MBA 507: MANAGEMENT ACCOUNTING SCHOOL OF BUSINESS INSTRUCTIONAL MATERIAL FOR DISTANCE LEARNERS

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1 MBA 507: MANAGEMENT ACCOUNTING SCHOOL OF BUSINESS INSTRUCTIONAL MATERIAL FOR DISTANCE LEARNERS REVISED EDITION 2013 PUBLISHED BY KENYA METHODIST UNIVERSITY P.O. BOX , MERU TEL: , 31146/

2 INTRODUCTION TO MANAGEMENT ACCOUNTING There are various definitions of management accounting; American Association of Accountants (AAA): Managerial accounting is the application of appropriate techniques and concepts in processing historical and projected economic data of an entity to assist the management in establishing plans for reasonable economic objectives and in the making of rational decisions with a view to achieving its objectives. Institute of Chartered Management Accountants of London: Managerial accounting is the application of professional knowledge and skills in the preparation of accounting information in such a way as to assist the management in the formation of policies and in the plan and control of operations. Institute of Chartered Management Accountants of England and Wales: Managerial accounting is the preparation of accounting information in such a way as to assist the management in creation of policies and the day to day operations of the undertaking. From the above definitions, we can conclude the following: i) Management accounting is concerned with providing information to the managers. ii) Management accounting deals in the principles of Financial Accounting to satisfy the reporting needs of the financial managers. iii) Any study of management accounting must be preceded by some study of management process and the organization in which the managers work. Two branches of accounting reflect the needs of internal and external users of information. Management accounting is concerned with the provision of information to people within the organization to help them make better decisions and improve the efficiency and effectiveness of existing operations whereas financial accounting is concerned with the provision of information to external parties outside the organization. Differences between MA and FA 2

3 1. Legal requirements It is a statutory requirement for public limited companies to produce annual financial accounts. Management accounting, by contrast, is entirely optional and information should be produced only if it is considered that the benefit to management exceeds the cost of collecting such information. 2. Focus on individual parts or segments of the business FA reports describe the whole of the business whereas MA focuses on small parts of the organization. MA also measures the economic performance of decentralized operating units such as divisions or departments. 3. Generally accepted accounting principles FA statements must be prepared to confirm with legal requirements and the GAAPS established by regulatory bodies such as FASB and Accounts standard Board. 4. Time dimension FA reports what has happened in the past in an organization whereas MA is concerned with future information as we as past information. Decisions are concerned with future events and management therefore requires details of expected future costs and revenues 5. Report frequency Detailed set of financial account are published annually and less detailed accounts are published semi-annually. Management accounting reports on various activities may be prepared daily, weekly or monthly as the need arises. Functions of management accounting A cost and management accounting system should generate information to meet the following requirements. 1. Allocate costs between cost of goods sold and inventories for internal and external profit reporting. 2. To provide relevant information to help managers make better decisions 3. To provide information for planning, control and performance measurement. 3

4 THE DECISION MAKING PROCESS 1. Identifying objectives The first stage in the decision- making process is the specification of goal or objective of the organization. The goals should ensure the organizations survival in the future and should be achievable. Goals of a firm include shareholders wealth maximization and profit maximization. 2. The search for alternative course of action This involves the search of a range of possible course of action or strategies that might enable the objectives to be achieved. It also involves the acquisition of information concerning future opportunities and environments. e.g developing new products for sale in existing markets. 3. Gather data about the alternatives When potential areas of activity are identified, management should assess the potential growth rate of activities, the ability of the company to establish adequate market shares and the cash flows for each activity for various states of nature. States of nature are uncontrollable factors such as economic boom, high inflation, recession, competitors etc. Data must be gathered both for long run or strategic decision as well as short term or operating decisions. 4. Select the appropriate alternative course of action The alternative are ranked in terms of their net cash benefits and those showing the greatest benefits are chosen subject to taking into account any qualitative factors. 5. Implementation of the decisions Once the courses of action have been selected, they should be implemented as part of the budgeting process. A budget is a financial plan for implementing management decisions. The budgeting process communicates to everyone in the organization the part they are expected to play in implementing managements decisions. 6. Comparing actual and planned outcomes and responding to divergences from plan. The managerial function of control consists of measurement, reporting and subsequent correction of performance in an attempt to ensure that the firm s objectives and plans are achieved. To monitor performance, accountants produce performance reports and present them to the 4

5 appropriate managers who are responsible for implementing the various decisions. Performance reports consist of a comparison of actual outcome (budgeted costs of revenues) should be issued at regular intervals and provide feedback by highlighting those activities that do not conform to plans. This enables managers to devote their scarce time on focusing on these items i.e. application of management by exception. CHANGING COMPETITIVE ENVIRONMENT Prior to the 1980s, many organizations both manufacturing and service operated in protected competitive environment due to barriers of communication, geographical distances and sometimes protected markets. There was little incentive for firms to maximize costs as cost increases could often be passed on to customers. Today, virtually all type of organizations have faced a major change in their competitive environment. The following factors have greatly influenced the change in competitive environment. 1. Globalizations of world trade restrictions on market entry have been lifted and this has increased the level of competition between firms. 2. Privatization of government controlled companies and deregulation in various industries. Pricing and competitive restrictions were virtually eliminated. 3. Changing products life cycles A product life cycle is the period of time from initial expenditure on research and development to the time at which support to customers is withdrawn. Intensive global competition and technical innovation combined with increasingly discriminating and sophisticated customers demands have resulted in a dramatic decline in product life cycles. large fraction of a products life cycle costs are determined by decisions made early in its life. This has created a need for management accounting to place greater emphasis on providing information at the design stage became many of the costs are committed or looked in at this time. 4. Changing 0customers tastes that demand ever- improving level of service in costs, quality, reliability, delivery and the choice of new products. To provide customer satisfaction, organizations must concentrate on those key success factors that directly affect it such as cost efficiency, quality, time and innovation. All these could easily be addressed by management accounting. 5

6 5. The emergence of e-business this is the use of IT to support business activities which has led to development of electronic barrier communication technologies. E-Commerce has provided the potential to develop new ways of doing things that have enabled considerable costs savings to be made from streamlining businesses process and generating extra revenues from the adapt use of on-line safer facilities. COST OBJECTIVES AND CLASSIFICATIONS In financial accounting,cost is defined a as the sacrifice made to obtain goods or services, such as sacrifice of materials, labour, etc.in management accounting, cost is used in many different ways, the reason is that there are many different types of costs and these costs are classified differently according to the immediate needs of the management. Basis of classification of costs: 1) Manufacturing cost or non-manufacturing costs Manufacturing costs. Manufacturing cost include the cost of direct materials, direct labour and direct factory overheads. Direct materials-these materials become an integral part of a company s finished product and can be conveniently traced into it. Direct labour-are those labour costs that can be physically traced to the creation of a product without a due cost or inconvenience. Manufacturing overheads-this includes all costs of manufacturing other than direct materials and direct labour e.g Indirect labour-labour cost that cannot be physically traced to production or involve alot of expenses in tracing them. Indirect materials-this can only be traced into the product at great costs or inconvenience e.g. paint to furniture Other costs of operating the factory e.g. electricity, insurance, maintenance and all other costs incurred to operate the manufacturing process in a company. Non-manufacturing costs Non-manufacturing costs can be classified into two categories i) Selling and marketing costs 6

7 This costs include all the necessary costs to secure customer orders and get the finished goods into the customer s premises.they include sales commissions, sales travel, salaries of salesmen, advertising,etc. ii) Administrative costs These include all executive, organizational and clerical costs that cannot logically be included in either manufacturing or marketing. They include executive salaries, general accounting, secretarial, public relations and similar costs having to do with the overall administration of the organization. 2) Classifying costs according to cost behaviour Costs can be classified according to how they react to changes in the level of business activity i.e. how they react to the number of goods sold, number of hours worked, etc. As the activity, level rises or falls, a particular cost may rise or fall as well or may remain constant. Thus, we have fixed cost and variable cost. Fixed cost Are those costs that remain constant in total regardless of the changes in the level of business activity within the relevant range. However, beyond some range, these costs may cease to be fixed. Variable costs These vary in total in proportion to changes in the level of activity but within the relevant range. Semi-variable costs These costs have an element of fixed as well as variable costs. They are also called step costs. 3) Classifying costs as period costs and product costs Product costs These consist of costs in the purchase or manufacture of goods. They are also known as inventorial costs. This is because they are first classified in the inventory stage until they are expensed. They are only treated as expenses (cost of goods sold) in the time period during which the related products are sold. Period costs 7

8 These are costs that are matched against revenue on a time period basis and are therefore not included as part of costs of the product. They are treated as expenses and deducted from the revenue in the time which they are incurred. 4) Classifying costs as direct and indirect costs Direct costs Is a cost that can obviously and physically be traced to the particular segment under consideration i.e. can be traced to a particular segment. Indirect costs These are costs that must be allocated in order to be assigned to the segment under consideration.they are also known as common costs e.g. manufacturing overhead cost. 5) Classifying costs as controllable and non controllable costs Controllable cost A cost is said to be controllable at a particular level of management if that level has the power to authorize its incurrence. Where there is no power to authorize its incurrence then the cost is non - controllable 6) Classifying costs according to time Under this classification, we have: Predetermined costs These are established costs that are computed in advance in the production process taking into consideration the previous period and factors affecting such costs. Historical costs Are those costs that are ascertained after they have been incurred and are available only when the production is complete. 8

9 7) Classifying costs according to planning and control These include, Budgeted costs These are estimates of expenditure at different phases of business operations such as manufacturing, administration, sales, research and development coordinated in a well-concealed framework. Standard costs These are budgeted costs which are translated into actual operations.they are scientifically predetermined cost of every business activity and are control tools. 8) Other costs They include: -opportunity costs -differential costs - sunk costs Opportunity costs The potential benefit, a cost of sacrifice when the selection of one course of action makes it necessary to give up another course of action. It is the cost of foregone alternative. It is therefore the maximum alternative earnings that might have been achieved if the production capacity of services had been put into alternative use. Differential costs Is any cost that is present in one alternative but is absent in the other alternative. Differential costs are changes in cost due to changes in the level of activity or method of production Sunk costs A sunk cost is a cost that has already been incurred and cannot be changed by any decision made now or in the future.it is an irrecoverable cost. Sunk costs are not relevant to decision making. 9

10 COST ESTIMATION The analysis of fixed and variable costs is very important in planning and control of operation. The fixed portion of a mixed cost represents the basic minimum charge for just having a good or service ready and available for use. The variable portion represents the charge made for the actual consumption of a service. There is therefore the need to break down costs to their fixed and variable elements. There are four methods used to estimate costs. Accounts classification method This involves examining each cost item and categorizing them as fixed, variable and semi variable. Advantages 1. It is a quick method of determining fixed and variable costs. 2. It is relatively inexpensive Disadvantages 1. It is subjective and usually uses the rule of thumb estimate (non-scientific estimate). 2. It arbitrarily deals with variable costs. 3. Step up costs are likely to be forced into either fixed or variable costs with subsequent loss of accuracy. 4. It uses historical data that may not reflect future conditions. Industrial engineering approach This method involves an estimation of the required production inputs for certain output by the engineers. The engineers will calculate the cost of raw material inputs based on the estimated or the material content of the product specification, labour input may be based on time and motion studies and an estimate of the capital input needed for production. A through observation by the expert engineers of the relation between inputs and outputs can lead to very accurate predictions of future costs and may yield results that will benefit the overall planning system of the firm. 10

11 The main disadvantage of this method is that it is costly. The production process is complex, the preparation of a full specification of inputs will require much expert work entailing a large cost which will be worthwhile only if the additional net benefits created surpassed the cost involved.however the industrial engineering approach or at least some variation of it, may be used if there are no past records on which to base an analysis.it is appropriate where there is a physical relationship between a cost and a cost driver. High low or range method The high-low method is the cheapest and the easiest to use. It attempts to segregate total past costs by examining only two observations i.e. those representing the highest and the lowest past activity over the relevant range. The difference in cost observed at the two extremes is divided by the change in activity in order to determine the amount of variable cost involved. Example Assume that the maintenance cost for Unga Ltd have been observed as follows within the relevant range of direct labour hours: Month Direct labour hours maintenance cost shs January 5500 shs745 February 7000 shs850 March 5000 shs700 April 6500 shs820 May 7500 shs960 June 8000 shs1000 July 6000 shs825 Required: Determine the fixed and the variable cost elements of the mixed cost. The visual inspection method or the scatter graph method This method entails plotting all the relevant observation on a scatter graph then fitting on a line on 11

12 the data by visual inspection. This is a more accurate way of estimating costs than the high low method since it includes all the points of observed cost data in the analysis using a graph. Cost is shown on the vertical axis and the volume or the rate of activity is shown on the horizontal axis. The line fitted to the plotted points is known as the regression line. The regression line in effect is a line of averages with the average and the variable cost per unit of activity represented by the slope of the line and the average fixed cost per unit represented by the point where the regression line intersect the cost axis. The least square method or linear regression analysis Linear regression analysis refers to the measurement of the average amount of change in one variable such as manufacturing cost that is associated with unit increases in the amount of one or more other variables such as output, labour hours, etc. It is a method of replacing Y (the independent variable) on X (the independent or predictor variables). The regression analysis fits a line of best fit to the data so as to minimize the sum of squares of the vertical distances from the regression line to the plotted points of the actual observations so that the sum of the squares of this deviations is less than the sum of the square deviations from any other line. Thus, it is a method of line fitting which is free from subjectivity. The least square method is based on computations that find their foundation in the equation of a straight line. Y = a + bx Where:- Y- Dependent variable a - fixed element b - degree of variability (variable element)/slope of line X - Independent/ predictor variable From this basic equation under a given set of observations, two mathematical equations known as normal equations which must be solved simultaneously to derive values of a and b for inclusion in the total cost function can be developed. 12

13 i) Σ y = na + bσx ii) Σxy = aσx + bσx 2 Example The following data relates to Mr Kamotho s business for the period Jan June 2003: Month Output (units) Total manufacturing costs (shs) (x) (y) January February March April May June Required: Determine the business fixed and variable cost for manufacturing cost. Test of reliability Reliability is based on the size of the deviations of the actual observations y from the estimated values on the regression line (y) y estimates The size of the deviations can be ascertained by squaring the difference The average of these deviations is known as residue variation or variance (Q2) This variance is computed as follows: Q 2 = Σ ( y-yˆ ) 2 N This only signifies the unexplained variation but not the total variation from the average. The dispersion of the actual observation around the average is as follows: 13

14 Q 2 = ( y y) N 2 1) Co-efficient of determination ( r 2 ) This explains the extent to which variation in the dependent variable y is explained by the variation in the predictor variable x. r 2 = 1 - Σ ( y-y) 2 /N Σ (y- y ) 2 /N 2) Correlation co-efficient(r) This is the square root of r.2. It measures the degree of association between two variables. If the association is so close, r and r 2 will be near 1 and it will be almost possible to plot the observation on a straight line. 3) Standard errors of estimates. This gives us an estimation of the absolute size of the probable deviations from the regression line.the standard error of estimates is computed as follows: S e = ( y y^ ) N 2 2 The standard error of estimate enables us to establish a range of values of the dependent variable y within which we may have some degree of confidence that the true value lies e.g. at 90% confidence level the true value lies at y estimate (yˆ) = yˆ (Se) Thus, the standard error of the estimate is similar to a standard deviation in normal probability analysis. It is a measure of variability along the regression line. 14

15 4) The standard error of the coefficients This measures the reliability of the regression line coefficient b of the variable cost. Se S b = ( x x) 2 or S b = ( x 2 Se x x) Example The following information relates to XYZ Ltd for the year ended 31 st Dec 2003 Hours Maintenance costs (shs) Required a. Determine the company s fixed and variable cost using the least squares method. b. Determine the coefficient of determination c. Determine the correlation coefficient. d. Determine the standard error of the estimates e. Determine the confidence interval of the true maintenance cost at 180 hours given at 90% confidence level 15

16 f. Determine the standard error of the coefficient g. Determine the confidence interval of the true variable cost at 90% confidence level. COST VOLUME PROFIT ANALYSIS This is a managerial technique used to determine how costs and profits are affected by the changes in the levels of this activity. It is a systematic method of examining the relationship between changes in activity (i.e. output) and changes in total sales revenue, expenses and net profit. It gives a deterministic analysis and seeks to evaluate the relationship between investment outlays, activity, volumes and profitability. Of particular interest in where sales revenues are able to cover all the costs. It called the break-even point (shows minimum scale of operation so as to stay in business). As a model of these relationships, CVP analysis simplifies the real world conditions that a firm will face. The objective of CVP analysis is to establish what will happen to the financial results if a specified level of activity fluctuates. Assumptions of Cost Volume Profit Analysis 1) The unit sales price and unit cost remains constant in the review period 2) All costs can be classified and identified as either fixed or variable with a reasonable amount of accuracy. 3) Variable costs should change proportionately with volume. 4) The fixed cost should remain constant. 5) The relationship between revenue, cost, volume and profits is linear over the relevant range. 6) The volume of production equals the volume of sales or changes in the beginning and ending inventory levels are insignificant in amount. 7) Volume is the only relevant factor affecting cost. 8) Whenever more than one product is sold, total sales will be some predictable portion also known as the sales mix 9. The analysis applies only to a short-term time horizon. Therefore cost volume analysis is used by the management to evaluate the inter-relationship of selling price, sales volume, sales mix and costs and profits so that acceptable profits can be achieved. In order to plan for profits, managers must estimate the selling price of each product, the 16

17 variable cost required producing it and selling it and the fixed cost expected of each period. This information is combined with the estimates concerning the expected sales volume and sales mix to arrive at a good profit plan. BREAK-EVEN POINT The BEP is the sales volume at which revenues and total costs are equal. At this level all the variable and fixed costs are covered by the sales revenue. It defines minimum production and sales level required to stay in the business. It also allows us to evaluate profitability associated with various output levels. In new markets e.g. we are able to compare the volume demanded in the market with break even point. From this comparison we determine whether it is worthwhile to venture into such markets. Graphical Analysis of BEP (Break-Even- chart) Mathematical determination of BEP Profits =TR TC ( SPXQ ) (( VCXQ ) FC) 17

18 = (SPXQ) (VCXQ)-FC At BEP,π =0 BEP, SPX Q VC X Q FC =0 Q(S.P VC)=FC Q(SP-VC) (SP VC) = FC (SP-VC) Q= FC (SP-VC) Where: Q-Break even quantity FC Fixed cost SP selling price VC Variable cost (SP-VC) Contribution margin per unit. BEP in Revenue = FC CM Ratio CM Ratio contribution /unit ratio S.P NOTE: - While the BEP is not the desirable performance target because of the lack of profit, it does indicate the level of activity necessary to avoid incurring a loss. As such the BEP will represent a target of minimum sales revenue that must be achieved by a business. 18

19 Example 1 A summarized income statement of XYZ LTD for the year 2007 is given below: Shs Sales (8000 per unit) Variable cost Contribution margin Fixed cost Net profit / loss Required: BEP in units and revenue. Margin of safety: The margin of safety indicates by how much sales may decrease before a loss occurs Is the excess of the actual sales over the break-even sales. Margin of safety = Actual sales Break Even sales Margin of safety is useful for a firm facing a declining market share.it shows the extent to which revenue can fall before contemplating a shut down decision. The BEP gives an indication of the level of sales that is required below which the firm will suffer the risk of insolvency. In such a situation the units to attain the cash BEP is given as: = FC Non-cash expenses CM/units Non cash expenses include depreciation, amortization, etc. Target profit 19

20 The units to produce to meet the target profit level: Level of sales to result in target profit = fixed costs + Target Profit Contribution margin per unit Where there n is a given tax level units to produce and sell in order to attain a given π level Target Profit Level of sales to result in target profit = fixed costs + 1-Tax Rate Contribution margin per unit Example 2 Assume that the manager of XYZ Co-Ltd wants to earn a net profit before tax of shs in the year 2007 and expects the same selling price and cost as the already experienced. Required: What sales volume will achieve this target profit? Example 3 ABC company produces and sells a certain product at shs800 each with VMC of shs380/per unit and FMC of shs1million.in addition the company incurs selling and administration expenses of 2.5% of sales revenue and FSC of Ksh Required : i) Determine the BEP in units and in revenue. ii) Determine the units that should be sold to earn an income of shs500, 000. iii) If the company was in the 35% bracket, how many units will have to be sold to achieve the shs targeted? iv) Management is considering a policy which will increase the FMC by shs400, 000 but cut down on VMC by 20%. a) What is the BEP in units and revenue under this policy? 20

21 b) Taking into a/c the 35% tax level, how many units will have to be sold to earn the target shs under this policy? v) At what sales level will the management be indifferent under the two policies? Example 4 Guerba enterprises operate in the leisure and entertainment industry and one of its activities is to promote concerts at locations in the city of Nairobi. The company is examining the viability of a concert in the Hurlingham area of Nairobi. The estimated fixed costs are Sh 600,000, which include fees paid to performers, the hire of the venue and advertising costs. Variable costs consist of a pre-packed buffet, which will be provided by a firm of caterers at a price, which is currently being negotiated, but is likely to be in the region of Sh 100 per ticket. The proposed price of the sale of ticket is Sh 200. The management of Guerba has requested you, as a management accounting trainee in the company to provide the following information. i) The number of tickets that must be sold to break-even ii) How many tickets must be sold to earn a target of sh.300, 000 iii) What profit would result if 8,000 tickets were sold? iv) What selling price would have to be charged to give a profit of Sh 3000,000 on sales of 8,000 tickets, fixed costs of Sh 600,000 and variable costs of sh100 per ticket? v) How many additional tickets must be sold to cover the extra cost of television advertising of sh80, 000? SALES MIX Refers to the relative combination in which a company s products are sold or the relative combination of quantities or product that comprise total sales. Managers try to achieve the sales mix that yields the greatest amount of products. Profits will be higher if higher margin products make up a relatively large proportion of total sales unless if sales consists mostly of low margin products. Example 5 ABC company produces 2 products A and B and has the following budget: 21

22 A B Total Expected sales in units Sales in revenue Variable Contribution margin Fixed costs Net income Required: Compute the company s BEP. EXAMPLE SIX The Super Bright Company sells two types of washing machines-a de-luxe model and a standard model. The financial controller has prepared the following information based on the sales forecast for the period: De-luxe Standard Machine machine Total Sales volume(units) Shs shs Unit selling price Unit variable cost Unit contribution Total sales revenue 360, , ,000 Less: total variable cost 180,000 66, ,000 Contribution to direct and common 180,000 54, ,000 Fixed costs Less:direct avoidable fixed costs 90,000 27, ,000 Contribution to common fixed costs 90,000 27, ,000 Less: common (indirect) fixed costs 39,000 Operating profit 78,000 22

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