Intro to Management Accounting Understanding Costs

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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 aint what you do, its the way that you do it
• Management
• It aint what you got, its 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) couldnt 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
• Cant 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 _at_5 each
• Day 2 buy 100 units _at_ 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 _at_ 5 100 500
• 100 _at_ 7 200 1200
• Issue 50 _at_ 5 -50 -250
• Remaining 150 950
• Charge to production 250
• Closing Stock value 950

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LIFO

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

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AVCO

• Cumulative Units av cost
• 100 _at_ 5 100 500 5
• 100 _at_ 7 200 1200 6
• Issue 50 _at_ 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
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Graphical representation of variable cost
behaviour
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Combination of fixed and 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 wont make a
  profit

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Relationship of income and costs
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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 units 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

• Salespersons 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
• Dont 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