CIMA management accounting decision management

MANAGEMENT ACCOUNTING – DECISION MANAGEMENT P2 Learning Outcomes and Syllabus Content A – Financial Information for Short-term Decision-Making – 30% Learning outcomes On completio

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CIMA’S Ofﬁ cial

Learning System

Managerial Level

Management

Accounting – Decision Management

Colin Wilks

Louise Burke

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CIMA Publishing is an imprint of Elsevier

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First edition 2008

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The CIMA Learning System xi

How to use your CIMA Learning System xi

1 Revision of Basic Aspects, Classiﬁ cations and

Approaches to Cost Accounting 1

Learning Outcome 3 1.1 Introduction 3 1.2 What is meant by cost? 3

1.3 Cost units 4

1.3.1 Composite cost units 4

1.4 Cost centres 5

1.5 Classiﬁ cation of costs 5

1.5.1 Classiﬁ cation of costs according to their nature 6

1.5.2 Classiﬁ cation of costs according to their purpose 6

1.5.3 Other examples of cost classiﬁ cation 6

1.6 Cost behaviour 7

1.6.1 Fixed cost 7

1.6.2 Variable cost 8

1.6.3 Semi-variable cost 10

1.6.4 Analysing semi-variable costs 10

1.6.5 Using historical data 13

1.7 The elements of cost 13

1.8 Summary 14

2 Absorption Costing, Activity-based Costing and Marginal Costing 15

Learning Outcome 17

2.1 Introduction 17

2.2 Overhead allocation and apportionment 17

2.3 Overhead absorption 18

2.4 Applying the overhead absorption rate 18

2.5 Selecting the most appropriate absorption rate 19

2.6 Predetermined overhead absorption rates 20

2.6.1 Under- or over-absorption of overheads 20

2.6.2 The reasons for under- or over-absorption 21

Contents

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MANAGEMENT ACCOUNTING – DECISION MANAGEMENT P2

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2.6.3 Accounting for under- or over-absorbed overheads 21

2.6.4 The problems caused by under- or over-absorption of overheads 22

2.7 Illustrative example 22

2.8 Recent developments in absorption costing methods 24

2.8.1 The criticisms of the traditional approach 24

2.8.2 Activity-based costing 24

2.9 The difference between marginal costing and absorption costing 28

2.10 Marginal costing and contribution 28

2.11 Preparing proﬁ t statements using marginal costing and absorption costing 29

2.11.1 Proﬁ t statements using marginal costing 30

2.11.2 Proﬁ t statements using absorption costing 30

2.12 Reconciling the proﬁ t ﬁ gures 31

2.12.1 Reconciling the proﬁ ts given by the different methods 31

2.12.2 Reconciling the proﬁ ts for different periods 32

2.12.3 Proﬁ t differences in the long term 32

2.13 Should marginal costing or absorption costing be used? 33

2.14 A comprehensive example of ABC 33

2.15 Summary 44

3 Breakeven Analysis 45

Learning Outcomes 47

3.1 Introduction 47

3.2 Breakeven or cost–volume–proﬁ t analysis 47

3.2.1 Calculating the breakeven point 47

3.3 The margin of safety 48

3.4 The contribution to sales (C/S) ratio 49

3.5 Drawing a basic breakeven chart 50

3.6 The contribution breakeven chart 52

3.7 The proﬁ t–volume chart 52

3.7.1 The advantage of the proﬁ t–volume chart 53

3.8 The limitations of breakeven (or CVP) analysis 54

3.9 The economist’s breakeven chart 55

3.10 Using costs for decision-making 55

3.10.1 Short-term decision-making 56

3.11 Evaluating proposals 56

3.12 Multi-product CVP analysis 58

3.13 Using the C/S ratio–an example 60

3.14 Summary 61

Revision Questions 63 Solutions to Revision Questions 67 4 Relevant Cost and Short-term Decisions 73

4.1 Introduction 75

4.2 Relevant costs 75

4.2.1 Non-relevant costs 75

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MANAGEMENT ACCOUNTING – DECISION MANAGEMENT

4.3 Opportunity costs 77

4.3.1 Examples of opportunity costs 77

4.3.2 Notional costs and opportunity costs 78

4.4 Avoidable, differential and incremental costs 78

4.4.1 Avoidable costs 78

4.4.2 Differential/incremental costs 78

4.4.3 Using incremental costs 78

4.4.4 Incremental revenues 79

4.4.5 Minimum price quotations for special orders 80

4.5 Limiting factor decision-making 80

4.5.1 Decisions involving a single limiting factor 80

4.6 Further decision-making problems 83

4.6.1 A practical example 85

4.7 Summary 91

Revision Questions 93

Solutions to Revision Questions 101

5 Linear Programming 109

5.1 Introduction 111

5.2 Basic linear programming 111

5.2.1 Formulating the mathematical model 112

5.2.2 The graphical method of solving linear programming models 113

5.2.3 Further examples of the construction and graphing of constraints 117

5.2.4 Multiple solutions 119

5.2.5 Slack and surplus 121

5.2.6 Shadow prices and opportunity costs 123

5.3 The Simplex method 124

5.3.1 Formulating the problem 124

5.3.2 Interpreting the solution 125

5.4 Worth and relative loss 126

5.5 Summary 128

Revision Questions 129 Solutions to Revision Questions 133

6 Pricing 139

6.2 Demand and the product life cycle 141

6.2.1 Price elasticity of demand 141

6.2.2 The product life cycle 146

6.2.3 The proﬁ t-maximisation model 148

6.2.4 Limitations of the proﬁ t-maximisation model 150

6.3 Pricing strategies based on cost 150

6.3.1 Total cost-plus pricing 150

6.3.2 Marginal cost-plus pricing 153

6.4 Other pricing strategies 154

6.4.1 Premium pricing 154

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6.4.2 Market skimming 154

6.4.3 Penetration pricing 155

6.4.4 Price differentiation 155

6.4.5 Loss leader pricing 156

6.4.6 Product bundling 156

6.4.7 Pricing with additional features 157

6.4.8 Using discounts in pricing 159

6.4.9 Controlled pricing 159

6.5 Summary 160

7 Risk and Uncertainty 169

7.2 Probability 171

7.2.1 The probabilistic model and expected value 171

7.2.2 Examples of expected value calculations 173

7.3 Decision trees 176

7.3.1 Method and applications 176

7.3.2 The value of perfect information 180

7.4 Uncertainty in investment appraisal 181

7.5 Standard deviations to measure risk and uncertainty 182

7.6 Maximin, Maximax and Regret Criteria 183

7.6.1 A practical example 183

7.6.2 The maximin approach 184

7.6.3 The maximax approach 184

7.6.4 The minimax regret approach 184

7.7 Simulation 187

7.8 Summary 187

8 Investment Appraisal 199

8.2 The different appraisal methods 201

8.2.1 Introduction 201

8.2.2 Net present value (NPV) 203

8.2.3 Payback (PB) 205

8.2.4 Discounted payback (DPB) 206

8.2.5 Discounted payback index (DPBI) or proﬁ tability index 207

8.2.6 Internal rate of return (IRR) 208

8.2.7 Multiple IRRs 209

8.2.8 Modiﬁ ed internal rate of return (MIRR) 211

8.2.9 Accounting rate of return (ARR) 212

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8.2.10 Example comparing ARR and NPV 213

8.2.11 Summary of the four investment appraisal methods 215

8.3 Making the cash ﬂ ows and NPV model more realistic 215

8.3.1 Using the annuity rate 215

8.3.2 Unequal lives 216

8.3.3 Asset replacement cycles 217

8.3.4 Capital rationing 220

8.3.5 The discount rate 221

8.3.6 Sensitivity analysis 221

8.3.7 Risk 225

8.3.8 Inﬂ ation 226

8.3.9 Incorporating the effect of taxation 228

8.4 Post-completion appraisal 231

8.4.1 The investment cycle 231

8.4.2 Beneﬁ ts of post-completion appraisal 233

8.4.3 Project abandonment 234

8.4.4 Role of post-appraisal in project abandonment 237

8.5 Summary 237

9 The Value Chain – TQM 261

9.2 Continuous improvement 263

9.3 Kaizen costing 264

9.4 Value analysis 264

9.5 Functional analysis 265

9.6 The value chain 265

9.7 Just-in-time concept 266

9.8 Total quality management (TQM) 269

9.8.1 Quality as a concept 269

9.8.2 Measuring the cost associated with delivering quality 270

9.8.3 TQM in practice 271

9.8.4 Accounting for quality 272

9.8.5 Criticisms of TQM 272

9.8.6 Conclusion 273

9.9 Business process re-engineering 273

9.10 Gain sharing arrangements 273

9.11 Summary 275

10 Activity-based Approaches 285

10.2 The overhead problem 287

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10.2.1 Cost behaviour 287

10.2.2 Absorption costing 288

10.2.3 Direct product proﬁ tability (DPP) 289

10.3 Activity-based costing (ABC) 292

10.3.1 Activity-based costing and activity-based management 292

10.3.2 Activity-based management: cost management of activities 293

10.3.3 Costing objects other than products 294

10.3.4 Activity-based management: customer proﬁ tability analysis 295

10.3.5 Distribution channel proﬁ tability 297

10.3.6 Activity-based management: strategic activity management 298

10.3.7 Using ABC in service industries and activities 299

10.3.8 Problems with implementing ABC 299

10.4 Pareto analysis 300

10.4.1 The rule 300

10.4.2 Uses of Pareto analysis 301

10.5 Summary 304

11 Learning and Experience Curves 327

Learning Outcome 329

11.2 The learning curve 329

11.2.2 The nature of the learning curve 329

11.2.3 Uses of the learning curve 333

11.2.4 Deriving the learning rate using logs 334

11.2.5 Learned behaviour 335

11.2.6 Experience curves 335

11.3 Summary 338

12 Costing Systems 345

12.2 Costing systems and manufacturing philosophy 347

12.2.2 Traditional manufacturing philosophy 348

12.2.3 Modern manufacturing philosophy 350

12.2.4 Volume versus variety 350

12.3 Accounting for pull systems – backﬂ ush accounting 352

12.4 Throughput accounting 355

12.4.1 The theory of constraints (TOC) 355

12.4.2 Throughput accounting (TA) 356

12.4.3 Throughput cost control and effectiveness measures 360

12.4.4 Summary of throughput accounting 361

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12.5 Cost planning and reduction over the life cycle 362

12.5.1 Target costing: a strategic proﬁ t management system 362

12.5.2 Using target costing in the concept and design stages 364

12.5.3 Target costing for existing products 365

12.5.4 Target costing support systems 365

12.6 Life cycle costing 367

12.6.1 Life cycle costing – introduction 367

12.6.2 Product life cycle costing 367

12.6.3 Customer life cycle costing 370

12.7 Summary 371

Revision Questions 373 Solutions to Revision Questions 379

Preparing for the Examination 383

Revision technique 385

Planning 385

Getting down to work 386

Tips for the ﬁ nal revision phase 386

Format of the examination 387

Structure of the paper 387

November 2007 Examinations 535

Index 567

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Acknowledgements

Every effort has been made to contact the holders of copyright material, but if any here have been inadvertently overlooked the publishers will be pleased to make the necessary arrangements at the ﬁ rst opportunity

This text has been structured to be studied independently of the Performance Evaluation paper, therefore the reader will notice some unavoidable overlap between the two texts.

How to use your CIMA Learning System

This Management Accounting – Decision Management Learning System has been devised as a

resource for students attempting to pass their CIMA exams, and provides:

This Learning System has been designed with the needs of home-study and learning candidates in mind Such students require very full coverage of the syllabus top-ics, and also the facility to undertake extensive question practice However, the Learning System is also ideal for fully taught courses

The main body of the text is divided into a number of chapters, each of which is ised on the following pattern:

should assimilate these before beginning detailed work on the chapter, so that you can appreciate where your studies are leading

explana-tory text supported where appropriate by worked examples and exercises You should work carefully through this section, ensuring that you understand the material being explained and can tackle the examples and exercises successfully Remember that in many cases knowledge is cumulative: if you fail to digest earlier material thoroughly, you may struggle to understand later chapters

The CIMA

Learning System

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as relevant journal articles or other readings, together with comments and questions designed to stimulate discussion

tackle exam-standard questions Make a serious attempt at producing your own answers, but at this stage do not be too concerned about attempting the questions in exam condi-tions In particular, it is more important to absorb the material thoroughly by complet-ing a full solution than to observe the time limits that would apply in the actual exam

to think that this provides the same beneﬁ ts as you would gain from a serious attempt

of your own However, if you are struggling to get started on a question you should read the introductory guidance provided at the beginning of the solution, and then make your own attempt before referring back to the full solution

Having worked through the chapters you are ready to begin your ﬁ nal preparations for

the examination The ﬁ nal section of this CIMA Learning System provides you with the

guidance you need It includes the following features:

real exam, and in particular the number of questions to attempt, which questions are compulsory and which optional, and so on

quickly identify questions by subject area

condi-tions, especially as regards the time allocation

of solution that would be expected of a well-prepared candidate

If you work conscientiously through this CIMA Learning System according to the

guide-lines above you will be giving yourself an excellent chance of exam success Good luck with your studies!

Guide to the Icons used within this Text

Key term or deﬁ nition

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Passing exams is partly a matter of intellectual ability, but however accomplished you are

in that respect you can improve your chances signifi cantly by the use of appropriate study and revision techniques In this section we briefl y outline some tips for effective study dur-ing the earlier stages of your approach to the exam Later in the text we mention some techniques that you will fi nd useful at the revision stage

Planning

To begin with, formal planning is essential to get the best return from the time you spend studying Estimate how much time in total you are going to need for each subject that you face Remember that you need to allow time for revision as well as for initial study of the material The amount of notional study time for any subject is the minimum estimated time that students will need to achieve the speciﬁ ed learning outcomes set out earlier in this chapter This time includes all appropriate learning activities, for example face-to-face tuition, private study, directed home study, learning in the workplace, revision time, etc You may ﬁ nd it help-

ful to read Better Exam Results by Sam Malone, CIMA Publishing, ISBN: 075066357X This

book will provide you with proven study techniques Chapter by chapter it covers the building blocks of successful learning and examination techniques

The notional study time for Managerial level Decision Management is 200 hours Note

that the standard amount of notional learning hours attributed to one full-time academic year of approximately 30 weeks is 1,200 hours

By way of example, the notional study time might be made up as follows:

Now split your total time requirement over the weeks between now and the assessment This will give you an idea of how much time you need to devote to study each week Remember to allow for holidays or other periods during which you will not be able to study (e.g because of seasonal workloads)

With your study material before you, decide which chapters you are going to study in each week, and which weeks you will devote to revision and ﬁ nal question practice

Prepare a written schedule summarising the above – and stick to it!

The amount of space allocated to a topic in the study material is not a very good guide

as to how long it will take you For example, ‘ Summarising and Analysing Data ’ has a weight of 25 per cent in the syllabus and this is the best guide as to how long you should spend on it It occupies 45 per cent of the main body of the text because it includes many tables and charts

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to be adapted to allocate enough time for the whole syllabus

Tips for effective studying

(1) Aim to ﬁ nd a quiet and undisturbed location for your study, and plan as far as sible to use the same period of time each day Getting into a routine helps to avoid wasting time Make sure that you have all the materials you need before you begin so

pos-as to minimise interruptions

(2) Store all your materials in one place, so that you do not waste time searching for items around the house If you have to pack everything away after each study period, keep them in a box, or even a suitcase, which will not be disturbed until the next time (3) Limit distractions To make the most effective use of your study periods you should

be able to apply total concentration, so turn off the TV, set your phones to message mode, and put up your ‘ do not disturb ’ sign

(4) Your timetable will tell you which topic to study However, before diving in and becoming engrossed in the ﬁ ner points, make sure you have an overall picture of all the areas that need to be covered by the end of that session After an hour, allow your-self a short break and move away from your books With experience, you will learn

to assess the pace you need to work at You should also allow enough time to read evant articles from newspapers and journals, which will supplement your knowledge and demonstrate a wider perspective

(5) Work carefully through a chapter, making notes as you go When you have covered

a suitable amount of material, vary the pattern by attempting a practice question Preparing an answer plan is a good habit to get into, while you are both studying and revising, and also in the examination room It helps to impose a structure on your solutions, and avoids rambling When you have ﬁ nished your attempt, make notes of any mistakes you made, or any areas that you failed to cover or covered only skimpily (6) Make notes as you study, and discover the techniques that work best for you Your notes may be in the form of lists, bullet points, diagrams, summaries, ‘ mind maps ’ ,

or the written word, but remember that you will need to refer back to them at a later date, so they must be intelligible If you are on a taught course, make sure you high-light any issues you would like to follow up with your lecturer

(7) Organise your paperwork There are now numerous paper storage systems available

to ensure that all your notes, calculations and articles can be effectively ﬁ led and ily retrieved later

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The syllabus comprises:

Learning aims

Students should be able to:

anal-ysis and in decision-making under multiple constraints;

vari-ety of contexts including process/product viability and pricing including evaluation of

the tension between short-term, ‘ contribution based ’ pricing and long-term, ‘ return on

investment ’ pricing;

tax-ation where appropriate, evaluate projects using discounting and traditional methods,

critically assess alternative methods of evaluation and place evaluation techniques in the

context of the whole process of investment decision making;

management, target costing and value analysis in managing future costs and evaluate the

actual and potential impacts of contemporary techniques such as JIT, TOC and TQM

on efﬁ ciency, inventory and cost;

probability analysis, expected value tables and decision trees as appropriate;

tech-niques to the value chain, ‘ gain sharing ’ arrangements and customer/channel proﬁ

tabil-ity analysis

Assessment strategy

There will be a written examination paper of three hours, with the following sections

Section A – 20 marks

A variety of compulsory objective test questions, each worth between 2 and 4 marks

Mini-scenarios may be given, to which a group of questions relate

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Learning Outcomes and Syllabus Content

A – Financial Information for Short-term

Decision-Making – 30%

Learning outcomes

On completion of their studies students should be able to:

(i) discuss the principles of decision making including the identifi cation of relevant cash fl ows and their use alongside non-quantifi able factors in making rounded judgements;

(ii) explain the particular issues that arise in pricing decisions and the conﬂ ict between ‘ marginal cost ’ principles and the need for full recovery of all costs incurred;

(iii) apply an approach to pricing based on proﬁ t maximisation in imperfect markets and evaluate the ﬁ nancial consequences of alternative pricing strategies;

(iv) explain the possible conﬂ icts between cost accounting for proﬁ t reporting and stock valuation and the convenient availability of information for decision-making;

(v) explain why joint costs must be allocated to ﬁ nal products for ﬁ nancial reporting purposes, but why this is unhelpful when decisions concerning process and product viability have to be taken;

(vi) discuss the usefulness of dividing costs into variable and ﬁ xed components in the context of short-term decision making;

(vii) apply variable/ﬁ xed cost analysis in multiple product contexts to break-even analysis and product mix decision making, including circumstances where there are multiple constraints and linear programming methods are needed to reach ‘ optimal ’ solutions; (viii) discuss the meaning of ‘ optimal ’ solutions and show how linear programming meth-ods can be employed for proﬁ t maximising, revenue maximising and satisfying objectives

Syllabus content

accept-ance/rejection of contracts, pricing and cost/beneﬁ t comparisons

solution are acceptable)

penetration pricing, loss leaders, product bundling/optional extras and product tiation to appeal to different market segments

based on relevant costs and revenues

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con-tribution/sales ratio, margin of safety etc

demand and one other production constraint

by graphical methods of two variable problems, together with understanding of the mechanics of simplex solution, shadow prices etc (Note: questions requiring the full application of the simplex algorithm will not be set although candidates should be able

to formulate an initial tableau, interpret a ﬁ nal simplex tableau and apply the

informa-tion it contained in a ﬁ nal tableau.)

B – Financial Information for Long-term

Decision-Making – 25%

(i) explain the processes involved in making long-term decisions;

(ii) apply the principles of relevant cash ﬂ ow analysis to long-run projects that continue for several years;

(iii) calculate project cash ﬂ ows, accounting for tax and inﬂ ation, and apply perpetuities

to derive ‘ end of project ’ value where appropriate;

(iv) apply activity-based costing techniques to derive approximate ‘ long-run ’ product or

service costs appropriate for use in strategic decision making;

(v) explain the ﬁ nancial consequences of dealing with long-run projects, in particular the importance of accounting for the ‘ time value of money ’ ;

(vi) evaluate project proposals using the techniques of investment appraisal;

(vii) compare, contrast and evaluate the alternative techniques of investment appraisal;

(viii) evaluate and rank projects that might be mutually exclusive, involve unequal lives and/or be subject to capital rationing;

(ix) apply sensitivity analysis to cash ﬂ ow parameters to identify those to which net present value is particularly sensitive;

(x) produce decision support information for management, integrating ﬁ nancial and non-ﬁ nancial considerations

crea-tion of capital budgets, go/no go decisions on individual projects (where judgements on qualitative issues interact with ﬁ nancial analysis), and post audit of completed projects;

project value where appropriate

stra-tegic decision making

of return, net present value and internal rate of return

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evalua-tion of the strengths and weaknesses of the techniques

project worth (payback, ARR, NPV or IRR)

with unequal lives and the proﬁ tability index in capital rationing situations

C – The Treatment of Uncertainty

in Decision-Making – 15%

(i) evaluate the impact of uncertainty and risk on decision models that may be based on CVP analysis, relevant cash ﬂ ows, learning curves, discounting techniques etc.;

(ii) apply sensitivity analysis on both short- and long-run decision models to identify ables that might have signiﬁ cant impacts on project outcomes;

(iii) analyse risk and uncertainty by calculating expected values and standard deviations together with probability tables and histograms;

(iv) prepare expected value tables and ascertain the value of information;

(v) prepare and apply decision trees

analysis

D – Cost Planning and Analysis for Competitive Advantage – 30%

(i) compare and contrast value analysis and functional cost analysis;

(ii) evaluate the impacts of just-in-time production, the theory of constraints and total quality management on efﬁ ciency, inventory and cost;

(iii) explain the concepts of continuous improvement and Kaizen costing that are central

to total quality management and prepare cost of quality reports;

(iv) explain and apply learning and experience curves to estimate time and cost for new products and services;

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(vi) explain how target costs can be derived from target prices and describe the ship between target costs and standard costs;

(vii) explain the concept of life cycle costing and how life cycle costs interact with ing strategies at each stage of the life cycle

(viii) explain the concept of the value chain and discuss the management of contribution/ proﬁ t generated throughout the chain;

(ix) discuss gain sharing arrangements whereby contractors and customers beneﬁ t if tract targets for cost, delivery etc are beaten;

(x) apply activity-based costing ideas to analyse ‘ direct customer proﬁ tability and extend this analysis to distribution channel proﬁ tability;

(xi) apply Pareto analysis as a convenient technique for identifying key elements of data and in presenting the results of other analyses, such as activity-based proﬁ tability calculations

con-straints and the implications of these methods for decision-making in the ‘ new turing environment ’

the learning rate and the learning index

-ciency of repetitive overhead activities

manu-facturing operations to Eastern Europe and the Far East

lim-ited number of contractors or security issues (e.g in defence work), normal competitive pressures do not apply

as customers or distribution channels, and the comparison of such costs with appropriate revenues to establish ‘ tiered ’ contribution levels, as in the activity-based cost hierarchy

Transitional arrangements

Students who have passed the Management Accounting – Decision Making paper under the Beyond 2000 syllabus will be given a credit for the Management Accounting – Decision Management paper under the new 2005 syllabus For further details of transitional arrange-ments, please contact CIMA directly or visit their website at www.cimaglobal.com

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Revision of Basic Aspects,

Classifications and Approaches to

Cost Accounting

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The word ‘ cost ’ can be used in two contexts It can be used as a noun, for example, when referring to the cost of an item Alternatively it can be used as a verb, for example, we can say that we are attempting to cost an activity CIMA’s deﬁ nition of cost used in these two contexts is as follows:

The terminology goes on to explain that the word cost can rarely stand alone and should

be qualiﬁ ed as to its nature and limitations You will know from your earlier studies, and will be seeing throughout this text, that there are many different types of cost and that each has its usefulness and limitations in different circumstances

As a noun: the amount of expenditure (actual or notional) incurred on, or attributable to, a speciﬁ ed thing or activity

As a verb: to ascertain the cost of a speciﬁ ed thing or activity

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STUDY MATERIAL P2

4

You should already be able to explain what a cost unit is, using your earlier cost accounting

knowledge The CIMA Terminology deﬁ nes a cost unit as ‘ a unit of product or service in

relation to which costs are ascertained ’

This means that a cost unit can be any item for which it is possible to determine the cost The cost unit selected in each situation will depend on a number of factors, including the purpose of the exercise and the amount of information available

Cost units can be developed for all kinds of organisations, whether manufacturing,

com-mercial or public service based Some examples from the CIMA Terminology are as follows:

Industry sector Cost unit

Professional services Chargeable hour

Activity Cost unit

Credit control Account maintained

The list is not exhaustive A cost unit can be anything which is measurable and useful for cost control purposes For example with brick-making, 1,000 bricks is suggested as a cost unit It would be possible to determine the cost per brick but perhaps in this case a larger measure is considered more suitable and useful for control purposes

Notice that this list of cost units contains both tangible and intangible items Tangible items are those which can be seen and touched, for example the 1,000 bricks Intangible items can-not be seen and touched but they can be measured, for example, a chargeable hour of account-ing service

1.3.1 Composite cost units

The cost units for services are usually intangible and they are often composite cost units, that is, they are often made up of two parts For example, if we were attempting to moni-tor and control the costs of a delivery service we might measure the cost per tonne deliv-ered However, ‘ tonne delivered ’ would not be a particularly useful cost unit because it would not be valid to compare the cost per tonne delivered from London to Edinburgh with the cost per tonne delivered from London to Brighton The former journey is much longer and it will almost certainly cost more to deliver a tonne over the longer distance Composite cost units assist in overcoming this problem We could perhaps use a ‘ tonne-mile ’ instead This means that we would record and monitor the cost of carrying one tonne for one mile The cost per tonne-mile would be a comparable measure whatever the length

of journey and this is therefore a valid and useful cost unit for control purposes

Other examples of composite cost units might be as follows:

Business Cost unit

Bus company Passenger-mile Hospital In-patient day

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For instance, an example of a production cost centre could be the machine shop in a factory The production overhead cost for the machine shop might be £100,000 for the period If 1,000 cost units have passed through this cost centre we might say that the pro-duction overhead cost relating to the machine shop was £100 for each unit

The CIMA deﬁ nition of a cost centre also mentions a service location, a function, an activity or an item of equipment being used as a cost centre Examples of these might be as follows but you should try to think of some others:

Type of cost centre Examples

Service location Stores, canteen

Item of equipment Packing machine

If you are ﬁ nding it difﬁ cult to see how a sales representative could be used as a cost centre, then work carefully through the following points:

1 What are the costs which might be incurred in ‘ operating ’ a sales representative for one period?

Examples might be the representative’s salary cost, the cost of running a company car, the cost of any samples given away by the representative and so on Say these amount to £20,000

2 Once we have determined this cost, the next thing which we need to know is the number of cost units which can be related to the sales representative

The cost unit selected might be £100 of sales achieved If the representative has achieved £200,000 of sales, then we could say that the representative’s costs amounted

to £10 per £100 of sales The representative has thus been used as a cost centre or lecting place for the costs, which have then been related to the cost units

You would have seen in your earlier studies that costs can be classifi ed in many ent ways It is necessary to be able to classify all costs, that is, to be able to arrange them into logical groups, in order to devise an effi cient system to collect and analyse the costs The classifi cations selected and the level of detail used in the classifi cation groupings will depend on the purpose of the classifi cation exercise

The CIMA Terminology deﬁ nes classiﬁ cation as ‘ the arrangement of items in logical groups

having regard to their nature (subjective classiﬁ cation) or purpose (objective classiﬁ cation) ’

The CIMA Terminology deﬁ nes a cost centre as ‘ a production or service

loca-tion, funcloca-tion, activity or item of equipment for which costs are accumulated ’

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1.5.1 Classification of costs according to their nature

This means grouping costs according to whether they are materials, labour or expense cost Within each of these classiﬁ cations there is a number of subdivisions; for example, within the materials classiﬁ cation the subdivisions might include the following: (a) Raw materials, that is, the basic raw material used in manufacture

(b) Components, that is, complete parts which are used in the manufacturing process (c) Consumables, that is, cleaning materials, etc

(d) Maintenance materials, that is, spare parts for machines, lubricating oils, etc

The list of sub-divisions is not exhaustive, and there may even be further subdivisions of each of these groups For example, the raw materials may be further divided according to the type of raw material, for instance, steel, plastic, glass, etc

1.5.2 Classification of costs according to their purpose

When costs are classiﬁ ed having regard to their purpose, they are grouped according

to the reason for which they have been incurred The broadest classiﬁ cation of this type is to divide costs into direct costs and indirect costs

It is important for you to realise that a particular cost may sometimes be a direct cost and sometimes an indirect cost It depends on what we are trying to cost

For example, the salary of the machining department supervisor is a direct cost of that department because it can be specifi cally identifi ed with the department However, it is an indirect cost of each of the cost units processed in the machining department because it cannot be specifi cally identifi ed with any particular cost unit

1.5.3 Other examples of cost classification

(a) Fixed and variable costs This classiﬁ cation is made according to whether a cost varies in

total when the activity level changes A ﬁ xed cost remains unaltered when activity ies The total expenditure on variable costs will change in line with changes in the level

var-of activity This particular classiﬁ cation can be particularly useful if we are classifying costs for decision-making purposes

(b) Production, selling and administration costs This classiﬁ cation is based on a functional

analysis of costs It groups costs according to the function of the business which has incurred them This sort of analysis is particularly useful for stock valuation purposes For example, selling overheads should not be included in the valuation of stock because

an item which is still held in stock would not yet have incurred any selling overheads

(c) Controllable and non-controllable costs Costs may be classiﬁ ed in management

report-ing systems accordreport-ing to whether they are controllable or non-controllable The costs which are within the control of management are highlighted in the reports so that management action is directed where it is most worthwhile

(d) Normal and abnormal costs A normal cost is one which management were expecting

to incur and which is at an expected level An abnormal cost is one which was not expected or which is larger or smaller than expected This type of classiﬁ cation is used

to draw managers ’ attention to the cost of abnormal events

(e) Relevant and non-relevant costs This method of classiﬁ cation divides costs according

to whether they are relevant to a decision being taken, or not relevant to the decision Examples of non-relevant costs are sunk costs or past costs, which you will be learning about in a later chapter

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Many factors affect the level of costs incurred; for instance, inﬂ ation will cause costs to increase over a period of time However, in the ﬁ eld of cost accounting, when we talk about cost behaviour, we are referring to the way in which costs of output are affected by

ﬂ uctuations in the level of activity

The level of activity can be measured in many different ways For example, we can record the number of units produced, miles travelled, hours worked, percentage of capac-ity utilised and so on

An understanding of cost behaviour patterns is essential for many management tasks, particularly in the areas of planning, decision-making and control It would be impossible for managers to forecast and control costs without at least a basic knowledge of the way in which costs behave in relation to the level of activity

In this section we will look at the most common cost behaviour patterns and we will consider some examples of each

1.6.1 Fixed cost

The CIMA Terminology deﬁ nes a ﬁ xed cost as ‘ a cost which is incurred for an

account-ing period, and which, within certain output or turnover limits, tends to be unaffected by

ﬂ uctuations in the levels of activity (output or turnover) ’

Another term which can be used to refer to a ﬁ xed cost is a period cost This highlights the fact that a ﬁ xed cost is incurred according to the time elapsed, rather than according to the level of activity

A ﬁ xed cost can be depicted graphically as shown in Figure 1.1

Examples of ﬁ xed costs are rent, rates, insurance and executive salaries

The graph shows that the cost is constant (in this case at £5,000) for all levels of ity However, it is important to note that this is only true for the relevant range of activity Consider, for example, the behaviour of the rent cost Within the relevant range it is pos-sible to expand activity without needing extra premises and therefore the rent cost remains constant However if activity is expanded to the critical point where further premises are needed, then the rent cost will increase to a new, higher level

This cost behaviour pattern can be described as a stepped ﬁ xed cost ( Figure 1.2 )

The cost is constant within the relevant range for each activity level but when a critical level of activity is reached, the total cost incurred increases to the next step

The possibility of changes occurring in cost behaviour patterns means that it is unreliable to predict costs for activity levels which are outside the relevant range For example, our records

Total fixed cost, £

Activity level

5,000

Figure 1.1 Fixed cost

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might show the cost incurred at various activity levels between 100 units and 5,000 units We should therefore try to avoid using this information as the basis for forecasting the level of cost which would be incurred at an activity of, say, 6,000 units, which is outside the relevant range When you are drawing or interpreting graphs of cost behaviour patterns, it is important that you pay great attention to the label on the vertical axis In Figures 1.1 and 1.2 the graphs depicted the total cost incurred If the vertical axis had been used to represent the

ﬁ xed cost per unit, then it would appear as in Figure 1.3

The ﬁ xed cost per unit reduces as the activity level is increased This is because the same amount of ﬁ xed cost is being spread over an increasing number of units

1.6.2 Variable cost

Total fixed cost, £

Activity level

Relevant range 1

Relevant range 2

Relevant range 3

Figure 1.2 Stepped fixed cost

Fixed cost per unit, £

Activity level

Figure 1.3 Fixed cost per unit

Examples of variable costs are direct material, direct labour

The graph in Figure 1.4 depicts a linear variable cost It is a straight line through the gin which means that the cost is nil at zero activity level When activity increases the total variable cost increases in direct proportion, that is, if activity goes up by 10 per cent, then the total variable cost also increases by 10 per cent, as long as the activity level is still within the relevant range The gradient of the line will depend on the amount of variable cost per unit The straight line parallel to the horizontal axis in Figure 1.5 depicts a constant variable cost per unit, within the relevant range

The CIMA Terminology deﬁ nes a variable cost as ‘ a cost which varies with a

measure of activity ’

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In most examination situations, and very often in practice, variable costs are assumed to

be linear Although many variable costs do approximate to a linear function this tion may not always be realistic A variable cost may be non-linear as depicted in either of the diagrams in Figure 1.6

The graph of cost A becomes steeper as the activity level increases This indicates that each successive unit of activity is adding more to the total variable cost than the previous unit An example of a variable cost which follows this pattern could be the cost of direct labour where employees are paid an accelerating bonus for achieving higher levels of out-put The graph of cost B becomes less steep as the activity level increases Each successive unit of activity adds less to total variable cost than the previous unit An example of a variable cost which follows this pattern could be the cost of direct material where quantity discounts are available

Total variable cost, £

Activity level

Figure 1.4 Linear variable cost

Variable cost per unit, £

Activity level

Figure 1.6 Non-liner variable costs

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The important point is that managers should be aware of any assumptions that have been made in estimating cost behaviour patterns They can then use the information which is based on these assumptions with a full awareness of its possible limitations

1.6.3 Semi-variable cost

A graph of a semi-variable cost might look like the one in Figure 1.7

Examples of semi-variable costs are gas and electricity Both of these expenditures consist

of a ﬁ xed amount payable for the period, with a further variable amount which is related

to the consumption of gas or electricity

Alternatively, a semi-variable cost behaviour pattern might look like the one in Figure 1.8 This cost remains constant up to a certain level of activity and then increases as the variable cost element is incurred An example of such a cost might be the rental cost of a photocopier where a ﬁ xed rental is paid and no extra charge is made for copies up to a certain number Once this number of copies is exceeded, a constant charge is levied for each copy taken

1.6.4 Analysing semi-variable costs

The semi-variable cost behaviour pattern depicted in Figure 1.7 is most common in tice and in examination situations

prac-Total cost, £

Fixed cost Variable cost

Activity level

Figure 1.7 Semi-variable cost

Total cost, £

Fixed cost Variable cost

Activity level

Figure 1.8 Semi-variable cost

A semi-variable cost is also referred to as a semi-ﬁ xed or mixed cost The

CIMA Terminology deﬁ nes it as ‘ a cost containing both ﬁ xed and variable

com-ponents and which is thus partly affected by a change in the level of activity ’

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When managers have identiﬁ ed a semi-variable cost they will need to know how much

of it is ﬁ xed and how much is variable Only when they have determined this will they be able to estimate the cost to be incurred at relevant activity levels Past records of costs and their associated activity levels are usually used to carry out the analysis The three most common methods used to separate the ﬁ xed and variable elements are as follows

(a) The high–low method

(b) The scattergraph method

(c) The least squares method of regression analysis

You will have learned about the least squares method in your earlier studies If you do not recall the details of the method then you should refresh your memory In this text we will look at methods (a) and (b) in more depth

(a) The high–low method

This method picks out the highest and lowest activity levels from the available data and investigates the change in cost which has occurred between them The highest and lowest points are selected to try to use the greatest possible range of data This should improve the accuracy of the result

We will demonstrate how the method works by using two examples The ﬁ rst example takes no account of inﬂ ation The second example demonstrates how index numbers can

be used to eliminate the effects of inﬂ ation

Example: ignoring inﬂ ation A company has recorded the following data for a

semi-variable cost:

Month

Activity level units

The highest activity level occurred in February and the lowest in May Since the amount

of ﬁ xed cost incurred in each month is constant, the extra cost resulting from the activity increase must be the variable cost

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Substituting back in the data for February, we can determine the amount of ﬁ xed cost:

– variable cost (2,450 units £7) 17,150

Now that the ﬁ xed and variable cost elements have been identiﬁ ed, it is possible to mate the total cost for any activity level within the range 1,750–2,450 units

esti-Example: taking account of inﬂ ation A transport company has recorded the following

data for a semi-variable cost, together with the relevant price index relating to each year

The cost for year 5 can now be estimated, using a price index of 120

£ Variable cost 3,100 £ 2 120/100 7,440 Fixed cost £18,500 120/100 22,200

The major problem with the high–low method is that it takes account of only two sets of data If these two measurements are not representative of the rest of the data then the estimate of ﬁ xed and variable costs may be very inaccurate It is a particular risk since it is results at the extremes of the range of activity levels that are most likely to be unrepresentative

(b) The scattergraph method

This method takes account of all available historical data and it is very simple to use However, it is very prone to inaccuracies arising from subjectivity and the likelihood of human error

1 First a scattergraph is drawn which plots all available pairs of data on a graph

2 Then a line of best ﬁ t is drawn by eye This is the line which, in the judgement of the user, appears to be the best representation of the gradient of the sets of points

on the graph This is demonstrated in Figure 1.9

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3 The point where the extrapolation of this line cuts the vertical axis (the intercept) is then read off as the total ﬁ xed cost element The variable cost per unit is given by the gradient of the line

From Figure 1.9 , the ﬁ xed cost contained within this set of data is adjudged to be £200 The variable cost is calculated as follows

1.6.5 Using historical data

Another problem which arises in the determination of cost behaviour is that the estimates are usually based on data collected in the past Events in the past may not be representative

of the future and managers should be aware of this if they are using the information for planning and decision-making purposes

In your earlier studies you will have acquired a thorough knowledge of the build-up of costs using a conventional absorption approach The following diagram ( Figure 1.10 )

taken from the CIMA Terminology is a useful summary of the various cost elements which

combine to form total cost

You should recall from your earlier studies how material and labour costs are collected and analysed to form part of the prime cost of a product or service

We will spend more time looking at the collection and analysis of overhead, building

on your earlier knowledge and seeing how the techniques which you have learned can be applied to more complex situations The analysis of overhead is the subject of the next chapter

Total cost, £

Activity level

160 120 80 40 0

500 400 300 200 100 0

Figure 1.9 Scattergraph

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In this chapter we have

levels change

Direct costs Materials Labour Expenses

Prime cost

Notes: 1 The above chart is based on the absorption costing principle.

2 In the case of marginal costing, the amount of production overhead absorbed would relate to the variable element only.

3 The relative sizes of the boxes are of no significance

Production

Production overhead

Production cost

Total cost Stock adjustment

PROFIT

Production

Administration Selling Distribution

Overhead Materials Labour Expenses

R&D

Absorbed overhead

Under/over absorbed overhead

Figure 1.10 Elements of cost

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Explain the possible conﬂ icts between cost accounting for proﬁ t reporting and stock

valuation and the convenient availability of information for decision-making

In this chapter we will discuss and demonstrate the alternative cost accounting techniques

of absorption costing, activity-based costing and marginal costing

We will then recognise the alternative uses of cost accounting information and the appropriateness of each technique to those uses

Having selected suitable cost centres for the organisation, the ﬁ rst stage in the analysis of overheads is to determine the overhead cost for each cost centre This is achieved through the process of allocation and apportionment

Cost allocation is possible when we can identify a cost as speciﬁ cally attributable to a

particular cost centre For example, the salary of the manager of the packing department can be allocated to the packing department cost centre It is not necessary to share the sal-ary cost over several different cost centres

Cost apportionment is necessary when it is not possible to allocate a cost to a speciﬁ c cost

centre In this case the cost is shared out over two or more cost centres according to the estimated beneﬁ t received by each cost centre As far as possible the basis of apportionment

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There are several different methods which can be used to absorb overheads You will have learned about them in your earlier studies and we will now review them and consider their relative advantages and disadvantages The following data will be used to demonstrate their calculation.

Data for cost centre 2, year 7

The overhead absorption rate for cost centre 2 could be any of the following:

62 100

We have demonstrated the six most common methods of calculating overhead tion rates but only one of them would be selected for each cost centre You should already know from your earlier studies how to apply the rates to calculate the overhead cost to be absorbed by each cost unit However to remind you and to give some revision practice, use the following data to determine the total production cost of job number 123

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Exercise

Job 123 was manufactured solely in one cost centre A direct labour hour rate is to be used

to absorb this cost centre’s overhead costs Data relating to job 123 is as follows:

Cost centre overheads are budgeted to be £2,300 with budgeted labour hours of 1,000 What is the total production cost of job 123?

Solution

Overhead absorbed (90 hours £2.30) 207

to absorb overheads according to how long a cost unit takes to produce The longer it takes, the more overhead will have been incurred in the cost centre during that time

In addition to these general considerations, each absorption method has its own tages and disadvantages:

(a) Rate per unit This is the easiest method to apply but it is only suitable when all cost

units produced in the period are identical Since this does not often happen in practice this method is rarely used

(b) Direct labour hour rate This is a favoured method because it is time-based It is most

appropriate in labour-intensive cost centres, which are becoming rarer nowadays and

so the method is less widely used than it has been in the past

(c) Machine hour rate This is also a favoured method because it is time-based It is most

appropriate in cost centres where machine activity predominates and is therefore more widely used than the direct labour hour rate As well as absorbing the time-based over-heads mentioned earlier, it is more appropriate for absorbing the overheads related to machine activity, such as power, maintenance, repairs and depreciation

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