Accelerated Revision Course 2017 (ARC2017) Management Accounting (MAC4861/2) Rendani Muthelo August 2017

Transcription

1 Accelerated Revision Course 2017 (ARC2017) Management Accounting (MAC4861/2) Rendani Muthelo August 2017

2 Introduction to costing

3 Objectives of this section Describe the three purposes for which cost information is required Understand the meaning of different cost terms Define and illustrate a cost object Define and illustrate a relevant range 3

4 INTRODUCTION TO COSTING The big picture Management accounting is concerned with the provision of information to people within the organisation to help them make better decisions and improve the efficiency and effectiveness of existing operations. Colin Drury The management accounting information provided to those people must satisfy the following requirements: Allocate costs between costs of goods sold and inventories for internal and external reporting ( Cost accumulation for inventory valuation and profit measurement ) Provide relevant information to help managers make better decisions ( Information for decision making ) Provide information for planning, control and performance measurement ( Information for planning, control and performance measurement ) 4

5 INTRODUCTION TO COSTING Cost terms and concepts The most fundamental cost term that we will encounter in Management Accounting are cost object A cost object is any activity for which a separate measurement of costs is desired. It is anything for which one wants to measure the cost of resources used The hotel is charging R300 per night per person sharing It cost R800 per consultation hour to see the doctor 5

6 INTRODUCTION TO COSTING Direct and indirect costs Direct costs are those costs that can be specifically and exclusively identified with a particular cost object The ability to trace back costs to an individual cost object provides a strong indication of whether a cost is direct cost or indirect cost As a result of indirect costs not being traceable to individual products, an estimate must be made of resources consumed by cost objects for indirect costs The perspective is critical: A cost can be a direct cost for a particular cost object and the same cost can be an indirect cost for another cost object The distinction of whether a cost is a variable cost or a fixed cost; or whether it is a manufacturing cost or a non-manufacturing cost is irrelevant for the classification of direct and indirect costs 6

7 INTRODUCTION TO COSTING Prime costs and manufacturing overheads Prime cost refers to direct costs and consists of direct materials and direct labour Direct material and labour costs comprise of all those materials and labour that can identified with a specified cost object Manufacturing overhead consists of all manufacturing costs other than prime costs. These costs are assigned to products using cost allocations Indirect materials cannot be identified with any one product because they are used for the benefit of all products or entire production process, e.g. a blade of a cutting machine Indirect labour refers to those workers that do not work on the product itself but who assist in the manufacturing operation and these are classified as overhead, e.g. an employee that is operating a machine 7

8 INTRODUCTION TO COSTING Product and period costs Product costs are those costs that are identified with goods purchased or produced for resale. These costs may include direct material, direct labour and (some of) indirect manufacturing costs that are normally included in inventory valuation Period costs are those costs that are not included in the inventory valuation and as a result are treated as expenses in the period in which they are incurred. No attempt is made to attach the period costs to products for inventory valuation purposes 8

9 INTRODUCTION TO COSTING Categories of costs Traditional cost accounting systems accumulate product costs as follows: Direct materials Direct labour Prime cost Manufacturing overheads Total manufacturing costs Direct materials form part of prime cost and indirect materials form part of overhead cost YY YY XX ZZ WW 9

10 Examination considerations INTRODUCTION TO COSTING The principles included in this section are not assessed individually However, understanding these principles assist strongly in analysing the scenario as well as identifying key issues this will become evident as go into detail with the rest of the costing topics 10

11 Cost assignment

12 Objectives of this section Describe the various denominator levels that can be used with an absorption costing system Justify why budgeted overhead rates should be used in preference to actual overhead rates Calculate and explain the accounting treatment of the under- /over-recovery of overheads Reallocate service departments overheads where service departments render services to each other and to production departments (SELF STUDY) 12

13 Introduction to cost assignment COSTING ASSIGNMENT Endunamoo note: In this course, the terms applied, absorbed, allocated and recovered shall be used interchangeably. You are more than welcome to use the word most preferred. The term indirect costs will mean indirect fixed manufacturing costs unless otherwise evident or indicated 13

14 Introduction to cost assignment COSTING ASSIGNMENT The focus with cost assignment is the allocation of indirect fixed manufacturing costs for the purposes of inventory valuation and profit measurement All the overhead costs need to be allocated to the products because they are necessary for the production of actual units The issue becomes how to allocate these overhead costs to individual units The overhead allocation rate is determined by dividing the budgeted overhead costs (numerator) by the budgeted level of activity during that period (denominator) The method described above is known as the traditional method of cost allocation 14

15 COSTING ASSIGNMENT The overhead allocation rate The issue is the numerator to use and the denominator, i.e. Use actual or budgeted costs as the numerator Use actual or budgeted costs as the denominator Use labour hours, units, machine hours, etc. as the denominator Key considerations with regards to the use of actual figures are: The use of actual overhead rate has its limitation because actual overhead rates causes a delay in the calculation of product cost The use of actual monthly rates causes fluctuations in the overhead rates throughout the year (e.g. heaters retailer) To remedy these challenges we always use budgeted figures to determine the overhead allocation rate 15

16 COSTING ASSIGNMENT Accounting treatment of over/under recovery The overhead allocation rate is applied to actual activity to determine the amount of overheads absorbed The amount absorbed is then charged to cost of sales (production costs) as an expense If the absorbed overhead amount is less than the actual overheads, an expense is recognised to account for the underrecovery On the other hand, an over-recovery is recognised in the case where the cost of sales is greater than the actual overheads incurred. This is treated as an income item in order to reduce cost of sales amount Under- or over-recovery should be broken down into an expenditure and volume variance 16

17 Analysis of overhead variances COSTING ASSIGNMENT Actual fixed overheads Budgeted fixed costs Allocated fixed costs (Allocation rate x Actual activity) Expenditure variance (Budgeted actual) Volume variance (Allocated budgeted) Under-/over-recovery Exam note The signs of the answers are important as they have different interpretation and accounting treatment Under- or over-recovery may be placed above or below the gross profit line item 17

18 COSTING ASSIGNMENT LE1: Allocation rate based on units Actual fixed overhead costs R Actual activity (production volumes) Budgeted fixed overhead costs R Budgeted activity (production volumes) Budgeted overhead rate to apply to the units produced will be calculated as = R / = R per unit Expenditure variance = R - R = R Unfavourable / Favourable Volume variance = R - R = R Unfavourable / Favourable 18

19 COSTING ASSIGNMENT LE2: Allocation rate based on hours Actual overhead costs for the most recent period R Actual activity (production volumes) Actual activity (machine hours utilised) Budgeted overhead costs for the most recent period R Budgeted activity (production volumes) Budgeted activity (machine hours to be utilised) Although the approach remains fundamentally the same, there are additional considerations or steps to be factored into the calculation of the allocation rate should the allocation base (denominator) be any activity other than units produced 19

20 COSTING ASSIGNMENT LE2SS: Allocation rate based on hours Calculate the overhead allocation rate based on machine hours: Budgeted overhead costs / Budgeted number of machine hours = R / = R per machine hour Calculate the number of machine hours required per unit produced as: Budgeted number of machine hours / Budgeted number of units produced = / = machine hours per unit Calculate the expected number of hours based on actual units produced as: Number of machine hours required per unit x Actual units produced = x = machine hours Calculate the amount of overhead costs to be allocated to production: Budgeted allocation overhead rate x Number of hours that should have been used = R_ per machine hour x machine hours = R 20

21 COSTING ASSIGNMENT Potential denominators The following are denominator level measures that could potentially be used for the purpose of determining the appropriate denominator: Practical capacity represents the maximum capacity that is likely to be supplied by the machine after taking into account unavoidable interruptions arising from machine maintenance and plant holiday closures Normal activity is a measure of capacity required to satisfy average customer demand over a longer term period after taking into account seasonal and cyclical fluctuations Budgeted activity is the activity level based on the capacity utilisation required for the next budget period 21

22 LE3: Determining product cost COSTING ASSIGNMENT Toddlers is a children s luxury toys manufacturer. It manufactures nonelectric and electric toys. Details regarding the two products are provided below: Toy Non-electric Electric Selling price per unit R2 000 R4 000 Direct materials R500 R1 200 Budgeted labour hours per unit 3 8 Budgeted production volumes Actual production volumes Budgeted machine hours Actual machine hours Budgeted direct labour hours Actual direct labour hours

23 LE3: Determining product cost COSTING ASSIGNMENT Additional information: Labour is a variable cost. The budgeted and actual manufacturing labour costs were R and R respectively Budgeted fixed costs comprised the following: Depreciation of manufacturing plant: R Depreciation of head office building: R Rental of factory building: R Salary of factory manager: R Salary of administration employees: R Other fixed manufacturing costs: R Actual fixed manufacturing costs amounted to R Variable selling costs are currently 10% of the selling price 23

24 LE3: Determining product cost COSTING ASSIGNMENT Fixed manufacturing costs are allocated to production based on machine hours. REQUIRED: 1) Calculate the gross profit per unit for the non-electric toy (NET) and electric toy (ET) 2) Calculate the contribution per unit for NET and ET 3) Calculate the expenditure and volume variances. Indicate whether the variances would be treated as an expense or income in the statement of profit or loss 24

25 COSTING ASSIGNMENT Exam technique: Determine product cost 1) Pay careful attention to the required. There s often a mark for adequately answering the required. Do not move forward until you have addressed the required 2) Determine what gross profit means. Gross profit = selling prices variable manufacturing costs allocated fixed manufacturing costs. How does this compare to the contribution per unit? 3) Determine which figures need to be based on budgeted figures and which need to be based on actual figures 4) Determine the allocation rate per allocation base - identify which costs would need to be included in the calculation 5) Identify the number of units of allocation base required per manufactured unit 6) For part (2), identify the link to part (1) and know your formulas 25

26 Cost, volume and profit analysis

27 Objectives of this section Describe the three purposes for which cost information is required Apply the numerical approach to answer break even questions Explain the meaning of operating leverage and how it influences profits Identify and explain the assumptions on which CVP analysis is based 27

28 Introduction to CVP analysis COST, VOLUME AND PROFIT ANALYSIS This section focuses on what will happen to the financial results of an entity if a specific level of activity or volume fluctuates CVP analysis examines the relationship between changes in activity and changes in total sales revenue, costs and net profit The information is required for making optimal short-term output decisions 28

29 COST, VOLUME AND PROFIT ANALYSIS Cost behaviour and relevant range Costs may be described as variable, fixed, semi-variable and semi-fixed in relation to how they react to changes in activity Variable costs vary in direct proportion to the volume of activity while fixed costs remain constant over wide ranges of activity for a specified period of time The behaviour of costs is a function of time and activity Over a sufficiently long period of time virtually all costs variable Therefore an activity or period needs to be defined before the cost behaviour could be accurately determined, e.g. the salary of trainee accountant with CTA Level 1 / 2 or ITC The range that represents the output levels that the firm has had experience of operating in the past and for which cost information is available is considered to be the relevant range 29

30 CVP analysis assumptions COST, VOLUME AND PROFIT ANALYSIS All other variables remain constant Single product or constant sales mix Total costs and total revenue are linear functions of output Profits are calculated on a variable costing basis Costs can be accurately divided into their fixed and variable elements Analysis applies only to the relevant range 30

31 Numerical approach to CVP COST, VOLUME AND PROFIT ANALYSIS The most common application of CVP is the determination of breakeven point, margin of safety, application of hi-low method and operating leverage Break-even refers to a point where the company makes neither a profit nor a loss Margin of safety refers to the excess number of units sold or budgeted to be sold above the break even units Scenario may deal with single product or multi-product case. If overheads are shared between the units, use multi-product break even approach The hi-low method is a simplistic mathematical technique which consists of examining past costs and activity, selecting the highest and the lowest activity levels and comparing the changes in costs which results from the two levels 31

32 COST, VOLUME AND PROFIT ANALYSIS Hi-low method Often costs are not easily distinguishable between variable and fixed costs and therefore a technique is required to identify the nature of a cost that exhibits the behaviour of a fixed and variable nature The hi-low method may be used (cautiously) to analyse costs within a respective relevant range where a cost comprises a variable and fixed component Hi-low method assumes that the activity levels and the related costs are representative of the cost behaviour within a defined relevant range 32

33 COST, VOLUME AND PROFIT ANALYSIS LE1A: Hi-low / Relevant range Tessa has an agreement with Eskom for the supply of electricity. In terms of the agreement, Tessa is charged an annual fixed amount for access to Eskom s grid ( fixed access fee ). This amount is payable irrespective of whether Tessa utilises electricity or not. In addition to the fixed access fee, Tessa pays for electricity consumption based on the amount of Kwh of electricity utilised during the year. Information relating to the electricity costs over the past three years is provided below: Financial year Kwh consumed Total costs FY R FY R FY R

34 COST, VOLUME AND PROFIT ANALYSIS LE1A: Hi-low / Relevant range There were no electricity price hikes throughout the period FY2015 to FY2017. In FY2017, Eskom announced that it will increase its fixed access fee by 10% in FY2018. The consumption rate per kwh will not be changed. REQUIRED Calculate the total budgeted electricity costs in FY2018 assuming that Tessa is planning to utilises a total of Kwh 34

35 COST, VOLUME AND PROFIT ANALYSIS LE1B: Hi-low / Relevant range Tessa has an agreement with Eskom for the supply of electricity. In terms of the agreement, Tessa is charged an annual fixed amount for access to Eskom s grid ( fixed access fee ). This amount is payable irrespective of whether Tessa consumes electricity or not. In addition to the fixed access fee, Tessa pays for electricity consumption based on the amount of electricity hours utilised during the year. Information relating to the electricity costs over the past three years is provided below: Financial year Kwh consumed Total costs FY R FY R FY R

36 COST, VOLUME AND PROFIT ANALYSIS LE1B: Hi-low / Relevant range There were no electricity price hikes throughout the period FY2015 to FY2016. In FY2017, Eskom increased the rate per Kwh consumed by 20%. It further announced that it will increase its fixed access fee by 10% in FY2018. The consumption rate per kwh will not be increased any further. REQUIRED Calculate the total budgeted electricity costs in FY2018 assuming that Tessa is planning to consume a total of Kwh 36

37 COST, VOLUME AND PROFIT ANALYSIS LE2: Single product break even Tessa manufactures non-electric vehicles. Pertinent information relating to the operations of Tessa are provided below: Tessa budgeted to sell vehicles in FY2018 at a price of R per vehicle. The steel component required for the manufacturing process is acquired in tonnes from an external supplier. The cost per tonne is R2 500 and each vehicle requires 75 tonnes to be manufactured. Other direct materials amount to R per vehicle. A total of 150 direct labour hours is required for the assembly of one vehicle. The assembly staff are all permanent staff and are paid an annual salary of R per staff. Each staff is budgeted to work a total of hours in FY

38 COST, VOLUME AND PROFIT ANALYSIS LE2: Single product break even Tessa employs its sales team on a permanent basis. The sales team are paid a fixed annual salary and a commission of 2,5% for each vehicle sold. The total budgeted costs for the sales team is R63 million. The total fixed manufacturing overheads are budgeted at an amount of R35 million. Included in this amount is R5 million for the depreciation on the manufacturing machine. Other fixed non-manufacturing overheads are budgeted to amount to R

39 COST, VOLUME AND PROFIT ANALYSIS LE2: Single product break even REQUIRED: 1) Calculate the number of vehicles that Tessa need to sell in order to break even in units and in revenue terms in FY2018 2) Calculate the margin of safety in units and in revenue terms. 3) Calculate the number of vehicles that Tessa would need to sell in order to generate an annual profit of R ) If fixed overheads increase by R , calculate the revised number of vehicles that Tessa would need to sell in order to break even. 5) Discuss the impact on the break even units calculated in (1) of an increase in the sales commission rate from 2,5% to 3,5%. No calculations are required. 39

40 COST, VOLUME AND PROFIT ANALYSIS Exam-technique: Single product break even The break-even calculation requires that the company generates sufficient contribution margin to cover the total fixed cost (i.e. manufacturing and non-manufacturing fixed costs) The contribution margin per unit is the selling price per unit less all variable costs per unit (manufacturing and non-manufacturing costs) The break-even point determines the number of units to be sold or the sales value required in order to generate neither a profit nor a loss If the company has a target profit or additional fixed costs then the total contribution margin generated should be sufficient to cover the total fixed costs and the required profit Pay attention to the required does it require break-even units or sales value? 40

41 Break-even complications COST, VOLUME AND PROFIT ANALYSIS Break-even analysis can be complicated by the following matters: Items sold for no consideration, e.g. donated items Promotional items, e.g. buy 1 and get 1 free Committed revenues, e.g. a hotel with committed revenues from conference facilities and attempting to determine break even for the number of guests required Transfer pricing arrangements, e.g. break-even from a divisional perspective versus company-wide perspective Special orders 41

42 LE3: Special case break even COST, VOLUME AND PROFIT ANALYSIS The Department of Labour introduced a new scheme available to manufacturers. In terms of the scheme, if a manufacturer registers at least 50 learnerships in FY2018 for individuals with no tertiary education, the Department of Labour will either: grant a 6% rebate on the selling price of each vehicle sold, or grant a fixed non-repayable grant of R Tessa has expressed its interest to participate in the scheme. Tessa indicated that its primary objective is to reduce the break even sales volume for FY2018. Recommend, with supporting calculations, whether Tessa should opt for the rebate or the fixed amount with regards to the grants available. 42

43 COST, VOLUME AND PROFIT ANALYSIS Exam-technique: Special case break even Rephrase the required and reduce it to basic language Did you note the verb recommend? Appreciate that this verb is a logical verb and requires a logical answer (not a correct answer) Therefore, you will get a credit for responding appropriately to it Identify the calculations you need to prepare in order to answer the required 43

44 LE4: Multi-product break even COST, VOLUME AND PROFIT ANALYSIS Marula Nature Reserve is a getaway place which offers its visitors a bushveld experience. It has 10 self-catering thatched roof chalets and a restaurant. The restaurant is located within the swimming pool area and is open every day of the year from breakfast to supper time. The manager of the restaurant found that sales can basically be classified between light meals and main meals. The following average revenues are earned from the two types of meals: Light meal Main meal Average food revenue per meal R45,00 R120,00 Average beverage revenue per meal R20,00 R50,00 R65,00 R170,00 44

45 LE4: Multi-product break even COST, VOLUME AND PROFIT ANALYSIS The actual number of meals sold during the recent financial year end was as follows: Light meal Main meal Number of meals The ratio of light meals to main meals was fairly constant throughout the year. The restaurant earns a profit margin of 55% on the food revenue based only on the food ingredients. The beverages selling price is based on a 100% mark-up on the actual purchase price of the beverage. 45

46 LE4: Multi-product break even COST, VOLUME AND PROFIT ANALYSIS The following costs are applicable to the restaurant division for the recent financial year end: 2% commission earned by the waiters at the restaurant on the selling price of all beverages sold. Staff costs (excluding commission) of R which are considered fixed costs. Cleaning and utility costs (water and electricity) amounting to R1,80 per light meal and R2,40 per main meal as calculated by the restaurant manager. Depreciation of R on non-current assets utilised. Other fixed costs of R , including consumables such as crockery, cutlery and linen. 46

47 LE4: Multi-product break even COST, VOLUME AND PROFIT ANALYSIS REQUIRED: Calculate the break-even number of meals for the restaurant. The break-even number of meals must be calculated in total, and then split between light meals and main meals. (10 marks) (Adapted UNISA 2015 Final Exam) 47

48 COST, VOLUME AND PROFIT ANALYSIS Exam-technique: Multi-product break even 1. Determine the appropriate sales mix based on units Do not use production mix Use budgeted figures, unless required otherwise Express the sales mix as a percentage Always check that the percentages add up to 100% 2. Calculate contribution for each unit (Contribution=SP ALL VC) 3. Calculate the weighted average contribution using the calculated sales mix percentage and the respective contributions 4. Calculate total fixed costs of the company do not split these 5. Break even in units would be determined as (4) / (3) 6. Multiply your answer by the sales mix percentage to get the respective number of break even units for each product 48

49 COST, VOLUME AND PROFIT ANALYSIS Operating leverage Operating leverage is used as a measure of the sensitivity of profits to changes in sales. The greater the degree of operating leverage, the more that changes in sales activity will affect profits The degree of operating leverage is determined by the company s cost structure (i.e. the relative amount of fixed costs to total costs) The higher the degree of operating leverage the higher the business risks of the company and vice versa The degree of operating leverage (DoL) can be measured for a given level of sales by the following formula: DoL = Contribution margin / Profit 49

50 LE5: Operating leverage COST, VOLUME AND PROFIT ANALYSIS Given the increased labour unrest in South Africa, Tessa is considering upgrading its existing manufacturing facilities from being labour intensive to being more automated. Management are uncertain about the future prospects of vehicles sales given the decline in the economy and they believe that there is a chance of a 10% decline in sales revenue and also a 20% increase in sales revenue. REQUIRED Evaluate the additional financial information overleaf and advise, with supporting calculations, the management of Tessa on whether or not they should proceed with the upgrade 50

51 LE5: Operating leverage COST, VOLUME AND PROFIT ANALYSIS All amounts in Rands Status quo Proposal Sales revenue Variable expenses ( ) ( ) Contribution margin Fixed expenses ( ) ( ) Profit (Adapted from UNISA Test 1, 2014) 51

52 Income effect of alternative accumulation systems

53 Objectives of this section Explain the differences between an absorption costing and a variable costing system Prepare profit statements based on an absorption and variable costing system Reconcile and explain the difference in profits between absorption and variable costing profit calculations Explain the arguments for and against variable and absorption costing 53

54 INCOME EFFECT OF ALTERNATIVE ACCUMULATION SYSTEMS Introduction to cost accumulation systems There are two distinct cost accumulation systems The absorption costing (also known as the full costing, conventional costing or traditional costing) system. This method is also a requirement in terms of IAS2 Inventories The variable costing (also known as the marginal or direct costing method) The two systems have different income effects, i.e. the choice of the cost accumulation system affects the reported profit after tax for the year 54

55 Variable and absorption costing Direct costs Prime costs Manufacturing overheads variable Manufacturing overheads fixed Under- or over-recovery of fixed overheads Non-manufacturing costs variable (often selling expenses) Non-manufacturing costs fixed INCOME EFFECT OF ALTERNATIVE ACCUMULATION SYSTEMS Variable costing Absorption costing 55

56 INCOME EFFECT OF ALTERNATIVE ACCUMULATION SYSTEMS Variable and absorption costing Variable costing Absorption costing Direct costs Included as product cost Included as product cost Prime costs Included as product cost Included as product cost (prime and direct costs (prime and direct costs same same thing) thing) Manufacturing overheads variable Manufacturing overheads fixed Under- or over-recovery of fixed overheads Non-manufacturing costs variable (often selling expenses) Non-manufacturing costs fixed Included as product cost Treated as period cost expense in full when incurred Not applicable as all overheads charged as period costs Not included as product costs often vary with units sold rather than production Treated as period cost expense in full when incurred Included as product cost Included as product cost allocated to products based on overhead allocation rate Under-recovery treated as expense while over-recovery treated as income Not included as product costs often vary with units sold rather than production Treated as period cost expense in full when incurred 56

57 INCOME EFFECT OF ALTERNATIVE ACCUMULATION SYSTEMS Pros and cons of various costing systems Variable costing Variable costing provides more useful information for decision making Variable costing removes from profit the effect of inventory changes Variable costing avoids fixed overheads being capitalised in unsaleable stocks Absorption costing Absorption costing does not understate the importance of fixed costs Absorption costing avoids fictitious losses being reported Fixed overheads are essential for production Consistency with external reporting (IAS 2 Inventories) 57

58 INCOME EFFECT OF ALTERNATIVE ACCUMULATION SYSTEMS LE1: Variable and absorption costing Bakers is a manufacturer of cakes. Information pertaining to the most recent financial period is provided below: Budget Actual Number of units produced Number of units sold Selling price per unit R300 R325 Variable manufacturing costs R120 R155 Variable selling costs R55 R54 Fixed manufacturing costs (allocation base: units) R R Fixed non-manufacturing costs R R

59 INCOME EFFECT OF ALTERNATIVE ACCUMULATION SYSTEMS LE1: Variable and absorption costing There were units of finished goods at the beginning of the period. The variable manufacturing cost of each item is R130 while the fixed cost per unit is R35 per unit. Bakers uses first-in-first-out (FIFO) method to accounts for its closing inventory. REQUIRED: 1) Prepare a statement of profit or loss of Bakers using the absorption costing method 2) Reconcile the absorption costing profit determined in part (1) to the variable costing profit. You are not required to prepare the statement of profit or loss using variable costing method 3) Calculate the number of units that Bakers needed to sell in order to break even (use budgeted financial information) 59

60 INCOME EFFECT OF ALTERNATIVE ACCUMULATION SYSTEMS Exam-technique: Variable / absorption costing Identify the easiest marks to score and make a decision of what might be required to pass the question. Easy marks can be identified as: Level 1: Marks that you can put in without having performed any calculations (likely to be ½ marks) Level 2: Marks that you can calculate by applying a mathematical operation to figures in the scenario (likely to be ½ marks) Level 3: Marks that require a greater level of application and that might need another figure to be determined first (likely to be a full credit or more) Know your format! There is likely going to be a credit for the correct layout. Variable versus absorption statement format? Acknowledge that the difference between the profit determined under variable and absorption costing is due to opening and closing stock 60

61 Activity based costing

62 Objectives of this section Describe the differences between activity-based and traditional costing systems Explain why traditional costing systems can provide misleading information for decision-making Identify and explain each of the four stages involved in designing ABC systems Apply an activity-based costing approach to costing information 62

63 ACTIVITY BASED COSTING Introduction to ABC There is a need for a cost accumulation system to generate relevant cost information for decision making for better and effective decision making The choice of an optimal cost system is based on cost/benefit analysis Both traditional costing system and ABC assign indirect manufacturing costs to cost objects (products) based on a twostage allocation process 63

64 ACTIVITY BASED COSTING Traditional costing system and ABC The major differences relate to the use of greater number of cost centres and a greater number and variety of second stage cost drivers: Traditional cost system pools overheads by departments (described as cost centres). These overheads are then traced to products using a small number of allocation bases, which vary directly with the volume produced. The allocation bases tend to be units produced, machine hours and direct labour hours (i.e. volume-based) ( this process is referred to as cost allocation ) An ABC system assigns overheads to each major activity (rather than departments). With ABC systems, many activity based cost centres (also known as cost pools) are established. Cost drivers are used as the basis for allocating costs to cost objects. The cost drivers may be volume or nonvolume based and aim to highlight cause-and-effect relationships ( this process is referred to as cost attribution ) 64

65 ACTIVITY BASED COSTING Cost allocation in a non-volume based environment In a traditional costing system, the costing of products is complicated and distorted as a result of the following factors: Non-volume related overhead costs being a large proportion of total overhead costs; and the application of product diversity Product diversity applies when products consume different overhead activities in dissimilar proportions difference in product size, product complexity and sizes of batches may cause product diversity. Traditional systems often tend to rely on arbitrary allocations of indirect costs because they rely extensively on volume-based allocations 65

66 ACTIVITY BASED COSTING Cost allocation in a non-volume based environment The implication is that high volume products are likely to be assigned with a greater proportion of indirect costs than they have consumed (consequently overpricing these products) whereas low volume products will be assigned a lower proportion (consequently underpricing these products) In contrast, ABC systems recognise that many indirect costs vary in direct proportion to changes other than production volume By identifying the cost drivers that cause the costs to change and assigning costs to cost objects on the basis of cost driver usage, costs can be more accurately traced (cause-and-effect relationship) making ABC superior 66

67 Hierarchy of cost Building blocks of ABC Activities consist of the aggregation of many different tasks, events or units of work that cause the consumption of resources. They tend to consists of verbs associated with objects Facility-sustaining activities are performed to support the facility s general manufacturing process and include general administrative staff, plant management and property costs Product-sustaining activities are performed to enable the production and sale of individual products. The costs of product-sustaining activities are incurred irrespective of the number of units of output or the number of batches processed and their expenses will tend to increase as the number of product types manufactured is increased ACTIVITY BASED COSTING They are incurred to support the organisation as a whole and are common and joint to all products manufactured in the factory / by the company There would have to be dramatic change in activity, resulting in an expansion or contraction in the size of the plant for facility-sustaining costs to change These costs should NOT BE assigned to products since they are unavoidable and irrelevant for most decisions Instead, they are regarded as common costs to all products produced in the plant and deducted as a lump sum from the total of the operating margins from all products Batch level activities are performed each time a batch of goods is produced. The cost of batch-related activities varies with the number of batches made, but is common (or fixed) for all units within the batch Unit level activities are performed each time a unit of the product or service is produced. The unit level costs include direct labour and direct materials. These activities consume resources in proportion to the number of units of products and sales 67

68 ACTIVITY BASED COSTING Appropriateness of ABC Both traditional and ABC systems vary in their level of sophistication but, as a general rule, traditional systems tend to be simplistic whereas ABC systems tend to be more sophisticated Ultimately the chosen level of sophistication should be made on cost versus benefits criteria The cost of errors need to be assessed in relation to the costs of implementing and operating an ABC system. In a highly competitive environment, the cost of error in pricing could have significant negative implications 68

69 ACTIVITY BASED COSTING Summary: Appropriateness of ABC A sophisticated ABC may be optimal for organisation having the following characterises: intensive competition non-volume related indirect costs that are a high proportion of total indirect costs a diverse range of products, all consuming organisation resources in significantly different proportions (i.e. high product diversity) 69

70 ABC in a service organisation ACTIVITY BASED COSTING Service companies are ideal candidates for ABC, even more than manufacturing companies. The reasons for this are: most of its costs are indirect most of the resources are supplied in advance and fluctuations in the usage of activity resource by individual services and customers does not influence shortterm spending to supply the resources However the following factors may create problems for the application of ABC Facility sustaining costs (such as property rents, etc.) represent a significant proportion of total and may only be avoidable if the organisation ceases business. It may be impossible to establish appropriate cost drivers If it often difficult to define products where they are of intangible nature. Cost objects can therefore be difficult to specify Many service organisation have not previously had a costing system and much of the information required to set up ABC system will be non-existent. Therefore introducing ABC is likely to be expensive? 70

71 ACTIVITY BASED COSTING Designing an ABC system The key steps involved in designing ABC systems are as follows: Identifying the major activities that take place in an organisation Assigning costs to cost pools/cost centres for each activity Determine the cost driver for each major activity Assigning the cost of activities to products according to the product s demand for activities 71

72 ACTIVITY BASED COSTING LE1: ABC allocations Alarmy is a manufacturer of alarm remote controls, ADT and Chubb. The table below shows data for next budget period: Products ADT Chubb Direct material per unit R160 R190 Direct labour cost per hour (variable) R200 R200 Budgeted production Direct labour hours per unit 1,20 2,00 Machine hours per unit 0,40 0,80 Batch size Machine setups per batch 4 5 Number of inspections per batch

73 ACTIVITY BASED COSTING LE1: ABC allocations The factory manager has identified the following cost pools as well as the related cost drivers: Activity pools Machine maintenance Machine setups Inspection / Quality control Total overheads Amount (R) Cost drivers Number of machine hours Number of machine setups Number of inspections Traditional costing systems uses budgeted machine hours to allocate overhead costs. 73

74 ACTIVITY BASED COSTING LE1: ABC allocations REQUIRED: 1) Calculate the product costs of ADT and Chubb based on (i) traditional costing and (ii) activity based costing 2) Compare the overhead per unit calculated in Part (1), and briefly discuss the reasons for the differences 74

75 ACTIVITY BASED COSTING Examination technique: ABC allocations Identify that there are two required for part (1), and therefore four distinct answers are required Think about the four-stage allocation process of ABC Marks are often allocated for each step with a greater amount of marks allocated to determining total activities for the cost drivers and determining the cost per cost driver Often cost drivers might be provided but in other cases, you might be required to identify these drivers The verb compare implies that there are at least two things to compare the question is what is being compared now that you have four things? How can cost allocation theory assist you in structuring and answering the required? 75

76 Job costing

77 Objectives of this section Describe the materials recording procedure Distinguish between first-in-first-out (FIFO), and average cost methods of stores pricing Describe the accounting procedure for labour costs Describe the accounting procedure for manufacturing and non-manufacturing overheads Describe accounting procedures for jobs completed and products sold. 77

78 JOB COSTING Overview of job costing Job costing focuses on assigning costs to products incurred during a period between costs of sales and the closing inventory Job-order costing relates to a costing system that is required in organisations where each unit or batch of output of a product or service is unique This section does not prescribe a new method of cost accumulation but it involves the application of traditional costing method in a joborder environment The most important thing from an examination perspective is preparation of journal entries for the accumulation of costs in order to determine the costs of goods sold and the closing inventory valuation (refer to Drury for examples and practice) A thorough understanding of IAS2: Inventories makes this section appear very easy 78

79 Process costing

80 Objectives of this section Explain when process costing systems are appropriate Explain the accounting treatment of normal and abnormal losses Prepare process, normal loss, abnormal loss and abnormal gain accounts Prepare a process costing statement and value inventories 80

81 Introduction to process costing PROCESS COSTING Process costing is appropriate in those situations where masses of identical units or batches are produced thus making it unnecessary to assign costs to individual units or batches of output The average cost per unit or batch of output is calculated by dividing total costs assigned to a product or service for the period by the number of units or batches of output for that period The concept of equivalent and completed units is important for process costing. An equivalent unit is the equivalent of a fully completed unit 81

82 PROCESS COSTING Accounting treatment of normal and abnormal losses Normal losses are inherent in the production process and cannot be eliminated. Their cost should therefore be borne by the good production this is achieved by dividing the costs incurred for a period by the expected output rather than the actual output Abnormal losses are avoidable and their cost should not be assigned to products but recorded separately as an abnormal loss and written off a period cost in the statement of profit or loss Scrap sales that results from the losses should be allocated to the appropriate process account (for normal losses) and the abnormal loss account (for abnormal losses) 82

83 PROCESS COSTING Weighted average cost basis For weighted average costing basis, the current period s costs include the cost of finishing off the opening work in progress, and the cost of the work in progress for the current period The opening work in progress is intermingled with the production of the current period to form one homogeneous batch of production The equivalent number of units for this batch of production is divided into the costs of the current period, plus the value of the opening work in progress, to calculate the cost per unit 83

84 PROCESS COSTING First-in-first-out basis FIFO is based on the assumption that current period unit costs should be reported rather than unit costs that are reported with the weighted average method that include costs incurred in the previous period Therefore FIFO assumes that the opening work in progress is the first group of units to be processed and completed during the current period The opening work in progress is charged separately to completed production, the cost per unit for the current period is based only on the current period costs and production for the current period 84

85 PROCESS COSTING LE11: Process costing CW Ltd makes one product in a single process. The details of the process for the most recent period were as follows. There were units of opening work in progress valued as follows: Amount (R) Material Labour Production overheads During the period units were added to the process and the following costs were incurred: Amount (R) Material Labour Production overheads

86 PROCESS COSTING LE11: Process costing There were units of closing work in progress, which were 100% complete for material, 90% complete for labour and 40% complete for production overheads. Material is included at the beginning of the process. A normal loss equal to 10% of new material input during the period was expected. The loss occurs at the beginning of the process. The actual loss amounted to units. Each unit of loss was sold for R100 per unit. REQUIRED: Calculate the cost of the output for the period, assuming: (i) FIFO basis (assuming opening stock was 60% complete) (ii) Weighted average method 86

87 Joint and by-products

88 Objectives of this section Distinguish between joint- and by-products Explain the alternative methods of allocating joint costs to products Describe and apply the accounting treatment of by-products Describe backflush costing 88

89 JOINT AND BY-PRODUCTS COSTING Introduction of joint and by-products costing The distinguishing feature of the production of joint and byproducts is that the products are not identifiable as different products until a specific point in the production is reached (i.e. split off point) Before this point, joint costs are incurred on the production of all productions emerging from the joint production process. It is therefore not possible to trace joint costs to individual products Our objective is still the same assignment of costs to products in order to separate costs incurred during a period between costs of goods sold and the closing inventory valuation The assignment of joint costs to products is of little use for decision-making 89

90 Joint vs by-products costing JOINT AND BY-PRODUCTS COSTING Joint products and by-products arise in situations where the production of one product makes inevitable the production of other products The difference between a joint product and a by-product can be determining by considering their relative sales value When a group of individual products is produced simultaneously and each product has a significant relative sales value, the outputs are usually called joint products Products that only have a minor sales value when compared with the joint products are by-products 90

91 Joint vs by-products costing JOINT AND BY-PRODUCTS COSTING Both products are not identifiable as different individual products until a specific point in the production process is reached After the split-off point, joint products may be sold or subjected to further processing 91

92 JOINT AND BY-PRODUCTS COSTING Methods of allocating joint costs The methods used to allocate joint costs can be subjective and therefore difficult to defend The main four methods are the following: Physical measures method Sales value at split-off method Net realisable value method Constant gross profit percentage method 92

93 JOINT AND BY-PRODUCTS COSTING LE12: Methods of allocating joint costs JBP Ltd is a manufacturer of three products, J, B and P. These products are manufactured in the same production facilities using a single production machine. The production process is such that the three products are not individual identifiable until a split-off point. The following information relates the manufacturing process during the recent month ended 31 January Total joint costs: R J B P Units produced Selling price per unit at split-off point R20,0 R15,0 R27,5 Further processing costs R R R Sales value post further processing R R R

94 JOINT AND BY-PRODUCTS COSTING LE12ASS: Physical measures method Products Units produced Proportion to total Joint costs allocated J % B % P % % Products J B P Total Selling price per unit at split-off point Units produced Total revenue Joint costs ( ) ( ) ( ) ( ) Gross profit

95 JOINT AND BY-PRODUCTS COSTING LE12BSS: Sales value at split-off method Products Sales value at split-off Proportion to total Joint costs allocated J % B % P % % Products J B P Total Selling price per unit at split-off point Units produced Total revenue Joint costs ( ) ( ) ( ) ( ) Gross profit

96 JOINT AND BY-PRODUCTS COSTING LE12CSS: Net realisable value method Products Sales value Further processing costs Net realisable value Proportion to total Joint costs allocated J ( ) % B (90 000) % P ( ) % ( ) % Products J B P Total Sales value post further processing Further processing costs ( ) (90 000) ( ) ( ) Joint costs ( ) ( ) ( ) ( ) Gross profit Gross profit margin 57% 57% 57% 57% 96

97 JOINT AND BY-PRODUCTS COSTING LE12DSS: Constant gross profit percentage JBP Ltd is a manufacturer of three products, J, B and P. These products are manufactured in the same production facilities using a single production machine. The production process is such that the three products are not individual identifiable until a split-off point. Company gross profit margin: 48% (this is assumed to be constant for each of the product produced by the company). The following information relates the manufacturing process during the recent month ended 31 January. Total joint costs: R J B P Units produced Selling price per unit at split-off point R20,00 R15,00 R27,50 Further processing costs R R R Sales value post further processing R R R

98 JOINT AND BY-PRODUCTS COSTING LE12DSS: Constant gross profit percentage Products J B P Total Sales value post further processing Gross profit at 48% ( ) ( ) ( ) ( ) Cost of sales Further processing costs ( ) (90 000) ( ) ( ) Joint costs allocated

99 JOINT AND BY-PRODUCTS COSTING Comparison of the methods of allocation Method Advantages Disadvantages Physical Measurement Sales value at split-off Simple to operate where there is a common unit of measurement Provides more realistic inventory valuations Can distort reporting and inventory valuation Can be difficult to find common unit of measurement Assumes that sales value determines prior cost Net realisable value Constant gross profit percentage Takes further processing costs into account Simple to apply if there is only one split-off point Appropriate only if a constant gross profit for each joint product is a logical assumption Assumes that a sales value at split-off can be determined Can be difficult to calculate for complex process with many split-off Only appropriate if a constant gross profit for each product makes sense 99

100 JOINT AND BY-PRODUCTS COSTING By products accounting treatment By products are products that have a minor sales value and that emerge incidentally from the production of a major product As the major objective is to produce the joint products, it can justifiably be argued that the joint costs should be allocated only to the joint products and that the by-products should not be allocated with any portion of the joint costs that are incurred before the splitoff point Any costs that are incurred in producing by-products after the splitoff point can justifiably be charged to the by-product, since such costs are incurred for the benefit of the by-product only By-product revenues or net-revenues should be deducted from the cost of the joint products (IAS2: 14) 100

101 LE14: Joint and by-products JOINT AND BY-PRODUCTS COSTING MAT Africa Ltd (MAT) and is situated in Epping, Cape Town and is a manufacturer of fibre-glass, resin, polyurethane, epoxy and related products. This product range consists of two products which are delivered out of a joint process, producing products GT, CP and KZ. Products GT and CP must incur further processing, whilst product KZ is sold off at the split-off point and is considered to be a by-product. During September 2016, units of raw materials at R1 400 per input unit of raw material, were processed. One input unit of raw material delivers 6 kilogram (kg) of GT, 5 kg of CP and 2 kg of KZ. 101

102 LE14: Joint and by-products JOINT AND BY-PRODUCTS COSTING The following additional information is available for the month of September 2016: GT CP KZ Sales price per 10 kg packaging (R) Opening inventory Kilogram Value (R 000) ,5 Closing inventory Kilogram Cost of further processing Variable cost per kilogram (R) Fixed cost (R 000)

103 LE14: Joint and by-products JOINT AND BY-PRODUCTS COSTING MAT uses an absorption costing system. Inventory is valued using the first-in-first-out (FIFO) method. By-product KZ is accounted for using the reversal cost method. REQUIRED Calculate the profit margin per product for products GT and CP, produced and sold by MAT Africa Ltd during September 2016 (13 marks) (Extracted from UNISA, 2016) 103

104 JOINT AND BY-PRODUCTS COSTING Examination technique Approach Respond to the required to PASS do not focus on the weird and complicated Profit for GT and CP Revenue Sales price Sales volume Cost of sales Opening stock Production costs Fixed costs Variable costs Closing stock Profit margin for GT and CP Joint costs Determine the total amount of joint costs Allocated to joint products Production, sales units and sales value? Balance allocated to GT and CP Marks 1 / 1 1 / 1 1 / 1 1 / 1 1 / 1 1 / 1 1 / 1 1 / 1 ½ / ½ 0 / 6½ 0 / ½ 104

105 Standard costing

106 Objectives After studying this section, candidates should be able to: Calculate and analyse variances Provide suitable explanations for variances found Reconcile budgeted income and expenses to actual income and expenses Decide on the appropriate accounting treatment of material variances 106

107 STANDARD COSTING Background Standard costing systems are generally applied and well suited in standard cost centres although they are also applied in revenue centres and profit centres The main features of a standard cost centre is that output can be measured and the input required to produce each unit of output can be specified Standard costing is most suited to an organisations whose activities consist of a series of common or repetitive operations and the input required to produce each unit of output can be specified It cannot be applied to activities of a non-repetitive nature, since there is no basis for observing repetitive operations and consequently standards cannot be set 107

108 STANDARD COSTING Purpose and benefits of standard costing Decision making: Standard costs are based on future target costs, often based on the elimination of avoidable inefficiencies. Therefore, a special order can be evaluated using standard costs Motivation: It provides the transparency required for an effective quantitative performance measurement tool Budgeting: It provides reliable and convenient source of data suitable for budgeting and consequently performance evaluation Control mechanisms: It allows for management by exception by highlighting areas that are not conforming to plan and that may require corrective action Profit measurement and inventory valuation: It simplifies the task of tracing costs to products as the use of actual costs could be too onerous 108

109 STANDARD COSTING Flexible budgets In variance analysis, standards should reflect variations in uncontrollable factors arising from the circumstances not envisaged when the targets were set, e.g. changes in the level of activity Due to some costs varying with changes in the level of activity, it is essential when applying variance analysis (and consequently performance measurement) to take into account the variability of costs, e.g. variable selling costs will be lower than budgeted if the sales volume is lower than budgeted Flexible budgets can be utilised where the uncontrollable volume effects on cost behaviour are removed from the manager s performance reports 109

110 STANDARD COSTING Standard hours produced In an environment where dissimiliar goods are produced, it may be impossible to measure output, e.g. Coca Cola sells soft drinks in 330 ml cans and 2L bottles and a change in the mix might make it difficult to ascertain the performance of the company The problem can be overcome by using standard hours produced This involves determining the amount of time, under efficient working conditions, it should take to produce each product Standard hours are an output measure that can act as a common denominator for aggregating the production of unlike products This measure also useful in management of budget allowances 110

111 STANDARD COSTING Sales variances Sales variances can be used to analyse the performance of the sales function or revenue centres In order to assess the efforts of the sales team on profitability, sales variances are determined in terms of: if absorption costing applies, standard gross profit (i.e. sales less standard manufacturing costs standard variable manufacturing costs plus an allocation of fixed costs); or if variable costing applies, standard contribution (i.e. sales less standard variable manufacturing costs) The standard manufacturing costs are used because the sales function is responsible for the sales volume and the unit selling price (this also ensures that production variances do not distort the calculation) 111

112 STANDARD COSTING LE1: Sales variances CA Ltd sells two products, Alpha and Omega. Budgeted and actual information relating to the products is provided below: Budgeted sales information Alpha: units at a selling price of R20,00 Omega: units at a selling price of R30,00 Actual sales information Alpha: units at a selling price of R17,50 Omega: units at a selling price of R35,00 112

113 STANDARD COSTING LE1: Sales variances The standard manufacturing variable cost is R12,00 and R20,00 per unit of Alpha and Omega respectively. The management accounts of CA Ltd revealed actual variable cost of R12,50 and R23,00 for Alpha and Omega respectively. The total demand for Alpha and Omega products in South Africa was budgeted at units. Due to strong competition from substitutes, the market size for Alpha and Omega products shrunk and the actual sales volume of CA Ltd for the two products represented a market share of 31,25%. REQUIRED: Calculate all the possible sales variances 113

114 STANDARD COSTING LE1SS: Sales variances exam technique 1) Determine all the possible variances that relate to sales the ability to identify all the related variances increases your chance of passing the question 2) Determine which variances are constituents of the other variances this will assist in double checking your answers 3) Define the variances the ability to explain what the variances represents greatly assists in answering discussion questions relating to the performance of a company, division or particular manager 4) Unless expected otherwise, do not determine any variance as a balancing figure 5) Identify all the elements that are required to calculate a specific variance this will assist in identifying irrelevant info 114

115 LE1SS: Sales quantity variances STANDARD COSTING Total sales variance Price variance Volume variance Mix variance Quantity variance Market size variance Market share variance 115

116 Insights from the sales variances STANDARD COSTING Considering price elasticity, the analysis of the total sales variance into price and volume components could be considered not meaningful (interrelatedness of variances) Although a change in the selling price is often a management decision, the decision might have been as a result of external forces that were not controllable by management For control and performance appraisal it may be appropriate to compare actual market share with target market share (CTA 2) In addition, the trend in market shares should be monitored and selling price compared with competitors prices A division of the sales volume variance into quantity and mix components demonstrates that increasing sales volume may not be desirable as promoting the sales of the most desirable mix of products 116

117 STANDARD COSTING Material variances The costs of the materials which are used in a manufactured product are determined by two basic factors the price paid for the materials; and the quantity of materials used in production The price variance is often within the control of the purchasing department and it normally arises due to the following: Failure by the purchasing department to seek most advantageous source of supply, changes in market conditions (controllable?), purchase of inferior quality materials (interrelatedness of variances to be considered), etc. On the other hand, the usage variance is normally controllable by the production department and may arise because of: Careless handling of materials, inferior materials, theft, changes in production method or quality controls, etc. 117

118 STANDARD COSTING LE2: Material variances CA Ltd sells product Alpha. Each Alpha unit weighs 1 kg. The production process of Alpha requires two inputs: Beta and Vega Budgeted information Number of production units of Alpha: units Number of kgs of Beta to be issued and utilised: kgs Number of kgs of Vega to be issued and utilised: kgs Actual information Number of production units of Alpha: units Number of kgs of Beta purchased: kgs Number of kgs of Beta issued and utilised: kgs Number of kgs of Vega purchased: kgs Number of kgs of Vega issued and utilised: kgs 118

119 STANDARD COSTING LE2: Material variances The standard cost of Beta is R30,00 per kg while Vega has a standard cost of R50,00 per kg. The production process has a standard loss on all material inputs. The management accounts of CA Ltd revealed that that the company spent an amount of R on the acquisition of Beta. Total purchases relating to Vega were R REQUIRED: a) Calculate all the possible material variances b) Process the journal entries to account for the above information 119

120 STANDARD COSTING Labour variances The costs of labour used in a manufactured product are determined by two basic factors wage rate paid for the unit of labour; and the efficiency of labour used in production The variances related to labour are normally controllable by the manager of the production department In South African with the outbreaks of strikes the controllability of the wage rate variance might be questionable The variances related to the efficiency of labour may arise as a result of use of inferior quality materials (interrelatedness of variances), different grades of labour (mix and yield variances), failure to maintain machinery in proper condition, the introduction of new equipment (relevance of standards) and changes in production methods (relevance of standards) 120

121 STANDARD COSTING LE3: Labour variances CA Ltd sells product Omega. Omega is manufactured primarily by the company s direct labour force. Labour is variable. Budgeted information Number of Omega units to be produced: units Number of clock hours: hours at R77,60 per hour Number of idle hours: hours Actual information Number of Omega units produced: units Number of clock hours: hours at R79,20 per hour Number of productive / working hours: hours 121

122 STANDARD COSTING Overhead variances Flashback: With the variable costing method, the fixed overheads are treated as period costs. No attempt is made to allocate a portion of these costs to production With absorption costing, a portion of fixed overheads is allocated to production based on an overhead allocation rate determined using budgeted figures The implication for standard costing is that with variable costing, only the expenditure variance is calculated whereas a volume variance is calculated for absorption costing method 122

123 LE4: Fixed overhead variances STANDARD COSTING CA Ltd is a manufacturer of Product Aries. CA Ltd uses the absorption method in valuing the closing inventory for management purposes. Fixed overheads are allocated based on machine hours. Information relating to Product Z is provided below. Budget Actual Fixed costs R R Machine hours Units produced REQUIRED Calculate all the variances relating to the information above 123

124 STANDARD COSTING Volume ratios Production volume ratio = standard hours / budgeted hours = / = 109.4% Production efficiency ratio = standard hours / actual hours = / = 95.1% Capacity usage ratio = actual hours / budgeted hours = / = 115% 124

125 STANDARD COSTING Insights from the overhead variances The variances calculated are not particularly useful for control purposes because generally fixed overheads do not fluctuate in relation to output in the short-term Any meaningful analysis of this variance requires a comparison of the actual expenditure for each individual item of fixed overhead expenditure against the budget An understanding of the in/efficient use of the available capacity does not result in strategies to control costs in the short term 125

126 STANDARD COSTING Ex-post variance analysis Standards or plans are normally based on the environment that is anticipated when the targets are set Ex-post variance analysis approach requires that if the environment is different from the anticipated, actual performance should be compared with a standard which reflects these changed conditions The variances need to be split into controllable (operational) variances and non-controllable (planning) variances Although not useful for cost control, the planning variance provides useful feedback information to management on how successful they are in forecasting prices - helps them to improve future estimates Managerial performance needs to be fair, motivating and be based on the variances that are within management s control; as such managerial performance should be based on operational variances 126

127 LE5: Ex-post variance analysis STANDARD COSTING CA Ltd is a poultry production company. The company s main input is maize which is used in the production of feed for its poultry. The budgeted average price of maize was R2 800 per tonne. During the year, there was a drought in the maize areas. This resulted in the average price of maize being R3 400 per tonne. CA Ltd purchased 300 tonnes at a price of R3 150 per tonne. REQUIRED Calculate the material price variance. Clearly indicate how much of this variance is attributable to planning and operational efficiency 127

128 LE6: Ex-post variance analysis STANDARD COSTING Abashwe (Pty) Ltd (Abashwe), one of the subsidiaries of Thobela, manufactures retail consumables and it uses three independent divisions with dedicated directors. The following details show direct labour requirements for the first six batches of a new product that were manufactured last month by Enfede, a division of Abashwe: Budget Output (batches) 6 Labour hours Total labour cost R

129 LE6: Ex-post variance analysis STANDARD COSTING The management accountant reported the following variances: Total labour cost variance Labour rate variance Labour efficiency variance R Unfavourable Rnil R Unfavourable The production manager confirmed that he forgot to inform the management accountant that he expected a 90% learning curve to apply to at least the first 10 batches. The HR Director received an from the office of the COO informing him that the reported labour costs variances reflect incompetence on the part of the human resources (HR) department and that this will be considered during annual performance appraisals. 129

130 LE6: Ex-post variance analysis STANDARD COSTING REQUIRED (a)calculate the planning and operational variances of Aaweh that analyses the actual performance, taking into account the anticipated learning effect. Note: The learning can be expressed in equation form as Y x = a x b. The exponent for a 90% learning curve is (6 marks) (a)prepare a draft memorandum on behalf of the HR director responding to the COO s . (5 marks) (Adapted from UNISA, 2016) 130

131 LE6SS: Ex-post variance analysis STANDARD COSTING Question Approach Marks Calculate the planning and operational variances Technical and difficult question? Reasonably attempt it (Bonus mark) Do not anything about learning curve? Ignore it and move on, because it is simply part of the steps but at least have something to move on with, e.g. 90% x 400 = 360 Variances require you compare actual hours, original budgeted hours and learning curve based hours and multiply by the standard rate. You therefore need to know how to respond to the required Calculate standard labour rate (C) Calculate revised standard (C) Planning variance = original budget against the revised standard (C) Operational variance = actual results against the revised standard (C) 1 / 1 0 / 2 1 / 1 1 / 1 1 / 1 1 / 1 131

132 LE6SS: Ex-post variance analysis STANDARD COSTING Question Approach Marks Prepare a draft memorandu m on behalf of the HR director responding to the COO s No mark for communication this time, unusual but guess it can happen The main issue was that there was an efficiency variance and not a labour rate variate Under whose control is the efficiency variance? Is it appropriate / fair / just to blame the HR department? Primary reason was the fact that the learning curve effect was not taken into account Any other possible reason? 1 / 1 1 / 1 1 / 1 1 / 1 132

133 STANDARD COSTING Investigation of variances The decision to investigate a variance should depend on cost versus benefits considerations Variances may be due to the following causes: random uncontrollable factors when the operation is under control assignable causes, but with the costs of investigation exceeding the benefits assignable causes, but with the benefits from investigation exceeding the costs of investigation The methods of investigating variances include: simple rule of the thumb models statistical models that focus on the probability of the variances being out of control? 133

134 STANDARD COSTING The role of standard costing within an ABC system Within an ABC system variance analysis is most suited to controlling the costs of unit level activities It also provides meaningful information for managing those overhead costs that are fixed in the short term but variable in the longer term if traditional volume-based cost drivers are replaced with activity-based cost drivers that better reflect the causes of resource consumption Variance analysis, however, cannot be used to manage all overhead costs It is inappropriate for the control of facility-sustaining (infrastructure) costs because the cost of these resources does not fluctuate in the longer term according to the demand for them 134

135 STANDARD COSTING LE7: Standard costing & ABC An administrator was recently appointed to process orders for the company. It was budgeted that the administrator would be paid an annual salary of R The administrator has the capacity to process orders per annum. It is budgeted that the administrator will process orders in the upcoming annual period. Actual results revealed that the administrator was paid an annual salary of R and managed to process only orders. REQUIRED: Calculate all the variances related to the cost of the administrator in a meaningful manner for management 135

136 Criticisms of standard costing STANDARD COSTING It is predicted that standard costing will demise in the future due to the following reasons: The changing cost structure that has resulted in the growth of indirect costs (it is claimed that standard costing is not particularly suitable for controlling such costs) Inconsistency with modern management approaches (such as just in time, quality management, lead-times, etc.) Its over-emphasis on direct labour? Delayed feedback reporting The above is based on the understanding standard costing as a control mechanism. It, however, ignores the other purposes/benefits of standard costing (refer to an earlier slide on the benefits of standard costing) 136

137 STANDARD COSTING Accounting for variances Standard costs can be used for planning, control and decisionmaking purposes without being entered into the books The benefit of incorporating standard costs into the cost accounting system is that it greatly simplifies the task of tracing costs for inventory valuation and saves a considerable amount of data processing time IAS2 Inventories requires the use of standard costing in external reporting to the extent that the standard costs approximate actual costs (i.e. standards are current and attainable) Only production variances are recorded, and sales variances are not entered in the accounts 137

138 STANDARD COSTING Accounting for variances Self-study: kindly study the example in Drury for the recording standard costs in the accounts 138

139 Relevant costing

140 Objectives of this section Distinguish between relevant and irrelevant costs and revenues Describe the key concepts that should be applied for presenting information for product-mix decisions when capacity constraints apply Apply linear programming 140

141 Introduction to relevant costing RELEVANT COSTING Relevant costing is not another costing system or method. It is a framework or a set of principles and concepts that assist management in identifying costs that are relevant for decision making Items (costs and revenues) are considered relevant if there is a differential impact on the cash flows from an outcome of the decision at hand Decision makers are economical or rational in their approach The decisions that could potentially be considered may include: Profitability maximisation (LE1) Disposal or discontinuation of operations (LE2) Outsourcing (make or buy) decisions (LE3) Special order (a once-off order) (LE4) Introduction or establishment of operations 141

142 RELEVANT COSTING Key definitions applicable to relevant costing Relevant cost are essentially future costs and revenues that will be changed by a particular decision, whereas irrelevant costs and revenues will not be affected by that decision Sunk costs are costs that have been incurred by a decision made in the past and that cannot be changed by any decision that will be made in the future Committed costs are costs that would be incurred irrespective on the outcome of the decision Opportunity costs are costs that measure the opportunity that is sacrificed when the choice of one course of action requires that an alternative is given up (i.e. benefit forgone) Limiting factors are scarce resources that constrain the level of output 142

143 RELEVANT COSTING LE1: Profit maximisation Power Ltd is a manufacturer of battery chemicals. Its main products are Dura, Cell and Ready. The production process is labour intensive and requires powder and chemical (acid ingredients) as the raw materials. The management accountant of Power Ltd is in the process of finalising the budget for the forthcoming financial period. He recently received calls from the main suppliers of the raw materials used in the production process indicating that they are expecting to encounter supply chain challenges in the upcoming annual period and will be only be able to supply the following quantities: Powder: kilograms Chemical: litres The management accountant has also ascertained that Power Ltd will only be able to source labour hours during the next period. 143

144 RELEVANT COSTING LE1: Profit maximisation Information relating to the upcoming budgeted period is provided below: Dura Cell Ready Budgeted number of units Selling price per unit R2 200 R2 800 R3 100 Raw materials - Powder (80c per gram) (R160) (R240) (R280) - Chemical (50c per ml) (R250) (R450) (R700) Direct labour (R200 per direct labour hour) (R300) (R400) (R500) Variable overheads (R100 per direct labour hour) (R150) (R200) (R250) Fixed overheads (R150 per unit) (R150) (R150) (R150) Gross profit per unit R1 190 R1 360 R

145 RELEVANT COSTING LE1: Profit maximisation In accordance with the existing contracts that Power Ltd has with various customers, the company is required to deliver in the next period units of Dura; units of Cell; and units of Ready. The external demand for Dura is limited to the number of the budgeted units to be produced whereas the demand for Cell and Ready is unlimited. The fixed overhead per unit is based on the maximum capacity available in the next period. REQUIRED: Calculate the optimal sales mix for Power Ltd and the net profit to be generated from the optimal sales mix 145

146 RELEVANT COSTING Decision tree for materials relevant costs Not on hand On hand Current purchase price or variable cost Do not replace Replace Alternative use No alternative use Current purchase price or variable cost Current purchase price or variable cost Lost contribution Lost resale value NIL Scrapping costs savings 146

147 RELEVANT COSTING Decision tree for labour relevant costs Spare capacity exists No spare capacity exists Variable cost Fixed cost Lost contribution Current rate of pay Overtime Current rate of pay NIL 147

148 LE2: Discontinuing a product line RELEVANT COSTING CA Ltd is a manufacturer of two products, Product A and Product B. Management of CA Ltd are considering discontinuing the production of Product A because it is not profitable and require your expert advice. The recent financial results of the company are presented below, along with the profitability of each product: Notes Product A Product B Total Total sales 1 R R R Direct raw materials 2 (R ) (R ) (R ) Contribution R R R Attributable fixed costs 3 (R ) (R ) (R ) Allocated common fixed costs 4 (R ) (R ) (R ) Net profit (R ) R R

149 LE2: Discontinuing a product line RELEVANT COSTING Additional notes relating to the financial results are provided below: 1) units and units of Product A and Product B were manufactured and sold during the period. This is estimated to continue in the foreseeable future. Product A and B are dependent products and discontinuation of Product A will result in a decrease in the selling price of Product B by 5%. 2) 2 units of direct material are required for production with each unit of Product A requiring 1 unit and another unit required for Product B. The supplier grants a 10% volume rebate on each unit purchased if total purchases during the year exceed units. 3) Attributable fixed costs of Product A comprises of depreciation on machine (R ) and direct labour costs (R ). The machine to which the depreciation relates would be sold at profit of R The carrying amount of the machine is R

150 RELEVANT COSTING LE2: Discontinuing a product line 3 continues) There are 8 unskilled workers and 1 supervisor. Each unskilled worker is paid a salary of R5 700 per month. If the production of Product A is ceased, the supervisor will be laid off and paid 120% of his annual salary as a retrenchment package while 2 unskilled workers would be relocated to Product B production line and retained at their existing annual salary. The remaining unskilled workers would be retrenched at a total cost of R ) Common fixed costs are allocated to each product line based on total revenue. Total common fixed costs are expected to reduce by 15%. REQUIRED Advise management on whether Product A should be discontinued? 150

151 RELEVANT COSTING LE3: Outsourcing decision Ciesta currently purchases one of its component, Component Z, that is used in the production of Product Y. The contribution generated from Product Y (after taking into consideration Component Z) is R20 per unit. The purchase price of Component Z is R15 per unit. Delivery costs of R1 per unit are also incurred. Ciesta has recently been experiencing challenges with the sourcing of Component Z and it is considering manufacturing the component itself. Ciesta currently purchases units of Component Z per annum, which is below the units required to satisfy the demand for Product Y. Should it manufacture the component internally, it will be able to fulfil its entire demand. 151

152 RELEVANT COSTING LE3: Outsourcing decision Ciesta currently sells units of Product Y. Information relating to the manufacture of Component Z is provided: The machine required to manufacture Component Z is available. Depreciation on this machine is R per annum and R of this amount would be allocated to the Component Z manufacturing process. Total direct materials of R would be required. Each manufactured unit would require 0.5 direct labour hours at a rate of R20 per direct labour hour. Ciesta currently has labour hours available as spare capacity. Existing staff can provide additional hours as overtime at a rate of time and a half. The balance would be sourced from cutting down production of an existing product. The existing product uses 2 hours per unit and generates a contribution of R30 per unit. 152

153 RELEVANT COSTING LE3: Outsourcing decision Assume labour is variable cost. REQUIRED: Should Component Z continue to be acquired externally or should it be manufactured internally? 153

154 RELEVANT COSTING LE4: Special order Joshua Manufacturing Ltd ( JML ) is a manufacturer of microwaves. These are manufactured at its premises based in Makwarela, Limpopo. These microwaves are sold nationally at a price of R5 200 each. JML recently received a special order from a new client, Grace (Pty) Ltd ( GPL ) to manufacture and deliver 100 microwaves. GPL is an independent retail chain of stores operating nationally. The total consideration for the order is proposed at R The requirements of the order are as follows: Material A: Each manufactured microwave requires 2 units of Material A. Material A is regularly used in the manufacture of JML s microwaves. There are currently 300 units of Material A on hand that were originally purchased at price of R150 per unit. The current replacement cost of Material A is R165 per unit. 154

155 RELEVANT COSTING LE4: Special order Material B: 4 units of Material B are required for one microwave. There are currently items of Material B on hand these were originally bought for R120 per unit. These items are not normally used by JML and are also not readily available. 750 items were earmarked for a special order for a delivery of 250 microwaves (the order is divisible and it can be partially fulfilled). The special order would generate a contribution of R400 per unit for JML. The remaining items of Material B were going to be scrapped at a disposal cost of R30 per unit. Alternatively, Material B could be imported from China at a cost of $11 (Assume R1 = $0,0625). Material C: 1 unit of Material C will also be required. 80 Material C is currently on hand as this was left from a special order that never materialised. Before GPL s special order, JML was contemplating on whether they should return Material C or modify Material C to be used in its normal production instead of Material A (see above for Material A details). 155

156 RELEVANT COSTING LE4: Special order Material C (continues): If Material C is returned to the supplier, JML will be refunded an amount of R Should JML decide to modify Material C, it will incur a modification cost of R15 per unit of Material C. The use of Material C in the production will allow to JML to save on the purchase of 415 units of Material A. The contribution to be generated from the product to be manufactured from Material A is R700 per unit. The replacement cost of Material C is currently R805. Labour: Labour is a fixed cost. A total of 800 labour hours will be required for the special order. JML currently has 500 labour hours available, of which 200 is normal time and 300 is overtime hours. The total labour costs (allocated and actually incurred) should these employees be used on the special order will be R Overtime is paid at time and a half. The effective cost of labour is R90 per hour. 156

157 RELEVANT COSTING LE4: Special order Labour (continues): Additional labour hours are obtainable from the sacrifice of production of either the following items budgeted to be produced by JML: Kettles: The selling price of a kettle is R280 per unit. The contribution earned from the sale of one kettle is R144. Each kettle requires 1,2 labour hours. Toasters: The selling price of a toaster is R500 per unit. The contribution earned from the sale of one toaster is R234. Each toaster requires 1,8 labour hours. 157

158 RELEVANT COSTING LE4: Special order REQUIRED: Calculate the contribution to be generated from the special order and advise whether JML should accept / reject the order 158

159 RELEVANT COSTING Decision making discussion questions 1) New client Creditworthiness needs to be assessed Reputation and credibility need to be assessed If customer branded, impact on company s brand presence 2) New supplier Reliability with regards to quality and delivery times 3) Imported items Delays impacting on lead time Foreign exchange exposure 4) Order fulfilled over time If workers required to work overtime, question impact on morale Penalties for late deliveries 159

160 RELEVANT COSTING Decision making discussion questions 5) Long term order Impact on pricing fixed costs to be included Provides stability of revenue and cash flows Future price expectations and order volumes 6) Limited capacity Sacrificing existing sales negatively impacts customer goodwill Permanent increase in capacity should be considered If capacity is increased, funding thereof should be considered 7) General Reliability of forecasts inflation considerations / omission of costs 8) New product Experience, skills and expertise 160

161 Relevant costing Basic principles and concepts

162 RELEVANT COSTING Decision tree for materials relevant costs Not on hand On hand Current purchase price or variable cost Do not replace Replace Alternative use No alternative use Current purchase price or variable cost Current purchase price or variable cost Lost contribution Lost resale value NIL Scrapping costs savings 162

163 LE4: Material available on hand RELEVANT COSTING LE4.1 No alternative use CA Ltd received a proposal to manufacture units of Product N. Product N requires 100 m of Material C. Material C is available on hand. However, the company does not have an alternative use for Material C because it was a remainder from a discontinued product. It was acquired at a price of R10 per m and the current replacement cost is R12 per m 163

164 LE4: Material available on hand RELEVANT COSTING LE4.2 No alternative use, but need to disposed CA Ltd received a proposal to manufacture units of Product N. Product N requires 100 m of Material C. Material C is available on hand. However, the company does not have an alternative use for Material C because it was a remainder from a discontinued product. CA Ltd was expecting to incur R2,50 per m in disposing of Material C in order to provide space for other materials. It was acquired at a price of R10 per m and the current replacement cost is R12 per m. 164

165 LE4: Material available on hand RELEVANT COSTING LE4.3 Alternative use, as stand alone CA Ltd received a proposal to manufacture units of Product N. Product N requires 100 m of Material C. Material C is available on hand. Material C is a remainder of the inputs for a discontinued product. CA Ltd had found a buyer for Material C who was willing to pay R10,50 per m. It was acquired at a price of R10 per m and the current replacement cost is R12 per m. 165

166 LE4: Material available on hand RELEVANT COSTING LE4.4 Alternative use, as stand alone CA Ltd received a proposal to manufacture units of Product N. Product N requires 100 m of Material C. Material C is available on hand. Material C is a remainder of the inputs for a discontinued product. CA Ltd had found a buyer for Material C who was willing to pay R15 per m. It was acquired at a price of R10 per m and the current replacement cost is R12 per m. 166

167 LE4: Material available on hand RELEVANT COSTING LE4.5 Alternative use, in other special product CA Ltd received a proposal to manufacture units of Product N. Product N requires 100 m of Material C. Material C is available on hand. Material C is a remainder of the inputs for a discontinued product. CA Ltd had planned to use Material C on another product that was going to generate a contribution of R8 per m for the company. 1m of Material C is required for this product. It was acquired at a price of R10 per m and the current replacement cost is R12 per m. 167

168 LE4: Material available on hand RELEVANT COSTING LE4.6 Alternative use, in other special product CA Ltd received a proposal to manufacture units of Product N. Product N requires 100 m of Material C. Material C is available on hand. Material C is a remainder of the inputs for a discontinued product. CA Ltd had planned to use Material C on another product that was going to generate a contribution of R8 per m for the company. 1m of Material C is required for this product. It was acquired at a price of R10 per m and the current replacement cost is R25 per m. 168

169 LE4: Material available on hand RELEVANT COSTING LE4.7 Alternative use, in other special product CA Ltd received a proposal to manufacture units of Product N. Product N requires 100 m of Material C. Material C is available on hand. Material C is a remainder of the inputs for a discontinued product. CA Ltd had planned to use Material C on another product that requires 4m of Material C per unit. The contribution per unit from the product is R32. It was acquired at a price of R10 per m and the current replacement cost is R25 per m. 169

170 LE4: Material available on hand RELEVANT COSTING LE4.8 Alternative use, in regular use CA Ltd received a proposal to manufacture units of Product N. Product N requires 100 m of Material C. Material C is available on hand. Material C is regularly used by the company in the production of the company s main product. The main product generates a contribution of R14 per m for the company. It was acquired at a price of R10 per m and the current replacement cost is R25 per m. 170

171 LE4: Material available on hand RELEVANT COSTING LE4.9 Alternative use, in other product CA Ltd received a proposal to manufacture units of Product N. Product N requires 100 m of Material C. Material C is available on hand. CA Ltd had planned to use Material C on another product that would require 4m of Material C per unit. The use of Material C would have avoided the company having to buy Material A which is normally used on the product. 1 Material A is required per unit. The contribution per unit from the product is R32. It was acquired at a price of R10 per m and the current replacement cost is R25 per m for Material C. The current replacement cost of Material A is R

172 RELEVANT COSTING LE5: Material not available on hand LE5.1 In regular use, acquired per unit CA Ltd received a proposal to manufacture units of Product N. Product N requires 100 m of Material C. Material C is not available on hand. The current replacement cost is R25 per m. 172

173 RELEVANT COSTING LE5: Material not available on hand LE5.2 In regular use, acquired in batches CA Ltd received a proposal to manufacture units of Product N. Product N requires 100 m of Material C. Material C is not available on hand. Material C is only available in batches of 6m at a price of R600 per batch. The existing production will require 1,000 metres. 173

174 RELEVANT COSTING LE5: Material not available on hand LE5.3 Not in regular use, no alternative use CA Ltd received a proposal to manufacture units of Product N. Product N requires 100 m of Material C. Material C is not available on hand. Material C is only available in batches of 6m at R600 per batch. The unused materials will be thrown away. 174

175 RELEVANT COSTING LE5: Material not available on hand LE5.4 Not in regular use, alternative use CA Ltd received a proposal to manufacture units of Product N. Product N requires 100 m of Material C. Material C is not available on hand. Material C is only available in batches of 6m at R600 per batch. The unused materials can be sold to third parties at R1 per m. 175

176 RELEVANT COSTING Decision tree for labour relevant costs Spare capacity exists No spare capacity exists Variable cost Fixed cost Lost contribution Current rate of pay Overtime Current rate of pay NIL 176

177 LE6: Labour is fixed or salaried RELEVANT COSTING LE6.1 Spare capacity exists CA Ltd received a proposal to manufacture units of Product N. Product N requires 100 hours of labour. The existing employee is paid a monthly salary of R The employee is expected to work 40 hours per week. Overtime is paid at time and a half of their equivalent hourly rate. Current production, i.e. excluding the special order, is budgeted to require 45 labour hours. 177

178 LE6: Labour is fixed or salaried RELEVANT COSTING LE6.2 No spare capacity exists CA Ltd received a proposal to manufacture units of Product N. Product N requires 100 hours of labour. The existing employee is paid a monthly salary of R The employee is expected to work 40 hours per week. Overtime is paid at time and a half of their equivalent hourly rate. Current production, i.e. excluding the special order, is budgeted to require 120 labour hours. 178

179 LE6: Labour is fixed or salaried RELEVANT COSTING LE6.3 No spare capacity exists CA Ltd received a proposal to manufacture units of Product N. Product N requires 100 hours of labour. The existing employee is paid a monthly salary of R The employee is expected to work 40 hours per week. Overtime is paid at time and a half of their equivalent hourly rate. The employee is working on a product that generates a contribution of R120 per unit. 1.5 labours hours are required per unit. Current production, i.e. excluding the special order, is budgeted to require 160 labour hours. 179

180 LE6: Labour is fixed or salaried RELEVANT COSTING LE6.4 No spare capacity exists CA Ltd received a proposal to manufacture units of Product N. Product N requires 100 hours of labour. The existing employee is paid a monthly salary of R The employee is expected to work 40 hours per week. No overtime is available. CA Ltd would be required to hire an additional employee at the existing rate and who is capable of working the same number of hours in order to obtain the required number of hours. Current production, i.e. excluding the special order, is budgeted to require 160 labour hours. It is not economical to reduce existing production. 180

181 LE6: Labour is fixed or salaried RELEVANT COSTING LE6.5 No spare capacity exists CA Ltd received a proposal to manufacture units of Product N. Product N requires 100 hours of labour. The existing employee is paid a monthly salary of R The employee is expected to work 40 hours per week. Overtime is paid at time and a half of their equivalent hourly rate. Overtime hours is limited to 50 hours after which CA Ltd would be required to hire an additional employee at the existing rate and who is capable of working the same number of hours in order to obtain the required number of hours. Current production, i.e. excluding the special order, is budgeted to require 160 labour hours. It is not economical to reduce existing production. 181

182 RELEVANT COSTING LE7: Labour is variable LE7.1 Spare capacity exists CA Ltd received a proposal to manufacture units of Product N. Product N requires 100 hours of labour. The existing employee is paid wages at a rate of R80 per hour. The employee is expected to work 40 normal hours per week. Overtime is paid at time and a half of their equivalent hourly rate. Current production, i.e. excluding the special order, is budgeted to require 50 labour hours. 182

183 RELEVANT COSTING LE7: Labour is variable LE7.2 No spare capacity exists CA Ltd received a proposal to manufacture units of Product N. Product N requires 100 hours of labour. The existing employee is paid wages at a rate of R80 per hour. The employee is expected to work 40 normal hours per week. Overtime is paid at time and a half of their equivalent hourly rate. Current production, i.e. excluding the special order, is budgeted to require 120 labour hours. 183

184 RELEVANT COSTING LE7: Labour is variable LE7.3 No spare capacity exists CA Ltd received a proposal to manufacture units of Product N. Product N requires 100 hours of labour. The existing employee is paid wages at a rate of R80 per hour. The employee is expected to work 40 normal hours per week. Overtime is paid at time and a half of their equivalent hourly rate. The employee is working on a product that generates a contribution of R120 per unit. 1.5 labours hours are required per unit. Current production, i.e. excluding the special order, is budgeted to require 120 labour hours. 184

185 Decisions under uncertainty

186 Decisions under uncertainty DECISIONS UNDER UNCERTAINTY CA Ltd is contemplating introducing a new product next year. It has the choice of introducing Product M or Product S but because of limited resources it can only launch one of them. The demand of the products is uncertain. Which product should CA Ltd manufacture? Product M Possible profit Estimated probability Recession R % Boom R % Product S Recession R % Boom R % 186

187 Linear programming

188 LINEAR PROGRAMMING Introduction to linear programming Linear programming is powerful mathematical technique that can be applied to the problem of rationing limited facilities and resources amongst many alternative uses in such a way that the optimum benefits can be derived from their utilisation It seeks to find a feasible combination of output that will maximise or minimise the objective function (i.e. quantification of an objective, and usually takes the form of maximising profits or minimising costs) Linear programming may be used when relationships can be assumed to be linear and where an optimal solution does, in fact, exist 188

189 LINEAR PROGRAMMING Requirements for linear programming The contribution per unit for each product and the utilisation of resources per unit are the same whatever quantity of output is produced and sold within the output range being considered The units produced and resources allocated are infinitely divisible (i.e. it is possible to produce ½ or ¼ of a unit) When there is more than one scarce resource existing, the optimum production programme is ascertainable with linear programming 189

190 LINEAR PROGRAMMING LE1: Basic example Drury currently makes two products. The standards per unit of product are as follows: Selling price R110 R118 Variable costs Material (Y: 8 units at R4 / Z: 4 units at R4) (R32) (R16) Labour (Y: 6 hrs at R10 / Z: 8 hrs at R10) (R60) (R80) Variable overheads (Y: 4 Mhrs at R1 / Z: 8 Mhrs at R1) (R4) (R6) Contribution R14 R16 Y Z 190

191 LINEAR PROGRAMMING LE1: Basic example During the next accounting period, the availability of resources are expected to be subject to the following limitations: Labour hours Materials units Machine capacity hours The marketing manager estimates that the maximum sales potential for product Y is limited to 420 units. There is no sales limitation for Product Z. REQUIRED Advise how these limited facilities and resources can best be used so as to gain the optimum benefit from them. (Drury) 191

192 LINEAR PROGRAMMING LE1SS: Basic example Step 0: Determine whether linear programming is applicable Step 1: Formulate the problem algebraically Step 2: Specify the objective function (max CM or min COSTS) Step 3: Specify the input constraints Step 4: Include the non-negativity requirement Step 5: Draw a graph with the axis being Product 1 and the other axis being Product 2 Step 6: Determine the interception points on the graph, by a process of substituting each variable by 0 Step 7: Using the slope of the objective function, determine the point at which the objective function would be maximised or minimised 192

193 LINEAR PROGRAMMING Shadow prices Shadow prices refer to the value of an independent marginal increase of a scarce resource; this is also the opportunity cost of an additional resource required The rationale is that an additional unit of a scarce resource is likely to change the optimal production and consequently might result in a higher contribution to be generated As a result the marginal cost (i.e. additional cost or the opportunity cost) of the additional unit to be acquired should not exceed the contribution to be generated by the additional contribution to be generated In other words, the cost of the additional material is the cost of the existing material + the opportunity cost (i.e. the shadow price) 193

194 LINEAR PROGRAMMING LE2: Shadow prices Consider the same facts as in LE1 and additional information provided below to determine the shadow prices. The supplier of materials has advised the company that it can provide 200 additional units of materials at a total cost of: (i) R870; and (ii) R

195 LINEAR PROGRAMMING Uses of linear programming Calculation of relevant costs Selling different products Maximum payment for additional scarce resources Control Managing constraints Capital budgeting Sensitivity analysis 195

196 Divisional performance measurement

197 Objectives After studying this section, the candidate should be able to: Distinguish between functional and divisionalised organisational structures Explain the meaning of return on investment and residual income Distinguishing between managerial and economic performance Evaluate divisional performance by employing appropriate performance measures (ROI, RI and EVA) Discuss the influence of these measures on capital investment decisions Discuss various approaches that can be employed to overcome the short-term orientation associated with accounting profit-related measures 197

198 DIVISIONAL PERFORMANCE MEASUREMENT Functional or centralised organisation In this form of organisation, all activities of the enterprise are grouped and divided according to functions like production, marketing, finance and others Managers have far less independence with respect to decision such as pricing, product mix and output decisions than divisional managers The organisation as a whole is an investment centre 198

199 DIVISIONAL PERFORMANCE MEASUREMENT Divisionalisation or decentralisation It involves the decentralisation of the decision making process The creation of separate divisions may lead to the delegation of different degrees of authority by the corporate head office (i.e. responsibility centres) Cost centres are responsibility centres whose managers are normally accountable for those costs that are under their control Profit centres are responsibility centres whose managers are responsible for both sales revenue and costs Investment centres are responsibility centres whose managers are responsible for both sales revenue and costs and also have responsibility and authority to make capital investment decisions 199

200 DIVISIONAL PERFORMANCE MEASUREMENT Divisionalisation A divisionalised structure is most suited to large companies that are engaged in several dissimilar activities because it is difficult for top management to be intimately acquainted with all the diverse activities of the various segments of the business Practical examples: Audi-VW AG (Audi & VW; Passenger vehicles & Trucks), Naspers (Multichoice, Media24) and Eskom (Generation, Transmission and Distribution) Activities that are closely related require carefully coordination and this might be easily achieved in a centralised organisation structure For a successful divisionalisation, the activities of a division need to be as independent as possible of other activities However, it should not undermine the notion that such divisions are an integral part of the holding company 200

201 DIVISIONAL PERFORMANCE MEASUREMENT Advantages of divisionalisation Divisionalisation can improve the decision-making processes Quality of decisions is improved because decisions can be made by the person who is familiar with the business and therefore in a position to make more informed judgments than central management Speedier decisions should also occur because information does not have to pass along the chain of command to and from top management Delegation of responsibility to divisional manager provides them with greater freedom, thus facilitating motivation because activities are made more challenging and provide them with an opportunity to achieve self-fulfilment (behavioural implications) 201

202 DIVISIONAL PERFORMANCE MEASUREMENT Disadvantages of divisionalisation The biggest problem is the agency problem which could lead to a lack of goal congruency The managers (agent) may compete with other divisional managers excessively and the divisional managers may be encouraged to take actions that will increase their own profits at the expense of the profits of other divisions and the company as a whole (and consequently shareholders) 202

203 DIVISIONAL PERFORMANCE MEASUREMENT Fundamental principle: Controllability Controllability principle purports that it is appropriate to charge to an area of responsibility only those costs that are significantly influenced by the manager of that responsibility (concept applicable to responsibility centres) In determining how divisional profitability should be measured, it must be decided whether the primary purpose is to measure the performance of the division or that of the divisional manager 203

204 DIVISIONAL PERFORMANCE MEASUREMENT Managerial versus economic performance Managerial performance If the purpose is to evaluate the divisional manager then only those items directly controllable by the manager should be taken into account Therefore allocation of head office costs ought not be included in the profitability measure Divisional performance (economic performance) However, if the purpose is to evaluate the divisional economic performance, the costs that would otherwise be incurred should the division be an independent company should be included 204

205 DIVISIONAL PERFORMANCE MEASUREMENT Divisional performance measurement Divisional profit This measure would be based on the annual accounting profit Return on investment (ROI) ROI is based on the divisional profit divided by investment Residual income RI is the divisional profit less a capital charge on the investment Economic value added (EVA) EVA is based adjusted divisional profit less a capital charge on the adjusted investment base 205

206 Divisional profit calculation DIVISIONAL PERFORMANCE MEASUREMENT Total sales revenues Less controllable costs Controllable profit Less non-controllable avoidable costs Divisional profit contribution Less allocated corporate expenses Divisional net profit before taxes R XX XX XX XX XX XX XX 206

207 DIVISIONAL PERFORMANCE MEASUREMENT Divisional profit For performance measurement basis, this measure should be evaluated relative to a budgeted performance For measuring managerial performance the application of the controllability principle suggests that controllable profit is the most appropriate measure because it takes into consideration the manager s ability to use only those resources under his control effectively The economic performance of the division should be evaluated after taking all the avoidable costs, even the ones outside the control of the manager, relating to the division, therefore making the divisional profit contribution an appropriate measure The allocation of the corporate costs is likely to be based on an arbitrary basis and therefore distorting the usefulness of divisional net profit before taxes 207

208 DIVISIONAL PERFORMANCE MEASUREMENT Advantages of Divisional profit It is an appropriate measure for a profit centre? It is easily understood and common figure for any company? 208

209 DIVISIONAL PERFORMANCE MEASUREMENT Disadvantages of divisional profit Divisional profit does not encourage to seek returns in excess of the cost of capital of the company It is an annual measure, i.e. short term in nature may encourage managers to take decisions that are inconsistent with NPV analysis (i.e. value destructive in the long term) It is based on accounting principles and therefore likely to be subject to manipulation or reflects the choices of accounting policy chosen by management It is an absolute measure and difficult to compare with divisions or companies of different sizes Ignores time value of money Ignores qualitative / non-financial factors (e.g. market share) Accounting profit does not generally represent operating cash flows generated by the company 209

210 DIVISIONAL PERFORMANCE MEASUREMENT ROI Return on investment = Divisional operating profit x 100 Divisional net investment Divisional operating profit refers to profit before interest and taxes generated by the division in a specific period Net investment refers to the non-current assets (e.g. machinery, factory buildings, etc.) and current assets (e.g. cash, accounts receivable, inventory and accounts payable) that are directly attributable and within the control of the divisional manager By taking into account the asset base required to generate the profit, ROI addresses some of the disadvantages of divisional profit as a measure of performance Therefore, ROI is more appropriate for an investment centre 210

211 DIVISIONAL PERFORMANCE MEASUREMENT Advantages of ROI It is easy to understand and calculate It can be used as a common denominator for comparing the returns of dissimilar businesses, such as other divisions and competitors, and other measures such as inflation, prior year performance and budgets (i.e. it is easily comparable) It can be compared with the entity s cost of capital thus making it useful for decision making 211

212 Disadvantages of ROI DIVISIONAL PERFORMANCE MEASUREMENT Because it is based on accounting profit, it carries along the disadvantages of divisional profit It is not suited for service industries because of low capital investment It does not take into account the risks of a division or project ROI can lead to a lack of goal congruence 212

213 LE1: Divisional profit & ROI DIVISIONAL PERFORMANCE MEASUREMENT CA Ltd has two divisions, namely SA Ltd and Africa Ltd. The financial results and divisional assets of the divisions for the recent year ended are provided below: SA Ltd Africa Ltd Gross profit R R Other income R8 500 R Operating expense (R ) (R ) Profit before tax R Divisional assets R R

214 LE1: Divisional profit & ROI DIVISIONAL PERFORMANCE MEASUREMENT Other income refers to interest income earned on the cash generated by the divisions. All the cash balances are managed centrally by CA Ltd and the divisions are required to remit cash balances to head office on a daily basis. Divisional assets include cash balances of R and R relating to SA Ltd and Africa Ltd respectively. The divisions are considering investments, of which details are provided below: SA Ltd Africa Ltd Capital investment required R R Additional annual contribution R R

215 LE1: Divisional profit & ROI DIVISIONAL PERFORMANCE MEASUREMENT CA Ltd s weighted average cost of capital is 18% per annum. REQUIRED: 1) Calculate the divisional return on investment for both SA Ltd and Africa Ltd. Motivate your answer (5 marks) 2) Determine whether any of the divisional managers would proceed with the proposed investment, assuming the divisional managers performance is assessed on the following metrics: (a) divisional profit and (b) return on investment (6 marks) 3) Using your answers in part (2), discuss whether the decisions of the divisional manager would lead to goal congruency or not (4 marks) 215

216 DIVISIONAL PERFORMANCE MEASUREMENT Residual income Residual income is defined as controllable profit less a cost of capital charge on the investment controllable by the divisional manager If the residual income is used to measure the managerial performance of investment centres, there is chance that managers will be encouraged, when acting in their own best interests, also to act in the best interests of the company It is considered superior to ROI because it takes into account the cost of capital RI is congruent with investors measure for overall company performance ROI, being a ratio, can be used for inter-division and intercompany comparisons 216

217 DIVISIONAL PERFORMANCE MEASUREMENT Advantages of residual income Residual income is more flexible, because different cost of capital percentage rates can be applied to investments that have different levels of risk It is consistent with the NPV approach as projects which yield a return higher than cost of capital return would be acceptable (i.e. goal congruent) The contribution of divisions to group profit is clearly measured If different cost of capital rates are used, comparability may be enhanced? 217

218 DIVISIONAL PERFORMANCE MEASUREMENT Disadvantages of Residual income Residual income is an absolute measure therefore difficult to compare the performance of a division with that of other divisions or companies of different size (i.e. the size of the investment is ignored) It is difficult to understand The use of different rates presents subjectivity into the calculation this could lead to adverse motivational effects Because it is based on accounting profit, it carries along the disadvantages of divisional profit 218

219 LE2SS: Residual income DIVISIONAL PERFORMANCE MEASUREMENT Assume the same information as LE1 other than the fact that managerial performance is evaluated based on residual income 219

220 Economic value added (EVA) DIVISIONAL PERFORMANCE MEASUREMENT EVA = NOPAT - (divisional assets x cost of capital) NOPAT (Net Operating Profit After Tax) = Conventional divisional profit +/- accounting adjustments EVA calculation seeks to ascertain whether value is being added for shareholders in terms of whether the funds invested in the business generate a return in excess of the cost of capital If the EVA > 0, economic value is created/added and if EVA < 0, economic value is destroyed 220

221 DIVISIONAL PERFORMANCE MEASUREMENT EVA adjustments The starting point is divisional accounting profit which is then adjusted to eliminate the distortions introduced by financial accounting There are approximately more than 160 adjustments to consider for our purpose, only the following are applicable: Non-cash items (e.g. depreciation, bad debts, etc.) Finance related costs, including the related tax Capitalisation and amortisation of discretionary expenditure (e.g. marketing, R&D, training costs) Economic depreciation The objective of the adjustments is to determine cash flows because this provides a better measure for EVA 221

222 DIVISIONAL PERFORMANCE MEASUREMENT EVA controllable investment base The capital charge used is normally the divisional weighted average cost of capital Controllable investment base to be used is the same as for the residual income and ROI adjusted for: Replacement values or market values of non-current assets need to be used where available Balance of expenditure incurred, capitalised and amortised over the period that the benefits will accrue in the future Non-cash expenses 222

223 DIVISIONAL PERFORMANCE MEASUREMENT Advantages of EVA EVA is more flexible, because different cost of capital percentage rates can be applied to investments that have different levels of risk It is consistent with the NPV approach as projects which yield higher than cost of capital return would be acceptable (i.e. goal congruent) EVA adjusts for distortions introduced by accounting principles EVA actively encourages increasing shareholders wealth It highlights the benefits of discretionary expenditures (such a training, research expenditure and marketing costs) 223

224 Disadvantages of EVA DIVISIONAL PERFORMANCE MEASUREMENT Historical figures are used in an attempt to calculate economic profit therefore not necessary an accurate figure Although easy to interpret, it is difficult to understand The use of estimates in estimating EVA presents subjectivity into the calculation could lead to adverse motivational effects 224

225 DIVISIONAL PERFORMANCE MEASUREMENT LE3: EVA CA Ltd has a division, Africa Ltd, whose performance is evaluated based on the EVA. The financial performance of Africa Ltd for the most recent period is provided below: Amount (R) Total revenues Cost of sales ( ) Gross profit Operating expenditure (note 1) ( ) Depreciation (note 2) ( ) Operating cash flow Interest expense ( ) Income tax expense ( ) Net income for the year

226 DIVISIONAL PERFORMANCE MEASUREMENT LE3: EVA Notes: 1. Operating expenses include bad debts (R ) and research and development expenditure (R ). The research and expenditure incurred is expected to yield benefits to Africa Ltd over a period of four years 2. The carrying amount and market value of non-current assets at year end were R4,5 million and R5,4 million respectively. Economic depreciation during the year was R Controllable investment (before EVA adjustments) is R5 million 4. WACC is estimated to be 15%. Tax rate is 28% REQUIRED: Calculate EVA of Africa Ltd. CA Ltd determines the controllable investment based on figures as at the end of the reporting period 226

227 DIVISIONAL PERFORMANCE MEASUREMENT LE3SS: EVA 227

228 DIVISIONAL PERFORMANCE MEASUREMENT LE3SS: EVA 228

229 DIVISIONAL PERFORMANCE MEASUREMENT Addressing the dysfunctional consequences Use of improved financial performance measures such a EVA that incorporate accounting adjustments that attempt to overcome the deficiencies of conventional accounting measures Lengthen the performance measurement period (i.e. use of share scheme or bonus banks) Incorporate non-financial measures using the balanced scorecard approach (e.g. competitiveness, productivity, quality, etc.) 229

230 DIVISIONAL PERFORMANCE MEASUREMENT CE: Performance management consideration CA Ltd produces two products, Product Z and Product Y. The sales representatives currently earn a commission of 2% - 5% on the total quarterly revenue. The commission is paid in the first week following the end of the quarter (i.e. if the quarter ends of 31 March, the commission is paid by 7 April). The following information relates one unit of Product Z and Y Critically evaluate the incentive system of CA Ltd and recommend any improvements that it should consider (20 marks) Product Z Product Y Selling price R1 000 R200 Variable costs R800 R50 Fixed cost per unit R100 R100 Gross profit per unit R100 R50 230

231 Internal transfer pricing

232 Objectives After studying this section, candidates should be able to: Describe the different purposes of a transfer pricing system Determine internal transfer pricing to assist in resolving transfer pricing conflicts Assist in setting international transfer pricing Assist in setting transfer prices when there is no external market for the intermediate product Identify and describe the five different transfer pricing methods 232

233 TRANSFER PRICING Objectives of transfer pricing system It provides information that is useful for evaluating the managerial and economic performance of the division in fair and justifiable manner It provides information that motivates divisional managers to make good economic decisions (i.e. decisions that ensures goal congruency) It ensures that divisional autonomy is not undermined It intentionally distributes profits between divisions and locations It encourages healthy competition between the divisions It is simple to operate and administer No single transfer price is likely to meet all of the stated objectives 233

234 TRANSFER PRICING Golden rule: Minimum transfer price The minimum transfer price acceptable by the supplying division would be the incremental costs plus any opportunity costs If spare capacity exists, it is likely that the minimum transfer pricing is the incremental costs of supplying the products (i.e. the variable production costs plus incremental fixed costs less any costs avoidable on internal transfers) If no spare capacity exists, the minimum transfer price is the incremental costs plus any opportunity costs (e.g. the lost contribution). Often this is equivalent to the market price if there are no avoidable costs. The minimum transfer price is based on relevant costing principles It sounds too simple well, it is that simple! 234

235 TRANSFER PRICING LE1: Minimum transfer price CA Ltd has two divisions, Seller and Buyer. Seller manufactures Product T. The external selling price of Product T is R100 per unit. The total manufacturing costs of one Product T is R80 while the fixed manufacturing costs per unit is R20. Packaging costs of R10 are incurred on all external sales. Buyer uses Product T in its manufacturing process. The units that are transferred to Buyer from Seller are not packaged. Buyer requires units of Product T. Seller has a total annual manufacturing capacity of Product T. Determine the minimum transfer price under the following spare capacity scenarios 235

236 TRANSFER PRICING LE1ASS: Spare capacity is available Scenario A: The external annual demand for Product T is (4 marks) 236

237 TRANSFER PRICING LE1BSS: Spare capacity is not available Scenario B: The external annual demand for Product T is (7 marks) 237

238 TRANSFER PRICING LE1CSS: Spare capacity is not available Scenario C: The external annual demand for Product T is In addition, Seller has received a special order that requires units of Product T. Seller expects to generate gross sales of R after incurring R of incremental production costs from the order. (8 marks) 238

239 TRANSFER PRICING LE1DSS: Spare capacity is not available Scenario D: The external annual demand for Product T is Seller is able to increase its capacity by hiring an additional machine at a total cost of R per annum. The machine will add a further capacity of Product T. (9 marks) 239

240 TRANSFER PRICING Golden rule: Maximum transfer price The maximum selling price for the buying division should be the incremental revenue less incremental costs If there is an external market for the transferred items, the transfer price should be limited to the external selling price Again! It is that simple! 240

241 TRANSFER PRICING LE2: Maximum transfer price Consider the same facts as LE1. Buyer manufactures Product Q. The selling price of Product Q is R800 and the cost of production, excluding the transferred item (Product T), is R450. The external selling price of a product similiar to Product T is R300. Determine the maximum transfer price for Buyer. 241

242 TRANSFER PRICING Market-based and cost transfer prices Market-based transfer prices The transfer price is set at a competitive market price Perfectly competitive market where item is homogeneous and no individual buyer or seller can affect the market prices need to exist Divisional performance is more likely to represent the real economic contribution of the division to total company profits Cost based transfer prices These may be based on marginal costs, full costs or cost plus a mark-up The main issue is that standard costs should be utilised and not actual costs in order to avoid inefficiencies being carried forward to the buying division as this might result in dysfunctional behaviour 242

243 TRANSFER PRICING Negotiated transfer prices The transfer price should lie between the minimum and maximum prices calculated (i.e. the starting point) The negotiated transfer prices could reduce the friction and bad feeling that may arise from centrally controlled market prices It is appropriate where it is difficult to establishing a sound system of transfer pricing. This is likely to be the case where some market imperfections exist for the transferred item, e.g. there are several different market prices Autonomy to buy or sell externally is a critical prerequisite Unequal bargaining power (as result of limited number of external selling/buying outlets, amount of internal demand for the item, degree of operating leverage) should not exist The time dedicated to the process is also an important factor Managers are likely to have better information about the potential costs and benefits of the transfer than others in the company 243

244 Dual-rate transfer pricing system TRANSFER PRICING It uses two separate transfer prices to price each inter-divisional transaction - For instance, the transfer price to be charged to the receiving division could be set at the variable cost of the supplying division while the price of the selling division could be set at market prices The appropriate level of the transfer price needs to achieve goal congruency and have the appropriate motivation implications The dual-rate transfer prices are not widely used because: Different transfer prices causes confusion (e.g. consolidation treatment), especially where many divisions are involved They reduce divisional incentives to compete effectively They are artificial, i.e. create a false impression of profitability 244

245 Two-part transfer pricing system TRANSFER PRICING The transfer price is set at the short-run variable cost plus a fixed fee for the privilege of obtaining these transfers at short-run variable costs The fixed fee is intended to compensate the supplying division for tying up some of its fixed capacity in order to provide products or services that are transferred internally The transfer price should cover a share of the fixed costs of the supplying division and also provide a return on capital The advantage of this approach is that both divisions will report inter-divisional profits and it also stimulates planning, communication and coordination amongst the divisions The fixed portion could be determined through the application of ABC principles 245

246 Thank you Presenters details Rendani Muthelo ARC2017 Administration E: T: M: