Management Accounting Flashcards
three rationales of management accounting
planning, decision-making, and controlling
define a relevant cost
list the three criterias a cost must qualify to be relevant
a cost that is going to be affect by a particular decision
its for one-off decisions
For a cost to be relevant it has to satisfy three criteria:
- Has to be a cashflow
- Has to be in the future
- There has to be a difference (increment)
Examples:
- an additional cash inflow
- an additional cash outflow
- an existing cash inflow lost
- an existing or potential cash outflow saved or avoided
non-relevant costs
+ examples
a cost will remain unaltered regardless of the decision
- Sunk or past costs
- Fixed overheads
- Committed costs
- you’ve already signed a contract, hence can’t change it
- Depreciation
- because it is not cashflow
opportunity cost
the loss of other alternatives when one alternative is chosen
a special type of relevant cost
avoidable costs
if it can be avoided, it’s a relevant cost
(Costs of an activity or sector of a business which would be avoided if the activity or sector did not exist.)
differential / incremental cost
- The difference in total costs between alternatives
- Useful to highlight the consequences
It’s the difference between the cost of two alternative decisions, or of a change in output levels. The concept is used when there are multiple possible options to pursue, and a choice must be made to select one option and drop the others.
analysing the cost of an item (formula)
a physical quantity measurement x a price measurement
Example
To manufacture Product X, we need 200 hours of labour time at a rate of £4 per hour. Labour cost = £800
(physical quantity is hours)
Variable costs vs. Fixed Costs
Variable costs increase in direct proportion to the increased level of activity.
Fixed costs do not vary whatever the level of activity, in the short-run.
Direct Costs vs. Indirect Costs
-
Direct costs are directly traceable to an activity of the business
- Costs directly related to a product, or a service, or a location
-
Indirect costs are spread over a number of activities of the business
- Costs not directly related to a product, or service, or location and have to be apportioned on a basis
Product Costs vs. Period Costs
Product costs (manufacturing costs) are costs associated with goods or services purchased, or produced, for sale to customers.
- These include direct materials, direct labour, and indirect manufacturing costs such as salaries for timekeepers, supplies of materials for repairs and maintenance
Period costs (non-manufacturing costs) are those costs which are treated as expenses in the period in which they are incurred.
- These costs are not included in the cost of sales (like a temporary external consulting task force)
- Examples: administrative and marketing costs
cost centers
- Something you want to find a cost for.
- A unit of organisation in respect of which a manager is responsible for costs under his or her control
- A location, or a function, or a group of machines
- Must be a homogeneous unit carrying out a single form of activity
profit centers
- Something you want to find out the cost and revenue.
- A unit of organisation in respect of which a manager is responsible for revenue and costs
investment centers
- Where the manager has autonomy on where and how the finance of an activity takes place.
- Should I expand oversees, open a new factory?
- A unit of organisation in respect of which a manager is responsible for capital investment decisions, revenue and costs
prime costs
costs directly traceable to the relevant jobs / each unit of product
(cutting glass for the phone)
aim of (traditional) absorption costing
Trying to attach indirect costs to the product.
- rent
- supervisor’s salary
The manufacturing overheads will be spread across a range of jobs, not directly traceable to each individual job.
Problems arise when we try to allocate the production overheads to the jobs.
absorption costing: allocate
assign a whole item of cost/revenue to a single cost unit, centre, account
Allocating should be the first thing to do, if enough information is available.
absorption costing: apportion
where there isnt enough data to allocate, spread costs over two or more cost units, centres, accounts
absorption costing: absorb
absorb (take onboard) overhead costs into products or services
absorption costing: three steps overview
- allocate/apportion indirect costs/production overheads to the cost centres
- apportion service cost centre to production cost centre
- absorb overhead costs into product
Limitations of Absorption Costing
- Major difficulty in traditional costing is the inclusion of fixed costs (attaching the heating cost to the product)
- Methods used to apportion these costs are arbitrary/subjective
- Different O/H base resulted in different O/H rates, resulted in different departmental costs and product costs
marginal costing aka. variable costing
Marginal costing assigns only the marginal costs (direct costs), costs which vary with the level of production, to the products.
Marginal costing is about decision-making, especially concerning short-term decisions - a lot better than absorption costing.
The main difference between absorption costing and marginal costing approach is the way we treat the Indirect Manufacturing Costs.
For absorption costing, we will apportion and absorb the Indirect Manufacturing Costs into the product to arrive at the Production Costs.
But for Marginal Costing, the Indirect Manufacturing Costs are treated as Period costs, not as part of the Product Costs.
Under marginal costing, the indirect manufacturing costs will be treated as ‘Other Expenses’, and will not be charged to the product to form part of the ‘Cost of good sold / Production Costs’
marginal costing and production costs
Marginal Costing will only take into account the PRIME COSTS as the PRODUCTION COSTS. Because prime costs are all directly traceable to each unit of product, in other words, each time when there is a change in the level of production, the direct costs will change. So we can also say that the marginal costing only takes into account all the variable costs, all the fixed costs will be treated as period costs rather than as the indirect manufacturing costs.
So marginal costing emphasises on differentiating between fixed and variable costs, product and period costs.
variable costing and break-even point
It emphasises the behaviour of fixed and variable costs, helps to predict cash flows in relation to sales volume, helps to correlate fluctuations in cash flows with fluctuations in sales volume
break-even point: why seperate fixed and variable costs
Fixed and variable costs need to be separated so that volume and variable costs can be manipulated to determine the changes in profit.
And because fixed costs remain the same at least in the short term, the fixed and variable costs are separated so that managers can play with the production and sales volume and variable costs to find out how much revenue they have to earn to make a profit.
calculating break-even point
1) break-even point (units) = fixed costs / contribution per unit
- to calculate much revenue do you need to make: break-even point units x selling price
2) break-even point (monetary) = fixed costs / contribution margin ratio
assumptions during break-even analysis
- Fixed costs remain constant
- Variable costs vary proportionally with volume of output
- All other factors remain unchanged.
- E.g., selling prices remain constant,
- methods and efficiency of production unchanged,
- volume is the sole factor affecting costs
- All units produced are assumed to be sold.
- All fixed costs must be stable in a CVP analysis.
- All changes in expenses occur because of changes in activity level.
affect of changing fixed costs on A) contribution margin ratio B) net profit
only net profit is affected
using this formula:
break-even point = fixed costs / unit contribution margin*
*selling price per unit - variable cost per unit
affect of changing variable costs on A) contribution margin ratio B) net profit
both net profit and contribution costs affected
using this formula:
break-even point = fixed costs / unit contribution margin*
*selling price per unit - variable cost per unit
affect of changing selling price on A) contribution margin ratio B) net profit
both net profit and contribution margin
using this formula
break-even point = fixed costs / unit contribution margin*
*selling price per unit - variable cost per unit
margin of safety (MOS)
measures the difference between current sales, where you are right now, and the break-even point, expressed as a %
(current sales - break-even point) / current sales
x 100
Limitations of Break-even analysis (CVP)
- The relationship between sales income and activity (quantity sold) may not be linear.
- Discounts, for example, influence the analysis
- The relationship between total costs and activity (quantity produced) may not be linear.
- economies of scale is not linear often
- It is dangerous to use CVP analysis outside the relevant range of activity. (fixed costs remain constant with a certain level of units)
- fixed costs only stay constant within a relevant range
- It is assumed that costs are matched to income, i.e. there is no increase or decrease in stock levels over the period. (everything you made you sold, which is unrealistic)
- the analysis assumes everything is sold
- With multi-product businesses there may be different breakeven points are produced for different sales mixes.
- can be done, but more complicated
- It is difficult to measure activity for ‘jobbing’ businesses where every item produced is different (e.g. construction of houses) firm).
- when building a house
operating gearing
refers to the proportion between Variable and Fixed Costs within Total Costs
Where fixed costs are high, greater volume activity is required for profits to increase. A small fall in sales will cause a disproportionately greater fall in profits.
Thus, a fall in sales of say 5% could, where fixed costs are high, result in profits falling by substantially more than 5%.
When sales are booming, profits will rise to a greater extent.
decisions using variable costing
(how to decide go-no-go)
The question is not does it make a profit or not, but does it make a positive contribution.
- Close down or continue operations
- Scarce resource and choice of activities
- Make-or-buy
The underlying basic assumption is that fixed costs cannot be eliminated in the short term.
- It would be wrong, as a general principle, to cease an activity that is making an accounting loss provided it is making a positive contribution.
- Stopping an activity would mean that less of the fixed costs were covered by contribution and the loss would be greater than before – in the short term.
- In cost terms, only close down if fixed costs saved are greater than contribution lost.
To maximise profit, maximise contribution.
formula for contribution per unit
contribution per unit = selling price per uni — variable cost per unit
limiting factor
any factor in short supply stopping the organisation from expanding its activities
- sales volume
- machine supply
- skilled labour
- raw materials
single limiting factor
Decision rule when introduced a single limitig factor:
Maximise the contribution per limiting factor (not per unit)
SEE EXAMPLE IN PPT LECTURE 8
The internal/external dilemma
Sub-contract or do it in-house?
Make or Buy?
The core principle is to compare the variable cost of manufacturing with the cost of buying the item from an outside supplier.
Other considerations include reliability of supply, quality of manufacturing, future price changes, etc.
budgets
In accounting, a budget is a plan for 12 months or less expressed in monetary terms (income & expenditure). It’s an allocation of scare resources.
A long-term plan leads on to a collection of short-term operational budgets.
how is budgeting related to planning and control
Management accounting is about planning, decision making and control.
Planning - co-ordinated and comprehensive plan for the whole business
Control - budgets guides managers, and enables comparison between planned/actual
limiting factors and budgeting
The first thing to establish is what the limiting factors are in the firm (probably the sales and production levels can’t be pushed above certain levels)
2 ways to estimate the sales / revenue (sales budget)
- Make a forecast based on the current economic conditions, goods sold by the company, and the actions taken by the competitors
- Internal forecast: ask the salesperson to estimate the sales in their own areas, then prepare the total estimation
production budget
Sales – Opening Stock + Closing Stock* = Production
*buffer stock
Production budget comes after sales budget
When preparing the production budget, the first thing to be settled is the level of closing stock
cash budget
A cash budget is needed to inform us about:
- Whether there will be a deficiency / shortage
- will the cash receipts are enough to cover all the cash payments
- When it will occur
- How much cash is needed to cover the shortage
The timing of all the cash receipts and cash payments are rarely at the same time
master budget
links the various budgets together at the end
including
- sales budget
- production budget
- cash budget
- administration expense budget
- manufacturing overhead budget
- direct labour budget
- purchases budget
Static vs. Flexible Budget
static budget - what was planned
flexible budget - adjusting for what actually happend
- taking the actual output (e.g. sales) and multiplying them with the rest of the budget elements
developing a flexible budget
- Identify the actual quantity of output
- Calculate the flexible budget for revenues based on budgeted selling price and actual quantity of output
- Calculate the flexible budget for costs based on budgeted variable cost per output unit, actual quantity of output, and budgeted fixed costs
Benefits of Budgeting
- Strategic planning and implementation of plans (milestones)
- Framework for judging performance (comparing planned vs. actual)
- Motivating managers and employees (budget targets not too easy, not too difficult)
- Co-ordination and communication (everyone orientates according to the budget goals)
Problems of Budgeting
Unrealistic targets de-motivate managers and employees (zero-sum challenge)
Participating in budgeting encourages a sense of belonging (motivation theory: more responsibility –> performance)
Problems arise when people see negative feedback as criticism of their work
Budget slack - managers tend to build in spare resources that allows lapse from actual performance (to get bonus)
(No cohesion within the group, individual performance will be affected
Politics - power struggle and rivalry actions when formulating the budgets)
the steps to calculate the optimum production plan when a single limiting factor is present
- identify the limiting factor (scarce resource)
- calculate the contribution per unit for each product
- calculate the contribution per unit of the limiting facotr for each product
- rank the products according to step 3
- allocate resources according to the ranking
alternatively
- determine maximum sales
- determine limiting factor
- calculate the contribution per unit of output for each product
- calculate the contribution per unit of the limiting facotr for each product
- rank products
- cacluclate production quantities
what is the decision rule when a single limiting factor is present
If a company sells multiple products and there exists a single limiting factor, which products should be produced at what quantities to maximise profit?
Maximise the contribution per limiting factor, not simply by unit.
other words for absorption costing
full costing
full absorption method
define absorption costing
Absorption costing means that all the indirect costs (fixed overhead, supervisor salary, etc.) will be inlcluded in the cost of unit.
Hence the name, full costing.
Reasons why managment would want to know the full cost of their products
- More realistic pricing for the products, as all costs are included
- More accurate profit calculation in the case of future sales, compared to variable costing
- Required for preparing external financial reports and valuing the inventory
- Avoids the seperation of costs into fixed and variable
- Uncovers inefficiencies of utilising resources (under-absorption, over-absorption of overheads)
- Aids managers identify cost centers
- Helps calculate gross profit and net profit seperately in the income statemtent
Problems associated with absorption costing
1. Difficulty in comparison and control of costs:
Absorption costing is dependent on level of output; so different unit costs are obtained for different levels of output.
An increase in the volume of output normally results in reduced unit cost and a reduction in output results in an increased cost per unit due to the existence of fixed expenses.
This makes comparison and control of cost difficult.
2. Not helpful in managerial decisions:
Absorption costing is not very helpful in taking managerial decisions such as selection of suitable product mix, whether to buy or manufacture, whether to accept the export order or not, choice of alternatives, the minimum price to be fixed during the depression, number of units to be sold to earn a desired profit etc.
3. Cost carried over because of fixed cost included in inventory valuation:
In absorption costing, a portion of fixed cost is carried forward to the next period because closing stock is valued at cost of production which is inclusive of fixed cost.
4. Fixed cost inclusion not justified:
Many accountants argue that fixed manufacturing, administration and selling and distribution overheads are period cost and do not produce future benefits and, therefore, should not be included in the cost of product.
5. Apportionment of fixed overheads by arbitrary, subjective methods:
The validity of product costs under this technique depends on correct apportionment of overhead costs.
But in practice many overhead costs are apportioned by using arbitrary methods which ultimately make the product costs inaccurate and unreliable.
6. Not helpful for preparation of flexible budgets:
In absorption costing no distinction is made between fixed and variable costs. It is not possible to prepare a flexible budget without making this distinction.
Cost-Volume-Profit Analysis
Break-even analysis: it looks at the impact that varying levels of costs and volume have on operating profit.
fixed costs / contribution margin
