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ACCA Paper F2Management Accounting

For exams in 2010

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Notes

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ExPress NotesACCA F2 Management Accounting

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Contents

About ExPress Notes 3

1. The Nature and Purpose of Cost andManagement Accounting

7

2. Cost Classification, Behaviour and Purpose 103. Business Mathematics and Computer

Spreadsheets12

4. Cost Accounting Techniques 145. Budgeting and Standard Costing 236. Short-term decision-making techniques 35

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Chapter 1

The Nature and Purpose of Cost andManagement Accounting

The Characteristics of Good Information

The qualities of good information can be summarized in the word ACCURATE:

Accurate, Complete, Cost-beneficial, User-targeted, Relevant, Authoritative, Timely and Easy to use

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Responsibility centres

Cost centres: Responsible for current expenses only

Revenue centres: Responsible for revenues, but not current expenses other than marketingexpenses

Profit centres: Responsible for revenues and current expenses

Investment centres: Responsible for revenues, current expenses and capital expenditure

KEY KNOWLEDGE

Management Accounting

The process of identification, measurement, accumulation, analysis, preparation,interpretation and reporting of information used by management to set targets, planresource allocation, evaluate investment choices and monitor/control the operatingperformance and the orderly conduct of the business.

Differences in purpose and scope, compared to Financial Accounting

Aimed at internal users (as opposed to financial accounting, which is aimed atexternal stakeholders)

Focused on present and future performance (as opposed to financial accounting,which reports past performance)

Not required by law and not regulated by accounting frameworks (as opposed tofinancial accounting, which is a legal requirement and is regulated by accountingframeworks)

Cost Centres Profit Centres Investment CentresRevenue Centres

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Focused on specific areas or activities (as opposed to financial accounting, whichprovides a holistic view of companys performance)

Employs non-financial indicators as well financial, while financial accounting usesonly financial measures.

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Chapter 2

Cost Classification, Behaviour andPurpose

In financial accounting, it is a convention to break down costs into:

KEY KNOWLEDGEProduction vs. Non-Production costs

Production costs: These are costs (both direct and indirect, also variable and fixed) which

relate to the production of goods; this is also referred to as manufacturing or factory cost. It

is these costs, accumulated, which provide the value at which goods are placed in inventory

(prior to sale) and form the cost of goods value when sold.

Non-production costs: These are expenses that are incurred independent of production and

include administrative, selling, distribution and finance costs. These costs can have thecharacter of period costs, as they relate to the period of time in which they occur.

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KEY KNOWLEDGE

Direct vs. Indirect costs

Direct costs: are costs that can be directly attributable to a product.

Indirect costs: these are costs that cannot be directly attributable to a product.

KEY KNOWLEDGE

Fixed vs. Variable costs

Fixed costs: are costs that remain constant regardless of the volume of production. A variety

of indirect costs are fixed.

Variable costs: vary in proportion with the volume produced. Direct costs are by their nature

variable in behaviour.

Although a variable cost increases with the level of activity, the variable cost per unit

remains fixed, while a fixed cost per unit falls with a rise in the level of activity.

Other types of costs:

Mixed costs: these are costs that contain a fixed and a variable element.

Step costs: costs that remain fixed within a defined range of production, but at a certain

level of output increase in a significant way to a new (fixed) level.

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Chapter 3

Business Mathematics and

Computer Spreadsheets

Expected Value

This is the average of possible outcomes weighted by the probability of each outcome.

Profit/(Loss) ProbabilityExpectedValue

340 10% 34.0

766 20% 153.2

278 50% 139.0

450 18% 81.0

-230 2% -4.6

100% 402.6

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Chapter 4

Cost Accounting Techniques

Materials

The ordering, receiving and issuing of materials from inventory must be controlled according

to procedures and documented at all stages with forms appropriate to the purpose.

The controls and procedures are designed to monitor inventory movements so as to

minimise discrepancies and losses and theft.

Economic Order Quantity

This is a method which seeks to minimize the costs associated with holding inventory.

To determine the total costs, the following data is required:

Q = order quantity

D = quantity of product demanded annually

P = purchase cost for one unit

C = fixed cost per order (not incl. the purchase price)

H = cost of holding one unit for one year

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The total cost function is as follows:

Total cost = Purchase cost + Ordering cost + Holding cost

which can be expressed algebraically as follows:

TC = P x D + C x D/Q + H x Q/2

It is this total cost function which must be minimized.

Recognizing that:

PD does not vary; Ordering costs rise the more frequently one places (during the year); and Holding costs rise the fewer times one places orders (due to larger quantities being

ordered each time),

It follows that there is a trade-off between the Ordering and the Holding costs.

The optimal order quantity (Q*) is found where the Ordering and Holding costs equal each

other, i.e.

C x D/Q = H x Q/2

Rearranging the above and solving for Q results in

Labour

Direct labour refers to work which is directly involved in the manufacture of a product.

Indirect labour (e.g. the supervisors salary or that of a security guard) forms part ofoverhead costs.

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Absorption Costing

This is one method which seeks to make the link between overheads and (product) cost

units. The diagram below provides a useful roadmap.

Total Production Costs

Direct Costs Indirect costs (overheads)

2. Allocate/Apportion to Cost Centers

Production A Production B Service C

1. Allocate

3. Reapportion fromService to Production

Production A Production B

4. Absorb

Cost Unit

The focus (above) is production. Overhead costs that are not incurred at the time of

production do not find their way into inventory.

It is useful to think of production costs as being those that end up as part of the inventory

(valuation) while other (non-production) costs are incurred outside, and normally after the

product leaves inventory.

Contribution

Contribution is defined as the difference between Sales revenue and the marginal cost of

sales, or

Contribution = Sales Variable costs (both production and non-production)

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Marginal costing

A marginal approach to costing focuses on the variable (marginal) costs generated in a

business and considers fixed costs as period costs. This allows the company to be able toquantify the amount by which its costs rise, if it produces/sells an additional unit of output.

Example

Below is data on a manufacturing company.

Selling price (per unit): 120

Cost card (per unit):

Direct materials 45Direct labour 18 Variable production O/Hs 9Total variable costs 72

There is a variable selling cost of $2 per unit

Year 1 Year 2(units) (units)

Budget (normal) production 1,100 1,100

Actual Production 1,000 1,100 Actual Sales 950 1,150

Actual fixed production O/Hs $16,500 $16,500 Actual SGA costs $ 7,000 $ 7,000

Based on the above data, a profit and loss statement for the Years 1 and 2 is shown on the

next page.

Assume that the beginning inventory is zero.

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Profit/Loss (Marginal costing)

Year 1 Year 2

$ $

Sales (950/1,150 units) 114,000 138,000

Less: Variable cost of sales

Opening inventory 0 3,600

Production costs:

o Variable(1,000 x $72) 72,000(1,100 X $72) 79,200

Less: closing inventory(50 x $72) (3,600) 0

(68,400) (82,800)Less: Variable selling costs

(950 x $2) (1,900)(1,150 x $2) (2,300)

Contribution 43,700 52,900

Less: Fixed production O/Hs (16,500) (16,500)Less: SGA costs (7,000) (7,000)

Profit 20,200 29,400

Inventory is valued at variable production costs.

Absorption Costing

This method argues that focusing on marginal costs is potentially misleading in the longer

run because fixed production costs have also to be covered. Accounting conventions require

that fixed production costs be reflected in each unit produced.

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Revised cost card (Absorption costing)

Cost card (per unit):

Direct materials 45Direct labour 18 Variable production O/Hs 9Fixed production O/Hs 15

Total production costs 87

Profit/Loss (Absorption costing)

Year 1 Year 2$ $

Sales (950/1,150 units) 114,000 138,000

Less: Variable cost of sales

Opening inventory 0 4,350

Production costs:

o Variable(1,000 x $72) 72,000(1,100 X $72) 79,200

o Fixed(1,000 x $15) 15,000(1,100 X $15) 16,500

Less: closing inventory(50 x $87) (4,350) 0

Over/(under) absorption 1,500 0(84,150) (100,050)

Gross Profit 29,850 37,950

Less: Variable selling costs(950 x $2) 1,900(1,150 x $2) 2,300

Less: SGA costs 7,000 (8,900) 7,000 (9,300)

Profit 20,950 28,650

Inventory is valued at the full production costs.

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Summary of Absorption costing and Marginal costing formats

Absorption Costing Marginal Costing

Revenue

Less: Cost of Sales

Variable/Fixed Variable production/

production costs non-productioncosts

Gross profit Contribution

Less: Expenses

Variable/Fixed Fixed production/

non-production costs non-productioncosts

Net Profit

Job costing / Batch costing

This refers to the calculation of costs associated with a specific job or customer order. Thisis appropriate in situations where each product or service is distinct, and possibly unique, inits delivery.

Batch costing is similar to job costing; the distinction lies in the identification of costs withspecific batches, which are numbered (separately identified) for this purpose.

Process Costing

Process costing is a technique that applies to the mass production of a large number ofidentical products, moving through a series of processing stages. The accumulated costs of

production can be averaged over the number of items produced.

The average cost is determined by the following formula:

Average cost per unit = Total cost of inputs Scrap value of rejected unitsNo. of units of input Normal loss

The total cost of inputs refers to labour, materials and overhead costs of production. Iflosses occur along the way that necessitate the scrapping of defective units, then to the

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extent that these items fetch a scrap value, then that (scrap) value will reduce the totalcosts.

Similarly, an accounting is made of the number of units introduced into a process with theexpectation that a normal loss will be incurred. The number of good units emerging from aprocess will therefore be the number of units entering it, minus the expected number lost inprocessing.

Abnormal gains and losses are accounted for as an adjustment to the accounts using thesame value as the good output (deducted in the case of loss and added in the case ofgains).

Equivalent units (EU)

This refers to the way in which partially-completed output (work-in-progress or WIP) isexpressed. If an unfinished unit of product contains 35% of the labour and materials costsof a complete unit, then the unit has a degree of completion of 35% in terms of value. It istherefore considered to have an EU of 35%, which is normally expressed in monetary terms.

Weighted average method

The weighted average method makes no distinction between units that were started (butnot finished) in a previous process and those started in the current process. Since all theunits, when completed, are visually identical, processing costs are averaged over all theunits.

First-In-First-Out (FIFO) method

The FIFO method does make a distinction between units that were started in a previousprocess and those begun in a current process. FIFO costing separates the costs that wereincurred in the previous period from costs of the current period.

Joint products / By-products

Joint products are two or more products that share a common processing path until the

point of separation. Until they go their own (separate) ways, the costs of production duringthe joint processing cannot be physically distinguished.

There are different methods used to apportion common costs to such products at the pointof separation:

Market value (based on expected sales price) Number of units (litres, tons, or some other objective physical measurement) Net realizable value = Final sales value Incremental processing costs

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By-products are goods which are incidental to the production process and which generatecash from sales, though the amount is modest in comparison to the overall revenues of thefirm. The cash received for by-products can be viewed as a bonus that reduces productioncosts.

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Chapter 5

Budgeting and Standard Costing

Budgeting: definition and purpose

Quantitative plan for the future, used to:

The master budget process

Annual frequency, preferably revised on a regular basis (rolling budget) Based on organizations objectives, expressed in financial, quantitative and

qualitative measures

b) Motivate

Employees

b) Evaluate

Performance

b) Control

Activities

a) Communicate

Objectives

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The operating budget sequence

Sales budget Production budget Ending inventory budget Direct materials budget, Direct labour budget, Factory overhead budget Cost of Sales budget R&D budget, Marketing budget, Distribution budget, Customer service budget, Admin

budget

Pro-forma income statement

The financial budget sequence

Capital budget Cash budget Pro-forma balance-sheet and pro-forma statement of cash-flows

Operating budgets

These are budgets that quantify the revenues and costs relating to a companys activities ata disaggregated level, meaning that there is direct input from department and functional

levels. They require both volume (e.g. units of output, quantities, hours, etc.) and price

specifications. Operating budgets are modelled on what will emerge as the companys

income statement. Examples include:

Sales budget Production budget Direct material usage Direct material purchases Direct labour budget Factory overhead budget Selling & distribution budget

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Administrative expenses budgetThe disaggregation of budgets referred to above allows the practice of responsibilityaccounting.

Principal budget factor

When a budget is prepared, management must identify any factors that will prevent thecompany from surpassing a certain level of activity.

A bank, for example, may be constrained from developing an extensive branch networkowing to the scarcity of suitably-skilled professional staff; or production may be constrainedby the built capacity of the plant or by the level of demand for a companys products. In

each of these cases, there is a limiting factor at work.

Fixed vs. flexible budgets

Traditional budgets tended to be rigid, i.e. they were not subject to modification during the

period to which they referred.

Example

A producer of office equipment has a budget for the coming year:

Output: 1,000 units

Costs:

Materials 75,000

Labour 200,000

Fixed O/Hs 100,000

Total 375,000

After 3 months, the company observes that sales are running ca. 20% higher than originally

projected and it has therefore increased its production by a similar amount. In order to lookback at what its budget would have been had the actual (higher) level of activity been

anticipated, management can prepare a flexed budget; this is effectively a re-calibration of

the original budget. It allows management to re-focus their efforts without losing time

tracking artificial spending excesses according to the original budget.

Output: 1,200 units

Costs:

Materials 90,000

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Labour 225,000

Fixed O/Hs 100,000

Total 415,000

Prepare a flexed budget for an output level of 1,075 units.

Based on the data (below), the

variable cost of labour is $125 per unit, and the fixed cost of labour is $75,000

Output: 1000 1200

Mats 75,000 90,000

Labour 200,000 225,000

Fix 100,000 100,000

Total 375,000 415,000

Therefore the cost of labour at output of 1,075 units is $209,375.

Absorption Costing

This method argues that focusing on marginal costs is potentially misleading in the longer

run because fixed production costs have also to be covered. Accounting conventions require

that fixed production costs be reflected in each unit produced.

Fixed Overhead Absorption Rate (FOAR) = Budgeted production O/HBudgeted level of production

Year 1 Year 2

(units) (units)Budget (normal) production 1,100 1,100

Actual fixed production O/Hs $16,500 $16,500

Fixed Overhead Absorption Rate (FOAR) = $15 ($16,500/1,100)

Cost card (Absorption costing)

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Cost card (per unit):Direct materials 45Direct labour 18

Variable production O/Hs 9Fixed production O/Hs 15Total production costs 87

Having established the OAR, we now have a basis on which the production department can

keep track of the fixed overheads being generated as the manufacturing process proceeds.

Actual output (units) x OAR = Fixed O/H absorbed

Basic variance analysis

The following data is from a manufacturing company

BudgetProduction: 1,100 unitsSales: 1,000 unitsSales Price: $120 / unit

Actual resultsProduction: 1,000 unitsSales: 950 unitsMaterials: 4,900 kg, $45,025Labour: 3,100 hrs, $19,050Variable O/Hs: $9,250Fixed O/Hs: $17,000Sales price: $115 / unit

Cost card (per unit)

Materials (5kgs x $9 per kg) 45Labour (3hrs x $6 per hr) 18 Variable O/Hs (3 hrs x $3 per hr) 9Fixed O/Hs (3 hrs x $5 per hr) 15

87

Variance calculations

Sales volume variance (Absorption costing)

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Budgeted sales volume 1,000 Actual sales volume 950

Sales volume variance 50 (A)@ standard margin ($120-$87) $1,650 (A)

Sales volume variance (Marginal costing)

Budgeted sales volume 1,000 Actual sales volume 950

Sales volume variance 50 (A)@ standard contribution ($120-$72) $2,400 (A)

Sales price variance

950 units should have sold @$120 114,000 Actual revenues (950 units x $115) 109,250

Sales price variance 4,750 (A)

Material variances

(i) Material price variance Materials used (4,900 kg) should have cost @ $9 44,100 Materials (4,900 kg) did cost 45,025

Materials price variance $925 (A)

(ii) Material usage variance 1,000 units should have used @ 5 kg 5,000 kg

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1,000 units did use 4,900 kgMaterials usage variance 100 kg (F)

@ standard $9 $900 (F)

Materials total variance: $ 25 (A)

Labour variances

(i) Labour rate variance Labour (3,100 hrs) should have cost @ $6 18,600 Labour (3,100 hrs) did cost 19,050

Labour rate variance $450 (A)

(ii) Labour efficiency variance 1,000 units should have taken @ 3 hrs 3,000 hrs 1,000 units did take 3,100 hrs

Labour efficiency variance 100 hrs (A)@ standard $6 $600 (A)

Labor total variance: $ 1,050 (A)

Variable O/H variances

(i) Variable O/H expenditure variance 3,100 hrs should have cost @ $3 9,300 3,100 hrs did cost 9,250

Variable O/H expenditure variance 50 (F)

(ii) Variable O/H efficiency variance 1,000 units should have taken @ 3 hrs 3,000 hrs 1,000 units did take 3,100 hrs

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Variable O/H efficiency variance 100 hrs (A)@ standard $3 $300 (A)

Variable O/H total variance: $ 250 (A)

Fixed O/H total variance (Absorption costing)

Overhead actually incurred $17,000 Overhead absorbed (1,000 units x $15) $15,000

Fixed O/H total variance $ 2,000 (A)

This can be broken down into two components:

(i) Fixed O/H expenditure variance Budgeted O/H should have cost (1,100 units x $15) 16,500 Actual O/H cost 17,000

Fixed O/H expenditure variance $500 (A)

(ii) Fixed O/H volume variance (Absorption Costing) Budgeted production 1,100 units Actual production 1,000 units

Fixed O/H volume variance 100 units (A)

@ standard $15 $1,500 (A)

Interpreting variances

Material price

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Favourable: Unanticipated discounts received, better purchasing/negotiation,cheaper (substandard) materials

Adverse: Price inflation, poor purchasing, better quality materials

Material usage

Favourable: Better quality materials, more efficient processing

Adverse: Substandard material, waste, poor quality control, theft

Labour rate

Favourable: Low pay rates, cheap workers

Adverse: Wage inflation

Labour efficiency

Favourable: More efficient production, motivated/better trained workers, bettermaterials and/or equipment

Adverse: Poorly trained workers, deficient work organization, materials orequipment

Overhead expenditure

Favourable: Cost savings, more efficient use of ancillary services

Adverse: Poor cost disciplines, complexity and bureaucracy

Overhead volume

Favourable: Using production capacities beyond the level budgeted

Adverse: Under-utilization of production capacities

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Inter-connections among variances

As can be seen above, a factor causing a favourable variance may at the same time be the

cause of an adverse variance in another part of the companys operations.

It is managements responsibility to understand these relationships and to be able toanticipate, and if possible quantify, the impact of their actions on overall performance.

At the same time, management needs to review standards for their relevance andusefulness, as well as apply common sense to the materiality and controllability of specificvariances.

Reconciliation of budgeted profit and actual profit

Operating statement

Prepare a reconciliation between the profit budgeted and that realized.

Budgeted profit (Absorption costing) 33,000

Sales volume variance 1,650 (A)


26,600

Cost variances:

Materials F A

Price 925

Usage 900

Labour

Rate 450

Efficiency 600

Variable

Expenditure 50

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Efficiency 300

Fixed

Expenditure 500

Volume 1,500950 4,275 3,325 (A)

Actual profit 23,275

Note: Closing inventory is valued at standard cost

Operating Statement based on Marginal costing

Budgeted contribution (Marginal costing) 48,000

Sales volume variance 2,400 (A)


40,850

Cost variances:

Materials F A

Price 925

Usage 900

Labour

Rate 450

Efficiency 600

Variable

Expenditure 50

Efficiency 300950 2,275 1,325 (A)

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Actual contribution 39,525

Fixed O/Hs Budgeted 16,500Fixed O/Hs Expenditure variance 500 (17,000)

Actual profit 22,525

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Chapter 6

Short-term decision-makingtechniques

Cost-Volume-Profit (CVP) Analysis

The breakeven formula

Total Costs = Fixed Costs + Unit Variable Cost x Number of Units

Total Revenue = Sales Price x Number of Units

If

TC = Total Costs,

FC = Fixed Costs,

V = Unit Variable Cost,

X = Number of Units,

TR = Total Revenue,

SP = Selling Price,

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C = SP V = Unit Contribution and

CM%= C/SP = Contribution Margin,

Then the break-even point(the output level at which TR=TC) is:

In units sold: X = FC/C In dollar sales: TR = FC/CM%

Safety Margin = Budgeted Sales Break-even point (units/dollars) C is an important indicator, as it shows the contribution of each unit sold towards

covering fixed costs. Therefore, in the short run, the firm may prefer to produce/sell

below break-even in order to recover some of its fixed costs.

Relevant costs, incremental analysis and linear programming

Relevant costs are costs expected to vary with the action takeno Past (sunk) costs are irrelevanto Fixed costs are irrelevant if there is idle capacityo Variable (marginal) costs are relevanto Opportunity costs (foregone benefits) are relevant

Incremental analysis uses relevant costs in order to quantify the short-term effects ofbusiness decisions taken.

Applying incremental analysis in business decision-making

Accept or reject a special ordero Accept if selling price exceeds variable production cost and there is spare

capacity

Make (in-sourcing) or buy (out-sourcing)
http://en.wikipedia.org/wiki/File:CVP-TC-FC-VC-Sales-Contrib-VC-PL-compat.s

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o Outsource least efficient activities if full capacity reached Capital budgeting

o Invest if marginal cost of investing is below marginal cost of not investing(marginal benefit foregone)

Disinvestmento Divest if (marginal revenue generated + cost of resulting idle capacity +

severance payments + restoration costs) fall below marginal cost ofproduction + salvage value of assets

Determining optimal mix of products where there are limiting factors

It addresses the problem of maximizing or minimizing a linear function subject to linearconstraints. The constraints may be equalities or inequalities.

(end of ExPress Notes)

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