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Intro to Management AccountingUnderstanding Costs

Week 6

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The role of the management accounting

system Control and prepare management

accounts which captures and processes data for

formulating overall strategies and long range/short range plans

making resource allocation decisions planning and control of operations &

activities evaluating of managers and operations reporting information for use in

external reports (annual accounts)

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Evolving themes in management accounting

Customer focus Key success factors: Cost, Quality,

Time, Innovation Total value chain analysis: Treating

each business function as a valued contributor

Continuous improvement Other concepts

Professional ethics Cost benefit approach Unstructured problem-solving

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Functions performed by management accountant

Scorekeeping (preparing an income statement of a business unit)

Attention Directing (preparing budget report)

Problem solving (comparison of costs of two photocopiers)

The controller partnering with management

Decision support

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Financial accounting –v-

Management accounting

Financial It ain’t what you do, it’s the

way that you do it Management It ain’t what you got, it’s the

way that you use it

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If you got income, you gotta have… Costs

Many management accounting techniques developed in manufacturing

Many are applicable to service industries

Common feature is identification of costs

Understanding behaviour of costs Controlling costs Using this information to improve the

organisation

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Types of cost Variable costs Rise and fall with levels of output

Direct materials Fixed costs Exists irrespective in changes in output

Rent of factory Stepped costs Remain constant (fixed) until trigger event

Renting more factory space if production exceeds certain level

Semi-variable costs Present fixed and variable elements

Telephone costs

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Variable costs Variable costs can be further broken down

into Direct costs Variable overheads

They generally can be related directly to a specific unit of production

Eg wood used for making chairs is a direct cost

If electricity consumed by a machine making chairs is known although there is no electricity in the product it can be directly related to the manufacture of the product – it is a variable overhead.

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Fixed Costs

Overheads of the organisation Some are production related Some are not Not directly related to the

product but The product (probably) couldn’t

be made without incurring overhead costs

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£s and units

Whereas Financial accounting concerns itself with £s only

Management accounting has a place for £s and units

But activities can be reduced to £s as a common measure

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Costing raw materials

Direct Materials + Direct Labour + Direct Expenses + = Prime Cost

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Direct Costs – Materials (Stock)

For high volume similar items purchased in batches need “broad” costing system

Can’t track individual items First-in-First-out (FIFO) Last-in-First-out (LIFO) (Weighted) Average Cost

(AVCO)

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Stock costing example

Day 1 buy 100 units @£5 each Day 2 buy 100 units @ £7 each Day 3 issue to production 50

units What is the direct cost to

production of Day 3 issue of material?

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FIFO

Cumulative Units £ 100 @ £5 100 500 100 @ £7 200 1200 Issue 50 @ £5 -50 -250 Remaining 150 950 Charge to production = £250 Closing Stock value = £950

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LIFO

Cumulative Units £ 100 @ £5 100 500 100 @ £7 200 1200 Issue 50 @ £7 -50 -350 Remaining 150 850 Charge to production = £350 Closing Stock value = £850

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AVCO Cumulative Units £ av

cost 100 @ £5 100 500 £5 100 @ £7 200 1200 £6 Issue 50 @ £6 -50 -300 Remaining 150 900 Charge to production = £300 Closing Stock value = £900

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Costs and EfficiencyCost Volume Profit

Analysis Understanding the behaviour allows Control which is needed because..

Increased revenue generation without control of costs

Affects profitability Decreases efficiency Reduces margins

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Graphical representation of fixed cost behaviour

Cost (£)

Volume of activity (units of output)

F

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Graphical representation of variable cost behaviourCost (£)

Volume of activity 0

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Combination of fixed and variable costs

Cost (£)

Volume of activity (units of output)0

F

Total cost

Fixed costs

Variable costs

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Reason for combination Assume Fixed Costs of £1,000 That is a cost irrespective of output Assume Variable costs of £1 per

unit At 0 output costs = £1,000 At 1 unit output costs = £1,001 At 10 units output costs = £1,010

etc…

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So does it matter? 1 There is a link between variable

costs and income Every time you make and sell a unit

you Gain income Incur a cost As income rises so do variable costs But your fixed costs remain the

same

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So does it matter? 2

Hopefully you sell products at more than the costs of production

But you still have to cover the fixed costs

Until fixed costs are covered you won’t make a profit

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Relationship of income and costs

Cost (£)

Volume of activity (units of output)0

F

Total cost

Fixed costs

Variable costs

Break even point

Total sales revenue

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An example…(a simple one)..

You plan to make and sell 10,000 units

Can sell for £3.00 per unit Costs are.. Workshop rent £15,000 per

annum Raw materials 50p per unit Electricity 20p per unit

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How much profit? Income (10,000 X £3) £30,000 Costs Rent £15,000 “Direct costs” (70p X 10,000) £

7,000

Profit £ 8,000

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Sounds OK then…

But what if only able to sell 6,500 units

Less units made = less variable costs

But fixed costs still have to be paid

Which means..

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Cancel world cruise, then? Income (6,500 X £3) £19,500 Costs Rent [still to be paid] £15,000 “Direct costs” (70p X 6,500) £

4,550

Loss £ 50

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Avoiding failure (probably) Identify which costs are variable And which are fixed This is important From this knowledge is it possible

to predict how viable a business proposition is?

Yes. To an extent. Enter Cost Volume Profit Analysis (CVP analysis)

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A bit of jargon The difference between income

(which exhibits variable behaviour) and

Variable costs is Contribution Every unit sold gives a contribution

to profit Each unit’s contribution erodes

fixed costs until we “Break even” Total Income = Total Costs (no

profit or loss)

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Finding the Break Even Point (BEP)

BEP in units is where Total Income = Total

VC + FC So where Income – VC = FC BEP (units) =

Fixed Costs Contribution

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Why do we want to know?

Markets for goods are uncertain

Allocation of resources Margin of safety How duff can your sales

predictions be without ending up making a loss

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Practical ExampleAcme Dog Products Ltd

The “Clip-it” patent spaniel ear clip

Variable costs = £7 per clip Fixed Costs = £350,000 Selling Price = £12 per clip What is the Break Even Point

(BEP)?

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The “Clip-it” patent spaniel ear clip

Can be done by plotting simply on a graph or

Fixed Costs £350,000 = 70,000 units

Contribution (12 – 7)

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Developing the scenario Simple BEP tells us how many units we

need to sell before we start to see a profit. Assume however..

Up to 50,000 units selling price = £15 Above 50, 000 units selling price = £10 New BEP = £350,000 = 43,750

units (£15 – £7)= £8

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Introducing stepped costs But if sales are over 50,000 units need extra warehouse

space at cost of £80,000 per annum This is a fixed cost At sales of 50,000 units contribution = 50,000 X 8 =£400,000 Fixed costs = (£350,000) Profit = £ 50,000

At sales greater than 50,000, then extra fixed costs = (£ 80,000) So need to cover additional costs of £

30,000

Therefore additional FC = £30,000 = 10,000 units Contribution = (10 – 7) BEP = 50,000 + 10,000 = 60,000 units

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How does this help decision making?

Choices (assuming can sell at least 50,000 units)

Sell no more than 50,000 units and make maximum profit of £50,000

If sell more than 50,000 units New BEP = 60,000 Every unit above BEP makes profit of £3 To make profit of £50,000 need to sell 60,000 units PLUS £50,000/£3 = 16,667 units Therefore 76,667 units Is this viable? Have we the resources? What is

long term prospect for this product? Etc……

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Using CVP analysis to improve profitability

Yorkies Ltd – produce specialised ear clips for Yorkshire terriers

Selling price = £8 Could make and sell 55,000 units Last year output was 40,000 units Variable costs

Direct materials £3.00 Direct labour £1.10 Overheads £0.70

Fixed costs Production £65,000 Selling £28,000

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BEP?

Fixed costs = £93,000 = Contribution = (£8-£4.8) = £3.2

So BEP was 29,063 units

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What was profit last year? Total Revenue = 40,000 X £8 =

£320,000 Total costs Variable (£4.80 X 40,000) £192,000 Fixed £ 93,000 £285,000

Revenue = £320,000 - £285,000 = £35,000

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More profit… What price would have to be charged

last year to have made a profit of £50,000?

Total Costs = £285,000 To cover costs and make £50,000

profit would need income of £285,000 + £50,000 = £335,000 Unit price = £335,000 = £8.38 40,000

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Modelling profit maximisation

Knowing the relationship between individual costs and income means

Prediction of profits Develop models to improve

efficiency Incentive schemes Provide benchmarks for success of

plans

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Management have an idea!

Management have suggested 2 scenarios to improve profits

Scenario A Spend £20,000 on advertising and raise selling

price by 5% Expect to see sales rise by 15% Scenario B Salesperson is currently paid £13,850 per annum Switch to paying them 30p for each unit sold up

to the new BEP Then 50p per unit over BEP Expect sales to increase by 20%

What are the EXPECTED outcomes?

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Scenario A Fixed costs now £113,000 Sales = (40,000 + 15%) 46,000 units Selling price = (£8 + 5%) £8.40 Contribution per unit = £8.40 - £4.80 =

£3.60

Total revenue = 46,000 X £8.40 = £386,400 Less variable costs = £220,800 Less fixed costs = £113,000 Profit = £ 52,600

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Scenario B Sales rise to 48,000 units Fixed costs go down by £13,850 to £79,150 Up to BEP variable costs up by 30p to £5.10 Therefore contribution = £8 - £5.10 = £2.90 BEP = £79,150 = 27,293 units £2.90 Up to BEP fixed costs are covered, so after BEP units sold = 48,000 – 27,293 =

20,707 All revenue is profit less variable costs Therefore 20,707 X £8 = £165,656 Less variable costs Now (£4.80 + £0.50) X 20,707 = £109,747 Profit = £ 55,509

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Scenario B

Salesperson’s earnings 27,293 X 30p = £ 8,188 20,707 X 50p = £10,354 £18,542

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Downsides to CVP analysis Cost classification

It is not always that easy to identify cost behaviour Variable costs

Don’t necessarily exhibit linear relationship with output (bulk discounts etc)

Time period Does the relationship between costs/income hold true

into the distant future? Complementary products

CVP analysis assumes a one product mix. What if several products being made is there a spillover effect?

Estimates Extrapolation to the future is based on best estimate.

Obviously things could change Non-cost factors

CVP analysis is number-only based