Question | Answer |
Classification of costs | Direct Costs
Easily pinned to an individual product
Total = PRIME COSTS
Indirect Costs
Not easily pinned to an individual product aka OVERHEADS |
Manufacturing costs vs Non-manufacturing costs | Manufacturing costs
Direct costs e.g. raw mat
Production overheads e.g. factory rent
Non-manufacturing costs
Distribution costs e.g. petrol for delivery vans
Administrative expenses e.g. office salaries
Financing costs e.g. interest payable |
Contribution p.u. formula | = SP - VC |
BEP formula & explanation | BEP = FC/Contribution p.u.
When activity is above BEP the business will make a PROFIT & below = a LOSS. |
MoS formula and explanation | Current Output – BE Output
MoS = the amount by which sales could fall & we still BE |
Budgeting: 7 stages in planning process | 1. Establish objectives
2. Identify possible alternative strategies
3. Evaluate alternative strategies
4. Select strategy
5. Implement long-tern plan in the form of annual budget
6. Monitor actual results
7. Respond to differences from plan |
Purpose of budgets (also 7) | Planning annual operations
Co-ordinating activities
Communicating plans
Providing a system of authorisation
Motivating managers
Controlling activities
Evaluating performance |
Standard costs = | Target costs for each operation that are built up to give a total cost of production for each product/service. |
6 Purposes of Standard costing | 1. A control device
2. To help setting budgets
3. For motivation
4. To identify efficiencies
5. For decision-making
6. To simplify book-keeping |
Two main approaches to establishing standards: | Past historical records
Engineering studies |
Flexed Budgets | Master Budget (prepared in advance) is important for planning, but limited use for control/evaluation purposes
After period ends, a Flxd Budget based on actual activity must be prepd to compare it with actual figures, and calc cost variances. |
Variance Analysis | Involves a series of calculations to analyse how actual differed from standard
If the difference led to an increase in profit, it is said to be a ‘favourable’ variance
If the difference led to a decrease in profit, it is known as an ‘adverse’ variance |
Materials Variances | Material Price Variance -
(SP – AP) x AQ
Material Usage Variance
(SQ – AQ) x SP |
Labour Variances | Labour Rate Variance
(SR – AR) x AH
Labour Efficiency Variance
(SH – AH) x SR |
VOH Variances | Variable Overhead Expenditure Variance (usually based on labour hours)
(Standard VOH rate – Actual VOH rate) x AH
Variable Overhead Efficiency Variance
(SH – AH) x Standard VOH rate |
Fixed Overhead Expenditure Variance
NB:For the purposes of variance analysis on this module, we are assuming that fixed overheads are not being absorbed | Actual fixed overheads – Budgeted fixed overheads |
Sales variance | Sales Price Variance
(Actual price – standard price) x actual volume sold
Sales Margin Volume Variance
(Actual volume – budgeted volume) x standard contribution per unit |
Adverse materials usage variance reasons | Poor wastage/pilferage control?
Staff training needed?
Poor quality of materials?
Quality of finished goods? |
Favourable materials price variance reasons | Efficient purchasing department? Or uncontrollable market forces?
Bulk buying? BUT note stock holding costs
New supplier? BUT note reliability of supply?
Inferior quality of materials? |
Adverse labour efficiency variance reasons | Use of lower skilled labour?
Poor control by production foreman?
Need for better working practices/training?
Need for productivity bonuses?
Need better equipment?
Quality – has this improved by taking more time? |
Adverse labour rate variance reasons | Use of higher grade of labour? – leading to higher quality, less waste?
Increased production leading to increased overtime?
Increase in rates of pay? – need to revise standards |
Investment decisions & the management accountant | Wherever there is a significant period of time between the initial outlay and future benefits
The importance of such decisions:
Resources involved
Difficulty of bailing out
Mgmt Accountant therefore must appraise capital investment opportunities caref |
Accounting Rate of Return (ARR) | Least-commonly used of the four methods
Only one to use forecast profits rather than cash flows
Corresponds to ROI/ROCE in financial statement analysis |
ARR Method of calculation: | 1. Calculate the average annual profit (= Total profits over life of project/Project life)
2. Calculate the average investment (= (Initial investment + Residual value)/2)
3. Calculate the ARR = Average annual profit/Average investment |
Advantages of ARR | - Straightforward calculation
- Readily understood by accountants; corresponds with ROCE/ROI
- Managers are familiar with the concept of a % return
- Superior to payback in that it at least takes account of whole project life |
Disadvantages of ARR | - Ignores pattern of returns and time value of money
- Uses profits rather than cash flows, therefore more subjective
- Expressed as a percentage only and does not reveal size of project |
Payback Period | Simply calculates ‘how long will it take to get our money back on this investment?’
Despite its limitations, payback is widely used in practice
Can be effective as a quick filter for ‘bad’ projects
‘Discounted payback’ is an alternative |
Advantages of Payback | - Straightforward calculation
- Quick & simple
- May be significant if company has cash flow problems
- Early cash flows are easier to forecast than later ones |
Disadvantages of Payback | - Ignores time value of money
- Ignores cash flows over full life of project
- Expressed as no. of years only: does not reveal size of project
- Target payback periods are arbitrary
- Leads to ‘short-termism’ |
NPV decision rule | Where NPV of project is positive, accept the project
Where NPV of project is negative, reject it
If there are two or more mutually exclusive projects, the project with the highest NPV should be selected |
Advantages of NPV | - Takes full account of amount & timing of all cash flows over project life
- Consistent with goal of shareholder value-maximisation
- Theoretically the most sound approach |
Disadvantages of NPV | - May be little-understood by non-financial managers
- Identification of appropriate cost of capital may be difficult |
IRR decision rule | IRR is simply the discount rate that results in a 0 NPV.
Where the IRR > cost of capital, accept the project
Where the IRR < cost of capital, reject the project
Where the are mutually exclusive projects, accept the one with the highest IRR |
Advantages of IRR | - Some managers prefer a ‘rate’ to an NPV
- No need to specify a cost of capital in order to calculate (but ‘hurdle rate’ still required |
Disadvantages of IRR | - Ignores overall size of project
- Cannot cope with changes in cost of capital during life of project
- Mathematical problems: e.g. can be more than one IRR if negative cash flows forecast during life of project |
Investment appraisal: 6 other considerations | 1. Query accuracy of forecasts
2. Consider non-financial factors
3. Risk assessment of projects
4. Impact of taxation
5. Effect of inflation
6. Need to identify relevant cash flows |
Working capital | AKA NCAs = current assets – current liabilities |
Reasons for holding inventories: | Transaction motive – for day to day (predictable) activities
Precautionary motive – just in case - precautionary
Speculative motive – prediction of price (inc) means firm want to wait until the price increases. |
Costs of ordering & holding inventories: | Costs of ordering inventories:
Preparing orders, receiving deliveries, paying invoices
Costs of holding inventories:
Warehouse storage and handling costs
Insurance
Deterioration, pilferage (stealing) and obsolescence
Opportunity cost |
Costs of not holding inventories: | Loss of sales
Loss of customer goodwill
Interruptions/stoppages to production
Extra cost of emergency deliveries
Higher price of emergency purchases
Effective techniques for inventory management are therefore essential |
Assumptions of EOQ model | Demand can be predicted with accuracy
Holding cost per unit is constant
Demand is constant over period
No buffer inventories
No discounts for bulk-buying
Note EOQ model can be modified to overcome some of these assumptions |
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