Management Accounting

Transcription

1 Management Accounting Course Text Professional, Practical, Proven Management Acc Manual 2017.indb 1 24/05/ :17

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3 Table of Contents FOREWORD...v SYLLABUS: MANAGEMENT ACCOUNTING...xi PART 1 INTRODUCTION Chapter 1: Introduction to Management Accounting...3 PART 2 COST CLASSIFICATION Chapter 2: Classifying Costs...17 Chapter 3: Analysing and Predicting Mixed Costs...27 PART 3 LABOUR COSTS Chapter 4: Labour Costs...37 PART 4 MATERIALS COSTS Chapter 5: Materials-Related Administration...47 Chapter 6: Managing Inventory Levels...53 Chapter 7: Valuing Inventory PART 5 OVERHEAD COSTS Chapter 8: The Traditional Approach to Overheads...75 Chapter 9: The Activity-Based Approach to Overheads...95 Chapter 10: Comparing the Two Different Approaches iii Management Acc Manual 2017.indb 3 24/05/ :17

4 Table of Contents Management Accounting PART 6 COST MEASUREMENT SYSTEMS Chapter 11: Overview of Cost Measurement Systems Chapter 12: Job Costing Calculations Chapter 13: Recording Job Costs in the Accounting Records Chapter 14: Batch Costing Chapter 15: Process Costing PART 7 BUDGETING AND STANDARD COSTING Chapter 16: Introduction to Budgeting Chapter 17: Introduction to Standard Costing Chapter 18: Operational Budgets Chapter 19: Budgeted Financial Statements Chapter 20: Cash Budgets Chapter 21: Flexible Budgeting & Limitations of Budgeting PART 8 MARGINAL COSTING FOR DECISION-MAKING Chapter 22: Marginal Costing and Contribution Chapter 23: Single-Product Cost-Volume-Profit Analysis Chapter 24: Multi-Product Cost-Volume-Profit Analysis PART 9 RELEVANT COSTS FOR DECISION-MAKING Chapter 25: Introduction to Relevant Costs Chapter 26: Special Pricing Decisions Chapter 27: Product Continuation / Discontinuation Decisions Chapter 28: Make-or-Buy Decisions Chapter 29: Limiting Factor Decisions PART 10 STANDARD COSTING VARIANCE ANALYSIS Chapter 30: Introduction to Variance Analysis Chapter 31: Cost Variances Calculations and Causes Chapter 32: Revenue Variances Calculations and Causes Chapter 33: Reconciling Budgeted Profit to Actual Profit INDEX iv Management Acc Manual 2017.indb 4 24/05/ :17

5 FOREWORD Foreword This text has been developed by Accounting Technicians Ireland for use by students participating in our programme of study and preparing for our examinations based on the syllabus published for the Academic Year While every effort is made to ensure that the information outlined in this text is accurate, Accounting Technicians Ireland cannot accept the responsibility for lack of, or perceived lack of, information contained herein. The text is intended to be a sufficiently detailed synopsis of the current syllabus material (and knowledge level required thereof) in relation to this module. Students should take particular note of the weighting attaching to this module, as clearly outlined in the syllabus. It is on the basis of this weighting that students should prepare their own timetable for study. This text also includes questions related to the topics for this module. These questions are part of a larger database of questions that students (and also lecturers) can access online for this subject. These questions (and suggested solutions) are available through your TouchPoint portal in the MyRevision area. We recommend that students refer to MyRevision having completed each chapter or a section of this module. This resource allows students to study and revise online through self-test questions. Exam standard questions are also available here. We also recommend students refer to the past exam papers for this module. These papers are published on our website ( along with suggested solutions and comments from the Examiner. Attempting these under exam conditions will help students to prepare for the examination and plan their study time appropriately. v Management Acc Manual 2017.indb 5 24/05/ :17

6 Copyright This text is issued by Accounting Technicians Ireland to students taking its examinations. It may not be used in whole, or in part, for any course of study and/or examination of any other body whatsoever without prior permission in writing from Accounting Technicians Ireland. This publication, or any part thereof, may not be made available in any library, and it may not be reproduced, in whole or in part, stored in a retrieval system or transmitted in any form or by any means photocopying, electronic, electrostatic, magnetic, pdf, mechanical, recording or otherwise, without prior permission in writing from Accounting Technicians Ireland, Pearse Street, Dublin 2. Acknowledgement This edition was reviewed and updated by Mr. Richie Hoare. Richie is a Senior Lecturer in Accounting at Galway-Mayo Institute of Technology (GMIT) and a Member of CIMA. Referencing For the purposes of consistency, all references to he or she will be referred to as he in this publication. No other implication whatsoever is implied from this policy. For the purposes of presentation, all references to euro or sterling will be referred to as euro is this publication. No other implication whatsoever is implied from this policy. vi Management Acc Manual 2017.indb 6 24/05/ :17

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11 SYLLABUS: MANAGEMENT ACCOUNTING Module: Management Accounting Mandatory Module SYLLABUS xi Management Acc Manual 2017.indb 11 24/05/ :17

12 Syllabus : Mandatory Module Management Accounting Management Accounting Subject Status Mandatory Terminal Exam 100% Module Pass Mark 50% Learning Modes Pre-requisite Direct Lectures, Workshops, Online Tutorials, Self Directed Learning Financial Accounting, Taxation and either Law & Ethics or Business Management Key Learning Outcome The key learning outcome of this module is to provide learners with knowledge and technical competency in the area of management accounting to support business functions, activities and decision-making. Key Syllabus Elements and Weightings 1. The Nature and Purpose of Management Accounting, Costing Terms and concepts...10% 2. Cost Accumulation for Inventory and Profit Measurement...35% 3. Standard Costing, Budgetary Planning and Control...30% 4. Information for Decision Making...25% Learning Outcomes linked to Syllabus Elements The Nature and Purpose of Management Accounting, Costing Terms and Concepts On completion of this aspect of the module, learners will have acquired the following knowledge, competencies and know-how: - (a) (b) (c) (d) (e) A knowledge of the role of management accounting in a business organization; An appreciation of business and stakeholder objectives and goals; An ability to contribute to business planning and control exercises through the use of management accounting; An understanding of principles and techniques used in management accounting. An understanding of costing system terminology and the ability to discuss various elements of a costing system; xii Management Acc Manual 2017.indb 12 24/05/ :17

13 Management Accounting Syllabus : Mandatory Module Module: Management Accounting Specific Functional Knowledge and Competencies Understanding Application Analysis NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING, COSTING TERMS AND CONCEPTS (10%) Role of Management Accounting The role of management accounting in support of business decision making Comparison and inter-relationship with financial accounting Business Planning and Control Management by objectives l l l l l Group and individual decision making processes l Organizational control and performance measurement Costing Terminology Cost centres and drivers l l Cost classification and coding systems l l COST ACCUMULATION FOR INVENTORY & PROFIT MEASUREMENT (35%) Costing Systems Cost Behaviour (including fixed, variable, semi-variable & stepped cost, and inflation) l l l l Types of costing systems l l Concepts of cost accumulation l l Costing of materials Stores routines l l l Materials handling l l Pricing of store issues l l Purchasing procedures l l Inventory control ratios l l Stockholding calculations l l Under and Over absorption of overheads l l Administrative, selling and distribution overheads l l xiii Management Acc Manual 2017.indb 13 24/05/ :17

14 Syllabus : Mandatory Module Management Accounting Specific Functional Knowledge and Competencies Understanding Application Analysis Labour costing Understanding and calculation of labour remuneration systems l l Remuneration and incentive schemes l l Overhead Costing Cost centre and cost units l l l Overhead apportionment and absorption calculations l l l Service Department Costing l l l Under and Over absorption of overheads l l Administrative, selling and distribution overheads Activity Based Costing Key principles and terminology of Activity Based Costing (ABC) l l l l Classification of costs using ABC l l l Transaction based cost drivers l l Overhead absorption calculations using ABC l l Advantages and disadvantages of ABC l l Benefits and problems of traditional and modern costing systems Marginal Costing Techniques l l Comparison of marginal and absorption costing Contribution and marginal costing calculations and costing statements Marginal costing in management decision making l l l l l l l l l Other Costing Techniques Job, Batch and Service costing calculations l l l Theory of process costing, including equivalent units, normal and abnormal gains/losses (Note: Joint and by-products are excluded) l l xiv Management Acc Manual 2017.indb 14 24/05/ :17

15 Management Accounting Syllabus : Mandatory Module Specific Functional Knowledge and Competencies Understanding Application Analysis STANDARD COSTING, BUDGETARY PLANNING AND CONTROL (30%) Standard Costing Theoretical aspects Concept of Standard Costing including definition, types of standards, standard setting, relationship with budgets Advantages and disadvantages of standard costing Standard Costing Practical Application Standard cost per unit calculations using absorption and marginal costing Calculation of variances, including l l l l l l l Materials price and usage l l l Labour rate and efficiency l l l Variable overhead expenditure and efficiency l l l Fixed overhead expenditure and volume l l Sales volume and price l l Preparation and explanation of variance analysis reports l l l Budgetary Planning & Control Processes Theoretical aspects Theory of budgetary planning and control l l Budgetary factors l l Budgetary processes Budgetary techniques, benefits and problems Behavioural and motivational aspects of budgeting Budgetary Planning & Control Practical Application Preparation of operational budgets, including l l l l l l l l sales l l l production l l l materials l l l labour l l l overhead l l l xv Management Acc Manual 2017.indb 15 24/05/ :18

16 Syllabus : Mandatory Module Management Accounting Specific Functional Knowledge and Competencies Understanding Application Analysis Preparation of projected Statements of Profit and Loss and Statements of Financial Position l l Cash Budgeting and flexible budgeting l l INFORMATION FOR DECISION MAKING (25%) Management accounting for Decision Making Cost-Volume Profit and Breakeven Analysis, including l l margin of safety l l target profit l l contribution/sales ratio l l Breakeven charts and formulae l l Application of cost-volume-profit analysis to multi-product scenarios Relevant Costing in decision making Preparation of cost estimates for decision making including relevant, opportunity and sunk costs Short term decision making calculations, including l l l l product elimination l l consideration of limiting factors l l make or buy l l Pricing decisions, including: mark-up l l margin l l full price l l Preparation of management accounting statements appropriate to typical decision making situations l l l xvi Management Acc Manual 2017.indb 16 24/05/ :18

17 Management Accounting Syllabus : Mandatory Module Assessment Criteria Assessment Techniques Format of Examination Paper 100% Assessment based on the final exam. The Paper Consists of SIX Questions which will examine all key syllabus elements to ensure that learning outcomes are achieved SECTION A (Marks awarded per question may vary) THREE Compulsory Questions. One question from each of the three major syllabus areas. SECTION B (All questions carry equal marks) THREE Questions in total Answer any TWO of these. Sample Paper Each of the 3 sample papers will examine appropriate parts of this syllabus. Essential Reading Management Accounting (Second Year) Author: Accounting Technicians Ireland Web Resources Other Resources Cost and Management Journal xvii Management Acc Manual 2017.indb 17 24/05/ :18

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19 Part 1 Introduction In first year, you studied financial accounting which is largely concerned with recording transactions that have happened in the past and presenting a summary of those transactions in the form of financial statements. However, as running a business requires managers to continually make decisions that will improve the future of their businesses, a different kind of information management accounting information - is required. This part of the course will focus mainly on what kinds of information managers require, how management accounting differs from financial accounting and the job of management accountants / financial managers Management Acc Manual 2017.indb 1 24/05/ :18

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21 Chapter 1: Introduction to Management Accounting CHAPTER 1 Introduction to Management Accounting CHAPTER OVERVIEW Accounting is the language used by businesses to communicate both financial information and non-financial information to individuals and groups who have an interest in how the business is performing. This chapter considers how management accounting information is communicated and why managers need this information. LEARNING OUTCOMES FOR THIS CHAPTER After studying this chapter, you should be able to: 1. Identify users of accounting information and their information needs 2. Understand the difference between management accounting and financial accounting 3. Appreciate the nature, purpose and uses of management accounting Management Acc Manual 2017.indb 3 24/05/ :18

22 Chapter 1 : Introduction to Management Accounting Management Accounting USERS OF ACCOUNTING INFORMATION AND THEIR INFORMATION NEEDS Users Of Accounting Information Users of accounting information can be broadly classified into two categories: Users who are external to the organisation (dark-shaded circles below). Users who are internal to the organisation (light-shaded circles below). Each user / user group has its own information requirements. Access to accounting information differs according to the relationship between the business and the user / user group Management Acc Manual 2017.indb 4 24/05/ :18

23 Management Accounting Chapter 1 : Introduction to Management Accounting USERS INFORMATION REQUIREMENTS An organisation s stakeholders, and their respective information requirements, include the following: Stakeholder Equity Investors Managers Information Required Information on investment values and the potential return to be earned from their investments Information for decision-making, planning and control purposes Employees Suppliers & Lenders Governments & Regulators Special-interest groups (such as environmental groups, community groups and lobby groups) Information about the organisation s ability to provide secure employment and pay market-rate wages / salaries Information about the organisation s ability to meet current and future financial obligations Information to assess tax liabilities, for economic projections, and for enforcement of legislation Information related to their specific interests MANAGEMENT ACCOUNTING VERSUS FINANCIAL ACCOUNTING Two branches of accounting have evolved to deal with the information needs of user groups - both internal and external: 1. Financial accounting is primarily concerned with providing information to external users. 2. Management accounting is concerned with providing information to users within the organisation to assist with effective decision making by managers. Although there are many differences between management accounting and financial accounting, the primary information used for the preparation of both management accounting reports and financial accounting reports stems from the same source costs incurred by the organisation and revenues earned by the organisation Management Acc Manual 2017.indb 5 24/05/ :18

24 Chapter 1 : Introduction to Management Accounting Management Accounting The major differences between management accounting and financial accounting can be summarised as follows: Legal Requirements Management Accounting No legal requirements. No audit requirement. Financial Accounting Legal and accounting regulations requirements. Statutory audit requirement (for certain types and sizes of businesses). Frequency Of Reports As required (normally monthly). Annually, semi-annually, Quarterly. Primary Users Internal management. External users. Time Focus Present and future. Historic. Format & Content Of Reports Detailed information in a format to suit management requirements. Summary information in a format prescribed by accounting regulations and law. The above differences are discussed in more detail below: Legal Requirements Businesses have a legal obligation to produce financial statements every year. These financial statements must be prepared in accordance with published accounting principles and, depending on certain criteria, are subject to statutory audit. Although there is no legal requirement or obligation to prepare management accounts, it is good business practice to regularly produce accounting information as a useful tool to assist management in carrying out their duties in a proper manner. There is no requirement to audit management accounts. Frequency of Reporting Financial statements must be prepared annually. There are sometimes regulatory requirements to present less-detailed accounting reports on a semi-annual or Quarterly basis. Where there is benefit to be gained from producing management accounts, the frequency of production is at management s discretion, typically ranging from daily, to weekly, to monthly, or ad-hoc, to suit management needs. Primary Users Financial accounting presents accounting information for use by a wide variety of external users, as well as internal managers. Management accounts are solely for the use of the internal management of the organisation. Time Focus Financial accounting reports focus on what has happened in the past. Management accounting uses accounting information to project future trends and control, or attempt to control, current and future business performance Management Acc Manual 2017.indb 6 24/05/ :18

25 Management Accounting Chapter 1 : Introduction to Management Accounting Format & Content of Reports Both the law and accounting regulations provide templates for the presentation of financial statements and instruction on minimum information disclosure. As financial accounting information is in the public arena, there is an inherent acknowledgment by regulators of the sensitivity surrounding the disclosure of certain information and the main focus of these disclosure requirements is on summarised financial data. Financial statements focus on the business in its entirety. Management accounting operates on the basis of meeting the needs of internal management. The format and content of management accounts depend upon the specific requirements of management. Different businesses will have different information requirements and their individual management accounts will reflect this. As internal reports, management accounts will often contain business-sensitive information for a restricted audience and can focus on both financial information and non-financial information, such as critical success factors (measures of factors or aspects of an organisation s performance deemed to be critical, or essential, to its competitive advantage and thereby its success). In addition, management accounts will often present very detailed information at a department level or product-line level. THE NATURE, PURPOSE AND USES OF MANAGEMENT ACCOUNTING Management accounting involves applying accounting and financial management principles to the provision of information to managers within an organisation to help them plan and control the organisation s activities and to make business decisions. Management accounting information for managers 1. What is the cost of making a product or delivering a service 2. How do actual costs compare to budget costs (control information) 3. How should the managers use scarce resources to get the best return for the company. As a consumer, you may not pay much attention to these questions, but as a manager of a business, you must pay attention to the factors, both financial and non-financial, that underpin these decisions. Failure to do so may result in the failure of the business. PLANNING, CONTROL AND DECISION-MAKING Every organisation has managers. These managers have a responsibility to the organisation s stakeholders to manage the organisation in the most-effective and most-efficient way, to maximise the organisation s potential. This involves the managers undertaking adequate planning for the short-term and long-term future of the business, ensuring that the business is being properly controlled to ensure plans succeed, and making decisions that will enable the business to survive and grow in the future. Management accounting equips managers with information required to carry out these tasks Management Acc Manual 2017.indb 7 24/05/ :18

26 Chapter 1 : Introduction to Management Accounting Management Accounting PLANNING The fundamental objective of planning is to assist management in deciding how to allocate an organisation s resources. There are 4 main types of planning: 1 - Strategic Planning This establishes, for management, the shape and direction to be taken by the organisation. This type of planning is normally ad-hoc and is driven by the recognition of a need for the revision / change of priorities. This normally results from seeing actual results achieved and / or projected outcomes under a variety of proposed strategies. 2 - Long-Range Planning This covers periods of anything from 2-10 years which plans for the proper gearing of the organisation to achieve its goals / objectives. 3 - Project and Situation Planning This is normally to do with planning the short-term use of a segment of the organisation s resources, such as the investment of surplus cash or, if spare capacity was identified, how best to use it (say for a once-off order). 4 - Short-Range Periodic Planning This type of planning is concerned with deciding how resources will be used in the short-term and predicting the financial outcome of these decisions (i.e. budgeting). Budgeting is a quantitative expression of a plan. It shows the expected financial implications of decisions taken and proposed decisions and helps identify the resources required to achieve goals set. CONTROL Control is a key feature of management accounting and follows on from planning. Control can be exercised at a strategic and / or an operational level. Strategically, the business plan of an organisation will be reviewed in light of developments to assess if the objectives of the plan can be achieved. Operationally, the performance of the organisation is reviewed in the context of detailed plans (including budgets) so that corrective action can be taken, if necessary. Control is not practical without initial planning and planning, without control, is somewhat pointless Management Acc Manual 2017.indb 8 24/05/ :18

27 Management Accounting Chapter 1 : Introduction to Management Accounting Types Of Controls There are 3 main types of controls 1 - Action Controls / Behavioural Controls These involve observing the actions of individuals as they go about their daily work (eg: work studies: quality and quantity controls) to assess whether both quantity targets and quality targets are being met, and, if not, to inform corrective action. EXAMPLE If a supervisor observes the workers on an assembly line and ensures that the work is done exactly as prescribed, then the expected quality and quantity of the work should ensue. 2 - Personnel and Cultural Controls Personnel and cultural controls involve establishing expected values, behaviours and norms which are used to support the achievement of targets. These are controls which help employees do a good job, by building on their natural tendencies. Cultural controls represent a set of values, social norms and beliefs that are shared by members of the organisation and that influence their performance. 3 - Results / Output Controls These involve collecting, analysing and reporting information about the outcomes of work effort. This type of control is focused on quantitative information and can be most-closely related to management accounting information produced. Such information may include variance analysis and other key target statistics. Results controls require performance targets to be set, establishment of actual results, measurement of performance and taking action accordingly. Management accounting controls are mostly defined in mandatory terms such as revenues, costs, profits, or ratios. Organisations should have a system of management reporting that produces control information in a specified format at regular intervals. Harmful Side-Effects Of Control When controls motivate behaviour that is organisationally desirable, they are described as encouraging goal congruence. However, when controls motivate employees to engage in behaviour that s not organisationally desirable, they can lead to a lack of goal congruence. It is by achieving goal congruence that desired objectives are achieved. DECISION-MAKING The first stage in the decision-making process should be to specify the goals or objectives of the organisation. These goals / objectives will vary depending on the type of organisation. It is simplistic to say that the only objective of a business is to earn profit - and clearly this would not be the case in a not-for-profit, or charitable, organisation Management Acc Manual 2017.indb 9 24/05/ :18

28 Chapter 1 : Introduction to Management Accounting Management Accounting In private-sector businesses, some managers might seek to establish a power base, build an empire, or ensure security. However, a commonly-held view, supporting the profit objective is that profit maximisation leads to the maximisation of overall economic welfare. In a not-for-profit, or charitable, organisation, the driver is social / welfare principles, not profit. In the public-sector, the primary goal / objective might be to provide a quality service to the public. Although the driver in these organisations is not profit, it would be desirable that they would at least be self-financing and not require government subvention. The planning, decision-making, and control process PERFORMANCE MANAGEMENT Performance management is a term used to describe the various activities carried out to ensure that an organisation s goals and objectives are being met in an effective and efficient manner. Performance management normally operates at 3 levels: 1. for the organisation as a whole 2. within departments or sections 3. in teams or for individuals. Performance management is used both in businesses and, increasingly, in not-for-profit organisations (eg: public service departments) Management Acc Manual 2017.indb 10 24/05/ :18

29 Management Accounting Chapter 1 : Introduction to Management Accounting Performance management can involve a range of qualitative and quantitative activities, but a main aim is to create goal congruence within an organisation. Goal congruence means that the aims and objectives of individuals match the aims and objectives of the organisation as a whole. Performance management targets are likely to include: Financial Targets market share manufacturing efficiencies gross profit / net profit Service Targets customer satisfaction measures service output measures repeat business innovative developments or improvements The benefits of good control and performance management can include: direct financial gains improved motivation and employee satisfaction and improved efficiency in systems and processes The design of a performance measurement system is essential to allow a company achieve its objectives. An organisation should identify the Critical Success Factors (CSF s) that are key to the achievement of the overall company objectives. For each CSF identified the management need to identify a Key Performance Indicator (KPI). The KPI s are then used as the basis for the development of the performance measurement system. Armstrong & Baron defined PM as A strategic and integrated approach to increasing the effectiveness of organisations, by improving the performance of the people who work in them and by developing the capabilities of teams and individual contributors. Benefits of PM may include: 1. Direct financial gains, e.g. increase sales, reduce costs 2. Create transparency in cultivating goals, thus creating confidence in the process for determining bonus payments. 3. Improved management controls 4. Achievement of long-term corporate objectives Management Acc Manual 2017.indb 11 24/05/ :18

30 Chapter 1 : Introduction to Management Accounting Management Accounting Performance Appraisal This applies where individual performance is formally monitored and feedback is delivered. This is done by establishing Key Performance Indicators (KPIs) for individuals, against which performance is rated or measured and the ratings summarised. Top performance is normally rewarded. The performance appraisal process should be seen as part of guiding and managing career development. It is also a method of measuring an employee s worth to the organisation. COST ACCOUNTING Management Accounting is concerned with both costs and revenues. The part of management accounting that is concerned with costs is often known as Cost Accounting. A Cost Accounting system is generally made up of the following five parts: 1. an input measurement basis 2. an inventory valuation method 3. a cost accumulation method 4. a cost flow assumption 5. a capability of recording inventory cost flows at certain intervals These five parts, and the alternatives under each part, are presented below. Many possible cost accounting systems can be designed from the various combinations of the available alternatives, although not all of the alternatives are compatible. Selecting one part from each category provides a basis for developing an operational definition of a specific cost accounting system Management Acc Manual 2017.indb 12 24/05/ :18

31 Management Accounting Chapter 1 : Introduction to Management Accounting PRACTICE QUESTIONS The following questions will test your knowledge of the material you have just covered in this chapter. You should also review the questions available online through MyRevision for this topic, as these will assist you significantly in your preparation for your examination. In addition, Sample papers for this subject can be downloaded from Question 1.1 (ref: 1460) Outline the main users of accounting information and the information requirements of each user / user group. Question 1.2 (ref: 1463) What types of financial information and non-financial information would the following people require: 1. A buyer in a retail clothing business 2. A production manager in a toy factory 3. The managing director of a private hospital 4. Project managers in an overseas charity aid organisation Question 1.3 (ref: 1465) Describe a typical planning and control cycle. Why is it important for businesses to implement this cycle? Question 1.4 (ref: 1467) Explain the basic principle of performance management and its potential benefits to organisations. Question 1.5 (ref: 1468) Give three examples of ways in which a cost accounting system could aid cost control in a haulage business Management Acc Manual 2017.indb 13 24/05/ :18

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33 Part 2 Cost Classification A fundamental part of management accounting is managing costs. However, in order to be able to properly manage costs, managers must first be able to understand the different types of costs in their businesses and how these costs change, or don t change, as the business changes. This part of the course is concerned with understanding, analysing and predicting the various types of costs incurred by businesses. CHAPTER 2 Classifying Costs CHAPTER 3 Analysing & Predicting Mixed Costs Management Acc Manual 2017.indb 15 24/05/ :18

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35 Chapter 2: Classifying Costs CHAPTER 2 Classifying Costs CHAPTER OVERVIEW In order to plan properly, control properly and make good business decisions, managers need to know, not just total cost data, but cost data broken down under different headings (called cost classifications). This chapter outlines common cost classifications used by managers. LEARNING OUTCOMES FOR THIS CHAPTER After studying this chapter, you should be able to: 1. Understand the meaning of cost, cost objects and cost centres 2. Understand the most common ways of classifying costs 3. Understand how cost classification impacts upon the design of costing systems Management Acc Manual 2017.indb 17 24/05/ :18

36 Chapter 2 : Classifying Costs Management Accounting COSTING TERMINOLOGY What is cost? Cost is one of the most common words used by managers in business, but what exactly does it mean? There is no one single definition of cost, however one definition could be: The expenditure (actual or notional) incurred on, or attributable to, a specific thing or activity. In management accounting, there is a cost vocabulary which provides meanings for cost in the context of the managerial activities of planning, control and decision-making. Cost unit/cost object Is an identifiably product or service for which an organisation wishes to measure costs. Cost Measurement Systems Cost measurement systems collect cost data and then assign these costs to cost objectives i.e. products or services. Cost Centre A cost centre can be defined as a function, a location, activity or an item of equipment for which costs can be measured and directly related to the cost units / cost objects for control purposes. A cost centre is used as a collecting place for costs (similar to a General Ledger account).. EXAMPLE Indirect Costs Cost centre Accounting department Furniture making department Telephone manufacturing department Legal department Cost unit/cost objective Preparation of accounts for clients Table/chairs Telephone Legal advice to client Cost Classifications The most commonly-used classifications of costs are as follows: 1. Direct costs & indirect costs 2. Product costs & period costs 3. Fixed costs, variable costs & mixed costs Whether a particular cost is a direct cost or an indirect cost is determined by the relationship of the cost to the cost object (eg. a product) Management Acc Manual 2017.indb 18 24/05/ :18

37 Management Accounting Chapter 2 : Classifying Costs Whether a particular cost is a product cost or a period cost is determined by whether the level of cost is related to the volume of activity or related to the passage of time (eg. the cost is payable each month, irrespective of output) Whether a particular cost is a fixed cost, a variable cost or a mixed cost is determined by the way the cost increases / decreases as the business volume of activity (eg. output) changes. This relationship between changes in cost and changes in volume is known as cost behaviour. CLASSIFYING COSTS AS EITHER DIRECT COSTS OR INDIRECT COSTS In order to gather cost data regarding a specific cost object, it is necessary to identify the relationship between the cost object and the item of cost. The key question involves establishing the traceability of the item to the cost object. Direct Costs Direct costs are costs that can be traced in full to a particular product or service (cost object). It can only be classified as a direct cost if the exact amount that relates to a product or service is known. Where costs are shared between products or services they are not classified as direct costs. EXAMPLE Direct Costs A business manufactures two types of chairs a Regency chair and a Wicker chair. The Regency chair uses Material A, the wicker chair uses Material B. Labour Team X works on the Wicker chair and Labour Team Y works on the Regency chair. As both the materials costs and the labour costs can be traced to a particular cost object, the costs can be classified as direct costs, as follows: Cost Object 1: Regency Chair Direct Costs 1. Cost of Material A 2. Labour cost of Labour Team Y Cost Object 2: Wicker Chair Direct Costs 1. Cost of Material B 2. Labour cost of Labour Team X Indirect Costs Indirect costs are costs that cannot be traced in full to a product or service. This means that indirect costs must be shared between different products or services. Indirect manufacturing costs are also known as production overheads Management Acc Manual 2017.indb 19 24/05/ :18

38 Chapter 2 : Classifying Costs Management Accounting EXAMPLE Indirect Costs Continuing the example (above), suppose that one supervisor is used to supervise the work of both Labour Group X and Labour Group Y. We know that each Labour Group works on a specific chair (cost object) and that the associated labour cost of each group is a direct cost of the individual chair (cost object). As the cost of employing the supervisor relates to both cost objects, it must be shared between them, using an appropriate estimation method. The cost of employing the supervisor is therefore an indirect cost of both cost objects. Sometimes some direct costs will be treated as indirect costs because the amount of the cost may be insignificant and tracing it to the cost object might not be cost-effective. EXAMPLE Direct Costs v Indirect Costs Continuing the example (above), suppose that glue and nails are used in making both chairs. It is probably possible to directly assign the amount of glue used and the number of nails used in the production of each chair, thereby classifying the cost of the glue and the cost of the nails as direct costs. However, in reality, the cost of the effort made in making this direct allocation will far outweigh the benefit to be gained from the more-accurate product cost. In this case, the business will treat the cost of the glue and the cost of the nails as indirect costs of manufacturing the chairs and share them between the two cost objects, using an appropriate estimation method. Using direct and indirect cost classifications ensures a more-accurate product costing for the cost object a factor very important for pricing and decision-making. The more costs that can be classified as direct costs, the more-accurate the product cost, but it is also important to be conscious of the associated costs / benefits to be derived from making the classifications. Distinguishing between direct costs and indirect costs The distinction between direct costs and indirect costs relies on the cost object itself. A cost may be a direct cost for one cost object and an indirect cost for another cost object. In the example above, the supervisor s salary was considered to be an indirect cost of the two individual cost objects (because it couldn t be traced to just one of them). If there was one supervisor for Regency chairs and a different supervisor for Wicker chairs, the cost of employing each supervisor would be a direct cost, because the cost of employing each supervisor could be directly traced to a specific cost object. CLASSIFYING COSTS AS EITHER PRODUCT COSTS OR PERIOD COSTS Product Costs Product costs are costs that are related to the manufacturing process and consist of both direct manufacturing costs and indirect manufacturing costs. The terms product cost and manufacturing cost are often used interchangeably Management Acc Manual 2017.indb 20 24/05/ :18

39 Management Accounting Chapter 2 : Classifying Costs The cost of manufacturing a product is made up as follows: DIRECT COSTS Direct Materials Cost X Direct Labour Cost X Direct Manufacturing Expenses Cost X Prime Cost (Total Direct Costs) X INDIRECT MANUFACTURING COSTS Indirect Materials Cost X Indirect Labour Cost X Manufacturing Overhead Cost X Total Manufacturing Cost = Total Product Cost X Period Costs Period costs are costs that are associated with a reporting period, rather than related to the manufacturing process. All non-manufacturing costs are treated as period costs. Examples of period costs include the following: 1. Advertising costs 2. Administration costs 3. Legal costs 4. Audit fees 5. Rent of an office building CLASSIFYING COSTS AS EITHER FIXED COSTS, VARIABLE COSTS OR MIXED COSTS Cost Behaviour Patterns Different costs vary in different ways in response to changes in a business activity level. The business activity level most commonly means its output level, but could also mean some other measure of activity, such as the number of labour hours worked or the number of machine hours used. The different ways in which costs vary are known as cost behaviour patterns. For decision-making purposes, management requires costs to be classified in accordance with cost behaviour patterns. Typical cost behaviour patterns Fixed costs Total fixed costs do not change in direct proportion with activity (units produced or sold). For example, regardless of the units made or sold the company will still pay the same rent on its factory Management Acc Manual 2017.indb 21 24/05/ :18

40 Chapter 2 : Classifying Costs Management Accounting Total Fixed cost behaviour pattern Although the total amount of fixed cost does not change as a business activity level changes, the amount of fixed cost per unit of output: will decrease as output volume increases and will increase as output volume decreases EXAMPLE Total Fixed Cost and Fixed Cost Per Unit A business pays rent of 10,000 per month. Rent is normally a fixed cost. Output Volume Total Fixed Cost Fixed Cost Per Unit of Output 50,000 units 10,000 10,000 / 50,000 units = 0.20 per unit 100,000 units 10,000 10,000 / 100,000 units = 0.10 per unit 200,000 units 10,000 10,000 / 200,000 units = 0.05 per unit QUESTION Draw a graph of the above fixed cost per unit. ANSWER Management Acc Manual 2017.indb 22 24/05/ :18

41 Management Accounting Chapter 2 : Classifying Costs Variable Costs Variable costs vary in direct proportion to activity. Examples of variable costs include direct materials costs and direct labour costs. A business total variable cost: will increase as the business increases output volume will decrease as the business decreases output volume. Total Variable cost behaviour pattern Although the total amount of variable cost will change as output changes, the amount of variable cost per unit (the total variable cost divided by the number of units of output) does not change as output changes. A graph of Variable cost per unit would look as follows: Mixed costs (semi-variable costs) Mixed costs are costs that contain a variable cost element and a fixed cost element. For example, a telephone bill will contain both a fixed and variable element. The line rental is the fixed element (regardless of the number of calls made this remains constant) and the number of calls is the variable element (the greater the number of calls the higher the bill) Total Cost = Total Fixed Cost + Total Variable Cost = Total Fixed Cost + (Variable Cost Per Unit x Output Volume) Management Acc Manual 2017.indb 23 24/05/ :18

42 Chapter 2 : Classifying Costs Management Accounting Mixed cost behaviour pattern Step Costs A step-fixed cost is fixed within a given range of activity but once that level of activity is reached the cost increases and becomes fixed again within a new range of activity. EXAMPLE Step Costs Production output up to 10,000 units can be accommodated at an existing factory, incurring a premises overhead of 150,000 per year. Production output in the range 10,000 units 15,000 units can be facilitated at an adjoining facility, incurring additional premises overhead of 60,000 per year Production output in excess of 15,000 units will require an additional new factory premises, at an estimated premises overhead cost of 150,000 per year QUESTION Draw a graph of the premises overhead cost. ANSWER Cost Premises Overhead Cost Activity Level (Volume of Output) Management Acc Manual 2017.indb 24 24/05/ :18

43 Management Accounting Chapter 2 : Classifying Costs COSTING SYSTEMS Cost Coding Businesses will set-up cost codes in their accounting software, so that cost data can be analysed according to how management wants to classify costs. It is important not to over-complicate this task. If a long, complicated list of codes is developed, too much time might be spent collecting and collating data. EXAMPLE Cost Codes On a building site, the coding might be as follows: 1. Labour cost Ground workers Block layers Carpenters Electricians Roofers, etc. 2. Materials cost Concrete Blocks Steel reinforcing Timber Slates / tiles 3. Machinery cost Rented Owned 4. Sub-contract cost (by category) 5. Security cost Labour Fencing Lighting Each of the above would be given a code number for the purpose of cost allocation Management Acc Manual 2017.indb 25 24/05/ :18

44 Chapter 2 : Classifying Costs Management Accounting PRACTICE QUESTIONS The following questions will test your knowledge of the material you have just covered in this chapter. You should also review the questions available online through MyRevision for this topic, as these will assist you significantly in your preparation for your examination. In addition, Sample papers for this subject can be downloaded from Question 2.1 (ref: 1472) Although methods such as the high-low method appear to make the task of predicting future costs a very simple one, there are issues that need to be borne in mind when using such methods. Outline three such issues. Question 2.2 (ref: 1469) Using examples, explain the following terms: 1. Cost Object 2. Relevant Range 3. Product Costs 4. Period Cost 5. Direct Cost 6. Indirect Cost 7. Cost Behaviour Question 2.3 (ref: 1470) Using examples, explain the following: 1. why total fixed cost does not change as the level of activity changes but fixed cost per unit does change, as the level of activity changes, and 2. why the opposite happens with variable costs (total variable cost does change as the level of activity changes but variable cost per unit does not change, as the level of activity changes). Question 2.4 (ref: 1471) Discuss cost classification with specific reference to: 1. Fixed Costs & Variable Costs. 2. Direct Costs & Indirect Costs. 3. Product Costs & Period Costs Management Acc Manual 2017.indb 26 24/05/ :18

45 Chapter 3: Analysing and Predicting Mixed Costs CHAPTER 3 Analysing and Predicting Mixed Costs CHAPTER OVERVIEW As variable costs change in proportion to output, but fixed costs do not, in order to predict the total cost of some future activity level, it is necessary to identify all costs as either fixed costs or variable costs. For some costs this is easy but, as mixed costs (also known as semi-variable costs) are partly fixed and partly variable, businesses need a method to break down mixed costs into their fixed cost and variable cost components. The most-common techniques for working out the amount of fixed cost and variable cost in a total (mixed) cost are: 1. account analysis; 2. regression analysis; and, 3. the high-low method. Once the amounts of fixed cost and variable cost in a total (mixed) cost are known, that information can be used to predict the cost associated with planned future activity levels. This chapter focuses on the high-low method of working out the amount of fixed cost and variable cost in a total (mixed) cost. LEARNING OUTCOMES FOR THIS CHAPTER After studying this chapter, you should be able to: 1. Analyse current mixed costs into fixed cost and variable cost elements, using the High-Low method 2. Use the fixed cost / variable cost breakdown of current mixed costs to predict future mixed costs Management Acc Manual 2017.indb 27 24/05/ :18

46 Chapter 3 : Analysing and Predicting Mixed Costs Management Accounting High-low method of analysing mixed costs The high-low method involves working out the total cost at various activity levels. As fixed costs will remain constant, even when the activity level changes (within the relevant range), the difference in total cost between the low activity level and the high activity level must be a variable cost. By dividing the cost difference by the difference in activity levels, we can estimate the variable cost per unit. By using the cost equation for mixed costs, we can solve the equation for the fixed cost element. Once the total fixed cost and the variable cost per unit are known, it will be possible to predict total costs at any activity level (within the relevant range). EXAMPLE 1 High-Low Method The following cost data has been collected by a business. Activity Level (Production Volume) Total (Mixed) Cost 1,000 units 7,000 2,000 units 9,000 3,000 units 11,000 4,000 units 13,000 5,000 units 15,000 It is obvious from the above table, that the total mixed cost increases as production volume increases. QUESTIONS 1. Calculate the business variable cost per unit 2. Calculate the business total fixed cost ANSWERS Working out the amount of fixed cost and variable cost in a total (mixed) cost, using the high-low method The High-Low method examines the difference in cost between the highest activity level and the lowest activity level. By choosing these two points, the cost over the full range of activity is examined whereas, if two other points were chosen we would be examining the difference in cost over a smaller range of activity Management Acc Manual 2017.indb 28 24/05/ :18

47 Management Accounting Chapter 3 : Analysing and Predicting Mixed Costs Using the highest level of activity and the lowest level of activity, we can identify the variable cost and fixed cost components of the total cost as follows: High / Low Volume Activity Level (Production Volume) Total (Mixed) Cost High 5,000 units 15,000 Low 1,000 units 7,000 Difference 4,000 units 8,000 Variable cost per unit = cost difference / activity level difference = 8,000 / 4,000 units = 2 per unit We can work out the fixed cost element using the cost equation for mixed costs and the cost details for either the high level or the low level. As fixed costs will remain constant, it doesn t matter which one we use. Total (Mixed) Cost = Total Fixed Cost + Total Variable Cost Total Cost = Total Fixed Cost + (Variable Cost Per Unit x Level Of Output) Using the high level. Total Cost = Total Fixed Cost + (Variable Cost Per Unit x Level Of Output) 15,000 = Total Fixed Cost + ( 2 per unit x 5,000 units) Total Fixed Cost = 15,000-10,000 Total Fixed Cost = 5,000 Using the low level. Total Cost = Total Fixed Cost + (Variable Cost Per Unit x Level Of Output) 7,000 = Total Fixed Cost + ( 2 per unit x 1,000 units) Total Fixed Cost = 7,000-2,000 Total Fixed Cost = 5,000 Using this Analysis to Predict Future Mixed Costs The business wants to know what the total (mixed) cost would be for 6,000 units. This can be done as follows: Total Cost = Total Fixed Cost + (Variable Cost Per Unit x Level Of Output) Total Cost = 5,000 + ( 2 x number of units) Total Cost = 5,000 + ( 2 x 6,000 units) Total Cost = 5, ,000 Total Cost = 17, Management Acc Manual 2017.indb 29 24/05/ :18

48 Chapter 3 : Analysing and Predicting Mixed Costs Management Accounting EXAMPLE 2 High-Low Method The following cost data has been collected by a business for the most-recent six months QUESTIONS Month Activity Level (Production Volume) Total (Mixed) Cost June 5,000 units 10,200 July 5,550 units 11,200 August 4,500 units 9,750 September 4,750 units 10,100 October 6,500 units 12,750 November 6,250 units 11, Calculate the business variable cost per unit 2. Calculate the business total fixed cost ANSWERS If we re-arrange the above data in volume order, instead of month order, we get the following: Activity Level (Production Volume) Total (Mixed) Cost 4,500 units 9,750 4,750 units 10,100 5,000 units 10,200 5,550 units 11,200 6,250 units 11,500 6,500 units 12, Management Acc Manual 2017.indb 30 24/05/ :18

49 Management Accounting Chapter 3 : Analysing and Predicting Mixed Costs It is now obvious from the above table, that the total mixed cost increases as production volume increases (although not necessarily proportionately). If we graphed the data, the graph would look as follows: We could estimate the total mixed cost for any activity level: 1. from the above graph, or, 2. using the high-low method Using the High-Low Method Using the highest level of activity and the lowest level of activity, we can identify the variable cost and fixed cost components of the total (mixed) cost as follows: High / Low Volume Month Activity Level (Production Volume) Total (Mixed) Cost High October 6,500 units 12,750 Low August 4,500 units 9,750 Difference 2,000 units 3,000 Variable cost per unit = cost difference / activity level difference = 3,000 / 2,000 units = 1.50 per unit We can work out the fixed cost element using the cost equation for mixed costs and the cost details for either the high level or the low level. As fixed costs will remain constant, it doesn t matter which one we use. Total (mixed) Cost = Total Fixed Cost + Total Variable Cost Total Cost = Total Fixed Cost + (Variable Cost Per Unit x Level Of Output) Management Acc Manual 2017.indb 31 24/05/ :18

50 Chapter 3 : Analysing and Predicting Mixed Costs Management Accounting Using the high level. Total Cost = Total Fixed Cost + (Variable Cost Per Unit x Level Of Output) 12,750 = Total Fixed Cost + ( 1.50 per unit x 6,500 units) Total Fixed Cost = 12,750-9,750 Total Fixed Cost = 3,000 (The same result will be achieved if you use the low level) Using this Analysis to Predict Future Mixed Costs Supposing we estimate that the activity level in December will be 7,250 units, it is possible to predict the total costs for December as follows: Total Cost = Total Fixed Cost + (Variable Cost Per Unit x Level Of Output) Total Cost = 3,000 + ( 1.50 x number of units) Total Cost = 3,000 + ( 1.50 x 7,250 units) Total Cost = 3, ,875 Total Cost = 13,875 EXERCISE Estimate the total mixed cost if the business output level was: 1. 7,000 units 2. 8,000 units Limitations of the High-Low Method of Analysing Mixed Costs A great advantage of the high-low method over alternative methods of working out the amount of fixed cost and variable cost in a total (mixed) cost is that it is easy to apply. However, the method provides only a very rough estimate of costs, for the following reasons: 1. The data points chosen (the highest point and the lowest point) are outliers. As such, they do not provide any indication of recurring cost patterns over a period of time and may distort cost patterns. For example, if you re-do the figures in Example 2 above using two different data points, you will get a slightly-different result because the change in costs is not exactly proportionate to output (as can be seen from the graph). 2. Using only two data points is not generally believed to provide sufficiently-accurate results in cost analysis Management Acc Manual 2017.indb 32 24/05/ :18

51 Management Accounting Chapter 3 : Analysing and Predicting Mixed Costs PRACTICE QUESTIONS The following questions will test your knowledge of the material you have just covered in this chapter. You should also review the questions available online through MyRevision for this topic, as these will assist you significantly in your preparation for your examination. In addition, Sample papers for this subject can be downloaded from Question 3.1 (ref: 1473) The following information relates to the activities of a research and development laboratory during the last two months: Month 1 Month 2 Volume of Activity Number of tests undertaken 1,100 (low) 1,276 (high) Costs Incurred Scientists salaries 35,720 35,720 Technicians salaries 18,110 18,110 Chemistry costs 30,250 31,460 Clinical assessment costs 20,900 23,617 Laboratory lease cost 28,860 28,860 Cost of chemical compound F1 25,000 29,000 Administration costs 32,050 32,050 REQUIREMENTS 1. Classify each of the above costs as either a fixed cost, a variable cost, or a mixed cost; 2. Use the high-low method to separate each of the mixed costs into their fixed cost and variable cost components Management Acc Manual 2017.indb 33 24/05/ :18

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53 Part 3 Labour Costs In all businesses, whether manufacturing businesses, service businesses, retail businesses etc., labour costs (the cost of employing people) are a significant part of the business cost base and therefore, need to be given due attention by management. CHAPTER 4 Labour Costs Management Acc Manual 2017.indb 35 24/05/ :18

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55 Chapter 4: Labour Costs CHAPTER 4 Labour Costs CHAPTER OVERVIEW One of the most-common ways of classifying total costs is to divide total costs into the following headings: 1. Materials Costs 2. Labour Costs 3. Overhead Costs This chapter is concerned with labour costs (the cost of employing staff). (Subsequent chapters will address materials costs and overhead costs). LEARNING OUTCOMES FOR THIS CHAPTER After studying this chapter, you should be able to: 1. Distinguish between direct labour cost and indirect labour cost. 2. Understand how labour costs are accounted for Management Acc Manual 2017.indb 37 24/05/ :18

56 Chapter 4 : Labour Costs Management Accounting Accounting for Labour Costs As labour costs generally comprise a significant percentage of a business cost base, it is important that these costs are controlled. The information necessary for this control should be recorded in the business accounting software. There are two main elements of accounting for labour costs: 1. Payroll Accounting 2. Labour Cost Accounting 1 - Payroll Accounting Although an employee s gross pay may be a fixed salary, or may be calculated as the number of hours worked multiplied by the rate paid per hour worked, payroll accounting is more complicated than this. Payroll accounting involves calculating the net pay to be paid to each employee. As well as the number of hours worked and the hourly rate of pay, payroll accounting must take into account holidays, absenteeism and deductions, such as pension, trade union subscriptions, benefit-in-kind deductions, tax and social insurance. The information required for payroll accounting includes HR records of salary and terms of employment, data from a time-recording system (where applicable), absenteeism reports, holiday requisitions and tax credit certificates received from Revenue. 2 - Labour Cost Accounting Labour costs can be either 1. direct costs or 2. indirect costs depending on the ability to trace labour costs to individual products or services (cost object). Remuneration / Performance Measurement / Incentive Schemes Measuring the performance of employees is an important aspect in controlling labour costs. Performance appraisal / performance review / performance measurement / career development discussions are all terms used to describe methods by which the performance of employees is evaluated, generally in terms of quality, quantity, cost and time. This evaluation is generally done by an employee s line manager or supervisor. A performance appraisal is a part of guiding and managing career development. It is the process of obtaining, analysing and recording information about the relative worth of an employee to the organisation. It is also a tool to be used by employees to measure their own performance against key performance indicators (KPIs) or targets, as reaching, or surpassing, these can assist in negotiations for increased pay, by way of salaries or bonuses Management Acc Manual 2017.indb 38 24/05/ :18

57 Management Accounting Chapter 4 : Labour Costs Having a sound employee-evaluation process in place will help: Improve morale Reduce labour turnover Increase productivity Reduce friction and frustration Enhance communication between managers and employees Instil a higher level of accountability for performance Link performance to pay, in a way that can easily be understood Improve the overall culture within a business Ideally, employers should agree KPIs / targets with each employee at the outset, so as to make the employee-appraisal process as objective as possible. Remuneration methods for employees 1. Time based method Under this method employees are paid an hourly rate for each hour worked and once a set level is reached overtime is paid. For example an employee is paid 20 per hour for the first 35 hours and time and half for any hours worked after 35 hours. 2. Incentive schemes. (Piecework schemes) Incentive schemes link remuneration to output. For example for every product an employee makes they receive 5. There are various forms of incentive schemes. (i) (ii) (iii) Straight piecework For every good unit an employee produces they get paid an agreed amount. Piecework with guaranteed day rates For every good unit an employee produces they receive an agreed amount, however the employee is guaranteed a minimum amount of pay regardless of the units produced (this will usually be the minimum wage as set by a government). Piecework minute Under this method an employee is allowed a certain time to produce each product (standard piecework minute) and will only be paid for this allowed time regardless of the actual time taken Management Acc Manual 2017.indb 39 24/05/ :18

58 Chapter 4 : Labour Costs Management Accounting EXAMPLE Mark was allowed 15 minutes to produce each product (standard piecework minute). He is be paid at the rate of 25 cents per piecework minute. In one week Mark worked 38 hours and produced 150 units. Calculate Marks s Gross wages. ANSWER 150 units x 15 minutes x 25 c = Even though he actually worked 38 hours he is only paid for (150 units x 15 minutes) 37.5 hours EXAMPLE How an Incentive Scheme Works A manufacturing business, which has 5 employees in its finishing department, is considering introducing a piece-work incentive scheme in that department. Details of how the 5 employees are currently paid are as follows: Basic working week 35 hours Overtime premium 25% The average hours currently worked, and output currently produced, by each employee, together with their pay rates, are as follows: Employee Total Weekly Hours Worked Basic Hourly Pay Rate Number of Units Produced Weekly Employee 1 38 hours 18 per hour 160 units Employee 2 40 hours 18 per hour 160 units Employee 3 36 hours 20 per hour 140 units Employee 4 35 hours 20 per hour 140 units Employee 5 35 hours 20 per hour 150 units The proposed incentive scheme would operate as follows: The piecework rate per unit would be calculated based on: 1. the standard time allowance per unit would be 15 minutes per unit. 2. a standard hourly rate of 18 per hour, with a standard piecework enhancement of 6%. All employees would receive the same piecework rate per unit Management Acc Manual 2017.indb 40 24/05/ :18

59 Management Accounting Chapter 4 : Labour Costs QUESTIONS 1. Calculate the normal weekly total pay due to each employee, on current pay terms. 2. On the basis of the proposed incentive scheme, calculate a piecework rate per unit. 2. Calculate the pay due to each employee, under the proposed incentive scheme. 4. Calculate the total weekly cost of producing 800 units per week, using current payroll terms (assuming all employees produce equal amounts at current rates of production). 5. Calculate the total weekly cost of producing 800 units per week, using the proposed incentive scheme. 6. Advise the business which (number 4 above or number 5 above) is the more cost-effective option. ANSWER 1 - Current Normal weekly Total Pay per employee Employee Calculation Result Employee 1 Total Hours 38 hours - Standard Hours per hour = Overtime Hours 3 ( %) per hour Employee 2 Total Hours 40 hours - Standard Hours per hour = Overtime Hours 5 ( %) per hour Employee 3 Total Hours 36 hours - Standard Hours per hour = Overtime Hours 1 ( %) per hour Employee 4 Total Hours 35 hours - Standard Hours per hour = Overtime Hours 0 hours Employee 5 Total Hours 35 hours - Standard Hours per hour = Overtime Hours 0 hours Management Acc Manual 2017.indb 41 24/05/ :18

60 Chapter 4 : Labour Costs Management Accounting 2 - Proposed Piecework Rate per unit Calculation Result Standard Weekly Basic Pay per hour Standard Weekly Production Basic Piecework Rate 35 hours = 2,100 minutes / 15 OR 1 per 15 minutes = 4 per hour x 35 hours 140 units 4.50 per unit Incentive Enhancement 6% 4.50 * per unit Standard Incentive Piecework Rate 4.77 per unit 3 - Pay due to each employee for current output under proposed incentive scheme Employee Calculation Result Employee units x 4.77 per unit Employee units x 4.77 per unit Employee units x 4.77 per unit Employee units x 4.77 per unit Employee units x 4.77 per unit Cost of producing 800 units on Current Payroll Terms (assuming all employees produce equal amounts at current rates of production) Target total production per week Number of employees Target average production per employee 800 units per week 5 employees 160 units per employee per week Management Acc Manual 2017.indb 42 24/05/ :18

61 Management Accounting Chapter 4 : Labour Costs Employee Current Output per week Current Hours per week Current Output per hour Weekly Target Output Time required for target (Target / current output per hour) Basic Hours Employee Units 38 hours 4.21 units per hour 160 units 38 hours 35 hours Employee Units 40 hours 4.00 units per hour 160 units 40 hours 35 hours Employee Units 36 hours 3.89 units per hour 160 units hours 35 hours Employee Units 35 hours 4.00 units per hour 160 units 40 hours 35 hours Employee Units 35 hours 4.29 units per hour 160 units hours 35 hours Total Output 800 units 5 - Pay Cost with Incentive Scheme per unit = 3,816 6 More Cost-effective Option The proposed incentive scheme is the more cost-effective option Overtime Hours 3 hours 5 hours 6.13 hours 5 hours 2.29 hours Basic Hourly Pay Rate 18 per hour 18 per hour 20 per hour 20 per hour 20 per hour Basic Pay (Basic Hours x Basic Pay Rate) Overtime Pay (Overtime Hours x Basic Pay Rate + 25%) Total Pay Total Weekly Pay 3, Management Acc Manual 2017.indb 43 24/05/ :18

62 Chapter 4 : Labour Costs Management Accounting PRACTICE QUESTIONS The following questions will test your knowledge of the material you have just covered in this chapter. You should also review the questions available online through MyRevision for this topic, as these will assist you significantly in your preparation for your examination. In addition, Sample papers for this subject can be downloaded from Question 4.1 (ref: 1476) Outline 3 examples of direct labour cost and 3 examples of indirect labour cost, giving reasons for your selections. Question 4.2 (ref: 1477) Outline the purpose of an incentive scheme Management Acc Manual 2017.indb 44 24/05/ :18

63 Part 4 Materials Costs In manufacturing businesses, materials are a significant part of the business cost base. It is therefore necessary to manage the cost of materials. This part of the course outlines simple procedures for doing this. These procedures can equally be applied to inventory of finished goods in non-manufacturing businesses. CHAPTER 5 Materials-Related Administration CHAPTER 6 Managing Inventory Levels CHAPTER 7 Valuing Inventory Management Acc Manual 2017.indb 45 24/05/ :18

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65 Chapter 5: Materials-Related Administration CHAPTER 5 Materials-Related Administration CHAPTER OVERVIEW Although in service businesses, cost control is very focused on the cost of labour and overheads, as materials costs are not significant, in manufacturing businesses, materials costs comprise a significant percentage of the business cost base. It is therefore important that proper systems are in place for controlling, and accounting for, materials. This chapter is concerned with the administrative procedures related to buying materials. LEARNING OUTCOMES FOR THIS CHAPTER After studying this chapter, you should be able to: Understand the administrative procedures related to buying materials Management Acc Manual 2017.indb 47 24/05/ :18

66 Chapter 5 : Materials-Related Administration Management Accounting Buying Materials The buying process begins when someone in an organisation recognises the need to acquire a particular item. In this regard, there are three main possibilities, as follows: 1. The business receives an order from a customer and recognises the need to obtain special materials which are not normally held in inventory, or 2. Warehouse staff recognise that the level of inventory of an item has fallen to a low level and needs to be replenished, to avoid running out of inventory, or 3. The warehouse receives a routine request from a production department for materials which should be, but are not, in inventory. (the above may depend on the organisation structure, which, in turn, depends on the size of the organisation, among other things) The main distinction between the above possibilities is that the first refers to items not normally held in inventory (non-inventory items) and the second and third refer to items that are normally held in inventory (inventory items). A request from a production department for materials, whether for inventory items or non-inventory items, is known as a Materials Requisition, the details of which will be entered into the business inventory management software system. Once the Materials Requisition has been created on the system, it is reviewed by warehouse staff, who will supply the materials requested. If there isn t any inventory of the item on hand, or, if inventory of the item is at a low level, then the buying process begins. Warehouse staff will create a Purchase Requisition on the system and send it to the Purchasing Department. For non-inventory items, the Purchasing Department will contact a number of suppliers, normally at least three, to obtain quotations for the supply of the materials required. Buyers will then select the best quotation having regard to price, quality, reliability of the supplier, delivery times etc. For inventory items, there will probably already be a preferred supplier. The buyer will then create a Purchase Order and send it to the selected supplier. When the items ordered are received, they will normally be accompanied by a Delivery Note from the supplier. The Delivery Note is created by the supplier and signed by the buyer. Warehouse staff will check the items received and then enter details of what has actually been received on a Goods Received Note (GRN), copies of which will be sent to both the Purchasing Department and the Accounts Department. Later, the supplier will send an Invoice to the Accounts Department which will be paid in due course - but only after checking that the quantity invoiced matches the quantity received and that the unit price charged matches the price on the Purchase Order Management Acc Manual 2017.indb 48 24/05/ :18

67 Management Accounting Chapter 5 : Materials-Related Administration Materials Warehouse Materials Requisition Reorder Materials issue to requisitioning area & Warehouserecords updated. Purchase Requisition Purchasing department Select supplier Purchase order Supplier Receiving department checks goods / materials to purchase order Goods Shipped Goods received note (GRN) Purchasing Department records order complete Accounts Department pays invoice Warehouse updates inventoryrecord Book Inventory In most busineses, as inventory-related transactions happen the balance of each inventory item is automatically updated by the business software. This is known as a perpetual inventory system. However, no matter how good the staff or the software may be, these balances can only ever represent what quantities should be in inventory. The quantities actually in inventory may be different due to theft, breakages etc. It is therefore important for businesses to occassionally physically count the quantities of items actually in inventory. Physical Inventory / Stock-take The process of counting of physical inventory (inventory in the warehouse or other storage location) at a particular date is known as either a Physical Inventory or a Stock-take. This generally occurs to coincide with the end of the business reporting period and, in larger companies, it may also be required for their interim (mid-year) Financial Statements. Some companies use a system of continuous inventory Management Acc Manual 2017.indb 49 24/05/ :18

68 Chapter 5 : Materials-Related Administration Management Accounting counting (cycle-counting) which involves a random selection of inventory items being checked in such a manner as to ensure that all inventory items are counted at least once each year, with regularly-used inventory, or high-value inventory, being counted more often than other items. Updating Book Inventory Quantities to Actual Inventory Quantities For all items where book inventory quantities are different than physical inventory quantities, management needs to find out why this is the case and, ultimately, the incorrect book inventory quantities need to be updated to the correct physical inventory quantities. This is done, by either increasing or reducing the book inventory quantities, in a manner similar to how financial accounting adjustments would be entered as General Journals. The following screenshot shows this being done in Microsoft Dynamics NAV Management Acc Manual 2017.indb 50 24/05/ :18