Summary mandatory literature Management & Financial Accounting

Deze samenvatting is gebaseerd op het studiejaar 2013-2014.

Chapter A: The accountant

A.1 Management accounting & Financial accounting

We can make a difference between management accounting and financial accounting. Managers use management accounting to attain the goals of an organization. In financial accounting, the focus is more on presenting the information to extern parties. When presenting the information to extern parties, an organization must conform to certain rules that are arranged in the law.

What management accountant and financial accountants exactly do, depends form organization tot organization. There are a few differences, though, between this to types of accountants.

Cost accounting provides management accounting and Financial accounting in information. It measures and reports financial and non-financial information. This contains information about the acquisition and consumption of the resources of an organization.

When we talk about cost management, we target at the actions that managers undertake in the short and long-term planning and control of costs that increase value for customers and lower the costs of products and services.

A.2 Accounting systemen

The accounting system aims to provide information for 5 purposes:

1. Formulating strategies

2. Cost control and planning of operations and activities

3. The allocation of resources

4. Performance measurement

5. Conform to external regulatory and Legal reporting requirements

The book defines planning as the goals that an organization chooses and how an organization wants to accomplish this goals. The budget is a plan expressed in a quantitative manner. The budget is also tool with the implementation and coordination of the plan.

Control consists of the action that implements the plan and the feedback that will help with future decision making.

Management by exception concentrates on the areas that are not operating in the way they should be operating. There is a difference between the expected results and the actual results. We call this difference the variance.

Management accountants perform 3 important functions:

1. Attention directing

2. Scorekeeping

3. Problem solving

Attention directing attempts to reveal opportunities and problems which need the attention from managers. Scorekeeping is the accumulation of data and the reporting of reliable results to all levels of management. In problem solving, managers make a comparative analysis to identify the best alternatives.

A.3 Design of management accounting systems

The design of a management accounting system must be based on the challenges that managers face The book names 4 themes that are important with effective planning and with decisions on controlling issues. The themes are:

1. Customer Focus

It is important that a company is constantly concerning about the value it can add for customers.

Managers have to invest enough in the satisfaction of their customers to contain customers that deliver profit and attract new customers.

2. Value chain en supply chain analysis

The value chain are functions of a company where value is added to the products and services of an organization. The functions are:

• Productie

• Marketing

• Distributie

• Research & Development

• Klantenservice

• Het ontwerpen van producten, diensten of processen

The supply chain describes the stream of goods, services and information from the beginning tot the end. The activities do not have to take place in just 1 organization.

3. Key succes factors

• Time, for example the speed with which a company can react to an order of a customer.

• Costs

• Quality

• Innovation

4. Continuous improvement en Benchmarking

A.4 Veranderingen in management accounting

Historically, there are 4 fases of development in the field of management accounting:

1. Before1950, In this period, budgeting and cost accounting was an important tool to determine the costs and maintain the Financial control.

2. After 1965, planning and control became more important for managers. The tools that managers used were responsibility accounting en decision analysis.

3. After 1985, managers focused more on reducing the waste of resources..

4. After 1995, managers tried to create value by making effective use of resources and technologies and by innovation.

Chapter B: Costs

To make decisions, managers have to know the costs of an object, we call this a cost object. A cost object can be a product, service or a department.

In a costing system, costs are collected according to a specific classification, like materials. This process is called cost accumulation. In a costing system, costs are also assigned to certain cost objects, this process is called cost assignment.

B.1 Direct en indirect costs

Direct costs are related to the particular cost object and can be traced to the cost objects in a cost-effective manner. Indi8rect costs cannot be traced to the cost object in a cost-effective manner. An example of a direct cost are the costs of material, because it is easy to determine the exact amount of material used in a specific object. The costs of the material can be traced to this object. When a fabric produces more kinds of products, it is hard to trace the costs of electricity to 1 specific product. In this example, the costs of electricity are indirect.

Cost tracing is the assigning of direct costs to a cost object. Cost allocation is the assigning of indirect costs to a cost object.

There are several factors that influence the classification of a cost as indirect or asx direct. These factors are:

1. The design of operations. When a facility is only used for the production of only 1 specific product, it is easier to think of the costs as direct.

2. Materiality of costs. The higher the costs, the easier it is to trace the costs to a cost object. When costs are very low, it is not cost-effective to trace them to a cost object.

3. The availability of a technology that gathers information.

B.2 Cost behavior

There are two basic types of cost behavior pattern:

1. Fixed costs

2. Variable costs

A fixed cost does not change when the volume is going up or down. A variable cost changes in proportion to changes in the total output.

When we define fixed and variable costs we make some important assumptions:

• The total costs are linear

• When we define costs as fixed or variable it must be in respect to a specific cost object.

• The time span is known.

• There is no more than one cost driver.

• Variations in the level of the cost driver are within a relevant range.

The relevant range is the range of the cost driver in which a precise relationship among cost and the level of activity or volume is valid.

On page 44 in the book, you can find some examples of simultaneous:

• Direct versus variable

• Direct versus fixed

• Indirect versus variable

• Indirect versus fixed

B.3 The costs per unit and total costs

We can determine the costs of a unit by dividing the total costs by the number of units. Because unit costs are just averages it better to base decisions on total costs. The relationships between total costs and the costs per unit are depicted on page 47.

B.4 Revenue or Capitalized costs

Revenue costs and capitalized costs are costs that are included in financial statements, like a balance sheet. Revenue costs are taken as expenses when they are incurred, for example the monthly rent paid. Capitalized costs are included as capital when they are incurred. These costs will provide benefits in the future.

B.5 Companies

We call companies a service-sector company when they deliver services or other intangible products to their customers. An example of this is a psychological consult. There is no stock at all at these companies and therefore labor is normally the most important cost category.

Merchandising-sector companies deliver tangible products to their customers that they bought in the same form from suppliers, for example a book store.

Manufacturing-sector companies deliver tangible products to their customers that are manufactured by themselves, for example a food-processing company.

A manufacturing-sector firm has the following types of stock:

1. Direct materials stock; This are the materials used in the manufacturing process.

2. Work-in-progress stock; This are the products that are not yet finished, but are already worked on.

3. Finished goods stock; The products that are done, but are not yet sold.

Manufacturing costs:

1. Direct manufacturing labor costs; This includes all the manufacturing labor costs that are made with producing the work-in-progress and the finished goods and that can be traced to the cost object in a cost-effective manner.

2. Direct material costs; The acquisition costs of all materials that are needed in the manufacturing process.

3. Indirect manufacturing costs; The costs that cannot be traced to the cost object in a cost-effective manner. For example the costs of electricity, or the salary of the plant manager. Another name for this cost category is manufacturing overhead costs.

With prime costs we mean all direct manufacturing costs. Conversion costs are all manufacturing costs except the direct materials costs.

Costs of goods sold can be calculated as follows:

Opening finished goods + Costs of goods manufactured – Closing finished goods

The book is all about different costs for different purposes. Exhibit 2.11 on page 52 shows 3 kinds of purposes:

1. Financial statements

2. Pricing and product-mix decisions

3. Contracting with government agencies

Chapter C: Job-costing

C.1 Costing Systems

There are another two terms, in addition to chapter one and two, which are also important when we talk about costing systems. The first term is Cost pool, which is the grouping of individual cost items. The second term is cost allocation base, which is the financial or non-financial denominator for systematically linking an indirect cost to a cost object.

There are two basic types of costing systems which organizations can use to assign costs to products:

1. Process-costing system; The cost object here is lots of units of the same product. We determine the cost of a product by taking broad averages to assign costs to the products. With this system, every customer gets the same product.

2. Job-costing system; Costs are assigned to a individual unit or batch. Here the products are custom made.

Many organizations combine elements of the process-costing system with the job-costing system.

C.2 Service Organizations and Job costing

Actual costing is used to find out the costs of individual jobs. In this method the direct costs are assigned to a cost object. This is done by multiplying the actual direct-cost rate with the actual quantity of the direct cost input and by allocating the indirect costs based on multiplying the actual indirect cost rate with the actual quantity of the cost allocation base.

In general, there are six steps in the job costing method. The six steps are:

1. Recognize the job that is the chosen cost object.

2. Recognize the direct costs for the job.

3. Recognize the indirect cost pools related to the job.

4. Choose the cost-allocation base which you are going to use in allocating each indirect-cost pool to the job.

5. Develop the rate per unit of the cost-allocation base used to allocate indirect costs to the job.

Actual indirect-cost rate = actual total costs in indirect-cost pool /

actual total quantity of cost-allocation

base

6. Allocate the costs to the cost object by adding all direct costs and all indirect costs.

C.3 Normal Costing

With normal costing, budgeted amounts are used to calculate indirect-cost rates, rather than actual amounts. Normal and actual costing trace direct costs to jobs in the same manner. The only difference is that normal costing makes use of a budgeted indirect-cost rate instead of an actual indirect-cost rate.

Budgeted indirect-cost rate = Budgeted total costs in indirect-cost pool/

Budgeted total quantity of cost-allocation base

C.4 Manufacturing and Job-costing

We can use the same six steps with manufacturing as with service organizations.

A job cost record shows us all the costs that are assigned to one specific job. A materials requisition record is used to charge departments for the materials that they used on a specific job. The last source document is the labour time record, which is used to charge departments for the labour time they used for a specific job.

C.5 Adjustments at the end of the period

When the assigned amount of indirect costs in a period is less than the actual amount in the period, we speak of underallocated indirect costs. With overallocated indirect costs the assigned indirect costs is higher than the actual indirect costs.

Under or over-allocated indirect costs = Indirect costs incurred – indirect costs allocated

There are two main ways to dispose an underallocation of manufacturing overhead:

1. Adjusted allocation rate approach; This approach restates all entries by using actual cost rates instead of budgeted cost rates. Every job with indirect costs is recalculated using the actual indirect-cost rate. At the end, end-of-period closing entries are made.

2. Proration approach; Proration stands for the spreading of under or overallocated overhead to costs of goods sold and closing stocks.

There are three ways in which we can prorate the under (over) allocated manufacturing overhead. For explaining this, we make use of an example were €200.000 of manufacturing overhead is underallocated.

Method 1

With the first method, proration is done in proportion to the closing balances of:

• Work in progress (WP)

• Finished goods (FG)

• Costs of goods sold (COGS)

Method 2

With this method, we prorate based upon the total closing balances in:

• Work in Progress

• Finished Goods

• Cost of Goods Sold

Method 3

With this method we write off the proration to the cost of goods sold.

Chapter D: Budgets and Variances

A variance is the difference between a budgeted amount and an actual result. Benchmarks are used as a point of reference. With this we can make comparisons. A standard is a preset amount. We speak of management by exception, if management focuses more on areas that are not operating as expected and less on areas which are operating as expected.

D.1 Budgets

In this chapter we discuss two types of budgets:

1. Flexible budgets; A flexible budget is changed in harmony with ensuing changes in actual output. We calculate this budget at the end of the period, because then we know the actual output.

2. Static budgets; A static budget is supported on one level of output, it is not changed after it is set. We calculate this budget at the begin of the period, because it is based on the planned output level.

A favourable variance (F) is a variance that enlarges operating income in relation to the budgeted amount. An unfavourable variance (U) is a variance that declines operating income in relation to the budgeted amount.

Budgets can differ in their level of detail. Level 0 has the least details and level 1 depicts more information and so on.

Static budget variance = Actual results – Static-budget amount of operating profit

When calculating en reporting the Static-budget variance, a level 0 only shows:

• The actual operating profit

• The budgeted operating profit

• Static-budget variance of operating profit

In a level 1 analysis the Static-budget variances are showed per component. The components are:

• Revenues

• Fixed costs

• Variable costs

• Contribution margin

• Operating profit

The total static-budget variance is the difference between the actual operating profit and the static budget operating profit.

There are 5 steps in creating a flexible budget. (We assume here that costs are either variable in relation to output or fixed). The 5 steps are:

1. Find out:

   1. The budgeted selling price per unit

   2. The budgeted variable costs per unit

   3. The budgeted fixed costs

2. Find out the actual size of the revenue driver.

3. Find out:

   1. The flexible budget for revenue, based on the budgeted unit revenue

   2. The actual amount of the revenue driver

Flexible-budget revenues = budgeted revenue per unit * actual amount of the revenue driver

4. Find out the actual amount of the cost drivers.

5. Find out:

   1. The flexible budget for costs, based on the budgeted unit variable costs and fixed costs.

   2. The actual amount of the cost driver.

Flexible budget variable costs (for example with manufacturing and marketing)

Manufacturing = Variable and direct costs of manufacturing + materials * amount of the cost driver

Marketing = Variable and direct costs of marketing * amount of the cost driver

Flexible-budget fixed costs

Manufacturing = Manufacturing overhead

Marketing = Marketing overhead

A level 2 analysis also shows the Flexible-budget variances, the flexible budget and the sales-volume variances, next to the actual results and the static budget. The flexible-budget variance is the variation between the actual results and the flexible-budget amount for the actual levels of revenue and cost drivers. The sales-volume variance is the difference between the flexible-budget amount and the static-budget amount. The flexible-budget variance and the sales-volume variance together is the static-budget variance.

The selling-price variance is the difference between the actual selling price and the budgeted selling price:

Selling-price variance = (Actual selling price – Budgeted selling price) * Actual units sold

D.2 Price and Efficiency variances

The flexible-budget variance can be explained in two other types of variances:

1. The price variance; This is the difference between the actual price and the budgeted price, multiplied by the actual quantity of input.

2. The efficiency variance; This is the difference between the actual amount of input used and the budgeted amount of input that should have been used, multiplied by the budgeted price.

There are two main sources of information which we can use to obtain budgeted input prices and input amounts. The first one is the actual input data from past periods. The disadvantages of this source of information is that the data includes past inefficiencies and that the data does not contain expected changes planned to occur in the budget period. An advantage is that it is a cheap source of information. Another source of information are standards. The advantages of this source are that they can exclude past inefficiencies and that it can take into account expected changes in the budget period.

D.3 Performance

Normally, there are two attributes of performance measured. The first one is the effectiveness, which is the degree to which a preset target is obtained. The second one is efficiency which is the relative amount of inputs used to obtain a given level of output.

Budgets can also be used to measure continuous improvement. For this, we can make use of continuous improvement budgeted cost. When this cost is reduced each period, it is successful. When a company uses continuous improvement it focuses on reducing the total costs.

D.4 Activity-based Costing

The cost objects in Activity-based costing (ABC) are individual activities. For example on a batch-level or on an output-unit level. In our example we use batch-level costs. This are the costs use of resources in activities that are related to a group of products.

In our example we prepare a flexible budget for company A. The following information is given:

To calculate the flexible budget for materials-handling labour costs, we follow the next steps:

1. First we calculate the number of batches in which the actual output units should have been produced. We calculate this by dividing the actual units of output produced by the budgeted batch size. So 302.400 / 300 = 1.008

2. We calculate the number of materials-handling labour-hours that should have been used. We do this by multiplying the number of batches in which the actual output units should have been produced with the budgeted materials-handling labour-hours per batch. So 1.008 * 5 = 5.040.

3. Finally, we calculate the flexible-budget amount for materials-handling labour-hours. This is done by multiplying the number of materials-handling labour-hours that should have been used with the budgeted costs per materials-handling labour-hour. So 5.040 * 14 = €70.560

After this the flexible-budget variance can be calculated as follows:

Flexible-budget variance = Actual costs – Flexible-budget costs.

= €82.215 - €70.560

= €11.655 U

The U states that materials-handling labour costs were €11.655 higher than the flexible-budget target.

We can also calculate the price variance and the efficiency variance in this example.

Price variance = (Actual price of input – Budgeted price of input) * Actual amount of input.

= (14,50-14) * 5.670

= €2.835 U

Efficiency variance = (Actual amount of input used – Budgeted amount of input allowed) * Budgeted price of input.

= (5.760 – 5040) * €14

= €8.820 U

D.5 Journal Entries

An example of journal entries using standard costs:

Company B purchases 50.000 units of materials

The actual amount of materials used is 45.000 units, and the standard amount allowed for the actual output is 40.000 units. The actual purchase price was €35, while the standard price was €33.

Entry 1. Isolate the direct materials price variance at the time of purchase:

Materials €1.650.000

Direct materials price variance €150.000

Creditors €1.800.000

Entry 2. Isolate the direct materials efficiency variance at the time of usage:

Work-in-progress €1.320.000

Direct materials efficiency variance €165.000

Materials €1.485.000

Chapter E: Overhead costs, rates and variances

E.1 Costs

Useful planning of variable overhead costs involves undertaking just the value-added variable-overhead activities and then managing the cost drivers of those activities in the most efficient manner. A value-added cost is one that, if removed, would decrease the value consumers get from using the product or service. A non-value-added cost would not.

Useful planning of fixed-overhead costs contains undertaking merely value-added fixed-overhead activities and then determining the suitable level for those activities.

E.2 Overhead rates

In the book, a three step approach is used to develop a budgeted variable-overhead rate:

1. First determine the costs to include in the variable-overhead cost pool.

2. Then choose the cost allocation base.

3. Finally, estimate the budgeted variable-overhead rate. There are multiple approached to calculate this. One of them is the standard costing approach.

E.3 Variable-overhead cost variances

Variable-overhead static-budget variance = Actual results – Static-budget amount

Variable-overhead sales-volume variance = Flexible-budget amount – Static-budget amount

Variable-overhead flexible-budget variance = Actual results – Flexible-budget amount

Earlier, we discussed the differences between level 0, 1, 2 and 3. In level 3 the

Variable manufacturing overhead flexible-budget variance is split into efficiency

and Spending variances.

The variable-overhead efficiency variance measures the efficiency with which

the cost allocation is used. We calculate this with the following formula:

Variable-overhead efficiency variance =

(Actual units of variable-overhead cost allocation base used for actual output

units Achieved – Budgeted units of variable-overhead cost allocation base

allowed for actual output units achieved) * Budgeted variable-overhead cost

allocation rate.

The variable-overhead spending variance is the discrepancy between the actual

amount of variable overhead incurred and the budgeted amount allowed for the

actual amount of the variable-overhead allocation base used for the actual output

units achieved.

We calculate this variance with the following formula:”

Variable-overhead spending variance = (Actual variable-overhead cost per

unit of cost allocation base – Budgeted variable-overhead cost per unit of cost

allocation base) * Actual amount of variable-overhead cost allocation base used

for actual output units achieved.

E.4 Budgeted Fixed-overhead rate

There are also three steps in developing a budgeted fixed-overhead rate:

1. Identify the costs in the fixed-overhead cost pool

2. Then estimate the budgeted amount of the allocation base

3. Finally calculate the budgeted fixed-overhead rate:

Budgeted fixed-overhead rate per unit of allocation base =

Budgeted fixed-overhead costs / Budgeted quantity of allocation base units.

E.5 Variances

The production volume variance is the difference between budgeted fixed overhead and the fixed overhead allocated. When we write this in a formula we get:

Production-volume variance = Budgeted fixed overhead – (fixed overhead allocated using budgeted input allowed for actual output units achieved * budgeted fixed overhead rate)

A 4-variance analysis is an analysis with all of the 4 variances presented. It looks like this:

E.6 Classifying of costs

There are 3 main categories to classify costs into:

1. Discretionary costs; These type of costs have two important elements. The first one is that they come from periodic decisions considered the maximum outlay to be incurred. The second on is that there is no computable and obviously relation between the outputs and the costs.

2. Engineered costs; With this type of costs there is an obvious relationship between the costs and the output.

3. Infrastructure costs; This type of cost comes from owning a property, plant and equipment.

E.7 Costing systems

An overview of the actual, normal and standard costing methods:

Chapter F: Process-costing

Process-costing is mainly used in companies which produce mass products. The costs are assigned by averaging the manufacturing costs. This is possible because the products are very homogenously and are produced in a similar way. The main difference between job costing and process-costing the way in which they average the unit costs. In job costing, costs are assigned to unique jobs. So, here, it is not right to average the total manufacturing costs to the jobs, because every job uses other materials or other amounts of materials and other resources. In process-costing all the products are (almost) the same, therefore we can take the average of the manufacturing costs.

It is important for organizations to know their product costs. Organizations can use this information to make a profit analysis or to evaluate their performance.

We will now discuss 3 different examples of process-costing. In the first one there is no work-in-progress inventory at the begin and end of the accounting period. In the second example there is no beginning work-in-progress stock, but there is an ending work-in-progress stock at the end of the period. In the third example we have both beginning and ending work-in-progress stock.

Example 1; No opening and closing WIP

In July 2007 500 products were started and finished.

Direct materials costs €25.000

Conversion costs €25.000

Products are all the same, so we just have to divide the total manufacturing costs by the amount of products.

€50.000/500 = €100 costs per unit.

Example 2; There is an opening but no closing WIP

Opening stock 0 units

Started 500 units

Completed 250

Work-in-progress 250

Direct materials costs €25.000

Conversion costs €25.000

The 250 units, which are still in production, are already fully processed with respect to the direct materials, because these materials are already added to the WIP units. The conversion costs for the partially finished goods cannot yet be assigned completely. To compute the conversion costs per unit, we can follow the next steps:

1. Summarize the flow of output of units

2. Calculate output in equivalent units

3. Calculate the equivalent unit costs

4. Summarize total costs

5. Assign the total costs to units that are completed and to the WIP units.

In step one, we summarize the following:

We started with 500 units. 250 units are finished and 250 are still in progress.

In step two we determine the equivalent units. We look at the amount of input and determine how many outputs could have been made with it. For example, when our conversion costs are completed for 50%, our equivalent units are 0,5*250=125 equivalent units.

Direct materials Conversion costs

WIP opening 0

Started units 500

To account for 500

Completed 250 250 250

WIP closing 250 250*100%=250 250*50%=125

Accounted for 500 500 375

In step three we calculate the equivalent unit costs. This is done by dividing the direct materials by their equivalent units and by dividing the conversion costs by their equivalent units. Equivalent unit costs in our example:

Total Direct materials Conversion costs

Costs added €50.000 €25.000 €25.000

Cost per equivalent unit 25.000/500=€50 25.000/375=€66,67

In step four we summarize the total costs for which we have to account for. Because there is no opening stock of work-in-progress, the total costs to account for is simply the direct materials plus the conversion costs, which is €50.000 In our example.

In the last step we assign the costs. With our example we show you how:

Total Direct materials Conversion costs

Completed (250) €29.167,50 250*50 250*66,67

WIP

• Direct materials €12.500 250*50

• Conversion €8.333,33 125*66,67

• Total WIP €20.833,75

Example 3; There is an opening en ending stock of WIP

WIP opening stock 250 units

Direct materials 100% complete

Conversion costs 60% complete

Started 300 units

Completed 400 units

WIP ending stock 150 units

Direct materials 100% complete

Conversion costs 50% complete

Direct materials €32.000

Conversion costs €21.000

Equivalent units direct materials 250 units

Equivalent units conversion costs 0,6*250=150

Cost per equivalent unit direct materials 32.000/400= €80

Cost per equivalent unit direct materials 21.000/300= €70

WIP opening stock

Direct materials (250*80) €20.000

Conversion costs (150*70) €10.500

Total €30.500

Direct materials costs added €20.000

Conversion costs added €15.000

We are going to use the 5 steps here also, that we used earlier in example 2. But now we make use of two other stock cost-flow methods. The first one is the weighted-average method and the second one is the first-in, first-out method.

F.1 The weighted-average method

This method computes the equivalent-unit cost of the work done to date and assigns this cost to equivalent units completed and to the WIP stock. The book describes a 5 step method with using the weighted-average method.

1. Summarize the flow of products

2. Calculate the equivalent units

3. Calculate the equivalent-unit costs

4. Define the total costs to account for

5. Assign the costs

Step 1: In our case:

Units

WIP opening 250

Started 300

To account for 550

Completed 400

WIP closing 150

Accounted for 550

Step 2 in our example:

Units Direct materials Conversion costs

WIP opening 250

Started 300

To account for 550

Completed 400 400 400

WIP closing 150 150 75

Accounted for 550 550 475

Step 3 calculate the equivalent-unit costs:

Total Direct materials Conversion costs

WIP opening 30.500 20.000 10.500

Cost added 35.000 20.000 15.000

Cost incurred 40.000 25.500

Units work done 550 475

Cost per equivalent unit €72,73 €53,68

Step 4: The total costs to account for are 30.500+35.000=€65.500

The assignment of the costs is processed as followed:

Units completed: 400*72,73 + 400*53,68 = €50.564

Total WIP closing: 150*72,73 + 75*53,68 =€14.935,50 (the 150 and 75 we calculated in step 2)

Total costs accounted for: €50.564 + €14.935,50 = €65.500

F.2 First-in, first-out method (FIFO)

Fifo has another method to assign costs than the weighted-average method. The costs of the previous periods equivalent units in WIP opening stock are assigned to the first units finished.

It also assigns the costs of equivalent units worked on during the current period first to complete beginning stock, then to start and complete new units and finally to units in WIP closing stock. The FIFO method assumes that first units in WIP assembly account are finished at first.

We can also make use of the 5 step approach when applying the FIFO method.

Step 1: Summarize the flow of the products

We make use of the same example as with the weighted-average method.

So, the summary has to look like this:

Units

WIP opening 250

Started 300

To account for 550

Completed:

From opening WIP 250

Started and completed 150 (400 completed-250 opening WIP)

WIP closing 150

Accounted for 550

In step 2 we compute the output in the form of equivalent units. We focus on the equivalent units of work done in the current period. That is why the opening WIP assigns no equivalent units to direct materials, and 100-60% *250 = 100 equivalent units to the conversion costs. Step 2 should look like this:

Direct materials Conversion costs

Opening WIP 0 100

Started and completed 150 150

WIP closing 150 75 (150*50%)

Accounted for 300 325

In step 3 we compute the equivalent-unit costs. For the direct materials, this is €20.000 / 300 = €66,67 and for the conversion costs it is €15.000 / 325 = €46,15.

In step 4 we must define the total costs to account for. This is the WIP opening + costs added in period. So, €30.500 + €35.000 = €65.500.

In step 5 we assign the costs:

Total Direct materials Conversion costs

WIP opening (250 units) €30.500

Added €4615 0*66,67 100*46,15

Total from opening stock €35.115

Started and completed €16.923

Total €52.038

WIP closing total €13.562

Total costs accounted for €65.500

F.3 Differences between the methods

The following table will show the difference between the weighted-average method and the FIFO method:

This table means that the weighted-average closing WIP is higher than with FIFO. This can be a huge difference. The weighted-average method also had a lower cost of goods sold and therefore has a higher operating income. This is seen when direct materials or conversion costs vary significantly per period and when the stock levels of work in progress are high compared to the total amount of units completed. So when managers reduce this differences, the differences between the two methods will become smaller.

An advantage of the FIFO method is that it delivers information to managers about their performance. An advantage of the weighted-average method is the simplicity in calculating.

F.4 Standard Costing

Organizations that use process-costing systems produce identical units of output. They can use standards costs to overcome the disadvantages of costing all products at a single average amount. This is specifically of use for companies who produce a wide variety of similar outputs.

Example:

Standard costs:

Direct materials 80 per unit

Conversion costs 60 per unit

Total 140 per unit

WIP opening stock 250 units

Direct materials 100% complete

Conversion costs 60% complete

Started 300 units

Completed 400 units

WIP ending stock 150 units

Direct materials 100% complete

Conversion costs 50% complete

WIP opening stock as standard costs

Direct materials 250*80 €20.000

Conversion costs 150*60 €9.000

Actual direct materials costs added €20.000

Actual conversion costs added €15.000

We again use the 5 step method. The first two steps are exactly the same as with the FIFO example. Step 3 is easier than with the other methods, because we do not have to calculate the equivalent costs per unit, because we use the standard costs.

The equivalent units are 300 for the direct materials and 325 for the conversion costs. The costs for direct materials therefore is 80*300=24.000 and the conversion costs therefore is 60*325= 19.500.

The costs to account for (step 4) is the cost added at standard costs plus the WIP opening. So: 20.000+9.000+19.500+24.000=€72.500

Finally we have to assign the costs (step 5) according to the FIFO method:

Total Direct materials Conversion costs

Completed

WIP opening 29.000

Direct materials added 0 0*80

Conversion costs added 6.000 100*60

Total from opening 35.000

Started and completed 21.000 150*80 150*60

Total 56.000

WIP closing

Direct materials 12.000 150*80

Conversion costs 4.500 75*60

Total costs to account for €72.500

F.5 Previous department costs

Previous department costs, or transferred-in costs are the costs that are incurred in a previous department that are carried forward as the product moves through the process. Transferred-in costs are treated as if they are a separate type of direct material added at the opening of the process. In the previous examples we used only the assembly department. Now, the goods flow from the assembly department through the testing department.

WIP opening stock 250 units

Transferred-in costs 100% completed

Direct materials 0% completed

Conversion costs 60% completed

Transferred in 500 units

Completed 600 units

WIP closing stock 300 units

Transferred-in costs 100% completed

Direct materials 0% completed

Conversion costs 80% completed

We take €150 as costs of equivalent units for transferred-in, and €120 for conversion costs.

WIP opening stock

Transferred-in 250*150 €37.500

Direct materials 0

Conversion costs 150*120 €18.000

Transferred-in costs €50.000

Weighted-average €53.000

FIFO €15.000

Direct materials added €15.000

Conversion costs €50.000

Example with the weighted-average method:

Step 1 is described above. In step two we calculate the equivalent units:

In step 3 we calculate the equivalent unit costs, in step 4 we define the total costs to account for and in step 5 we assign the costs:

Example with FIFO method:

Step 2:

Step 3,4 and 5:

Chapter G: Allocation of costs

G.1 Why?

When we have to deal with indirect costs, we cannot trace the costs to a specific cost object in a cost-effective manner. But how do we allocate this indirect costs? There are four reasons to allocate costs to cost objects. The first one is to provide managers with information, so they can make decisions. The second is that allocating costs will help motivate managers and employees. The third one is to justify the costs that are made and the last reason is the reporting to external parties.

The value chain includes the following business functions:

When an organization designs a cost allocation system, they consider cost-benefit issues. They incur costs of gathering data and education costs, of teaching management how to deal with the system. It is easy to determine the costs of implementing the system, but it is harder to determine the benefits of the system.

G.2 Indirect cost pools

In our example Organization X has two assembly departments and one maintenance department. The indirect costs of the products that are produced consists out of the costs that are incurred at corporate headquarters and costs that are incurred at manufacturing. Organization X now has to choose which cost categories should be included in the indirect costs. It also has to decide on how many cost pools should be used. A cost pool is a group of individual cost items. Homogeneity is an important factor in deciding on cost pools. Then X has to choose which allocation base should be used for each cost pool.

A homogeneous cost pool is a group of activities which have the same cause-and-effect relationship of their costs. When using homogeneous indirect-cost pools, the costs of a product or service can be determines more accurate. When homogeneity is higher, than a company needs less cost pools to explain precisely the differences in how products use the resources of an organization.

The cause-and-effect relationship is the variable that cause the resources to be used in an organization.

There are different reasons for an organization to change their single cost pool allocation into a multiple cost pool allocation:

1. Views of line managers and employees

2. Changes that are made in the layout of the plant or changes in operations.

3. Changes in the diversity of products or changes in the way the products make use of the resources.

G.3 Allocating from department to department

There are three issues that arise when allocating costs from one department to another department:

• Single-rate method or dual-rate method

• Budgeted rates or actual rates

• Budgeted quantities or actual quantities

Single-rate method or dual-rate method

The single-rate method makes use of only one cost pool and allocates the costs to cost objects by using the same rate per unit of the single allocation base. The dual-rate method categorizes the costs in one cost pool first into two subpools. Normally the two subpools are a variable-cost subpool and a fixed-cost subpool. Each of the subpools has its own allocation rate or a different allocation base.

Example:

Data Organization X:

Fixed costs of operating the facility €300.000 per year

Total capacity 1.500 hours

Budgeted quantity

Division A 800

Division B 400

Total budgeted quantity 1.200

Budgeted variable costs €200 per hour

Single-rate method:

Total cost pool €540.000 (€300.000+1200*200)

Budgeted usage 1.200 hours

Budgeted total rate per hour rate €450 (540.000/1200)

Allocation rate Division A €450 per hour used

Allocation rate Division B €450 per hour used

Dual-rate method:

Division A:

Fixed costs €200.000 per year ((800 hour/1200 hour)*€300.000)

Variable costs €200 per hour used

Division B

Fixed costs €100.000

Variable costs €200 per hour used

The difference between the two methods can be seen by stating the costs that are allocated to the divisions against each other. Assume that Division A actually uses 900 hours and division B uses 300 hours actually. Cost allocation would be as follows:

Single-rate method:

Division A 900*€450= €405.000

Division B 300*€450= €135.000

Dual-rate method:

Division A €200.000+(900*€200)= €380.000

Division B €100.000+(300*€200)= €160.000

A huge advantage of the single-rate method is its low costs of implementation. A disadvantage is that it leads to divisions that take actions which appear to be in their own interest, but are not in the best interest for the firm as a whole.

Budgeted rates or actual rates

When using budgeted rates, the departments will know in advance what rate will be charged. When using actual rates, there will be some uncertainty because rates will be unknown until the end of the period. An advantage of budgeted rates is that it will motivate managers to increase efficiency.

Budgeted quantity or actual quantity

This decision also had an impact on the behavior of the managers. When we base our evaluation only on actual quantity, we do not know the exact usage until the end of the period. When we make use of budgeted quantities, we can make a long and a short term planning. When fixed costs are allocated on the basis of a long term budgeted quantity, managers could underestimate their planned usage. With this, the managers are more certain about sticking to the budget. This problem of underestimating could be solved by giving an increase in salary to managers who estimate the forecasts accurate. Another solution is the imposing of cost penalties.

G.4 Support departments

An operating department, also called a production department, adds value to a product or service, which a customer is able to see. A support department delivers services that maintain the other internal departments in the firm.

The book examines three methods of allocating the costs of the support departments:

1. Direct method

2. Reciprocal method

3. Step-down method

To explain these three methods, we make use of an example. Organization Y has two support departments, Maintenance and Information Systems. The data of the costs of these support departments for 2008 is:

Direct method

This method is also called the direct allocation method. This method is the most widely used method for allocating costs of support departments.

This method ignores the hours that the support departments use from each other. In our example the cost allocation base for allocation the costs of the Maintenance department is 4800+8000=12800 hours. Machining must account for 4800/12800=3/8 and Assembly must account for 8000/12800=5/8.

The cost allocation base for the allocation of the costs of the Information Systems department is 3200+400=3600 hours. Machining must account for 3200/3600=8/9 and Assembly must account for 400/3600=1/9.

With the direct allocation method, costs are allocated as follows:

Reciprocal method

In this method, the services delivered among all support departments, are explicitly included. This method knows three steps, when implementing it:

First step: Make equations which include the support department costs and the reciprocal relationships. M is the complete reciprocated costs of Maintenance and IS is the complete reciprocated costs of Information Systems.

In our example, the equations should look like:

M=€1.200.000 + 0,1IS

IS=€232.000 + 0,2M

The percentages, 0,1 and 0,2, is the percentage work used of Information Systems by Maintenance and vice versa.

Complete reciprocated cost are the actual costs incurred by the service department plus a part of the costs of the other support department that delivers services to it.

Second step: Solve the equations, by substituting equation one in the second equation.

In our example:

M =1.200.000+0,1(232.000+0,2M)

=1.200.000+23.200+0,02M

0,98M =1.223.200

M =1.248.164

Substituting this in the second equation:

IS =232.000+0,2(1.248.164)

=481.632

Third step: Allocate the costs of the support departments to the other departments according to usage percentages. In our example the cost allocation base are the usage percentages.

Cost allocation using the reciprocal method:

Step-down allocation Method

This method is also called the sequential allocation method. In this method, the support departments are ranked. First, the costs of the first support department are allocated to all the other departments including other support departments. Then The costs of the second support department are allocated to all departments that are ranked below this support organization.

This allocating is repeated until all the support departments no longer have costs that are assigned to them.

There are two approaches for ranking the departments. In the first method the departments are ranked according to the percentage of the support department’s total support provided to other support departments. In our example, this should look like:

1. Maintenance 20% provided to other support departments

2. Information Systems10% provided to other support departments

In the second approach, departments are ranked according to the total euros of service they provided to other support departments. In our example, this should look like this:

1. Maintenance €240.000 provided tot other support departments. This is computed by multiplying the percentage of service provided to other support departments with the budgeted manufacturing overhead costs before allocation. So, 0,2*€1.200.000.

2. Information Systems €23.200

The cost allocation base for this method is:

Allocation of costs with the Step-down method:

G.5 Common costs

A common cost is a cost that is shared by two or more users. The book discusses two methods to allocate common costs:

1. Incremental method

2. Stand-alone method

The incremental method uses a ranking method to rank the cost objects and uses this ranking to allocate costs among those cost objects. The object that is ranked the first, is called the primary party and the second-ranked object is named the incremental party. For example Person 1 lives in X and has to work in Y for company A and a few days later it has to work in Z for company B. The costs to fly from X to Y are €1500. The costs to fly from X to Z are €1.000. The person decides to fly from X to Y to Z and then back to X, which costs €1.900. This is a common cost for organization A and B. The cost allocation with the incremental method would be:

In this method, the primary party usually receives the highest costs.

The stand-alone method first determines the cost-allocation weights. In our example this is computed as follows:

A: €1.500/ (€1.500+€1.000) =0,60

B: €1.000/ (€1.000+€1.500) =0,40

Costs are then allocated by multiplying the cost-allocation weights with the common cost. Our example:

A: 0,6*€1.900 = €1.140

B: 0,4*€1.900 = €760

Chapter H: Joint-costs

H.1 Terms

The costs of a single process that produces more than one product is called a joint cost. The juncture in the process, when one or more products in a joint-cost setting become separately identifiable is called the split-off point. The costs that are made after the split-off point are called the separable costs, when they are assignable to one or more individual products. When one of the joint products has a relatively high sales value, we call this product the main product. The products that have a relatively low sales value are called a by-product.

H.2 Methods

There are two main methods for allocating joint costs:

1. Use market-based data to allocate costs.

2. Use physical measure-based data to allocate costs.

To describe the methods we make use of another example. The data:

• 450 litres milk produced (400 of good product, 50 of waste)

• Stock:

• The cost of purchasing 500 litres milk and processing it to its split-off point is €500.

The question is now, how much must we allocate of this €500 to the closing stock of cream and liquid skim?

When we use market-based data we can apply three kinds of methods:

1. Sales value at split-off method

2. Estimated net realizable value method

3. Constant gross-margin percentage NRV method

Sales value at split-off method

This method allocates the costs based on the relative sales value at the split-off point. In our example the split-off value for cream is €600 (€3*200 litre) and €400 for liquid skim.

Allocation of the joint cost:

Estimated net realizable value method

With this method, joint cost are allocated based on the relative estimated net realizable value. We make use of a new example to illustrate this method.

Data:

The joint cost of processing the raw milk is €500 into cream and liquid skim. The processing costs of processing the cream into butter cream is €280. The processing costs of processing the liquid skim into condensed milk is €520. 100 litres of cream will be processed into 80 litres butter cream. The butter cream is sold for €6 per litre. 300 litres of liquid skim is processed into 200 litres of condensed milk. This condensed milk is sold for €5 per litre.

The allocation of joint cost using the estimated NRV method:

Constant gross-margin percentage NRV method

This method allocated the joint costs so that the overall gross-margin percentage is the same for all the individual products. There are three steps involved in this method:

1. First compute the overall gross-margin percentage

2. Make use of the overall gross-margin percentage and subtract the gross margin from the final sales values to get the total costs that each product should bear.

3. Subtract the expected separable costs from the total costs to get the joint-cost allocation.

The allocation of joint cost with the constant gross-margin percentage NRV method:

Step 1:

Step 2:

Step 3:

Physical measure method

This method allocates the costs based on their relative proportions at the split-off point by using a common physical measure like the weight of a product. In our example we allocate the joint costs as follows:

The question now is which method managers should choose to allocate joint costs. The benefits-received criteria prefers the sales value at split-off point method for a few reasons:

1. This method does not suppose in advance that an exact number of subsequent steps must be taken for further processing.

2. This method has a meaningful (in euros) denominator in his calculations, which is missing in the physical measure method.

The method is a simple to implement. The estimated NRV method can be very complex in organizations with multiple products and multiple split-off points.

Because all the methods of allocating joint costs are subject to criticism, some managers refuse to allocate the joint costs at all. They rather carry all stocks at estimated NRV. They recognize income, when the production is completed.

There is also criticism on this method, because income is recognized before the sales are made. Therefore, other companies, carry their stocks at estimated NRV minus a normal profit margin.

50 litres of butter cream are sold and 180 litres of condensed milk are sold.

The allocation of the separable costs and no joint costs is done as follows:

H.3 Process further?

To determine if a company must process its product further after the split-off is done by comparing the incremental revenues minus the incremental costs

For example there are two products A of 100 litres and B of 200 litres. The sales value per litre at the split-off are €5 voor A and €3 for B. The joint costs incurred up to the split-off point are €1000. There is an option for the manager to further process B 200 litres into 150 litres of C. The additional costs would be €200 and the selling price per litre of C would be €8.

Must the manager choose to further process product B?

Incremental revenue of C €600 ((150*8)-(200*3))

Incremental costs of C €200

Incremental operating profit €400

So, it is profitable to further process product B into C.

H.4 Accounting for By-products

To illustrate the accounting for by-products we use an example of two products, consisting out of one main product and one by-product. BV generates two products A and B. A is sold for €50 and B is sold for €2. Both products are sold at the split-off point and are not processed any further. The costs to process A and B are €20.000

There are two major questions when using accounting methods for by-products. The first one is when the by-products are first recognized in the general ledger. Here we can choose for the time of production or the time of sale. The second question is where the by-product revenues appear in the income-statement. Here we can choose for a cost reduction of the main or joint products or as a separate item of revenue. Out of these questions, there appear to be four methods to account for by-products:

Chapter I: Stock-costing

I.1 Variable and absorption costing

Variable costing is a stock-costing method in which all variable manufacturing costs are included as inventorial costs. The fixed manufacturing costs are not included in these inventorial costs; we account for them in the period in which they are incurred.

Absorption costing is also a stock-costing method in which both the variable manufacturing costs and the fixed manufacturing costs are included in the inventorial costs.

We assume that the denominator, for computing the variable and fixed manufacturing overhead allocation rates, is a output related variable.

To show the differences between these two methods, we use an example:

Organization X uses a normal costing system. This means that the direct costs are traced to products using actual prices and the actual inputs used. The indirect costs are traced using a budgeted indirect cost rate * actual inputs used.

The allocation base for all indirect manufacturing costs is units produced.

The allocation base for all variable indirect marketing costs is units sold.

Data 2008:

1. Budgeted and actual number units produced are both 1 million.

2. Also the budgeted and actual number units sold is the same, 900.000

3. The budgeted and actual fixed costs are the same.

4. Work in progress is minimal

5. No opening stock

6. Variable costs are driven by an output unit related variable.

7. Closing stock is 100.000

8. Selling price €20

Costs at organization X:

Unit inventorial costs of organization X under variable and absorption costing:

Comparison between variable costing and absorption costing in income statements over 2008. (in €000)

Variable costing:

Absorption costing:

Chapter J: CVP Analysis

A cost-volume-profit (CVP) analysis observes the behavior of total revenues, total costs and operating profit as changes occur in the output level, selling price, fixed costs or variable costs. This analysis is used by managers to give an answer to questions like: If we increase our price, how will it affect our sales level?

J.1 Drivers

The revenue driver is the factor that has an effect on revenues, for example units sold or the price of products. A cost driver is a factor that has an effect on costs, like the number of packages shipped.

To predict revenues and costs one could consider multiple revenue drivers and cost drivers. When one uses multiple revenue drivers and cost drivers, we call it the general case. Such an analysis is very time consuming. We can also focus on a single revenue driver and a single cost driver. This is called the special case or CVP analysis.

In this chapter we assume that total costs only exists out off variable costs and fixed costs: Total costs = Variable costs + Fixed costs.

Operating profit = Total revenues – Total costs

Net profit = Operating profit – Income taxed

The following abbreviations are used in our examples:

USP = Unit selling price

UVC = Unit variable costs

UCM = Unit contribution margin (USP-UVC)

Q = Quantity of output units sold

FC = Fixed costs

OP = Operating profit

TOP = Target operating profit

NP = Net profit

J.2 Assumptions

The CVP analysis that is argued in this chapter is based on a few assumptions:

• Total costs = fixed costs + variable costs (with respect to the level of output)

• The behavior of total revenues and total costs is linear in relation to output units within the relevant range.

• The unit variable costs, fixed costs and the unit selling price are known and are constant.

• The analysis either covers a single product or assumes that the proportion of different products when multiple products are sold will remain constant as the level of total units sold changes.

• All revenues and costs can be added and compared without taking into account the time value of money.

• Changes in the level of revenues and costs arise only because of changes in the number of products units produced and sold. The number of output is the only revenue and cost driver.

J.3 Breakeven point

The breakeven point is the point of output where the operating profit is 0. We will discuss 3 methods of computing the breakeven point:

1. Equation method

2. Contribution margin method

3. Graph method

Data example:

• Purchase €150 per product.

• If units cannot be sold, then they can be returned for €150.

• Selling price €230

• Fixed costs €2000

Equation method

Solve the following equation:

Revenues – Variable costs – Fixed costs = Operating profit

(USP*Q) – (UVC*Q) – FC = OP

In our example:

230Q – 150Q - €2000 = €0

80Q=€2000

Q=25 units

If the organization in our example sells fewer than 25, then it will make a loss. At 25 units it will breakeven and make no profit or loss and if it sells more than 25 units, then it makes a profit.

Contribution margin method

This method simplifies the formula of the equation method as follows:

(USP*Q) – (UVC*Q) – FC = OP

(USP – UVC) *Q = FC + OP

UCM * Q = FC + OP

Q = (FC + OP) / UCM

The operating profit is 0 at the breakeven point. So,

Breakeven number of units = FC / UCM

Graph method

In this method, the total costs line and the total revenues are plotted in a graph. The point where the two lines cross, is the breakeven point.

To compute, how many products should be sold to earn a specific amount of operating profit, one must use the equation method or the contribution margin method and solve Revenues – variable costs – fixed costs = target operating profit.

A profit-volume (PV) graph Is a graph that shows how changes in the output level affect the operating profit.

J.4 Taxes

When there is not accounted for taxed, the income statement looks as follows:

Revenues

Variable costs -

Contribution margin

Fixed costs -

Operating profit

When one does account for taxes, the operating profit is calculated as follows:

Operating profit = Target net profit / 1 – Tax rate

J.5 Sensitivity analysis

This technique determines how results change when the predicted data is not achieved. It is an approach that recognizes uncertainty. Uncertainty is the change that the actual data will deviate from the expected amount.

The margin of safety is the excess of budgeted revenues over the breakeven revenues. The margin of safety gives an answer to the following question: How far can the revenues fall below budget before the breakeven point is reached?

J.6 Cost planning

When there is a certain amount of uncertainty and risks are high, managers are likely to consider multiple costs structures as an option. To describe this, an example is used:

Peter’s fixed costs consists out of rent payments. He gets three different rental options:

1. A fixed rental payment of €2000

2. Fixed payment of €1400 and 5% of the revenues of Peter

3. No fixed payment, but 20% of the revenues of Peter

The examining of the risks in CVP format looks as follows:

1. The first option has fixed costs of €2000. The breakeven point is at 25 units. After this 25 units, each unit sold brings €80 operating profit.

2. Breakeven point is at 20 units. And there is an additional operating profit of €70 per units sold after 20 units.

3. The breakeven point is 0 units, which means that an additional operating profit is made from selling the first unit. The additional operating profit is €40 per unit.

Which Peter must choose depends on how high he thinks the demand will be. Option 3 is the option with the least risks. This relationship between risks and return can be summarized in a measure, which is called operating leverage. Operating leverage describes the effects that fixed costs have on changes in operating profit, when there are changes in the amount of units sold. For our example, with a sale of 40 units, this should look like:

The number 2,67 means that, when sales are 40 units, a percentage change in sales and contribution margin will result in 2,67 times that percentage change in operating profit.

J.7 Revenue Mix

The revenue mix is also called the sales mix and it is the relative mixture of quantities of products or services that constitutes total revenues. Overall revenue targets may still be achieved when the combination changes, but the effects on operating profit depend on how the original proportions of lower or higher contribution margin products have shifted. When for example, a company decides to sell two kinds of products, the breakeven point must depend on the revenue mix. The following method can be used, when the budgeted revenue mix will not change at different levels of total revenues. The breakeven point of product X and Y are:

Revenues-variable costs-fixed costs = Operating profit

J.8 Contribution margin

Contribution margin = Revenues – Variable costs

Gross margin = Revenues – Cost of goods sold

Contribution margin percentage = total contribution margin / revenues

Variable-cost percentage = total variable costs / revenues

Gross margin percentage = gross margin / revenues

Chapter K: Cost behavior

K.1 Assumptions

We one estimates cost functions, there are usually two assumptions made:

1. Variations in the total costs of a cost-object are explained by variations in a single cost driver.

2. Cost behavior is sufficiently approximated by a linear cost function of the cost driver within the appropriate range. A linear cost function is a cost function where, within the relevant range, the graph of total costs versus a single cost driver forms a straight line.

To explain the cost functions we use an example of two organizations X and Y who negotiate with each other about a telephone line between A and B. Organization X offers organization Y three types of cost structures:

1. Option 1: €5 per minute of using the phone. The number of phone-minutes is used as the cost driver. With this option, there are no fixed costs. The €5 is completely a variable costs and is the slope efficient. The slope efficient is the amount by which total costs change for a unit change in the cost driver. The relevant range is the range of the cost driver where the relationship between total costs and the driver is valid. The cost function for this example is:

2. €10.000 per month. Now, the costs are completely fixed. This fixed costs are a constant or an intercept, which are the component of total costs that does not vary with changes in the level of the cost driver. The slope is 0. The cost function is:

3. €3.000 per month plus €2 per minute of using the phone. This option is a mixed cost, because there is both a fixed and a variable component. The intercept is €3.000 and the slope is €2. The cost function is:

K.2 Terms

A linear cost function is usually written as:

Cost estimation is trying to measure past relationships between total costs and the drivers of the costs. Managers can also make use of cost predictions, which are forecasts about future costs. With this managers can make a more informed planning and control decisions.

When estimating a cost function, one must determine whether a cause-and-effect relation exists between the cost driver and the resulting costs. This relationship can arise in different ways:

1. By a physical relationship between the cost driver and the costs.

2. From a contract.

3. When it is implicitly established by logic and knowledge of operations.

K.3 Cost estimation methods

The book describes 4 different ways to estimate costs:

1. Conference method

2. Account analysis method

3. Industrial engineering method

4. Quantitative analysis of past or current cost relations

Conference method

This method estimates cost functions by analyzing costs and their drivers from different departments of an organization. It is a method that can be conducted very quick and through the pooling of expert knowledge it is also a method with high credibility.

Account analysis method

This method estimates cost functions by categorizing cost accounts in the ledger as variable, fixed or mixed with respect to the identified cost driver.

Industrial engineering method

This method is also called the work-measurement method and it estimates cost functions by analyzing the relations between inputs and outputs in physical terms. A disadvantage of this method is, that it can be very time consuming and it is often too costly to analyze the whole cost structure of an organization.

K.4 Steps

When estimating a cost function, one can use the following six steps:

1. Choose the dependent variable. This choice depends on the goal for estimating a cost function.

2. Identify the independent variable or cost driver. The independent variable is the variable that is used to forecast the dependent variable. The independent variable is usually referred to as the cost driver.

3. Collect data on the dependent variable and the cost driver.

4. Plot the data

5. Estimate the cost function

6. Evaluate the estimated cost function

There are different methods to estimate cost functions. The book discusses:

1. The high-low method

2. The regression analysis method

High-low method

This method just uses the highest and the lowest scores of the cost driver. The line that connects this two points is the estimated cost function.

For example:

The slope coefficient is computed by dividing the difference between costs associated with highest and lowest observations of the cost driver by the difference between highest and lowest observations of the cost driver.

The slope of the coefficient = 750/50= €15 per machine hour.

To calculate the intercept, one can use the highest or the lowest observation of the cost driver. Since, is the same as

Using the highest score:

30

So, the cost function is:

Regression analysis method

This method uses all the information that is available to estimate the cost function. It measures the average amount of change in the variable that is associated with a unit change in one or more independent variables. Simple regression analysis determines the relation between the dependent variable and one independent variable. Multiple regression analysis determines the relation between the dependent variable and several independent variables. The residual term is the difference between the actual costs and the predicted costs.

K.5 Choosing cost drivers

To estimate costs, managers have to identify the right cost drivers. Managers need knowledge of underlying processes to determine the right cost driver. The book considers three criteria for choosing the right cost driver:

1. Goodness of fit

2. Economic plausibility

3. Slope of regression line; a flat regression line indicates a weak relation.

K.6 Non-linearity

A non-linear cost function is a cost function where the graph of total costs versus the level of a single activity is not a straight line. An example of a non-linear cost function is a step cost function.

This is a cost function in which the cost is the same over various ranges of the cost driver, but the cost increases by discrete amounts as the cost driver moves from one range to the next.

K.7 The learning curve

A learning curve is a graph that shows how labour hours decreases as units of products increase and workers learn. The experience curve is a graph that displays how full product costs per unit decrease as units of output increase.

The cumulative average-time model is a model where the cumulative average time per unit decreases with a constant percentage every time the cumulative quantity of units produced doubles.

The incremental unit-time learning model shows how the incremental unit time decreases with a constant percentage each time the cumulative quantity of units produced is doubled.

Chapter L: Decision Making

L.1 Information

A decision model is a formalized way for decision making. The process of making decisions consists out of 5 steps:

1. The first step is gathering information;

2. Making forecasts

3. Choosing alternatives

4. Implementing the decision

5. Evaluating performance

L.2 Relevance

Relevant costs are the expected future costs that differ among other courses of action . Relevant revenues are those expected future revenues that vary among alternative courses of action.

An example:

(in the first two columns all the data is given and in the third and fourth only the relevant data is given)

Both with all information and relevant information, alternative 1 and 2 differ 25.000 in operating profit. With the relevant data, revenues, direct materials, manufacturing overhead and marketing can be ignored, because these amounts are the same with alternative 1 and 2.

The difference in total costs between the two alternatives is called a differential cost.

One can categorize the consequences of the alternatives into two categories:

1. Quantitative factors

2. Qualitative factors.

Quantitative factors are results that one can measure in numerical terms. An example of a quantitative factor are the direct labour costs. This is a financial quantitative factor. There are also non-financial quantitative factors, like the percentage on-time flight arrivals. These factors are numerically, but are not expressed in financial terms.

Qualitative factors cannot be measured in numerical terms. For example the satisfaction of customers.

Incremental costs are the additional costs to obtain an additional quantity over the budgeted quantity.

L.3 Make-or-buy decisions

With outsourcing a company purchases goods and services from outside vendors instead of producing the goods themselves, which is called insourcing.

Make-or-buy decisions are decisions about whether to outsource or insource.

An example of a make-or-buy decision:

The question is: What are the relevant costs in a make-or-buy decision?

Assume that the capacity now used will become idle when the product one is making is outsourced and the Fixed overhead costs of €30.000 will continue to be incurred next year, no matter what decision is made. Suppose that €5.000 in salaries will not be incurred in the product is completely outsourced.

The cost computations:

L.4 Opportunity costs

When a manager has to deal with capacity constraints and opportunity costs, he has to decide which project to adopt. For example, the manager has three alternatives to choose from:

1. Make A and do not make B

2. Buy B and do not make A

3. Buy B and use the excess capacity to produce A

In our previous example we showed the make or buy decision of product B. The costs to make the product themselves were €185.000 and the costs from buying product B were €160.000. It is expected that with also producing A the additional profits will be €20.000. So, the relevant costs of buying product B is €160.000 - €20.000=€140.000, which is lower than making B inhouse. So, the best choice is to buy B and produce A.

Opportunity costs are the costs of income that is foregone by not using a limited resource in its best-alternative use.

The book shows two methods for analyzing the alternatives:

1. Total-alternatives approach

2. Opportunity-costs approach

The total-alternatives approach:

Opportunity-costs approach:

We can also explain opportunity costs in the costs of carrying stock. For example:

Materials requirements €100.000 kg

Cost per kg below 100.000kg €10.00

Cost per kg over 100.000 kg €9,80

The organization has to choose out of 2 alternatives:

1. Buy 100.000 kg at the beginning of the year

2. Buy 8.333 at the beginning of each month.

Average investment in stock:

1. (100.000*9,80) / 2 = €490.000

2. (10.000* 10) / 2= €50.000

Annual interest rate is 5 percent.

Costs of alternatives:

This table shows that it is better to purchase at the beginning of every month.

L.5 Product-mix decisions

This part discusses product-mix decisions when there are capacity constraints. One must assume that as short-run changes in product-mix occur, the only costs that change are those that are variable with respect to the number of units produced. Looking at individual product contribution margins, one gets insight in the product mix that maximizes operating profit.

For example, a company that produces engine, one for automobiles and one for trucks. Data on the two kinds of engines:

It looks like producing truck engines delivers more profit, but one should also look at the highest contribution margin per unit of the constraining factor.

Assume that there are only 600 hours of machining available for producing engines. It takes 2 hours to produce a automobile engine and it takes 4 hours to produce a truck engine.

Now, you can see that producing the automobile engine is the more profitable choice.

L.6 Customer profitability

In this example we will make choices among different customers on the basis of customer profitability. Organization Furniture delivers furniture to three stores, 1, 2 and store 3.

Data on customer profits:

Additional information:

• Materials handling labour costs change with the number of units shipped

• Materials handling equipment are identified with individual customer accounts. Any equipment not used remains idle. The equipment has a useful price for one year and has a salvage value of 0.

• The rent is allocated to each customer account on the basis of the amount of warehouse space occupied by the products to be shipped to that customer.

• Marketing costs change with the number of sales visits made to customers

• Purchase-order costs change with the number of purchase orders received.

• Administration is allocated to customers on the basis of euro sales made.

Relevant-cost analysis of dropping a customer

In the data about customer profits you can see that customer 3 delivers a loss of €11.500. The manager now has to consider whether to drop customer 3 or not.

Dropping customer 3 will lead to a saving of cost of goods sold, materials handling labour, marketing and purchase orders incurred with customer 3. The excess capacity that will exists will become idle and the administration costs will not change.

The relevant cost analysis of dropping customer 3:

Because the operating profit will be lower when dropping customer 3, the manager will decide to keep customer 3. This analysis can also be made when you must make the choice of adding a customer.

Chapter M: Activity-based costing

M.1 Under and overcosting

The term cost smoothing is used to describe a costing method that uses broad averages to unirformly assign the costs of resources to cost objects when the individual products use those resources in a non-uniform manner.

Cost smoothing can lead to overcosting or undercosting. Undercosting occurs when a product consumes relatively high levels of resource, but is reported to have a relatively low total cost. Overcosting occurs when a product consumes a relatively low level of resources, but is reported to have a relatively high total cost.

The risks of undercosting is that organizations think they sell profitable products while they are in fact unprofitable. The risk of overcosting is losing market share to competitors, because products costs less than is reported.

Product-cost cross-subsidization is a term that illustrates that at least one product is miscosted and because of that also other products in the organization are miscosted.

M.2 Single indirect-cost pool system

To illustrate how companies use a job-system with a single indirect-cost pool, we make use of an example:

Organization Automobile makes lamps for cars. IT produces two kinds of lamps the L1 and the L2. The production processes run as follows:

1. Design of products and processes

2. Manufacturing operations

3. Shipping and distribution

Organization automobiles is working at capacity. The market for L1 is very competitive and it appeared that a new competitor could deliver L1 for a price of €50 which is below the price of automobile of €60. The market of L2 is not that competitive and automobile sells L2 for a price of €140. The manager of automobile has to decide if it will drop the production of L1 of it has to seek a manner to reduce costs drastically. To make such a decision, management first have to examine its cost to sell L1 and L2.

To assign the costs to the products, automobile makes use of a job-costing system with a single indirect-cost rate. The steps are:

1. Determine the chosen cost objects; The cost object are 60.000 units of L1 and 15.000 units of L2. The goal is to compute total costs of manufacturing and distributing these products.

2. Determine the direct costs of the products;

3. Select the costs-allocation bases to use for allocating indirect costs to the products; Automobile uses direct manufacturing labour as the only allocation base to allocate indirect costs to L1 and L2. This year 40.000 direct labour hours were used.

4. Determine the indirect costs associated with each cost-allocation base; Automobile groups all indirect costs €2.400.000 into a single overhead cost pool.

5. Calculate the rate per unit of each cost-allocation base used to allocate indirect costs;

6. Calculate the indirect costs allocated to the products; Automobile uses 30.ooo total direct manufacturing labour hours for L1 and 10.000 labour hours for L2

7. Calculate the total cost of the products by adding all direct and indirect costs assigned to them;

L1 costs 58,33 which is more than the price of €50 from the competitor. When computing margins, the managers of Automobile found that the margins on L1 were very small and the margins on L2 were very high. They found the outcome very odd, because they are very experienced in L1 and L2 they only started recently.

The managers know for sure that direct materials and direct manufacturing labour costs are assigned in the right way, but they do not no if the overhead costs are allocated in a feasible way.

M.3 Refining the cost system

A refined cost system has smaller broad averages for assigning the cost of resources to cost objects and provides better measurement of the costs of indirect resources used by different cost objects. There are four reasons why organizations refine their costing systems:

1. Increase in indirect costs

2. Increase in product diversity

3. Competition

4. Advances in information technology

The book describes three guideline for refining a costing system:

1. Indirect cost pools; the amount of pools must be expanded until each of the pools is more homogeneous. This means that the costs of the pools have the same cause-and-effect relationship with the cost allocation base.

2. Cost allocation bases; Cause-and-effect relationships must be used when determining cost allocation bases.

3. Direct-cost tracing; Categorize as many of the total costs as direct costs of the cost object as is economically feasible.

M.4 Activity-based costing

Activity-based costing (ABC) is often used to refine costing systems.ABC does this by focusing on individual activities as the fundamental cost objects. An activity can be seen as a task, an event or unit of work. We use our previous example to explain ABC more in detail.

There are 7 major activities performed in Automobile:

1. Design products and processes

2. Set up machine

3. Operate machines

4. Maintain and clean the machines

5. Set up batches for shipment

6. Distribution

7. Administration

By defining an determining the costs of performing each activity, ABC tries to work with a greater level of detail in understanding how an organization uses the resources. We will now show the difference between the old costing system and ABC, by focusing on the setup activity.

Setup data for L1 and L2:

The total costs op setups are €300.000. So, the setup costs per hour are 300.000/2000= €150

Allocating of the setup costs:

Automobile should use the setup hours as a cost allocation base, because there is a strong relationship between setup related overhead costs and setup hours, while there is almost no relationship between setup related overhead costs and direct manufacturing labour hours.

Cost hierarchies

A cost hierarchy organizes costs into several cost pools on the basis of the different types of cost driver in determining cause-and-effect relationships.

Ouput-unit-level costs are resources sacrificed on activities performed on each individual unit of a product or service.

Batch-level costs are resources sacrificed on activities that are related to a Group of units produced rather than to each individual unit of product or service.

Product-sustaining costs are resources sacrificed on activities undertaken to support individual products or services.

Facility-sustaining costs are resources sacrificed on activities that cannot be traced to individual products or services, but which support the organization as a whole.

M.5 Implementing ABC

To illustrate the implementation of ABC, we make use of our Automobile example. We follow seven steps and we make use of the guidelines that were given earlier:

1. Determine the chosen cost objects; The cost objects in our example are L1 and L2. The goal is to compute the total costs of manufacturing and distributing the products.

2. Determine the direct costs of the products;

   	Cost hierarchy category	L1 Total	L1 per unit	L2 Total	L2 per unit	Total
   Direct materials	Output-unit level	€1.100.000	€18,33	€700.000	€47	€1.800.000
   Direct mfg labour	Output-unit leven	€600.000	€10,00	€200.000	€13	€800.000
   Maintenance	Batch level	€120.000	€2,00	€150.000	€10	€270.000
   Total direct costs		€1.820.000	€30,33	€1.050.000	€70	€2.870.000

3. Select the cost-allocation bases to use for allocating indirect costs to the products; Since Automobile knows 6 different activities the activity-cost rates for the indirect-cost pools will be:

4. Determine the indirect costs associated with each cost-allocation base.

5. Calculate the rate per unit of each cost-allocation base used to allocate indirect costs to the products. This is already done in step 3.

6. Calculate the indirect costs allocated to the products;

7. Calculate the total costs of the products by adding all direct and indirect costs;.

M.6 Comparing the costing systems

The comparison is showed at page 356 of the book.

M.7 Profit management

Activity-based management describes decisions of the management that use activity-based costing information to satisfy customers and manage profitability.

Chapter N: Pricing decisions

N.1 Factors

There are three important factors that have an influence on pricing decisions:

1. Customers

2. Competitors

3. Costs

N.2 Costing and Pricing

To explain costing and pricing in the short run, we make use of an example;

A one-off special order from a customer for the next four months. Acceptation or rejection of the order will not influencer the price per unit or the units sold from existing sales outlets. And it is unlikely that the customer will place any future orders.

Data:

Capacity of the organization is 1 million products per month. Current production and sales are 700.000. The selling price is €100 per product. Costs of the organization are as follows:

Details of the fixed manufacturing overhead costs:

The question: If another company wants 150.000 products for the next 4 months and asks us and another company to bid a price. Every price above €45 will be non-competitive. What price should we bid?

In this example, only the manufacturing costs are relevant, because all the other costs will not change if the project is accepted. There are additional fixed manufacturing overhead costs incurred when accepting the project. Materials procurement costs will rise with €100.000 and the process-changeover costs will rise with €100.000.

Analysis of the relevant costs:

The relevant costs per case are then 6.350.000/150.000 = €42,33. So, any bid above €42,33 will improve the profitability of the organization of our example.

Pricing decisions are also made for the long run. To make such a pricing decision it is important for managers to obtain useful pricing-cost information.

There are different methods for long-run pricing decisions:

1. Market-based approach

2. Cost-based approach (which is also called the cost-plus method)

The market-based approach bases its price on what customers want and how competitors react to decisions of the organization.

The cost-based method bases its price on the costs of making the product and what price is needed to earn back the costs and make the desired profit.

N.3 Target Costing

A target price is the forecasted price of a product that potential customers are willing to pay for the product.

A target operating profit per unit is the operating profit that a firm wants to earn on each unit of output sold.

A target cost per unit is the forecasted long-term cost per unit of a product that, when sold at target price, enables the firm to achieve the target operating profit per product.

The relevant costs are all the costs, because an organization must recover all its costs in the long run.

Implementing and developing target pricing is done by following the following steps:

1. Develop a product that will satisfy the need of potential customers.

2. Choose a target price, based on the perceived value of the product and on the prices that competitors charge. And choose a target operating profit per unit.

3. Derive a target cost per unit by taking the target price and subtract the target operating profit per unit.

4. Perform value engineering to attain target costs.

Value engineering is a systematic evaluation of all elements of the value-chain business functions. And it has the goal to reduce the costs while simultaneously satisfying the needs of the customers.

Cost incurrence is seen when a resource is sacrificed or used up. Costing systems only recognize costs when they are incurred.

Locked-in costs or designed-in costs are the costs that have not been incurred yet and will be incurred in the future on the basis of decisions that have already been incurred.

Locked-in costs are hard to alter. So, that is the reason why we distinguish between locked-in costs and incurred costs.

An example of achieving the target costs is given in the book at page 388.

N.4 Cost-plus pricing

With this method the formula for setting price adds a markup to the cost base:

Cost base €X

Markup Y

Selling price €X+Y

Example: Organization Bestel produces a product called Value. Product costs are €800 and the organization uses a markup of 15%. So the selling price becomes:

Cost base €800

Markup €120

Selling price €920

How is the markup percentage determined? An approach to determine the markup rate is to choose one to earn a target rate of return on investment.

This is the target operating profit that an organization must earn divided by the invested capital. The chapter in the book treats the total assets as the invested capital.

When we assume that the target rate of return on investment of Bestel is 20% and the invested capital is €100.000.000. There are 200.000 units produced by Bestel. Then the target operating profit can be computed by:

Invested capital €100.000.000

Target rate of return on investment 20%

Total target operating profit €20.000.000

Target operating profit per unit €100

The markup rate is then calculated by dividing the target operating profit per unit by the full product costs per unit.

Because it is sometimes hard for organizations to determine the invested capital for producing a product, they use alternative cost bases and markup percentages that do not require the computations of the invested capital.

There are some advantages of including fixed costs per unit in making pricing decisions:

1. Price stability; Including the fixed costs will limit the ability of managers to cut prices and therefore will promote price stability.

2. Simplicity; There is no detailed analysis needed of cost behavior patterns.

3. Full product cost recovery

N.5 Life-cycle product costing

The product lifecycle is the time from the initial R&D to the time at which support to customers is withdrawn.

Life-cycle budgeting forecasts the revenues and costs attributable to each product from its initial R&D to its final customer servicing and support in the marketplace.

Life-cycle costing tracks and accumulates the actual costs attributable to each product from start to finish.

Example of life-cycle budgeting:

Organization that produces Software, assume the following budgeted amounts over a six year product life cycle:

Years 1 and 2:

R&D costs €250.000

Design costs €50.000

Years 3-6

Budgeted life cycle revenues and costs for different alternatives:

A customer-profitability analysis refers to the reporting and analysis of customer revenues and customer costs

Customer revenues are the inflows of assets from customers received in exchange for products or services being provided to those customers.

Price discounting is the reduction of selling prices below listed levels in order to encourage an increase in purchases by customers.

N.6 Customer costs

A customer cost hierarchy categorizes costs related to customers into different cost pools on the basis of different types of cost drivers of different degrees of difficulty in determining cause-and-effect relationships.

Chapter O: Capital decisions

O.1 Cost analysis

The book discusses two different dimensions of cost analysis:

1. The project dimension

2. The time dimensions

O.2 Stages

Capital budgeting entails six stages:

1. Identification stage; Which types of capital expenditures are needed to achieve the objectives of the organization?

2. Search stage; Explore several alternative capital expenditures that will accomplish the objectives of the organization.

3. Information acquisition stage; Consider the consequences of the predicted costs and the predicted consequences of alternative capital investments

4. Selection stage; Which project will be implemented?

5. Financing stage; Obtain funding for the project.

6. Implementing and control stage

Methods that help managers with making decisions about whether to implement a project or not:

1. Discounted cash flow methods

   1. Net present value method

   2. Internal rate of return method

2. Payback method

3. Accounting rate of return.

We assume that you already know the first two methods. So, only the accounting rate of return will be described.

O.3 Accounting rate of return method

The accounting rate of return (ARR) is an accounting measure of income divided by an accounting measure of investment. It is also called the return on investment.

Chapter P: Budgeting

P.1 Features

A budget is a proposed plan, expressed in quantity, by management for a future time period and is an aid to the coordination and realization of the plan.

A lot of firms follow the following budgeting cycle:

1. Planning the performance of the organization. This must be done for the organization as a whole, but also for the individual subunits.

2. Providing a frame of reference. Expectations must be set so actual results can be compared.

3. Investigation of variations from the plan.

4. Planning, with considerations to feedback and other changed conditions.

The master budget coordinates all the individual budgets into one organization-wide set of budgets.

P.2 Roles

There are four kinds of roles that budgeting can have:

1. Strategy

2. Framework for evaluating performance

3. Coordination and communication

4. Motivation

Strategy

Budgeting is most useful when it is done as an integral part of an organization’s strategic analysis.

Strategy is a description of how a firm matches his capabilities with the opportunities in the market to achieve the overall goals of the firm.

Evaluating performance

When one uses past performance to evaluate actual results there are two limitations, which budgeted performance measures do not have:

1. Past results incorporate past miscues and substandard performance

2. Future can be different from the past.

Coordination and Communication

Coordination is balancing all the elements of production and departments in order to achieve the goals of the firm.

Communication is getting those goals or objectives understood and accepted by all departments.

P.3 Types

A rolling budget is a budget that is constantly accessible for a specified future period by adding a month, quarter or year in the future as the month, quarter or year just ended is dropped.

An operating budget is the budgeted profit statement and its supporting budget schedules.

The financial budget is a part of the master budget that contains the capital budget, cash budget, budgeted statement of cash flows and the budgeted balance sheet.

P.4 Developing a budgeted operating profit statement

To illustrate how to do this, we make use of an example:

Our example is about an organization that manufactures two types of aircraft replacement parts: A and B. We assume the following in our example:

1. The sales of the two parts is the only source of revenue

2. There is no work-in-progress stock

3. We use the FIFO method to cost direct materials stock and the finished goods stock.

4. The unit costs of direct materials purchased and finished goods sold will not change.

5. Variable production costs are variable in relation to direct manufacturing labour hours. Variable non production costs are variable in relation to revenues.

6. All manufacturing costs are allocated using a single allocation base, which is direct manufacturing labour-hours, for computing inventorial costs.

Forecasts:

Manufacturing overhead costs:

Variable: €26 per direct manufacturing labour hour.

Fixed: €420.000

Other expected costs:

We will perform nine steps when we develop a budgeted operating profit statement:

1. Develop the revenue budget

2. Develop the production budget

3. Direct materials usage budget and direct materials purchases budget

4. Direct manufacturing labour budget

5. Manufacturing overhead budget

6. Closing stock budget

7. Cost of goods sold budget

8. Other costs budget

9. Budgeted operating profit statement
    

1. Developing the revenue budget

This budget must be made the first, because production and stock levels do usually depend on the forecast level of revenues.

2. Developing the production budget

3. Develop the direct materials usage budget and the direct materials purchases budget.

Direct materials usage budget in kg and euro’s:

Direct materials purchases budget:

4. Direct manufacturing labour budget

5. Manufacturing overhead budget

At a budgeted level of 30.000 direct manufacturing labour hours

6. Closing stock budget

Calculation of units costs of manufacturing finished goods

Closing stock budget:

7. Cost of goods sold budget

8. Other costs budget

9. Budgeted operating profit statement

P.5 Budgeting

Kaizen budgeting is an approach to budgeting where continuous improvement is the key word during the budget period into the resultant budget numbers.

Activity-based budgeting has a focus on the cost of activities necessary to produce and sell products. This type of budgeting entails four key steps:

1. Find out the budgeted costs of performing each unit of activity.

2. Find out the demand for each individual activity.

3. Compute the costs of performing each activity.

4. Describe the budget as costs of performing various activities.

P.6 Responsibility accounting

The structure of an Organization is an arrangement of lines of responsibility eithin the entity.

A responsibility centre is a subunit of an organization, whose manager is accountable for a specified set of activities.

Responsibility accounting is a system that measures the plans and actions of each responsibility centre. Four types of responsibility centers are:

1. Cost centre

2. Profit centre

3. Revenue centre

4. Investment centre

Controllability is the degree of influence that a specific manager has over costs, revenues or other items in question.

A controllable cost is any cost that is primarily subject to the influence of a given manager of a given responsibility centre for a given time span.

Chapter Q : Variances

Q.1 Mix variances

Example: An organization makes orange juice. To make this juice, three types of oranges are needed; Type 1, 2 and 3. To produce 1 ton of juice, the following direct materials input standards are:

0,8 (50%) ton A at €70 per ton €56

0,48 (30%) ton B at €80 per ton €38,40

0,32 (20%) ton C at €90 per ton €28,80

Total standard costs of 1,6 ton oranges €123,20

Budgeted costs per ton of oranges are €123,20 / 1.6 ton = €77.

There is no stock of oranges. So, all price variances relate to oranges purchased and used.

Actual results:

3250 ton A €227.500

2275 ton B €186.550

975 ton C €93.600

6500 ton oranges €507.650

Standard cost of 4000 ton of orange juice at €123,20 per ton = €492.800

Total variance €14.850 Unfavorable

Applying the standard ratio of 1.6 ton of oranges to produce 1 ton of orange juice, 6400 instead of 6500 ton of oranges should be used. Quantities of each type should be:

A 0,50*6400= 3200

B 0,30*6400= 1920

C 0,20*6400= 1280

Direct materials price and efficiency variances in the orange juice case:

Q.2 Total direct materials yield and mix variance

In our example:

Q.3 Direct manufacturing labour yield and mix variances

To illustrate these variances we make use of our example. There are three grades of direct manufacturing labour: Grade 1, 2 and 3.

Budgeted costs for August 2008 are:

900 hours Grade 1at €12 €10.800

2100 hours Grade 2 at €16 €33.600

3000 hours Grade 3 at €24 €72.000

6000 total hours €116.400

Actual results:

885 hours Grade 1 at €13 €11.505

1770 hours Grade 2 at €18 €31.860

3245 hours Grade 3 at €23 €74.635

5900 hours total €118.000

Direct manufacturing labour price and efficiency variances:

Direct manufacturing labour yield and mix variances:

Q.4 Revenue and sales variances

To illustrate this, we again use an example.

Budgeted results for July 2009:

Actual results:

Static-budget variance

In our example:

Flexible-budget variance

In our example:

Sales-volume variance

In our example:

Sales-quantity variance

In our example:

Sales-mix variance

In our example:

Market-size variance

Market-share variance

Chapter R: Transfer pricing

R.1 Management control systems

A management control system has the goal to gather and use information to aid and coordinate the process of making planning and control decisions throughout the organization and to guide employee behavior. This system has the objective to improve the collective decisions that are made within the firm.

The information that is needed for management control is gathered and reported at different levels in the organization:

1. Total organization level; For example the stock price or the total employment.

2. Customer or market level; For example customer satisfaction.

3. Individual facility level; For example labour costs, or the amount of absenteeism.

4. Individual activity level; For example scrap rates or the number of sales transactions.

Management control systems should be aligned to the strategies and the goals of an organization. A management control system should also be designed to fit the organization’s structure and the decision making responsibility of individual managers. Thirdly, an effective management control system must have the ability to motivate managers and employees. Motivation is the desire to achieve an objective and having a resulting drive towards that objective.

Goal congruence is attained when individuals and groups work towards the objectives, that top management desires, of an organization

Effort is the exertion towards the objective, it includes physical and mental aspects.

R.2 Decentralization

With Decentralization, also the managers at lower levels of the hierarchy in an organization, have the power to make decisions themselves.

Decentralization has the following advantages:

1. It creates an increased responsiveness to local needs; Because the right information leads to good decisions, managers at lower levels can make better decisions than the top managers. Because the lower managers are better informed about their customers, competitors and factors that have an influence on the performance of jobs.

2. Its lead to a quicker manner of decision making; Because of this increased speed in decision making, firms can attain a competitive advantage over other firms.

3. It increases motivation.

4. It aids development and learning with managers

5. It sharpens the focus of managers

There are also several disadvantages of decentralization:

1. It leads to suboptimal decision making, which is also called incongruent decision making. Incongruent decision making is the case, when the decisions made at a subunit is more than offset by the costs or loss of benefits to the organization as a whole.

2. It leads to duplication of activities.

3. The attention of the managers is more focused on the subunit than on the organization as a whole.

4. It leads to higher costs of gathering information.

To measure the performance of each subunit, the management control system uses one or more of the four types of responsibility:

1. Cost centre; the manager is only accountable for the costs

2. Revenue centre; Only for revenues

3. Profit centre; Only for profits

4. Investment centre; The manager is accountable for investments, costs and revenues.

R.3 Transfer pricing

An intermediate product is a product that is distributed from one subunit to another within one organization.

A transfer price is the price that a subunit charges for the product or service he delivered to another subunit.

Normally, three different methods can be used for determining transfer prices:

1. Cost based transfer prices; basing the price on the costs of that product

2. Market based transfer prices; using the price of a similar product

3. Negotiated transfer prices; this happens when subunits are free to negotiate the transfer price between themselves or if they are involving with external parties.

Autonomy is the degree in which one is free to make decisions.

R.4 Market based transfer pricing

Transferring products at market prices, normally leads to optimal decisions if three conditions are present:

1. The intermediate market is perfectly competitive

2. Interdependencies of subunits are minimal

3. There are no additional costs or benefits to the corporation as a whole in using the market instead of transacting internally.

We speak of a perfectly competitive market when there is a homogenous product with equivalent buying and selling prices and no individual buyers or sellers can affect those prices by their own actions.

R.5 Cost based transfer pricing

This method can be of use, when there are no comparable prices of similar products available.

Many organizations base their transfer prices on full costs. However, these transfer prices can lead to inefficient decisions. For an example, see the book at page 624 and 625.

Dual pricing uses two different transfer pricing methods to price each interdivisional transaction. For example, when the selling division receives a full cost plus markup based price and the buying division pay the market price for the internally distributed products.

R.6 Guideline

Chapter S: Performance Evaluation

S.1 The balanced scorecard

The most balanced scorecards measure the following elements:

1. Profitability

2. Customer-satisfaction

3. Internal measures

4. Innovation

S.2 Design

When designing an accounting-based performance measure, one must entail the following steps:

1. Choose the variables that represent the financial objectives of top management.

2. Choose definitions of the items included in the variables in step 1.

3. Choose measure for the variables in step 1

4. Choose a target against which you can compare results.

5. Choose the timing of the feedback.

S.3 Performance measures

To illustrate all the performance measures we use organization Hotel as an example. Organization Hotel operates whit three hotels A, B and C.

Annual financial data:

Return on Investment

This performance measure is one of the most popular measures, because it uses all the important features of profitability.

The ROI is more helpful when we divide it into the following components. This approach is known as the DuPont method of profitability analysis:

In our example the ROI becomes:

Residual income

In our example, when we assume the required rate of return to be 12%:

Economic value added (EVA)

The weighted average cost of capital is the after tax average cost of all the long-term funds used by Hotel. Suppose that the cost of equity capital is 15% and the costs of debt is

The WACC in our example is then:

The computations of EVA in our example are:

Return on sales

This measure is one component of the DuPont analysis.

For our example:

S.5 Definitions

When companies design an accounting based performance measure they use different definitions of investment in step two:

1. Total assets available

2. Total assets employed

3. Working capital (current assets minus current liabilities)

4. Shareholders equity

S.6 Other performance measures

Current cost is the cost of purchasing an asset today identical to the one currently owned. In the book you can see that using current costs, the ROI will change.

S.7 Levers of control

A diagnostic control system help a manager diagnose if a company is performing according to standards.

Boundary systems give employees and managers standards of behavior and codes of conduct that are expected of every employee and managers

Belief systems describe the mission, vision, purpose and core values of the firm. They articulate the norms of behavior that is expected from all employees and managers.

Interactive control systems are information systems that help managers in focusing learning and the attention of the organization on the key strategic issues of the organization.

Chapter T: Quality

Quality knows many different descriptions. Normally, quality is referred to as quality of design and conformance quality.

Quality of design measures how closely the features of products or services match the needs and wants of the customers.

Conformance of quality is the performance of a product or service according to design and production specifications.

T.1 Costs

Costs of quality are the costs of preventing, or costs that arise with the production of a low-quality product. These costs are categorized into 4 categories:

1. Prevention costs

2. Appraisal costs

3. Internal failure costs

4. External failure costs

The costs of quality can be determined with a 5 step approach:

1. Identify all quality related activities and activity cost pools

2. Determine the quantity of the cost allocation base for each quality related activity.

3. Compute the rate per unit of each cost allocation base

4. Compute the costs of each quality related activity by multiplying the quantity of the cost allocation base by the rate per unit of the cost allocation base

5. Obtain the total costs of quality by adding the costs of all quality related activities in all value chain business functions

T.2 Identifying quality problems

Statistical quality control (SQC) distinguishes between random variation and non-random variation in an operating process. A control chart is a tool that is often used in SQC. A control chart is a graph of series of success observations of a specific procedure taken at regular intervals of time.

A pareto diagram shows how often each type of failure occurs.

A cause-and-effect diagram illustrates potential causes of failures. Firstly, the causes that occur the most are analyzed. The cause-and-effect diagram is also called a fishbone diagram. Research showed, that managers in US electronics companies considered the following features as the most important in contributing to improvements of quality:

1. Better process design

2. Improved product design

3. Improved products from suppliers

4. Better training of operators

5. Investments in technology and equipment

T.3 Non-financial measures

There are different measures to measure customer satisfaction, for example:

• On time delivery rate

• Percentage of products that experience early or excessive failure

• Number of defective units shipped to customers as a percentage of total units shipped.

T.4 Evaluation of quality performance

The advantages of costs of quality (COQ) measures are:

• COQ pays attention to the high costs that poor quality can have

• Financial COQ measures can compare different quality improvement programmes and setting standard or goals for achieving the highest cost reduction as possible.

• Financial COQ serves as a common denominator for evaluating trade-offs among prevention and failure costs.

The advantages of non-financial measures are:

• The quality is easy to quantify and understand

• There is a direct attention for the physical processes and on the exact problem that needs the attention from management

• Delivers intermediate short run feedback on whether or not quality improvement are working in the right way.

T.5 Theory of constraints

The theory of constraints (TOC) illustrates approaches to maximize operating profit when faced with bottleneck operations. It defines three types to measuring:

1. Throughput contribution

2. Investments

3. Operating costs

The goal of TOC is to higher the throughput contribution, while lowering the investments and operating costs. The steps in managing the bottlenecks are:

1. Recognize that the bottleneck resource determines throughput contribution of the whole plant.

2. Find the bottleneck resource

3. Be sure that the bottleneck is always busy and subordinate all non-bottlenecks to the bottleneck.

4. Increase the efficiency and the capacity of the bottleneck resource; there are many ways to take care of this, for example:

   1. Eliminate idle time; this is the time the machine is neither being set up to process products nor actually processing products.

   2. Shift products that do not have to be made on the bottleneck machine to other non-bottleneck resources or to outside facilities.

   3. Process only those parts or products that increase sales and the throughput contribution.

   4. Reduce setup time and processing time at bottleneck resources.

   5. Improve the quality of parts or products manufactured at the bottleneck resource.

Throughput accounting is a management tool which is partly informed by the TOC. Its focus is on the rate at which a business can earn profits. And a key feature is the focus on the return per bottleneck, which underscores an important management accounting concern to maximize contribution per unit of a given limiting factor.

Chapter U: Just-in-time

U.1 Systems

Just-in-time systems are systems in which materials arrive exactly as they are needed. A key feature of just-in-time is just-in-time production. Just-in-time production is a system where each element on the production line is produced immediately as needed by the following step in the production line.

Kanban is a visual card. In a kanban system , employees at one operation use a card to signal those at another process to produce a specified amount of a specific part.

U.2 Features

A just-in-time system has 5 main elements:

1. Production is organized in manufacturing cells, which is a grouping of all the different types of equipment used to manufacture a given product.

2. Workers are trained to be multiskilled so that they are capable of performing a variety of operations and tasks.

3. Total quality management is exercised to eliminate defects.

4. The focus is on eliminating the setup time, which is the time that is needed to get equipment, tools and materials ready to start the production of a component or product. The focus is also on manufacturing lead time, which is the time from when an order is ready to start on the production line till when it becomes a finished good.

5. Suppliers are carefully selected to obtain delivery of quality tested parts in a timely way.

Computer-integrated manufacturing CIM is a method to reduce the setup time. In plants with this system, a computer gives instructions that automatically setup and run equipments.

Just-in-time purchasing is the purchase of goods or materials such as that delivery immediately precedes demand or use.

Just-in-time production has many financial benefits, for example:

• Lower stocks

• Less space is needed for stocks

• Reduction in setup costs

• Decreasing costs of carrying and handling stocks

• Reductions in paperwork

U.3 Managing goods for sale

Accounting information plays an important role in stock management. We discuss the importance of accounting information in retail organizations.

The next costs are important when managing stocks and goods for sale:

1. Purchasing costs; These costs consist of the costs of goods acquired from suppliers. This costs are normally the highest costs.

2. Ordering costs; These costs consist of the costs of preparing and issuing a purchase order.

3. Carrying costs; The costs consist of the costs of stock held for sale. These costs also include the opportunity cost of the investment tied up in stock and the costs associated with storage.

4. Stockout costs; These costs occur when a company runs out of a particular item for which there is customer demand.

5. Quality costs; With this cost, there are four categories:

   1. Prevention costs

   2. Appraisal costs

   3. Internal failure costs

   4. External failure costs

U.4 Economic order quantity decision model

The economic order quantity decision model EOQ computes the optimal amount of stock to order. The simplest model only takes into account the ordering costs and the carrying costs. EOQ assumes the following:

• The same fixed amount is ordered at each reorder point

• Demand, ordering and carrying costs are certain. The purchase order lead time is the time between the placement of an order and its delivery. This time is also certain.

• Purchasing costs per unit are unaffected by the amount ordered.

• No stockouts occur.

• When management must decide on the amount of the purchase order, management only considers the cost of quality to the extent that these costs affect ordering costs or carrying costs.

Where;

C=Relevant carrying costs of 1 unit in stock for the time period used for D.

D=Demand in units for a specified time period.

P=Relevant ordering costs per purchase order.

U.5 Just-in-time purchasing

Just-in-time purchasing is the purchase of goods or materials such that a delivery immediately precedes demand or use.

Chapter V: Strategic management accounting

V.1 Concept

When an organization formulates its strategy, an organization must understand the industry in which it operates. The analyses of the industry can be done by using Porters model. This model gives an analysis of 5 forces:

1. Competitors

2. Potential entrants to the market

3. Equivalent products

4. Bargaining power or customers

5. Bargaining power of suppliers

There are two main strategies that a company can adopt:

1. Product differentiation

2. Cost leadership

Product differentiation is the ability of the organization to offer products or services that are perceived by its customers to be superior and unique in comparison to those of its competitors.

Cost leadership is the ability of an organization to achieve lower costs in comparison to its competitors through productivity and efficiency improvements, elimination of waste, and tight cost control.

V.2 Definition

According to CIMA (2000), Strategic management accounting is a form of management accounting in which emphasis is placed on information which relates to factors external to the firm, as well as non-financial information and internally generated information.

V.3 The balanced scorecard

The balanced scorecard translated the mission and vision of an organization into a comprehensive set of performance measures that provides the framework for implementing its strategy. It does not focuses solely on financial goals. It measures the performance of a company on four key perspectives:

1. Financial

2. Customer

3. Internal business processes

4. Learning and growth

Reengineering is the fundamental rethinking and redesign of business processes in seeking to achieve improvements in critical measures of performance.

The third element of the balanced scorecard, internal business processes, can be categorized into three sub processes:

1. The innovation process

2. The operations process

3. After-sales service

A good balanced scorecard has different elements:

1. It shows the strategy of an organization by articulating a sequence of cause-and-effect relationships.

2. It help communicate the strategy to all members of the organization by translating the strategy into a coherent and linked set of understandable and measurable operational targets.

3. The balanced scorecard focuses in financial goals and measures.

4. It limits the number of measures used by identifying only the most critical ones.

5. It highlights supoptimal trade offs that managers may make when they fail to consider operational and financial measures together.

There are also a few possible pitfalls when implementing the balanced scorecard:

1. Do not assume the cause-and-effect relationship to be precise, because they are merely hypotheses.

2. Do not seek improvements across all of the measures all the time.

3. Do not use only objective measures in the balanced scorecard.

4. Do not fail to consider both costs and benefits of initiatives such as spending on information technology and R&D before including these objectives in the balanced scorecard, because management will otherwise focus on measures that will not result in overall long-run financial benefits.

5. Do not ignore non-financial measures when evaluating managers and employees, because this will reduce the significance and importance that managers give to non-financial measures.

The tableau de bord is used as a performance measurement and control approach by a lot of organizations. It is a management tool, which looks a bit like the balanced scorecard.