Management and Cast Accaunting

COLIN DRURY Management and Cast Accaunting Second edition CHAPMAN AND HALL University and Professional Division LONDON. NEW YORK. TOKYO. MELBOURNE. MADRAS

Contents Preface XVI Part I: Introduction to Management and Cost Accounting 1 1 The Scope of Management Accounting 3 The users of accounting information 3 The meaning of information 4 Measurement theory 6 The communication of information 6 The value of information 8 The decision-making process 10 The management process 15 The role of the management accountant in the management process 17 Behavioural and organizational aspects of management accounting 18 Cost accounting and management accounting 19 Summary of the contents of the book 20 Guidelines for using this book 22 Summary 23 2 Cost and Revenue Classification 25 Cost objectives 25 Classification of costs 26 Cost accounting: classification of costs for stock valuation and profit measurement 26 Classification for decision-making and planning 31 Classification for control 39 Self-assessment questions 41 Summary 41 References and further reading 42 43 Part II: Cost Accumulation for Stock Valuation and Profit Measurement 47 3 Accounting for Materials and Labour 49 Materials contral procedure 49 Pricing the issues of raw materials 54 Treatment of stores losses 58 Treatment of transportation costs 58 Treatment of materials handling costs 59 Just-in-time purchasing 59 Accounting for labour 60

VIII Contents Labour cost accounting 60 Payroll accounting 61 Incentive schemes 61 Accounting treatment of various labour cost items 62 Labour costs for decision-making 64 Control of labour and materials costs 64 Self-assessment questions 64 Summary 66 Appendix 3.1: Stores pricing methods 67 70 4 Accounting for Overhead Expenditure 76 An overview of the procedure of apportioning overheads to products 77 B1anket overhead rates and departmental overhead rates 77 Procedure for calculating department overhead rates 78 IIIustration of overhead apportionment and absorption 80 Pre-determined overhead rates 84 Under and over recovery of overheads 85 Measuring capacity 86 Overhead absorption rates and new manufacturing technology 89 Non-manufacturing overheads 90 Overheads for decision-making 91 Overheads for eon troi 91 Self-assessment questions 92 Summary 94 Appendix 4.1: Inter-service department transfers 96 Appendix 4.2: Overhead absorption rates 99 101 5 Accounting Entries for a Job Costing System 110 Control accounts 110 Recording the purchase of raw materials 111 Recording the issue of materials 114 Accounting procedure for labour costs 115 Accounting procedure for manufacturing overheads 116 Non-manufacturing overheads 117 Accounting procedures for jobs completed and products sold 118 Costing profit and los s account 118 Interlocking accounting 119 Contra et costing 119 Self-assessment question 124 Summary 125 127 6 Proces s Costing 137 Flow of costs in a process costing system 137 Normai and abnormallosses 139 Accounting for the sale of scrap 141 Abnormal gains 142 Opening and ciosing work in progress 145 Previous process cost 147 Opening work in progress 148 Weighted average method 149 First-in-first-out (FIFO) method 151 Equivalent production and normallosses 153 Equivalent production and abnormallosses 155

Contents IX Proces s costing for decision-making and cost control Batch costing Self-assessment questions Summary Appendix 6.1: Losses which occur part way through a process 7 Joint Produet and By-product Costing Methods of apportioning joint costs to joint products Limitations of joint cost allocations for decision-making Accounting for by-products By-products, scrap and waste Defective units Self-assessment question Summary 8 Absorption Costing and Variable Costing Problem of terminology External and internal reporting Variable costing and absorption costing: a comparison of their impact on profit Som e arguments in support of variable costing Som e arguments in support of absorption costing The variable costing versus absorption costing debate Relevant costing Internal profit measurement Current cost accounting Self-assessment question Summ ary Part III: Information for Decision-Making 9 Cost-Volume-Profit Analysis The economists' model The accountants' cost-volume-profit model Changes in fixed costs and selling prices A mathematical approach to cost-volume-profit analysis Margin of safety Constructing the break-even chart Alternative presentation of cost-volume-profit analysis Cost-volume-profit analysis assumptions Cost-volume-profit analysis and computer applications Application of cost-volume-profit analysis to non-manufacturing decisions Self-assessment questions Summary 10 Measuring Costs and Benefits for Decision-making Measuring relevant costs and benefits Quantitative and qualitative factors Deleting a segment Special selling-price decisions Decision-making and the influence of limiting factors 157 159 159 161 162 164 171 172 177 179 181 182 183 184 185 194 194 195 198 200 201 202 203 204 207 207 208 210 219 221 221 223 226 228 231 232 232 234 237 238 241 243 245 254 255 257 257 259 261

x Contents Make or buy decisions 263 Replacement of equipment 264 Conf1ict between decision-making and performance evaluation models 265 Problems in determining the relevant costs of materials 266 Problems in determining the relevant cost of labour 267 Emphasis on the short term 269 A comprehensive example 271 Self-assessment questions 274 Summary 276 277 11 Accounting Information for Pricing Decisions 291 The economists' pricing model 292 Calculating optimal selling prices using differential calculus 295 Oligopoly and perfect competition 296 Problems with the economists' model 297 Cost-based pricing formulae 298 Limitations of cost-plus pricing 301 Reasons for using cost-based pricing formulae 302 Relevant costs for pricing decisions 303 Pricing reviews 306 Specific products made to order 307 Choosing a pricing policy 308 The impact of new manufacturing technology 309 Self-assessment question 310 Summary 311 314 12 Decision-making Under Conditions of Risk and Uncertainty 321 A decision-making model 321 Risk and uncertainty 323 Probabilities 324 Probability distributions and expected value 325 Measuring the amount of uncertainty 326 Attitudes to risk by individuals 329 Decision tree analysis 330 Use of cost information for pricing decisions under conditions of uncertainty 332 Problems with using probability theory in decision-making 335 Cost-volume-profit analysis under conditions of uncertainty 335 Buying perfect and imperfect information 336 Maximin, maximax and regret criteria 337 Portfolio analysis 338 Self-assessment question 341 Summary 342 Appendix 12.1: Cost-volume-profit analysis under conditions of uncertainty 344 348 13 Capital Investment Decisions (1) 360 Objectives of capital budgeting 360 A decision-making model for capital investment decisions 361 The theory of capital budgeting 363 The opportunity cost of an investment 364 Compounding and discounting 365 The concept of net present value 367

Contents XI Calculating net present values 368 Constant annual cash inflows 370 The internal rate of return 370 Relevant cash flows 373 Timing of cash flows 374 Comparison of net present value and internal rate of return 374 Techniques which ignore the time value of money 378 Payback method 378 Accounting rate of return 380 Surveys of practice 381 The effect of performance measurement on capital investment decisions 382 Qualitative factors 383 Evaluating investments in computer-integrated manufacturing technologies 384 Self-assessment question 385 Summary 386 388 14 Capital Investment Decisions (2) 397 A comparison of mutually exclusive investments with unequallives 397 Capi tal rationing 400 Taxation and investment decisions 403 The effect of inflation on capital investment appraisal 405 Calculating risk-adjusted discount rates 408 Calculating a project's cost of capital 411 Weighted average cost of capi tal 412 Traditional methods of measuring risk 412 Authorization of capital investment proposais 418 Review of capital investment decisions 419 Self-assessment questions 421 Summary 423 Appendix 14.1: Evaluating the lease versus purchase decision 426 429 Part IV: Information for Planning and Control 443 15 The Budgeting Process 445 Stages in the planning proces s 446 Why do we produce budgets? 449 Conflicting roles of budgets 451 The budget period 451 Administration of the annual budget 452 Stages in the budgeting process 453 A detailed illustration 456 Sales budget 458 Production budget and budgeted stock levels 460 Direct materials usage budget 460 Direct materials purchase budget 460 Direct labour budget 461 Factory overhead budget 461 Selling and administration budget 462 Departmental budgets 462 Master budget 463 Cash budgets 465 Final review 465

XII Contents Computerized budgeting The budgeting process in non-profit-making organizations Planning, programming budgeting systems Incremental and zero-based budgeting Self-assessment question Summary 16 Control in the Organization Control systems Feedback and feed-forward controls Responsibility accounting Flexible budgeting The impact of new technology Control of non-manufacturing cosrs Control in non-profit organizations Management audits Management by objectives Self-assessment questions Summary 17 Standard Costing and Variance Analyses( 1) Establishing cost standards Types of cost standards Operation of a standard costing system Variance analysis Material variances Material price variances Material usage variance Joint price usage variance Total material variance Labour variances Wage rate variance Labour effeciency variance Totallabour variance Overhead variances Total fixed overhead variance Fixed overhead expenditure or sp end ing variance Volume variance Volume efficiency variance Volume capacity variance Summary of fixed overhead variances Variable overhead variances Variable overhead expenditure variance Variable overhead efficiency variance Sales variances Total sales margin variance Sales margin price variance Sales margin volume variance Difficulties in interpreting sales margin variances Reconciliation of budgeted profit and actual profit Performance reports Standard variable costing Self-assessment questions 465 466 467 470 472 473 475 485 486 487 487 493 499 500 502 503 504 505 506 509 516 516 518 519 521 522 522 525 526 526 527 527 528 528 528 529 530 530 531 532 532 533 534 534 535 535 536 536 537 537 537 540 541

Contents X11I Summary of variance formulae 542 544 18 Standard Costing (2): Further Aspects 555 Direct materials mix and yield variances 555 Sales mix variances 558 Standard cost accounting 559 Criticisms of standard costing variance analysis 567 A relevant cost approach to variance analysis 569 The investigation of variances 572 Statistical quality control 576 The impact of new manufacturing technology 578 Self-assessment question 578 Summary 579 581 19 Behavioural Aspects of Accounting Control Systems 592 The use of budgets as targets 593 The use of accounting control techniques for performance evaluation 597 Participation in the budgeting and standard setting process 602 Bias in the budget process 605 Management use of budgets 606 Conclusion 608 Summary 610 613 Part V: The Application of Quantitative Methods to Management Accounting 617 20 Mathematical Approaches to Cost Estimation 619 Non-mathematical techniques 620 Mathematical techniques 622 Tests of reliability 626 Multiple regression analysis 631 Requirements for using mathematical techniques 633 Problems which may arise when using mathematical cost equations 634 Cost estimation when the learning effect is present 636 Estimating incremental hours and incremental cost 638 Learning curve applications 640 Self-assessment questions 641 Summary 642 Appendix 20.1: Partial table of t-values 643 645 21 Quantitative Models for the Planning and Control of Stoeks 652 Why do firms hold stocks? 652 Relevant costs for quantitative models under conditions of certainty 653 Determining the economic order quantity 654 Assumptions of the EOQ formula 657 Application of the EOQ model in determining the length of a production run 658 Quantity discounts 659 Determining when to place the order 660 Uncertainty and safety stoeks 661 The use of probability theory for determining safety stoeks 662 Control of stoeks through classification 664

XIV Contents Other considerations 665 just-in-time purchasing and manufacturing 666 Self-assessrnent questions 668 Summary 669 670 22 The Application of Linear Programming to Management Accounting 676 Single resource constraints 676 Two resource constraints 677 Linear programming 677 Graphical method 679 Simplex method 684 Interpreting the final matrix 688 Opportunity cost 689 Substitution process when additional resources are obtained 689 Uses of linear programming 690 The use of linear programming in capi tal budgeting 693 Practical problem s in applying linear programming 695 Application to other business problems 696 Self-assessment questions 696 Summary 698 700 Part VI: Divisional Performance Evaluation 711 23 Performance Measures and Control in Divisionalized Companies 713 Functional and divisionalized organizational structure 713 Profit centres and investment centres 715 Advantages of divisionalization 715 Disadvantages of divisionalization 716 Prerequisites for successful divisionalization 716 Measuring divisional performance 717 Factors to be considered in designing managerial performance measures 717 Evaluating the economic performance of the division 719 Controllable and non-controllable expenses 720 Return on investment and residual income 720 Controllable and non-controllable investment 722 Valuation of controllable investment 722 The effect of performance measurement on capital investment decisions 723 Reconciling short-terrn and long-term residual income measures 726 Determining the divisional cost of capital 730 Use of non-accounting measures 732 Self-assessment question 732 Summary 733 736 24 Transfer Pricing in Divisionalized Companies 744 Objectives of transfer pricing 744 Market prices 746 Transfer pricing in imperfect markets 748 Effect of cost-plus transfer prices 752 The use of Iinear programming in establishing optimum transfer prices 753 Transfer pricing conflicts 756 Resolving transfer price conflicts 757 Negotiated transfer prices 758

Contents xv International transfer pricing 759 Recommended procedure for transfer pricing 760 Surveys of company practice 761 Self-assessment question 761 Summary 763 Appendix 24.1: Economic analysis of transfer pricing 765 769 Part VII: Past, Current and Future Developments in Management Accounting 779 25 Past, Current and Future Developments in Management Accounting 781 A review of past developments in management accounting 781 The behavioural perspective 782 The economic perspective 783 The gulf between theory and practice 784 The impact of information technology on management accounting 786 The impact of new manufacturing technology on management accounting 788 Calculation of produet costs 789 Relevant costs for decision-making 790 Cost control and performance evaluation 791 Summary and conclusion 792 Appendices 795 Appendix I: Present Value Factors 795 Appendix II: Cumulative Present Value Factors 800 Appendix III: Areas in Tail of the Normai Distribution 804 Appendix IV: Capital recovery factors 805 Appendix V: Future Value of fi at the End of n Periods 806 Notes 807 Self-assessment Answers 813 Index 854