and standard costs per unit for each product for the following year are as follows:

P Q R S

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Rand/U Rand/U Rand/U Rand/U

Selling price 2 000 1 500 1 500 1 750

Costs:

Dir. materials 410 200 300 400

Dir. labour 300 200 360 275

Variable overheads

250 200 300 175

Fixed overheads 360 300 210 330

Profit 680 600 330 570

Machine X: Minutes/Unit

120 100 70 110

Use the throughput costing approach to arrange the products in order of preference.

P Q R S

SP R2 000 R1 500 R1 500 R1 750

- Mat. 410 200 300 400

=Through. contr. R1 590 R1 300 R1 200 R1 350

Machine X (minutes) 120 100 70 110

=Through. contr./

machine R13,25 R13 R17,14 R12,27

Order 2 3 1 4

11. HYBRID COSTS AND SIMPLE JOB COSTING SYSTEMS

Hybrid costs: A system with features of a job costing system and a process costing system, e.g. at Ford Motor Company where cars are manufactured in a constant flow but with specific combinations.

12. OPERATIONAL COSTING

This is a hybrid costing system applied in batches of similar products. Each batch is sometimes a variation of a single design and goes through a series of selected activities or operations. Operational costing has elements of both job and process costing and is therefore regarded as the product costs between job and process costs. These product costs can be combined with actual costs or normal costs or standard costs. ABC can also be added to the combination.

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13. JIT H737

JIT is a system in which materials arrive when needed and production takes place when a product is requested. The most common way of working with this pull aspect of JIT is the Japanese kanban system (Japanese word for visual record or card).

Main elements of JIT H737

i) Production is organised into manufacturing cells where equipment is grouped together.

ii) Employees are trained to be multi-skilled so that they can be moved easily.

iii) Total quality management (TQM) is instituted aggressively to eliminate defects.

iv) Reducing setup time is emphasised.

v) Suppliers are selected because of their ability to supply quality inspected parts or raw materials.

Financial benefits of JIT H737

i) Lower investment in inventory.

ii) Reduced carrying and handling costs of inventory.

iii) Reduced risk of obsolete inventory.

iv) Lower investment in storage for inventory.

v) Reduced setup costs and total manufacturing costs.

vi) Improved quality leads to a cost reduction in spoilage.

vii) Higher income as a result of quick response by customers.

viii) Decreased paperwork.

14. BACKFLUSH COSTING H740

The absence of inventory in a JIT system brings the weighted average, FIFO and LIFO closer together, and therefore also direct and absorption costing systems.

Backflush costing is a system in which recording transactions is delayed until the product has been completed. Only then are they recorded. An extreme form of applying this principle is to wait until the finished product has been sold before recording transactions.

NB. No work-in-process is recorded in backflush costing.

Trigger points where transactions can be recorded are:

i) Purchase of materials

ii) Completion of products

A job costing system is organised in seven steps in backflush costing. See Horngren 740-743. Also see the example on pp. 742-743.

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Do 20.33 in Horngren as practice and compare your answers with the suggested solution below.

H + F + D 20.33

1.a) Raw material + WIPC (work-in-process control)

Dr R550 000

Creditors R550 000

b) Conversion costs control Dr R440 000

W/SR/Crede 440 000

c) FGC (21 000 x 25 + 20) Dr R945 000

Raw mat. + WIPC 525 000

Conversion costs added 420 000

d) COS Dr 900 000

FGC (20 000 x 45) 900 000

2. Raw material + WIPC

FGC

a) R550 000 c) R525 000 c) R945 000 d) R900 000

Balance b/f 25 000 Balance b/f 45 000

Labour + Overheads control COS

b) R440 000 c) Added R420 000 d) FGC R900 000

Underalloc. 20 000

15. ECONOMIC ORDER QUANTITY (EOQ) AND JIT H733

ASSIGNMENTS


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Study unit 18

18 COST MANAGEMENT AND THE THEORY OF CONSTRAINTS


Study material: Horngren - Chapters 12 and 19 [Drury - Chapter 21]

LEARNING OUTCOMES


Discuss the following developments in management accounting and apply the principles in support of an improved manufacturing environment and management of costs:

* Life cycle costing.

* Target costing.

* Kaizen costing.

* Cost of quality.

* Benchmarking.

* Balanced scorecard.

* Value-chain analysis.

* Activity-based management.

* Business process re-engineering.

* Just-in-time.

* Theory of constraints.

Discuss quality management based on:

* Methods to identify quality problems.

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* Relevant costs and the advantages of quality improvement.

* Quality and customer satisfaction measures.

* Evaluating quality performance.

* Time as a competitive tool.

1. INTRODUCTION D537

Cost management focuses on reducing costs, particularly relevant in times of fierce competition in the global market.

Cost management is an action by management to reduce costs, e.g. by instituting more effective and efficient processes without affecting customer satisfaction negatively.

Purpose of cost management: Reduce costs without affecting the quality and increase customer satisfaction.

2. DEVELOPMENTS TO SUPPORT COST MANAGEMENT D538+, M380

Life cycle costing H469-471: An estimate and accumulation of costs in a product’s lifetime (life cycle) to determine whether the profit from the manufacturing stage is sufficient to cover the costs in the pre- and post-manufacturing stages.

Target costing D539, H460-465: A customer-oriented technique initially started by the Japanese, but adopted widely in Europe and the USA. Four steps were discussed earlier, i.e. start with the target price and work backwards. An important element is that teamwork is required to achieve the target costs. This team includes designers, engineers, purchasing, manufacturing, marketing and management accounting staff. Costs are managed and controlled in the development stage of the product.

Kaizen costing D543: These costs begin where target costs end. Target costing requires a proactive approach to cost management in the pre-production stage and kaizen costing requires a proactive approach to cost management during the production stage of a product’s lifetime.

Cost of quality D548: See paragraph 4.

Benchmarking D554: A systematic approach to identify the best practices an organisation can use to improve performance. Compare with the best, top achievers in the market.

Balanced scorecard: Rewriting the enterprise’s mission and strategy in a comprehensive set of performance measures that provides a framework for implementing its strategy. It contains financial and non-financial goals of the organisation.

Value-chain analysis D552: A systematic interdisciplinary determination of factors that may influence the cost of a product or service to achieve a specific purpose at a required standard of quality and reliability of target costs. In this process activities that do not add value can be eliminated. Consequently, customer satisfaction can be guaranteed and costs managed more effectively.

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Activity-based management (ABM) D544: This entails the cost management applications of an activity-based costing approach.

Business process re-engineering (BPR) D547: A re-engineering of the business process to avoid activities that do not add value.

JIT D556: See Study unit 16.

3. OPTIMISED MANUFACTURING TECHNOLOGY

CAM, CAD, CIM, FMS, NC, MRP, JIT

4. TOTAL QUALITY MANAGEMENT (TQM) H691

Quality is a competitive tool because TQM is a very important factor of success in reducing costs and increasing customer satisfaction. In times of intense competition, improved quality and prompt delivery can attract customers.

Aspects of quality: Quality design and conformance quality. Quality design measures how closely the features of products and services can meet the needs of customers. Conformance quality is the performance of a product or service in meeting the design and product specifications.

Cost of quality (COQ): This entails the costs of preventing poor quality or improving quality. These costs focus on quality assurance and can be classified as prevention costs, appraisal costs, internal failure costs and external failure costs H693. Note the seven steps that Horngren discusses.

4.1 Methods (techniques) to identify quality problems H696

i) Control chart: This is a graph of a series of successive observations of a specific step, procedure or activity taken at regular intervals. Each observation is plotted on the graph and only those outside the specified limits are recorded as non-random and must be investigated. See example in Horngren 697. A control chart is an important aid in statistical quality control (SQC).

ii) Pareto diagram: Observations outside the control limits are used as input for the Pareto diagram. A Pareto diagram shows how frequently each type of defect occurs. According to the example in Horngren 697, unclear copies are the most frequent problem and therefore result in high rework expenses and repair costs. Other problems are copies that are too light, too dark, paper jams, etc.

iii) Cause-and-effect diagrams: The most frequently occurring problem as identified by the Pareto diagram is analysed using the cause-and-effect diagram. A cause-and-effect diagram identifies potential causes of defects. On p. 698 of Horngren a diagram is shown of the most frequently occurring problem, i.e. unclear copies. On this cause-and-effect diagram, four main categories of potential causes of defect are shown, i.e. human error, methods and design factors, machine-related factors and material and component factors.

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4.2 Relevant costs and advantages of quality improvement H698

To identify the relevant costs for each cost of quality category, each cost in these categories must be divided into fixed and variable costs.

4.3 Quality and customer satisfaction measures H695

Products and services may be of good quality, but they must also meet customers’ needs before they can be sold. Customers will be satisfied if a product or service is good value for money, delivered as promised, the product has no defects and they are assured that the product will not fail in any way or disappoint when used.

Financial measures of customer satisfaction: Financial indicators of customer dissatisfaction are repair costs during guarantee period, lost contribution margin as a result of lost sales and lower prices at which damaged goods must be sold.

Non-financial measures of customer satisfaction: These include number of defect units sold as a % of the total units shipped, number of customer complaints, the difference between the delivery date and the date required by the customer, on-time deliveries.

Non-financial measures of internal performance: Prevention costs, appraisal costs and internal failure costs are examples of financial measures and quality performance within the business. It is essential to measure financial and non-financial internal performance.

4.4 Evaluating quality performance H700

Advantages of measuring COQ

i) It focuses attention on the cost of poor quality.

ii) It provides information for comparing different quality improvement programmes.

iii) It provides information regarding prevention or the cost of rectifying defects (mistakes).

Advantages of non-financial measures of quality

i) Non-financial measures are sometimes easy to quantify and understand.

ii) They focus attention on the problem areas.

iii) They provide immediate short-term feedback on whether quality improvement efforts have succeeded.

4.5 Time as a competitive tool H701

Operational measures of time: Two measures:

i) Customer response time: This is how long it takes from when an order is placed for a product or service until the product or service is delivered.

ii) On-time performance: Examples are manufacturing cycle time, which is the time from the beginning of the production line to the finished product, and order delivery time, which is the time from completion of production to delivery to the customer.

Effect of uncertainty and bottlenecks on delays H703

On-time performance H702

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5. THEORY OF CONSTRAINTS (TOC) AND THROUGHPUT CONTRIBUTION H706-707

TOC: Methods of maximising operating income when there are bottlenecks and when there are no bottlenecks. The purpose of this theory is to increase throughput contribution margins while reducing investment and operating costs. Three important measures:

i) Throughput contribution margin: Sales less direct materials.

ii) Investment: Total inventory (materials, WIP and finished goods) plus R&D costs plus equipment and buildings.

iii) Operating expenses: All operating expenses except materials.

TOC has a short-term time horizon and assumes that all operating expenses are fixed. There are four steps to manage bottleneck situations H703.

6. TIME DRIVERS AND COSTS OF TIME H702

Uncertainty and bottlenecks as time drivers.

Relevant income and relevant costs of time.

Additional sources used in this study unit

Drury, C. 2000. Management and cost accounting. London: Business Press

Morse, W J., Davis, J.R. & Hartgraves, A.L. 2000. Management accounting. A strategic approach. Ohio: South Western.


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IM 21.7Evaluation of quality management programme

Synthetic slabs cost reduction (R)

Elimination of synthetic slabs stores losses 68 711 units x (R40-1)/100 26 797

Specification check 14 000

Savings on purchase quantity of synthetic slabs:

(2 748 450 – 2 090 651) x R40/100 263 120

Less: increase price: 2 090 651 x R4/100 (83 626)

Curing/moulding process cost:

Variable cost reduction (2 679 739 – 2 090 651) x R20/100 117 818

Scrap sales forgone of sub-components (267 974 – 20 907) x R5/100 (12 353)

Finishing process cost reduction:

Variable cost reduction (See note 1) 158 656

Scrap sales forgone (361 765 – 51 744) x R10/100 (31 002)

Finished goods stock:

Holding costs (45 000 – 1 500) x R15/1 000 653

454 063

Less: cost of quality management programme 250 000

Net (cost) / benefit of proposed changes 204 063

** Note 1: Variable cost of reduction for curing/moulding process

Existing cost

Type AX 964 706 x R15/100 = 144 706

Type BX 1 447 059 x R25/100 = 361 765

506 471

Amended cost

Type AX 826 667 x R12/100 (99 200)

Type BX 1 243 077 x R20/100 (248 615)

Net reduction in cost 158 656

b) See ‘Cost of quality’ in Chapter 21 for the answer to this question.

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2. NON-FINANCIAL QUALITY MEASURES

Outgoing quality return on each product.

Returned refrigerators % of each product.

On-time deliveries.

Employee turnover.

ASSIGNMENTS


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Documents

RECP 674 Advanced Management Accounting (CTA LEVEL)