MANAGEMENT ACC KU-1
MANAGEMENT ACC KU-1
BY
EMAIL: [email protected]
Credit Units: 4
Contact Hours: 60
Learning outcomes
Use cost information to make informed short and long- term decisions
Use standard costs for planning and control purposes
Prepare budgets for organisations
Monitor budget performance
Prepare organisational performance and evaluation reports.
Indicative Course Content
Cost management
Target costing
Business process engineering
Balanced scorecard
Just-in-time production process
Total Quality Management
Continuous improvement
Delivery methodology
Assessment
Coursework 40%
Reading List
The Management Accountant is part of management but not just a service arm to
management. He acts as a Manager and decision maker and exercises managerial
influence and of course is responsible for the management of the entire cost and
management accounting system.
Financial accountants and book keepers have the task of maintaining the ledger system of
accounting records, from which the financial statements will be prepared. The financial
accounts can be a source of management information. In general, however, they are
insufficient for management’s requirements.
This profit statement above may be adequate to give shareholders a superficial picture of
the trading results of the whole business. However, it doesn’t give managers enough
information about the business performance. Managers need much more detail to answer
questions such as:
Which of our products sell best? How much sales revenue do we earn from each
product or product line?
How much profit do we earn from each product?
Do we make a loss with any of our products?
How does the cost per unit sold compare with the cost per unit of last year?
Are costs higher than expected, and if so, in which areas?
How much more would we have needed to sell to make a profit of £500000 for
the year?
AN ACCOUNTING SYSTEM
An Accounting system aims at providing accounting information which could be in form
of cost information, financial and qualitative information; Typical of accounting systems
are three subsystems:
Financial Accounting system
Cost Accounting System
Management Accounting System.
Financial accounting system: Deals with the maintaining of accounting records and
preparation of final accounts/or financial statements; the main purpose of which is to
provide financial information which is channeled through financial reports which include
the balance sheet, income statement, and cash flow statements.
Management Accounting: Encompasses the two accounting systems i.e. cost and
financial accounting and it aims at providing information needed for:
Planning
Controlling
Decision making
Formulation of strategy
Control of company resources (assets)
Cost Accounting: The accounting system which deals/ or aims at the ascertainment of
costs of the product/ or services to be provided by the organization.
CIMA defines Cost Accounting as the establishment of budgets, standard costs and
actual costs of operations, processes, activities or products; and the analysis of variances,
profitability or social use of funds.
These two appear to be the same but differ greatly in scope and purpose;
a. Scope: the scope of management accounting is broader than cost accounting.
Cost accounting only provides cost information for managerial uses while
management accounting provides all types of information (financial, cost) and the
information regarding qualitative factors gathered from the environment.
b. In cost accounting, the main emphasis is on cost ascertainment and cost control
while management accounting’s main emphasis is on decision making.
Examples of decisions made at the design stage which impact on the cost of the product
include:
The number of different components
Whether the components are standard or not
The case of changing over tools.
Most Japanese companies have developed target costing as a response to the problem of
controlling and reducing costs over the product life cycle.
Example:
A car manufacturer wants to calculate a target cost for the new car, the price of which
will be set at $17950; the company requires an 8% profit margin.
Calculate the target cost.
Management can therefore set benchmarks for improvement towards target costs by
improving technologies and process, techniques which can be employed include.
Reducing on the number of components.
Using standards wherever possible.
Training staff in more efficient techniques.
Using different materials.
Using cheaper staff.
Acquiring new, more efficient technology.
Cutting out non value added activities (using activity analysis).
Target costing should be applied throughout the entire life cycle and cost savings should
actively be sought and made continuously over the life of the product.
Target costing is difficult to use in service industries due to the characteristics and
information requirements of service businesses.
Characteristics of services
(1) Intangibility: refers to the lack of substance which is involved with service
delivery. There is no substantial material or physical aspects to a service, no taste
no feel visible presence etc. For example, if you go to the theatre you cannot take a
play with you.
Illustration 1
$ $ $ $
The Marketing Director believes that customers will be prepared to pay $500 for a solar
panel but the Finance Director believes this will not cover all of the costs throughout the
life cycle.
Required
Calculate the cost per unit looking at the whole life cycle and comment on the
suggested price.
Year 0 1 2 3
Productions costs
Marketing costs
Distribution costs
(a) Explain life cycle costing and state what distinguishes it from more
traditional management accounting techniques.
(1) Design costs out of products: Between 70% to 90% of a products life cycle are
determined by decisions made early in the life cycle, at the design or development stage.
Careful design of the product and manufacturing and other process will keep cost to a
minimum over the life cycle.
(2) Minimize the time to market: This is the time from conception of the product to
its launch. Competitors watch each other very carefully to determine what types of
product their rivals are developing. If the organization is launching a new product it is
vital to get it to the market place as soon as possible as this will increase its market share.
(3) Minimize the break even time (BET). A short BET is very important in
keeping an organization liquid the sooner the product is launched the quicker the research
and development costs will be repaid providing an organization with funds to develop
further products.
(4) Maximize the length of the life span: product life cycles are not predetermined
They are set by the actions of management and competitors. Once developed some
products lend themselves to a number of different uses this is especially true of materials
such as plastic, nylon and other synthetic materials. The life cycle of the material is then
a series of individual product curves nesting on top of each other as shown below.
Sales
Revenue
Time
By using different national or regional markets one after another an organization may be
able to maximize revenue. This allows resources to be better applied and sales in each
market to be maximized.
Customers also have life cycles, and an organization will wish to maximize the return
from a customer over their life cycle. The aim is to extend the life cycle of a particular
customer or decrease the churn rate, as the Americans say. This means encouraging
customer loyalty e.g. supermarkets and other retail outlets issue loyalty cards that offer
discounts to loyal customers who return to the shop and spend a certain amount with the
organization existing customers tend to be more profitable than new ones. They also
become more profitable over their life cycle approx.4-20 years.
Bottleneck resource or binding constraint: an activity which has a lower capacity than
preceding or subsequent activities, thereby limiting through put.
The overall aim of TOC is to maximize through put contribution (Sales Revenue –
Material cost) while keeping conversion cost (all operating costs except materials costs)
and investment costs (inventory, equipment etc) to a minimum.
1. It is seen as too short term as all costs other than direct material are regarded as
fixed. It concentrates on direct material costs and does nothing for the control of other
costs such as overheads.
2. An organization could be producing in excess of the profit maximizing output as
through put accounting attempts to maximize through put.
Advantage
Through put accounting helps to direct attention to bottlenecks and focus
management on key elements in making profits, inventory reduction and reducing
the response time to customer demand.
Environmental Accounting
Read about: - Environmental Accounting
- Managing Environmental costs
- Various types of environmental cost i.e.
Conventional costs
Potentially hidden costs
Contingent costs
Image and relationship costs
- Accounting for environmental costs
Input/output analysis
Flow cost accounting
TOPIC 3:
ACTIVITY BASED COSTING (ABC)
Management Accounting Page 21
The traditional methods of overhead allocation are based on direct material and labour
which used to dominate the total cost of production. In addition, companies used to
produce small range of products, the overheads were relatively small and any distortions
in the cost information resulting from inappropriate allocation system was insignificant.
Information processing costs used to be high that sophisticated overhead allocation
methods were unjustifiable.
Currently companies produce a wide range of products and direct labour forming a small
percentage of the total costs. At the same time overheads are increasingly high with
intense global competition decision errors based on poor cost information can be highly
regretted.
Limitations of Traditional Costing System
(i) Allocation of organization resources/costs those are unrelated to physical volume.
These costs result from non-volume related activities of material handling,
procurement, set up activities, inspection activities, etc.
(ii) Traditional costing systems assume that all resources are consumed in relation to
their production volumes. This distorts production cost, serious distortions of
costs are more pronounced in organizations producing a wide range of products
that differ in volume and complexity. Traditional volume based costing systems
tend to over-cost high volume products and under-cost low volume products.
(iii) All fixed costs are clustered in one cost pool and one cost driver is employed to
charge costs to products.
(iv) They pay no consideration to non-volume factors that may cause costs, e.g.
management time, setup activities.
Exercise 1:
Asingya Ltd manufactures four products W, X, Y, & Z. Output and cost data for the
period just ended are as follows:
Management Accounting Page 25
Product Outpu No. of No. of Material Direct Machine
t production material cost per labour hour per
(Units) runs in a period orders made unit( $) hours per unit
unit
W 10 2 2 20 1 1
X 10 2 2 80 3 3
Y 100 5 5 20 1 1
Z 100 5 5 80 3 3
30800
a) Use both traditional (conventional) cost system and ABC system to determine the
cost of each product. Compare the results got using the two systems and comment
according.
b)
Overhead costs $
Relating to machine activity 220,000
Relating to production run set ups 20,000
Relating to handling of orders 45,000
285,000
Required:
Calculate the production overheads to be absorbed by one unit of each of the products
using the following costing methods.
(a) A traditional costing approach using a direct labour hour to absorb overheads
Review Question 2
JK (U) KLtd manufactures and sells three products ie Doughnuts, Ice-cream & Yoghurt.
The company’s production department consists of processing & Packaging.
The management Accountant of JK (U) Ltd has provided you with the following
budgeted information for the six month period ending 31st Dec 2016
Additional information
i) All units produced will be sold in the six month period
ii) Production takes in batches of 1,000 units
iii) The following estimates have also been provided for the period
Required
a) Prepare budgeted statement of profit/loss( income statement) for the period
ending 31st December 2016 based on activity based costing
b) Explain the short falls of ABC method over the conventional cost allocation
methods.
Review Question 3
XYZ ltd plans to produce Sausages which have to be processed through three cost centres
A,B & C. the following budgeted data have been obtained from the books of XYZ Ltd.
Cost Centres
A B C
Material cost per 2,000 4,000 3,000
unit (ugx)
Direct labour hrs per 2 5 1
unit
Rate per direct 1,500 2,000 3,000
labour hr (ugx)
No of inspections to 5 3 2
be made
No of machine 7 8 10
setups
No of orders made 12 20 8
No of requisitions to 7 5 8
be made
XYZ has budgeted to produce 5,000 units of Sausages and also plans incur the following
overhead costs
Required
Using ABC with appropriate/suitable cost drivers determine
i) The total cost of producing sausages
ii) The unit cost of each sausage
iii) The selling price of sausages assuming the company targets to get 25% profit
on selling price
iv) Determine the total number of hours that will be required by the company to
realise its budgeted output.
Review question 4
a) Explain the reasons behind the development of ABC
b) Clearly point out ways in which ABC will assist management in discharging their
role of cost control
c) Explain the limitations of ABC
d) Point out the steps in applying ABC in a manufacturing company
TOPIC 4
Marginal costing together with absorption costing are costing techniques that try to
explain what constitutes the unit cost of the product or the composition of costs in the
unit cost of the product or service. The two that is, marginal/variable costing and
absorption (full costing) are two extremes of product costing in inventory valuation and
their application is influenced by what organizations intend to achieve. However, it is
crucial of recognize that none of the two techniques is superior to the other.
This represents a costing system that treats only those costs of production that varies with
output as product costs. Under this system, only variable manufacturing costs are
assigned to the products and are included in the inventory valuation. The system
All fixed costs are regarded as time based and are linked to accounting periods rather
than units of output.
Ordinarily, direct materials, direct labour and variable manufacturing overhead costs are
included in production costs under this method. Fixed manufacturing overhead costs are
not included and they are treated as period costs and charged against profit in the period
in which these goods are sold or in the period to which they relate.
Marginal costing is the accounting system in which variable costs are charged to cost
units and the fixed costs of the period are written off in full against the aggregate
contribution. The technique allocates only variable/marginal costs to the product/service
and treats fixed manufacturing and non-manufacturing costs as period costs.
Under this technique, variable costs represent the cost of sales or cost of production
which are deducted from total sales generated in a period to get total contribution (i.e
total sales –total variable costs).
All other costs including fixed manufacturing cost and non-manufacturing costs are
treated as operating costs and hence offset from the registered total contribution to get net
income of profit/loss.
UGX
Sales xxx
Less: Marginal Cost of sales
Opening stock (quantity x unit variable cost) xx
Add: Production cost (Quantity produced x unit variable cost) xx
Cost of goods available for sale xx
Less: Closing stock (units x unit variable cost) (xx)
Marginal Cost of sales (xxx)
Total contribution xxx
Less operating expenses (costs)
Variable selling and distribution cost (xx)
Net contribution xxx
Less: Fixed manufacturing overhead costs xx
Fixed administration overhead costs xx xxx
Net income or profit/loss xxx/(xxx)
EXAMPLE 1
KK LTD produces a single product and has the following budget:
Company budget per unit
UGX
Selling price 10
Direct materials 3
Direct wages 2
Variable overheads 1
Fixed production overhead is UGX 10,000 per month and production volume is
5,000 units per month.
Required
Calculate the cost per unit to be used for stock valuation under marginal costing.
Example 11
Required
Derive the profit statement under marginal costing for the month if sales are 4,800 units.
Required
Prepare in a columnar form profit statement based on marginal costing technique
REVIEW QUESTION 2
Review Question 3
The following are the production cost of BB and sons Enterprises Ltd.
Level of Activity
60% 70% 80%
Output (in units) 1,200 1,400 1,600
Cost (in UGX)
Direct materials 24,000 28,000 32,000
Direct labour 7,200 8,400 9,600
Factory overheads 12,800 13,600 14,400
Total cost 44,000 56,000 56,000
ii) The profit of the period calculated using marginal costing is more easily related to
sales than it is in absorption costing. This means that contribution increases with every
unit sold and this has a direct impact on the profit or loss recorded by an enterprise. This
clearly indicates that managers can easily anticipate income and take viable decisions
accordingly.
iii) It avoids fixed manufacturing overheads being capitalized in un-saleable stocks. Stock
is valued on the basis of unit variable costs which is always lower than absorption costing
stock figure. Failure of marginal costing to capitalize fixed manufacturing costs in
inventory, profits are not always exaggerated.
iv) Profit statement (internal reports) produced on the basis of marginal costing may be
used as a basis for measuring managerial performance since most of the costs involved
are controllable.
v) Advocates of marginal costing argue that fixed manufacturing costs are incurred in
order to have the capacity to produce. Moreover, they will be incurred regardless of
whether anything is actually produced. Since these costs are not caused by any particular
unit of product and are incurred to provide capacity for a particular period, the matching
principle would dictate that fixed manufacturing overheads cost must be expensed in the
current period.
ii) Though the system is based on the principle that fixed costs can be easily separated
from variable costs, it is not always the case. Costs are made of different categories
including semi-fixed costs which have both attributes of fixed and variable costs.
The existences of semi-fixed and semi-variable costs posses a lot of challenge to
separate the fixed and variable costs. This implies that the premise of separating the
two costs where marginal costing is based is highly questionable.
iv) The opponents of marginal costing system argued that it is and appropriate to
exclude fixed manufacturing overhead costs from the production costs. They are not
borrowing the view that fixed costs are incurred to maintain productive capacity
which is not at all affected by the levels of volume in the short run.
v) Marginal costing system is only useful as information provides for short run profit
planning and decision making technique. In long run planning and decision, one
needs more information on the variability of costs. The danger of using variable
costs is that it can be generated into a short sighted approach to decision making.
Absorption costing includes variable overheads and fixed overheads where variable
overheads are those manufacturing costs that vary in relation to changes in production
output, for example production supplies, equipment utilities like water and material
handling wages.
Fixed overheads are a set of costs that do not vary as a result of changes in activity, for
example rent, insurance, office expenses, administrative salaries, depreciation etc.
The registered gross profit may be adjusted accordingly. (i.e. upwards or downwards)
because of over or under absorbed fixed manufacturing overheads. All non-
manufacturing costs are subtracted from the gross margin to get net profit for the year.
It should be clearly understood that fixed manufacturing overhead costs are charged to
units of output produced on the basis of per unit fixed manufacturing overhead rate
obtained by dividing the standard fixed manufacturing overhead by the normal output or
budgeted output level as follows:
The computed unit fixed cost implies that for every unit of output produced, the amount
of unit fixed cost will be recovered by the firm. This means that level of actual output
determines the amount of overheads recovered. If the actual output is greater than the
normal level of output. It means more manufacturing overheads than incurred/budgeted
will be absorbed into the production costs. This therefore, indicates that there is over
absorption of fixed manufacturing overheads. The over absorbed (excess) amount is a
credit to the income statement as a gain. This indicates favourable volume or capacity
variance.
However if the actual output is below the normal level of output, it means that some of
the fixed manufacturing overhead costs have not been absorbed into production costs.
This represents under- recovery or under absorption of fixed manufacturing costs, which
are charged against profits in the income statement.
Example 1: James and Jolly Limited produces a single product and has the following
budget:-
Company budget per unit
$
Selling Price 20
Direct Materials 6
Direct Wages 4
Variable overheads 2
Fixed production overhead is $20,000 per month, production volume is 10,000 units per
month.
Required
i) Calculate the cost per unit to be used for stock valuation in absorption costing.
ii) Calculate the profit per unit for James & Jolly Ltd using absorption/full
costing.
Example 11:
RECONCILIATION OF PROFITS
Reconciliation of profits can EITHER be started with marginal costing profits, add the
difference in closing stock and then deduct the difference in opening stock (of marginal
and absorption costing) so as to arrive at net profit figures as per absorption costing.
OR
Start with absorption costing profits, add the difference in opening stock and less the
difference in closing stock so as to arrive at net profit figures of marginal costing system.
Management Accounting Page 42
ILLUSTRATION
UGX
Marginal costing profit xx
Add difference in closing stock xx
Less difference in opening stock (xx)
Add/subtract over/under absorption xx
Net profit as per absorption xxx
Practice Exercise 1
A company produces a single unit of product for which the variable production cost is £6
per unit. Fixed production overhead is £10,000 per month and budgeted production and
sales volume is 5,000 units each month. The selling price is £10 per unit. Suppose that
in a particular month, production was in fact 6,000 units with 4,800 units sold and 1,200
units left as closing stock
Assume all costs were as budgeted.
a) Prepare the profit statement for the month under absorption costing
b) Prepare the profit statement for the month under marginal costing
c) Prepare a statement to reconcile the two reported profit figures.
Practice Exercise 11
Fixed production overhead is £10,000 per month; production volume is 5,000 units per
month.
Show profit statements for the month if sales are 4,800 units under:
a) Total Absorption costing
b) Marginal costing
Unit Cost
£
Direct material 2
Direct labour 1
Variable production overhead 2
Fixed production overhead 3
8
Production and Sales
Year 1 2 3
Production (in 000s units) 100 110 90
Sales (in 000s units) 90 110 95
Required:
a) Prepare in a columnar form an operating statement using (i) marginal costing and (ii)
absorption costing.
b) Explain why the profit figures reported under the two techniques disagree
c) Reconcile the profits obtained under the two techniques
Practice Exercise iv
Lugazi sugar works produces sugar packed in 50kg bags and sells each bag for shs
60,000. For the financial year 2016, it’s budgeted to produce and sell 180,000 bags with
annual fixed production cost of shs 720,000,000/=
During the month of November 2016, the following results were observed.
Stock movement in units:
Opening stock 3,000
Production 16,000
Closing stock 4,000
The cost for each bag produced and sold were constant throughout the year as under;
Direct materials shs 24,000/=
Direct labour shs 12,000/=
Variable production overheads shs 3,000/=
During the month, fixed selling & administration costs amounted to 30,000,000/=
Required
TOPIC 5
DECISION MAKING TECHNIQUES- use of C-V-P Analysis
Introduction
Cost-volume-profit (CVP) analysis is a technique which uses cost behavior theory to
identify the activity level at which there is neither a profit nor a loss (the breakeven
activity level). This is important management information because management needs to
know the minimum activity level that must be achieved in order for the business not to
incur losses.
CVP analysis may also be used to predict profit levels at different volumes of activity
based upon the assumption that costs and revenues exhibit a linear relationship with the
level of activity.
Selling price
Variable cost of production
Fixed costs
Activity level (production and sales units).,
CVP Analysis is an analytical technique or tool used to study the behavior of profit in
response to the changes in volume, costs and prices. Analysis of such factors on profits is
an essential step in the financial planning and decision making.
The main objective of CVP Analysis is to establish what will happen to the financial
results if a specified level of activity or volume fluctuates. This technique helps in
providing information to managers which is based on establishing;
Profit planning is based on break-even analysis and can be worked out using either;
The limitations arise from the shortcoming of the assumptions given above.
(a) It is not true that the selling price will always remain constant at all levels of
sales because to induce sales the company may lower the price.
(b) The costs of production per unit does not remain constant as at a certain stage,
the costs fall per unit due to the learning curve effect and the economies of scale
and may raise again later at diseconomies of scale.
(c) The economies today are dynamic leading to changes in technology of
production and yet it has been assumed constant.
(d) There are fluctuations in production and leading to changes in stock levels that
are assumed to be constant
(e) It’s not easy to separate costs to variable and fixed elements
(f) Difficult to apply in a multi-product firm.
Advantages of CVP Analysis
a) Graphical representation of cost and revenue data (Breakeven charts) can be more
easily understood by non financial managers.
b) Highlighting the breakeven point and margin of safety gives managers some
indication of the level of risk involved
c) A break even model enables profit or loss at any level of activity within the range
for which the model is valid to be determined, and the C/S ratio can indicate the
relative profitability of different products.
BREAK-EVEN CHART.
Cost
Revenue TR
Profits TC
BEP
Angle of incidence = where TR line cuts the
TC line
FC
Losses MOS
The accountant’s model introduces the concept of angle of incidence which represents the
angle at which total revenue line cuts the total cost line. If the angle is large it indicates
that profits are being made at a high rate and if the angle of incidence is small it shows
that whereas profits are being made, they are being made under less favorable conditions.
According to the accountant’s model, the output level that maximizes profit is the
maximum practical capacity. But a relevant range is always observed in determining the
maximum level capacity. Relevant range refers to the output range that is planned at
which a firm expects to operate usually in one year or short run. The accountant’s model
is not applicable in the long run but only in the short run
Revenue
Cost Economist model
TC
Losses
BEP 2 TR
Profits
FC
BEP 1
Losses
Out put
MC=MR MR=MC
The economist’s explanation is that the relationship between output and total cost or total
revenue is curve linear (no clear relationship). The TR line is curve linear indicating that
more units of output can be sold if the selling price is reduced. Thus the TR line does not
increase proportionate without price reduction. The economists argue that more units can
be sold if the selling price is reduced.
The economists recommend firms to operate at the point where the gap between MR is
exactly equal to MC. At this point the gap between TR curve and TC curve is so wide.
The economist’s model helps management in addressing both short and long term plans
and decisions.
Margin of safety (MOS): Is the difference between current operating activity level and
the Break even activity (BEP). It’s preferable to express this as a percentage and can be
measured using units or shillings. I.e
Current Activity
It measures the extent to which the sales should fall before the organization starts making
losses. The higher the MOS, the safer the organization in times of a depression and the
lower the MOS, the higher the risk the organization faces during depression.
ANGLE OF INCIDENCE:
Angle of Incidence: Is the angle between the total revenue (TR) curve and the total cost
(TC) curve and the higher the angle, the higher the risk of the company and vice versa.
During a boom, a company with a large angle of incidence will be at a better position
because its profits will increase faster but during a recession, it suffers heavily because
the profits decrease faster.
If the organization’s target is to realize a certain profit, then the quantity to be produced is
given by planned quantity for planned profit is
Sales – FC –VC
PQ –FC –VQ
P-V
Q = FC = FC
∏ = Sales – FC – VC
∏ = PQ-FQ-VQ
FC + ∏ = Q
P-v
Sales =FC + ∏ x P or = FC + ∏
Expected sales
MARGIN OF SAFETY.
Current Activity
FC + ∏ - FC = FC + ∏ - FC =∏
FC +∏ c/u FC +∏
MOS as ratio = ∏
FC + ∏
Illustration 1
The following standard cost statement relates to a product which sells for 100,000/=, per
tonne.
Details Amount(shs)
Direct materials 30,000
Direct wages 20,000
Variable overheads 10,000
+ 60,000
Fixed overheads 20,000
Total cost 80,000
The fixed overheads were based on output of 3,000 tonnes.
Required:
QUESTION 1
a) MBA students at UMU came up with the idea of producing and selling a single
product in the next financial year after their programme. They managed to come
up with the following data relating to their planned level of operations.
The product will be sold at 2000/= per unit and price will remain constant for
some time. The unit costs to be incurred in producing and marketing the product
will include the following:
ii) Assuming the students are planning to earn a profit of 400,000/=. How many units
can be produced so as to realize their plan?
iii) Basing on the answers got in (ii) above, what will be the margin of safety in units.
QUESTION 2
Uganda clays Ltd manufactures and sells tiles. The tiles are homogeneous and the
customers like the long lasting product so much that all that is produced is sold. The
company uses marginal costing technique and below is a projected marginal costing
profit statement for the next accounting year.
Sales (2,000 tiles)---------------------------------------------------- shs 50,000,000/=
Less variable costs……………………………………………shs 30,000,000/=
Contribution…………………………………………………..shs 20,000,000/=
Management Accounting Page 54
Less Fixed costs
Fixed office & Administration………. 2,400,000/=
Fixed selling & Distribution………… 2,600,000/=
Fixed Production Overhead…………. 2,200,000/= shs 7,200,000/=
Net profit 12,800,000/=
Production is uniform throughout the year. Likewise costs are incurred and revenue
generated uniformly throughout the year. You are the newly appointed Management
accountant of the company and you are supposed to do profit planning basing on the
forecast statement above.
Required
i) Calculate the monthly breakeven point (in Units and Sales)
ii) Calculate the number of tiles that can be sold per year to earn a profit of Shs
20,000,000/=
iii) Calculate the Contribution sales ratio
iv) Calculate the margin of safety in units
QUESTION 3
A company expects to sell 10,000 units and the variable cost per unit is 1,000/= annual
fixed costs is ushs 20,000,000/=
Required
i) What price would be charged in order to breakeven at a given level of
activity?
ii) Using the price calculated in (i) above, determine the units that should be sold
in order to yield a desired profit of ushs 1,000,000/=
iii) What is the profit that will result from a 10% reduction in cost per unit and
ugx 5,000,000/= decrease in fixed costs assuming that the current sales above
will be maintained.
Question 4
A company plans to earn an after tax profit of ugx 1,200,000/= and that the income tax
rate is 30%. The unit selling price and variable cost amount to ugx 10,000 and ugx 6,000
respectively. The fixed costs will amount to ugx 20,000,000. You are to determine the
amount of units and sales value to enable the firm earn the desired profit.
The only situation when the mix of products does not affect the analysis is when all
the products have the same ratio of contribution to sales (C/S ratio)
Example 1
KK ltd manufacturers and sell 3 products milk, ice cream and yogurt in the following
quantities
Milk 500 liters
Ice cream 200 liters
Yoghurt 300 liters
1,000 litres
The selling prices and variable production and distribution cost for each product are
as follows milk, ice cream yogurt
Selling price 800 1000 600
Variable production cost 300 600 400
Products A B C
Sales units 600 2,500 2,000
Unit selling price 2,500 1,000 3,000
Unit variable cost 1,000 400 2,200
Review question 1
Maria Autos has two models of cars, Carina and Carib. They are sold in a ratio of 6:4.
The following details are given.
Carina Carib
(UGX) (UGX)
Average sales price 12,000 20,000
Less average variable costs
-Cost to Maria Autos (9,600) (14,600)
- Supplies used to prepare cars for sale (200) (400)
- Sales commission (1,200) (2,000)
Average contribution margin per car 1,000 3,000
Revision Question 2
1. Muchomo Ltd purchases and markets a wide variety of goods. Turnover and costs for
the previous two quarters are as follows:
Quarter 1 Quarter 2
Turnover 850,000 1,250,000
Total costs 400,000 560,000
Required:
a) Calculate the break-even turnover per quarter
Revision Question 3
Required;
a) Calculate the breakeven point in units and in value
Revision Question 4
Druid Limited makes and sells a single product W, which has a variable production cost
of $10 per unit and a variable selling cost of $4. It sells for $25. Annual fixed
production costs are $350,000, annual administration costs are $110,000 and annual fixed
selling costs are $240,000
Required;
Calculate the volume of sales required to achieve an annual profit of $400,000.
Revision question 5
(a) Despite its usefulness in profit planning, cost control and decision making, cost-
volume-profit (C-V-P) analysis lies on premises that are unrealistic.
Required: Outline Six assumptions and limitations underlying C-V-P analysis.
(b) Maji Maji Enterprises Limited deals in the bottling of drinking water. The
Management Accountant has submitted the following statement for the period ended
31 October 2016.
Revision question 6
Norvik a UK Company operates in the leisure and entertainment industry and one of its
activities is to promote concerts at locations throughout Africa. The company is
examining the viability of a concert in Nairobi Kenya. Estimated fixed costs are £60,000.
These include the fees paid to performers, the hire of the venue and advertising costs.
Variable costs consists of the cost of a pre-packed buffet which will be provided by a
firm of caterers at a price, of £10 per ticket sold. The proposed price for the sale ticket is
£20.
The management of Norvik has requested you to assist them with the following
information:
i) The number of tickets that must be sold to break even
ii) How many tickets must be sold to earn £30,000 target profit before tax?
iii)Assuming, the tax rate is 25%, how many tickets must be sold in order to make a
profit of £30,000 after tax?
iv)What profit would result if 8,000 tickets were sold?
v) What selling price would have to be charged to give a profit of £30,000 on sales of
8,000 tickets, fixed costs of £60,000 and variable cost of £10 per ticket?
vi)How many additional tickets must be sold to cover extra cost of television advertising
of £8,000? (assuming the selling price per unit remains £20 and variable cost per unit
is £10)
Standard costing is a control technique which establishes and compares standard costs
and revenues with actual results to obtain variances which are used to stimulate improved
performance.
The pre-determined costs are known as standard costs and the difference between the
standard and actual cost is known as variance. The process by which the total difference
between standard and actual results is analyzed is known as Variance Analysis.
Types of Standards
(1) Ideal cost standard: is a standard which can be attained under perfect operating
conditions, i.e. no-wastage, no inefficiencies, no idle time, and no breakdowns.
This standard demands perfection and hence it obviously unrealistic and
unattainable.
(2) Basic cost standard: is a long term standard which remains unchanged over the
years and is used to show trends. They are established and operated without
revision for a number of years.(a long term standard wc is used by the orgn for a
long period of time without revision)
(3) Currently attainable standards: is a standard which can be attained if
production is carried out efficiently, machines are properly operated or materials
are properly used. However allowances are made for normal losses and machine
breakdown time.
Variance Analysis
This is the process of analyzing variances by subdividing the total variance in such a way
that management can assign responsibility for any deviation on standard performance.
The main objective of variance analysis is to detect operating problems and report them
so that corrective action may be taken where possible.
Variances provide feedback information for management control and thus serve as red
flags to alert management.
A favourable variance – Means that the actual cost incurred is lower than the
predetermined cost or the actual performance is greater than the expected level of
performance.
The following conditions should be in place for the analysis to provide positive results to
the organization.
Types of variances
Efficiency Capacity
variance variance
This is the difference between the standard cost of direct materials specified for the
output achieved and the actual cost of direct materials used. The overall material variance
is known as material total variance which is calculated as:
Material cost variance = Standard cost for actual output – actual cost
MCV = SC – AC
Material price variance can further be subdivided into material price and material usage
variances.
(i) Material price variance. This represents that portion of material cost variance
which is due to the difference between the standard price specified and the actual price
paid. The formula is given as under:
(MPV) = Actual quantity (Standard price – Actual price)
MPV = AQ (SP – AP)
If the actual price for materials is greater than the specified price (standard price), then
unfavourable or adverse variance is registered and the reverse represents favourable
variance.
Reasons for material price variance. It arises due to the following reasons:
Change in basic prices of materials
Failure to purchase the standard quantity, thereby resulting in a different price
being paid,
This is that portion of the material cost variance which is due to the difference between
the standard quantity specified and the actual quantity used.
Material usage variance = Standard price (Standard quantity for actual output –
Actual quantity)
If the actual quantity materials used in production is greater than the specified quantity
(standard quantity), then unfavourable or adverse variance is registered and the reverse
represents favourable variance.
Example I
Material usage variance is further sub-divided into: (a) Material mix variance
Arises where more than one type of material is used for producing the product. If there is
a shortage of one or more of the specified materials, it is possible that the proportion can
be changed or different material may be used. These may be cheaper or more expensive
hence resulting in a mix variance. The Chartered Institute of Accountants, London,
defines material mix variance as “that portion of direct materials usage variance which is
due to the difference between the standard and actual composition of a mixture.” The
formula is given as under:
Revised standard quantity represents the revised standard proportion of actual input. The
revised standard quantity can be computed as follows:
The Company planned to produce one unit of product M by using standard mixes of raw
materials X&Y in the following proportions and prices
Raw-material Standard
X 80 units @60/=
Raw-material Actual
Required
This represents part of materials usage variance which is as a result of difference between
standard output and actual output. In this case yield can be defined as the amount of
output expected from a given quantity of materials. In many cases a changed mix will
have an impact on the yield of the final product.
The difference between the actual output (yield) and the standard (expected) output is
multiplied by the price per unit of standard output to compute the materials yield
variance. This is given by the following formula:
If the actual yield is more than the standard yield, the material yield variance is
favourable and vice-versa.
The standard or expected yield can be computed as under:
Standard yield = Unit output x Actual input
Total standard materials units
In example 2, the standard yield = 1 x 340,000 = 1,700 Kgs
200
The standard price per unit of output = X:80 units x shs 60 = UGX.4,800
UGX.10,800
Material yield variance = (Actual yield – Standard yield) x Standard price per unit of
output.
(i) Material yield variance = Standard quantity - Revised standard qty x S. Price
For actual output for actual output
3,240,000 favourable
= 10,800 = UGX.54
200 units
One can apply any of the three approaches or methods to calculate the yield variance and
none of the methods is superior to the other.
The primary labour variance is the labour total cost variance which can be analyzed into
the basic components of Labour rate variance, labour efficiency variance and idle time
variance.
(i). Labour cost variance. This represents the difference between the standard labour
cost for the actual production and the labour cost. To be more specific, labour cost
variance is the difference between total standard labour cost and total actual labour cost.
This can be determined by using the following formula:
Labour cost variance (LCV) = Standard labour cost for actual output – Actual cost
LCV = Standard hour rate x std. hours for actual output – actual hours x actual hour
rate
LCV = (SR x SH) – AH x AR)
Labour cost variance can be broken into labour rate variance, labour efficiency variance
and idle time variance.
Example 1.
The standard cost sheet of KK Ltd shows that the production of each unit requires 1hour
at UGX.2,000 each. During the period, 2,500 units were produced in 2,100 hrs with a
total amount of UGX.3,570,000. Out of the 2,100 hours taken on production, 100 hours
were spent waiting for materials and tools by employees.
Required: Determine
(i) Labour cost variance (LCV)
(ii) Labour rate variance (LRV)
(iii) Labour efficiency variance (LEV) and idle time variance (ITV).
Example 2:
The details regarding the composition and weekly wage rates of labour force engaged on
a job scheduled to be completed in 30 weeks are as follows:
Standard Actual
Category of No. of Weekly wage No. of Weekly wage
Skilled 75 60 70 70
Semi-skilled 45 40 30 50
Unskilled 60 30 80 20
The work is actually completed in 32 weeks
Required .
unit
If the actual production is more than standard production, the difference would be a
favorable variance and vice-versa.
Example 3
Mat Ltd planned to produce 5,000 units of certain product in 10 days and categories of
workers involved in production process include:
Standard Actual
Category of No. of workers Rate per Day No. of workers Rate per Day
Workers (UGX) (UGX)
variable overhead
Expenditure variance (VOEV )
= {Standard variable –
Overhead rate
Actual variable overhead
Absorption rate } x
A/Hours
(SVOAR) - (AVOAR)
{forStandard }
Variable overhead efficiency variance hours – Actual hours
¿ = x
¿ actual output taken
Std . overhead
rate
The standard variable overhead absorption rate is calculated by dividing the budgeted or
standard variable overheads by the budgeted or normal output for the period.
Required
Calculate variable overhead variances.
NB: The causes of the variable overhead variances are exactly the same as those for
labour variances.
Fixed overhead cost variance = (Absorbed or charged fixed costs – Actual fixed costs)
¿ }
¿ standard ¿ Overhead rate ¿ – Actual ¿ overhead costs ¿
¿
= (SH x SFOAR– AFC)
Fixed overhead volume variance is further sub-divided into fixed overhead efficiency or
productivity variance and fixed overhead capacity variance.
It is important to note that the sum of fixed overhead efficiency variance and fixed
overhead capacity variance is equal to fixed overhead volume variance.
}
Standard Actual
Actual
(i) Sales contribution = ¿ x contribution x contribution
quantity
margin margin
Standard
(iii)
Sales contribution Sales margin ¿
(
Volume variance : volume variance
= contribution
margin
{
Actual
quantity
Budgeted
quantity }
SCV = SCM (AQ – BQ)
Standard Standard
But: (a) Standard contribution margin (SCM) = –
Selling price Variable cost
Example 1:
MK (U) Ltd. Produces ice cream whose standard selling price is 400/= and the cost of
production from standard cost card being:
The budgeted output for the period was 16,000 units but during the period, 15,000 units
were produced and sold at 380/= each.
Required:
Calculate the sales variances.
Example 2
N&M (U) Ltd provided the following sales data to you for further analysis. Managers are
not sure whether the company has performed to its expectations or not. You have
therefore been identified to assist in providing information that can assist them in
assessing the company’s level of performance. The sales data is given below:
Budgeted sales
Product Uni Unit selling price Unit variable cost
ts
Ice cream 8,00 1,000 600
0
Chocolate 12,0 800 300
00
Sandwich 5,00 2,000 1,2
Management Accounting – Page 82
0 00
Actual sales
Product Uni Unit selling price Unit variable cost
ts
Ice cream 10,0 800 500
00
Chocolate 11,0 900 400
00
Sandwich 7,00 2,100 1,1
0 00
In an attempt to provide the information, you are required to compute the following sales
variances;
i) Sales contribution/ margin price variance
ii) Sales contribution/ margin volume variance
iii) Sales contribution/ margin mix variance
iv) Sales contribution/ margin yield variance
Required: Calculate the above variances and advise accordingly.
Standard/Budgeted data:
Unit variable costs:
- Direct material 6 metres at 50/= per meter = 300
- Direct labour 2 hours at 80/= per hour = 160
- Variable overhead 60/= per direct labour hour = 120
580
Budgeted fixed overhead for the year UGX 250,000 and the standard selling price is
700/= per unit.
Daniel Furniture Ltd plan to produce 5,000 units and the company’s budgeted operating
statement is shown below:
Required:
Calculate all the relevant variances and reconcile them
Upper limit
Standard cost
Type of standard used: Some types of standards will always show adverse variances
especially the ideal standards. Such variances need not to be investigated.
Cost benefit analysis: Some variances may incur more costs of investigation relative to
the benefit derived there from. If that is the case, then it should not be investigated.
Interdependence of variances: At times, one variance has an influence over the other and
normally reversing the directions. Before investigating such variances, the
interdependence should first be looked out for and the variance report should take this
into account e.g. a favourable price variance may mean that poor quality materials were
bought at a cheap price causing unfavourable materials usage variance due to
unnecessary wastage.
Also unfavourable labour efficiency variance could be due to difficulty of handling such
materials.
Controllability: Some variances arise from external factors which cannot be controlled
by management and thus investigating and reporting on such variances is meaningless.
This is typical of the material price variances, labour rate variance and sales contribution
price variance which are determined by market forces of demand.
Topic 7
BUDGETING AND BUDGETARY CONTROL
A budget is a plan that can be expressed in quantitative or qualitative form. It's usually
prepared for a period of one year but it can be for shorter time periods in order to
facilitate control.
A budget is a financial plan that serves as a formal statement of revenue and expenses of
an organization. A budget provides a time frame for decisions about the services and
activities. A budget provides indications of revenue flows.
A forecast is a predication about possible future events. A budget is more than just a
forecast. It is a commitment and it is a method of control. Actual performance is
continuously compared with the budgeted performance and if variances arise corrective
action is instigated &/or the differences explained.
Budgeting refers to the act of preparing a budget. The budgeting process provides
managers with the opportunity to match carefully the goals of the organization with the
resources necessary to accomplish those goals.
Example: AB Ltd budgets to have sales of £2m per quarter. If the sales only reach £1.8m
there's an adverse variance of £0.2m. If the shortfall is outside the company's control, e.g.
due to a recession, then the budget will have to be revised. If the shortfall is due to
reasons within the control of the company e.g. due to a poor marketing strategy, then
management can take the necessary action to get over the shortfall.
Feedback is the traditional control system where information is accumulated about what
has already happened, this information is examined and action is then taken.
(c) "Passing the buck" - one department may blame another for failing to
achieve targets.
3. Sub optimal Decisions - These can arise where managers try to obtain short-run
divisional gains which, in the long-run, are detrimental to the organization as a
whole e.g. when departments under-invest to obtain high returns on capital
employed.
4. "Slack" - Managers often try to obtain a larger budget allowance than is really
needed which may go to hide inefficiencies. (Some slack is, however,
permissible for contingency purposes.)
5. Unnecessary spending - This can take place when a manager fully utilizes the
budget allowance through fear of future cutbacks
6. Setting Standards - There is the problem of setting the right standards and
subsequently revising them.
e) Sensitivity Analysis
Production budget.
The production budget is derived from the quantities that are expected to be produced in
the period
Sales budget.
The sales budget consists of the expected sales units and the selling price per unit. To get
the expected sales per unit, the sales manager will base on past data as well as the future
Cash budget
This is a forecast of expected cash inflows and expected cash out flows. It will show
either a shortage or surplus. In case of a shortage, negotiations for other sources of
finance can begin
Management Accounting – Page 90
Labour budgets
The labour budget will represent the labour requirements to meet the production levels.
The labour budget is derived from the production budget.
This shows the estimated costs of raw materials to be used in the production process.
Raw material budgets will show the quantities and estimated prices of raw materials
The budget will show expected expenditure on acquisition of non current assets e.g.
machinery, buildings etc
Example 1
The following information has been made available from the records of Mk Ltd
enterprise for the next six months of 2006
MK Ltd anticipated to sell each units at 2,000/= every month. The company had opening
stock of finished goods amounting to 500 units.
MK Ltd planned to reserve closing stock of finished goods at the end of the month and
are part of the produced units.
Information got from the production manger indicates that each unit requires the
following composition of cost to be complete.
Total 16,000
The stores manager states that the company’s policy is to reserve raw materials
equivalent to 5% of the next month’s requirement because the suppliers are unreliable.
Closing inventory of raw materials in June will be the same figure as in May.
The raw materials are purchased from the suppliers at 1,500/= per litre
i. Sales budget
ii. Production budget
iii. Raw materials utilization/ cost budget
iv. Labor cost budget
A cash budget is a detailed estimate of cash receipts from all sources and cash payments.
The cash budget contains every type of cash inflow and outflow (Capital and revenue).
Receipts include
Cash sales
Receipts from accounts receivable
Receipts from disposal of assets
Interest received
Rental income etc
Payments include
Payments to creditors
Salaries
Acquisition of fixed assets
Payment of loans etc
Cash budgets have the following purposes
Management Accounting – Page 93
Ensure that sufficient cash is available
in case of surpluses , short term investments can easily be invested in
In case of cash deficits , action can be taken immediately to look for sources of
finance
Cash budgets show whether the capital expenditure will be financed internally or
externally.
CASH BUDGETING
In business cash is king’ remember if you fail to plan, you plan to fail! Cash is one of the
most popular assets in the organization. Its presence or absence can affect the company’s
performance greatly. The more cash that is available to the business, the more, the ability
to meet its obligations as and when they fall due.
a) Persistent making of losses: Even a business with bigger reserves will reach a
point where it no longer has anywhere to get capital if it continues to make losses.
b) Inflation: A business can be making profits using historical cost but still not
receiving enough cash to buy the replacement assets. High price levels increases
in monetary terms but what money can really buy decreases.
c) Growth: A business might need to acquire more fixed assets and to support
higher amounts of stocks and debtors. These additional assets must be paid for
somehow (or financed by creditors).
d) Seasonal business: When a business has seasonal or cyclical sales, it may have
cash flow difficulties at certain times of the year, when
(i) Cash inflows are low, but
(ii) Cash outflows are high, perhaps because the business is building up its
stocks for the next period of high sales.
(e) Large one-off expenditure: A single non-recurring item of expenditure may
create cash flow problems i.e. repayment of loan capital, purchase of
exceptionally expensive items e.g. freehold property.
HOW TO EASE CASH SHORTAGE
1. Postpone capital expenditure – where possible i.e. if company’s policy is to
replace cars every 2 years, it might decide to replace every after 3 years.
2. Accelerating cash inflows, which would otherwise be expected in a later period,
e.g. press debtors for early payments.
3. Reversing past investment decisions by selling assets previously acquired.
4. Negotiating a reduction in cash outflows by:
Taking a longer credit from suppliers
You are in business to make money (cash). This cash must be effectively managed to
generate more wealth.
Definition of a cash budget:
A cash budget is “a detailed budget of cash inflows and outflows incorporating both
revenue and capital items.” It is a statement in which estimated future cash receipts and
payments are tabulated in such a way as to show the forecast cash balance of the
organization/project/business at the end of each operating period.
A cash budget is prepared to show the expected receipts of cash and payments of cash
during a budget period.
Receipts of cash may come from one or more of the following:
a) Cash sales, Government contributions/Grants, donations and debt collections etc.
b) Payments by debtors (credit sales)
c) The sale of fixed assets
d) The issue of new shares
e) Bank loans or micro finance loans
f) The receipt of interest and dividends from investments outside the business.
g) Borrowings from family members and friends.
Payments of cash may be for one or more of the following:
Purchase of stocks and materials
Staff salaries and other payroll costs or other expenses
Purchase of capital items
Management Accounting – Page 97
Payments of interest, dividends
Taxation
Required:
1) Prepare a cash budget for the period 1st June to 31st December 2009.
2) Advise the management of ABC LTD using information provided by the cash
Budget.
Illustration 2
a) Stefan brothers Inc is planning to request for credit from its bank and the following
sales forecast have been made.
Month 2013 Amount $ ‘000
May 850
June 850
July 1600
August 2,350
September 3,100
October 1,600
November 1,700
December 475
January 2014 850
Collection estimates were obtained from the credit and collection department as follows;
i) Collection within the month of sale 10%
ii) Collection within the month following sale 70%
iii) Collection in the 2nd month following sale 20%
APPROACHES TO BUDGETING
Fees charges x
Rent x
Interest x xx
The aim of PPBS is to enable the management of non profit making organizations to
make more informed decisions about the allocation of resources to meet the overall
objectives of the organization.
This is done by first establishing the overall objectives of the firm which is followed by
analyzing or evaluation of programmes that might achieve these objectives and finally the
Advantages of PPBs
It provides information on the objectives of the organization.
It cuts across conventional lines of responsibility and departmental structures by
drawing together the activities that are directed towards a particular objective.
It concentrates on long-term effects.
It provides information on the impact that existing and alternative programmes
will have on objectives and associated programme costs.
It enables resource allocation choices to be made on the basis of benefit and cost
relationships.
Disadvantages
The information needed for PPBs is far from readily available.
It is always difficult to define the objectives and to measure the output of a
service e.g. social service.
It is always difficult to determine costs collected because many activities are of a
multipurpose nature and it is always obvious to determine and allocate such costs
collected.
INCREMENTAL BUDGETING
This is a budgeting approach where budgets are made and formulated basing on the
previous year’s budget.
This is done by adjusting some budget items down or upwards to reflect the current state
of affairs.
The attention is focused on the marginal or incremental difference between this year’s
budget and last year budget.
DISADVANTAGES
Mistakes of the previous budget are carried forward to the following year.
It is argued that such an approach fails to consider whether a particular item is
required or whether the amount currently incurred is reasonable.
Once the item appears in the budget its inclusion in further budgets is taken for
granted and only incremental changes in the item are considered.
It encourages complacency in managers i.e. discourages innovation, but they just
relax.
ADVANTAGES
It is easy to apply not so much time is taken.
It does not require experts.
Advantages
Unlike incremental budgeting, it does not assume that last year’s allocation of
resources is necessary appropriate for the current year.
It provides or produces in a readily accessible form more and better management
information.
Its application involves the participation of lower level management in the
budgeting process, and the smaller the decision units are, the greater this
involvement will become.
Unexpected events that occur during the financial year can be more readily
adjusted e.t.c.
Disadvantages
Skilled manpower is needed
Consumes a lot of time in preparing the budget
Expensive to operate e.t.c
Budget period
Control period
Is a period normally shorter or equal to budget period within which budgets are reviewed
and adjustments made? It is normally seen where there is continuous or rolling budgets.
Is any factor that limits the activities of the organization? It can be sales and manpower
resource, material shortages or plant capacity. A limiting factor like shortage of raw
This implies that when an organization is budgeting it will have to look at how many
units can be produced from the available raw materials.
Budget center
Is a section of an entity for which control may be exercised and budgets prepared.
Budget manual
A budget manual is a book that lays down the procedure of budgeting, the people
responsible and the budget time table.
i. Purpose of budget
ii. Organizational structure
iii. Budget centers ,their Heads and responsibility
iv. Types of budgets prepared by the organization
v. Membership of budget committee
vi. Procedures for preparing budget and format
vii. Budget time table specifying stages in which the budget should be prepared.
Budget committee
The budget committee formulates the general procedures to be followed during the
process. It is always headed by a chairman who is a senior member of management
assisted by the budget officer who should be an accountant and plays the role of a
secretary to the committee
Planning stage:
Control stage:
Fixed budget: This is designed not to change irrespective of the changes in output.
The original budgets at the planned outputs are compared with the actual
performance with at whatever level of output.
Flexed budget: This is one which recognizes cost behavior patterns and is
designed to change as volume of output changes. This is useful for control
purposes.
Steps in flexing the budget
How can senior management ensure that the budgeting system can be most
effective?
Research findings assert that managers prefer to work towards achieving objectives
which motivate them. It appears that motivation is the glue which holds the budgeting
and control systems together so creating this motivation is the key. There appear to be a
number of factors involved.
1 Budgets (targets) should be set at a level which is stringent and challenging but
attainable. If set too high to be unattainable the staff may be demoralized and may
not try to achieve the targets.
2 Departmental managers in consultation with their staff should be permitted to
participate in the setting of their budgets by so doing they will have ownership of
them and will strive to attain them. Participation clarifies responsibilities,
increases communication throughout the organisation and can help to promote
line-staff relations.
Budgetary process or cycle varies from one organization to another depending on its size
and policies. However the following stages do apply to various organizations.
Planning Activities: Any meaningful budget should start from planning activities to be
done in the forthcoming period. How core are those activities in the main stay of the
organization i.e. prioritizing. Core activities should have the first call on resources.
Releasing funds without being sure of activities to be funded is poor budgetary
management.
Other than financial resources other limiting factors include; human resources, raw
materials, weather for the case of farmers, etc.
The chief executive officer normally communicates budget policy guidelines and hints on
the limiting factor before the onset of preparation of budgets.
Preparation of Budgets
Having determined the various budget constraints and having an idea on likely resources
inflows, the various expenditure and revenue budgets are then prepared. Revenue
budgets should be prepared before expenditure budgets. Proposed expenditure will be
based on the expected revenues. The various budgets of sections are compiled into one
document for the organization called the Master Budgets, which is then sent for
discussion
Once the various budgets have been prepared and perhaps compiled into a mater budget,
a budget committee is constituted to discuss and approve the budget. The chairperson of
the budget committee should be the chief executive officer of the organization and the
Accountant or Finance officer should the secretary.
The Accountant must identify inconsistencies and bring them to the appropriate manager
who will then rectify them. Such modifications may be several until the budgets are
acceptable to all parties concerned. During the co-ordination process, a budgeted P&L
A/C , Income and expenditure statement, balance sheet and cash flow statement should
be prepared to:-
Ensure that all parts of the budget combine to produce an acceptable whole.
If not further adjustments may be necessary until acceptability is achieved.
When all budgets have been harmonized they are summarized into a master budget
consisting of:-
Budgeted P & L, Income Statement, Balance sheet and Cash flow statement
After the Budgets have been approved the budgets are then passed down to the
appropriate responsibility centres for implementation.
The approval of the master budget is the authority for the responsibility center to carry
out the plans contained in each budget
Periodically actual results should be compared with budgeted results and comparisons
should be made on a monthly basis. A report should be sent to the budget committee in
the first week of the following month so that it has the maximum motivational impact.
During the year the Budget committee should periodically evaluate the actual
performance and re-appraise the company’s future plans in view of changes in actual
conditions from those originally expected. If these changes are major this may lead to
budget revisions/adjustments for the remaining period.
Topic 8
The term decision relevant approach is used to describe the specific costs and benefits
that should be reported for short term decisions. We shall assume that the objective when
examining alternative courses of action is to maximise the present value of future net
cash inflows.
It is important that you note at this stage that a decision relevant approach adopts
whichever planning horizon the decision maker considers appropriate for a given
situation. However, it is important not to focus excessively on the short term, since the
objective is to maximise long term net cash flows. We start by introducing the concept of
relevant cost and applying the principle to decisions relating to the following:
Dropping a segment
Make or buy
Special order
Joint products
Extra shift
Limiting factor situations
Relevant and Irrelevant information
7.1.1 What are relevant costs and revenues?
A managerial decision is a choice between alternative options, possibly including the
option of doing nothing. The choice is likely to have cost implications, in the sense that
the amount of some costs will differ depending upon which option is selected. Such costs
are described as relevant to the decision: the manager must consider what will happen to
these costs as a result of this decision. On the other hand, there may be costs which
remain the same no matter which option is selected; such costs are not relevant to the
decision. A similar argument applies to relevant and non-relevant revenues.
A relevant cost is a future cash flow which arises as a direct result of a decision. . It’s a
future cash flow that will differ between the various alternatives being considered.
In relevant costing the only costs and revenues that should be considered are those which
differ as a result of a decision or decisions; i.e. only those which vary under the different
alternatives being considered. Occasionally relevant costs are also referred to as
differential costs or incremental costs.
The money spent on research is a sunk cost and irrelevant to the decision. The question
for the company’s management is: Should we make a product for a variable cost of $8 in
order to sell 4,000 units at $10 each. Contribution and profit would increase by $8,000.
A B C Activity
A change in activity from point A to point B does not affect the level of total fixed costs
because both the activity levels lie on the same fixed cost step. For such a decision the
fixed cost is irrelevant because it is not changing. However a change in activity level
from point B to point C does affect the level of fixed costs. Thus a decision causes the
total fixed costs to change and in such circumstances they are relevant. When fixed costs
become relevant in such a way, the extra fixed cost is usually referred to as the
Incremental fixed cost.
It is concluded that the analysis should eliminate all irrelevant figures, i.e. those
unaffected by the decision. This, of course, considerably simplifies the decision, because
it eliminates from consideration many irrelevant costs.
Note that fixed costs are not always irrelevant. If they vary between decision
alternatives, they are relevant and must be taken into account
Are Materials
No
already in stock?
Cost of Purchases
Yes
Will they be
No
replaced?
Replacement Cost
Does Spare
Capacity Exist? Yes
Explanatory notes:
1. The material cost of 6,000,000 is irrelevant as it is a sunk cost. However, 2,000,000/=
and 4,000,000/= are the relevant amounts as they are the salvage and future values
respectively.
2. The cost of labour amounting to 2,000,000/= is a relevant amount as it’s a future cost.
3. When the contract is undertaken, a net benefit of 1,800,000/= will have to be foregone
by switching off labour, this is an opportunity cost of labour to be charged to the contract.
4. The Subcontract fees of 3,300,000/= of which 1,100,000/= is not escapable leaving
relevant cost of 2,200,000/=.
5. The revenue of 10,000,000/= was received prior to liquidation and therefore sunk
revenue. However, 28,000,000/= is the relevant future revenue.
When spare capacity exists, say a machine is under-utilized and the capacity can be
utilized into manufacture of the component, relevant cost of manufacture will be the
variable cost of manufacture and the specific or additional fixed cost, where possible.
Where spare capacity does not exist say machine is fully busy, the manufacture of the
component will require the withdrawal or suspending the production of existing products.
This will cause opportunity cost and therefore, the opportunity cost will be taken into
consideration.
However, if the spare capacity that will be created in case the components are to be
purchased can be utilized in the most effective way, the amount realized from that spare
capacity is relevant to decision- making.
Example
JK enterprises manufactures 1,000 components used to make the final product and the
cost structure is as below.
Cost per unit ($)
Direct materials 2
Direct labour 6
BMK who is an outside supplier is offering to sell the component to JK for $ 11 each.
The labour force is in short supply and existing labour force is fully occupied. To produce
the component the company will have to divert 2 workers who are currently producing
product A and each worker’s contribution is $ 4 per unit if each component is to be
produced. These 2 workers are part of the permanent staff but each worker’s salary will
increase by $1 for every component produced.
All the materials to make the required components are already in the warehouse and have
no alternative use at all. The materials were purchased at a cost of $ 2 per unit.
If the components are to be manufactured, purchasing manager's salary will decrease by $
2 for every component manufactured though the supervisor’s salary will increase by $3
per unit made.
For every component manufactured or purchased, quality test will be carried out at rate of
$4 per unit.
Required:
i) Advise the firm whether the component should be manufactured or purchased or
whether the offer should be accepted.
ii) Other than the cost criterion, what qualitative factors are likely to affect the decision
made above?
Before the decision of shut down is taken, its impact on overall profits must be assessed.
As long as the production line recovers all the variable costs and makes a contribution
towards the recovery of fixed costs, it may be preferable to operate and not to shut down.
If the profits rise due to shutting down, then shut down otherwise maintain the production
line.
However, management should consider the investment in the training of its employees
which would be lost in the event of a temporary shutdown. Another factor is the loss of
established markets for the products the company has been selling. The danger of
obsolescence of the plant cannot be ignored.
The Company is concerned about its poor profit performance and it considering whether
or not to cease selling Rooks. It is felt that selling prices cannot be raised or lowered
without adversely affecting net income if the production of Rooks is suspended 5,000/=
of fixed costs will be avoided because the cost is directly related to the production of
Rooks. Assume that Rooks cannot be substituted by any other product and that
investment in assets cannot be reduced if this product is dropped. All other fixed costs
are considered to remain the same.
Required
Advise the Company on the shutdown of Rooks and make any reservations.
The level output of the company may be restricted by shortage of resources known as
limiting factors. A limiting factor is an element that restricts the output and the profit
potential earning capacity of the firm. Limiting factors could be shortage of labour,
materials, equipment or factory space.
A limiting factor is any factor that is in scarce supply and that stops the organization from
expanding its activities further i.e. it limits the organizations activities.
An organization may be faced with just one limiting factor (other than maximum sales
demand) but there might also be several scarce resources – with two or more of them
putting an effective limit on the level of activity that can be achieved examples of
limiting factors include:
Sales demand
Production constraints such as:
Labour- the limit may either be in terms of total quantity or particular skills.
Materials – There may be insufficient available materials to produce enough units
to satisfy sales demand.
Manufacturing capacity – There may not be sufficient machine capacity for the
production required to meet sales demand.
To make matters worse, within a short time it is unlikely that these production constraints
can be removed and additional resources acquired. Where the limiting factors apply,
profit can be maximized when the greatest possible contribution to profit is obtained each
time the scarce or limiting factor is used.
Contribution per limiting factor = Unit contribution (unit selling price – variable cost)
Units of scarce resource to make complete unit
(c) Rank the products by contribution per limiting factor with one being
assigned to product with highest contribution per limiting factor and
in that order.
(d) Produce to full satisfaction of each product following the ranking
order until the limiting factor units are used up.
Illustration
Sausage King makes two products, the Mash and Sauce. The unit variable costs of the
above products are as follows:
Required
Determine the production budget that will maximize profit assuming that fixed costs per
month are $ 20.000 and that there is no opening inventory of finished goods or work in
progress.
Note: where there is only one ‘real’ scarce resource the method above can be used to
solve the problem. However where there are two or more resources in short supply
This decision arises, when a customer outside the normal customer base offers a price
less than the normal selling price. For the decision to be accepted, we first look at the
operating capacity to service the order and then compute the relevant cost of the order
that is, marginal cost (direct cost) with the price offered and if there is any contribution,
we accept the offer.
Example
Mugimu produces a single product and has budgeted for the production of 200,000 units
during the next quarter. The cost estimates for the quarter are as follows:
Review question
A one off order for 3,000 garden chairs has been received from an overseas customer for
the coming period. Your budgeted production for the period is for 16,000 chairs which
represent 80% of your special capacity to manufacture garden chairs.
Budgeted data for the period is as follows:-
UGX.
Sales 672,000
Materials 192,000
Labour 196,000
Overheads 200,000 588,000
Profit 84,000
You ascertain that UGX. 20,000 of labour and 20% of overheads are fixed in nature and
the rest of the costs are variable.
Required:
(a) Prepare a cost statement to show whether the order should be accepted. If
the customer was prepared to pay:
(i) 30/= per chair
(ii) 36/= per chair and give reasons for your answer.
(b) What other factors need to be taken into consideration before the order is
accepted or rejected?
The company has just received an offer from an outside supplier who can provide 8,000
shifters a year at a price of only $ 19 each. Should the company stop producing the
shifters internally and start purchasing them from the outside supplier?
2. A firm manufactures component BK 200 and the costs for the current production level
of 50,000 units are:
Costs / unit
Materials 2.50
Labour 1.25
Variable Overheads 1.75
Fixed Overheads 3.50
Total cost 9.00
Component BK 200 could be bought in for 7.75 and if so, the production capacity utilised
at present would be unused. Assuming there are no overriding technical considerations,
should BK 200 be bought in or manufactured?
3. K.C Ltd purchases every year 10,000 units of spare part from another manufacturer @
2 per unit. The production manager of K.C Ltd has presented a proposal before the
management that the production of this spare part be undertaken by the co. in order to