BMAC5203
BMAC5203
BMAC5203
Accounting for Business
Decision Making
INTRODUCTION
BMAC5203 Accounting for Business Decision Making is one of the courses
offered by the Business School at Open University Malaysia (OUM). This course
is worth 3 credit hours and should be covered over 8 to 15 weeks.
COURSE AUDIENCE
This course is offered to all learners taking the Master in Business Administration
programme. This module aims to impart the fundamentals of accounting,
designed for business students without any exposure to basic accounting. This
module intends to describe the importance of Accounting Information in
business decisions, to discuss the basic concepts, principles of financial and
management accounting, and apply accounting in planning, control and decision
making which will be useful for subsequent courses.
STUDY SCHEDULE
It is a standard OUM practice that learners accumulate 40 study hours for every
credit hour. As such, for a three-credit hour course, you are expected to spend
120 study hours. Table 1 gives an estimation of how the 120 study hours could be
accumulated.
INTRODUCTION
BMAC 5203 Accounting for Business Decision Making is one of the courses
offered by the Business School at Open University Malaysia (OUM). This course
is worth 3 credit hours and should be covered over 8 to 15 weeks.
COURSE AUDIENCE
This course is offered to all learners taking the Master in Business Administration
programme. This module aims to impart the fundamentals of accounting,
designed for business students without any exposure to basic accounting. This
module intends to describe the importance of Accounting Information in
business decisions, to discuss the basic concepts, principles of financial and
management accounting, and apply accounting in planning, control and decision
making which will be useful for subsequent courses.
STUDY SCHEDULE
It is a standard OUM practice that learners accumulate 40 study hours for every
credit hour. As such, for a three-credit hour course, you are expected to spend
120 study hours. Table 1 gives an estimation of how the 120 study hours could be
accumulated.
Study
Study Activities
Hours
Briefly go through the course content and participate in initial discussions 5
Study the module 60
Attend 4 tutorial sessions 10
Online participation 12
Revision 15
Assignment(s), Test(s) and Examination(s) 20
TOTAL STUDY HOURS ACCUMULATED 120
COURSE OUTCOMES
By the end of this course, you should be able to:
1. Explain the basic aims (viz. stock valuation, profit determination, decision
making, planning and control) of management accounting (managerial)
information systems in an organisation;
2. Explain the role of ethics in the managerial decision making process; and
COURSE SYNOPSIS
This course is divided into ten topics. The synopsis for each topic is listed as
follows:
This topic will help you understand how accounting information is created and
how decision makers, both internal and external, use this information to make
decisions. You will also realise that there is a standard set of rules and regulatory
framework governing how to record and report financial information.
Topic 4 begins with a discussion on the concept of cost in decision making. There
can be multiple categories of cost or expenses or organisations, such as,
administrative cost and distribution cost and costs can be classified in different
ways for different purposes for decision making.
Topic 7 touches on budgets and discusses the Budgeting Process from the
conception of the plan to the expected execution of it. „What‰ and „How‰
resources are to be used over a specified time period including control that uses
feedback on actual operating results to compare with the plan to evaluate
performance in achieving the plan and goals will also be discussed.
Topic 8 discusses the Flexible Budget and its importance. Using the Fixed
Budgets and Flexible Budgets, Variance Analysis will be discussed.
Topic 9 describes the Variance Analysis such as Direct Materials Price and
Efficiency Variances, Direct Labour Price and Efficiency Variances, Variable
Overhead Spending and Efficiency Variance, and Fixed Overhead Spending and
Production-Volume Variances.
Learning Outcomes: This section refers to what you should achieve after you
have completely covered a topic. As you go through each topic, you should
frequently refer to these learning outcomes. By doing this, you can continuously
gauge your understanding of the topic.
apply it to real situations. You should, at the same time, engage yourself in higher
order thinking where you might be required to analyse, synthesise and evaluate
instead of only having to recall and define.
Summary: You will find this component at the end of each topic. This component
helps you to recap the whole topic. By going through the summary, you should
be able to gauge your knowledge retention level. Should you find points in the
summary that you do not fully understand, it would be a good idea for you to
revisit the details in the module.
Key Terms: This component can be found at the end of each topic. You should go
through this component to remind yourself of important terms or jargon used
throughout the module. Should you find terms here that you are not able to
explain, you should look for the terms in the module.
PRIOR KNOWLEDGE
This is an introductory course. There is no prior knowledge needed.
ASSESSMENT METHOD
Please refer to myINSPIRE.
REFERENCES
Garrison, R. H., Noreen, E. W., Brewer, P. C., Cheng, N. S., & Yuen, K. C. K.
(2012). Managerial accounting, an asian perspective (13th ed.). McGraw-
Hill Companies, Inc.
Hansen, D. R., & Mowen, M. M. (2003). Management accounting (6th ed.). South
Western College Publishing.
Zimmerman, J. L. (2000). Accounting for decision making and control (3rd ed.).
McGraw Hill Companies, Inc.
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Describe how accounting information supports managerial
accounting and financial accounting;
2. Explain how management accountants affect strategic decisions;
3. Describe the financial accounting framework and the Managerial
Accounting System (MAS);
4. Describe the set of business functions in the value chain and identify
the dimensions of performance that customers are expecting of
companies;
5. Explain how management accounting fits into an organisationÊs
structure; and
6. Recognise what ethical behaviour means to managers and
management accountants.
INTRODUCTION
Accounting for decision making is the process of identifying, measuring,
reporting, and analysing information about economic events of organisations
used by management to plan, evaluate, control and make decisions. Therefore,
accounting is an information system and seen as an integral part of the total
information system of an organisation.
This topic will help you understand how accounting information is created and
how decision makers, both internal and external and use this information to
make decisions. You will also realise that there is a standard set of rules and
regulatory framework governing how to record and report financial information.
ACTIVITY 1.1
Since the decision-making process for each stakeholder involves choosing from
among alternative courses of action in order to achieve their respective
objectives, each group requires different kinds of information. There are different
sections of accounting that provide different kinds of information, namely,
financial accounting and management accounting.
A customer will want a continuous supply of materials or parts for the finished
goods. Therefore, the financial information becomes vital in making decisions, as
to how stable the entity is and its track record. The creditors will want to know
the financial strength of the entity to decide the amount to be loaned out to an
entity.
SELF-CHECK 1.1
Choose a listed company and list down all the possible users of its
financial information and discuss their needs.
ACTIVITY 1.2
MASB has adopted the global set of accounting standards which is known
as the International Financial Reporting Standards (IFRS). This was issued
by the International Standards Board (IASB), with effect from 1st January
2012.
The MIA is a statutory body established under the Accountants Act, 1967 to
regulate and develop the accountancy profession in Malaysia. Under the
Accountants Act, all practicing accountants have to register themselves as
members of the MIA. The MIAÊs responsibilities include education and
quality assurance, as well as enforcement, to ensure that the credibility of
the accounting profession is maintained, and that public interest is
continuously upheld.
In addition, the MICPAÊs Code of Professional Conduct and Ethics and the
MIAÊs By-Laws (on Professional Ethics, Conduct and Practice) provide
guidance to the accounting professions on their professional and ethical
conduct.
(b) Partnership;
The major differences between the types of entities above are its:
(b) Ability to get funding; sourcing funds via Initial Public Offer (IPO); and
SELF-CHECK 1.2
Strategies are set out to allow an organisation to match its own capabilities with
the opportunities in the marketplace to accomplish its objectives, be it short,
medium or long term. Management accountants are involved in formulating
strategies by providing information on the sources of competitive advantage
of the organisation, as well as, general costing information. Management
accounting assists in formulating strategy by helping the managers to answer
critical decision making questions regarding the value chain, supply chain
analysis and the key success factors of the organisation.
The supply chain depicts the flow of goods, services, and information beginning
from the sources of materials and services, to the conveyance of products to
consumers, regardless of whether those activities occur in the same organisation
or in different organisations.
Figure 1.1 describes the relationship between management accounting and value
chain. It covers six areas of concern in maintaining the efficiency and
effectiveness of a business to be sustainable. These six domains need to be well
coordinated to establish a profitable and sustainable business.
Thus, organisations are able to maintain an edge over their competitors. The two
major strategies in a managerial accounting system are namely, Cost Leadership
Strategy, for example, used by Air AsiaÊs as Low cost and No Frills and DominoÊs
Pizza, and the next strategy is Product Differentiation Strategy, for example, used
by Ferrari as specialised in high performance cars and also by Starbucks.
These steps form the planning where the selection of organisational goals and
forecasting their results under numerous alternative ways of attaining those
goals are carried out. The decision on how to attain the anticipated goals,
communicating those goals and the mechanism of applying it to the entire
organisation are done. These are where the proper planning, control and making
decisions are essential in making future decisions.
ACTIVITY 1.3
In general, there are four standards of ethical conduct that needs that to be
adhered by managers and Management Accountant namely:
(a) Integrity;
(b) Objectivity;
(c) Competence; and
(d) Confidentiality.
Drury, C. (2015). Management and cost accounting (9th ed.). Cengage Learning.
Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J. O.
(2014). Introduction to management accounting (Global Edition 16th ed.).
Pearson Education Limited.
INTRODUCTION
Measuring income is crucial to businesses because there is a need to know how
well the entity is doing economically and financially. Businesses need to be able
to measure the success of their operations. However, the only way to be certain
of a businessÊs success is by liquidating the entity by selling its assets and
liabilities. The remaining cash will be a measure of the entityÊs worth. For
accounting purposes, accountants measure the performance of business entities
over discrete time periods, commonly a fiscal year, explained as the accounting
time period concept.
The most common ways to measure income are the accrual basis and cash basis
methods. Although both cash and accrual basis have their merits, the accountants
have conventionally measured income on an accrual basis. Generally, governments
conduct their accounting using the cash basis, unless the government has
reverted to the accrual basis. Based on the accrual basis, expenses are recognised
in the same period as their related income, known as the matching principle.
Some of the other basic accounting principles and concepts that are implicit in
financial statements, such as, the separate entity concept, reliability concept,
going concern convention, materiality convention, monetary unit assumption,
historic cost assumption, time-period concept, consistency principle, disclosure
principle and conservatism principle will also be discussed in this topic.
ACTIVITY 2.1
Think about any financial ratio that you have come across before and
what it means.
The framework will guide the building of the ideology of whatever that is to
be built. The conceptual framework is a framework that is broad based and
predominantly conceptual in nature, to guide the users of this framework to
carve out more specific rules and regulations.
For example, when a credit sale is made, the double entry is a debit to
Accounts Receivable and a credit to sales accounts, to record the particular
sales at the same time, not when the cash is collected from the customer.
Generally, accountants have used the accrual basis as a basis to record the
business transactions of an organisation. Accrual accounting gives rise to the
usage of accruals, prepayments and other adjustments.
SELF-CHECK 2.1
Discuss the accounting basis that is used in private entities and the
public sector in Malaysia.
(a) Relevant
Information is relevant when it is useful in making an impact on decision
making. When an accounting system provides relevant information, the
decision making becomes easier and meaningful. Relevance involves
the content of the information and its timeliness for decision making.
The impact of complying with relevant is to confirm a decision that a
stakeholder has made or is planning to make in the future.
(b) Reliability
Reliability promotes that information is to be based objectively on correct
data. The information presented to the stakeholders is represented
faithfully without any form of biasness or error and the specific transactions
and/or events that are reported in the financial statements are true and fair.
Reliability is maintained with the ability to verify the financial information.
For example, preparing the financial statement based on accounting
standards establishes the reliability of the accounts and its value
representations.
(d) Timeliness
Timeliness is vital to plan and control business processes of an organisation.
Timely information will be helpful for organisations to be competitive.
Organisations use huge data analyses to be able to forecast and respond to
the ever changing business environment and be competitive. Timely
information for pricing, planning and costing purposes are important to
serve the customers and also to enjoy significant savings from informed
decision making and risk taking. The preparation of budgets on a timely
manner, say two months before the year end and the variance analysis
prepared before the formulation of the budgeting parameters, are some
examples of the need of timeliness to make useful decisions .
(e) Prudence
Prudence is when preparing financial statements, organisations are to
exercise caution and ensure that the reported figures are realistic. In a
prudent approach, the rules of thumb are not to expect any gains, but to
provide for possible losses and to record an asset at the lowest reasonable
amount and a liability at the reasonably highest amount. In the event of a
loss if unsure recognise it, but in the event of a gain do not recognise unless
it is realised, and when doubtful, record expense not an asset. The inclusion
of provision of doubtful debts is to be prudent, in case some amount from
the accounts receivables is uncollectible.
(f) Completeness
Completeness means that organisations need to record all items regarding
the affairs of business in the statements. Some items deemed not so
important should be recorded in the notes to accounts, which form a major
part of the annual report.
(g) Comparability/Consistency
Business entities should apply similar accounting methods for different
time frames, for example, the usage the methods of depreciations and
inventory valuations are to be consistently applied over the years.
This is vital to make sure that the financial information is comparable for
analysis purposes.
(h) Materiality
Business entities are to follow accounting rules strictly only for significant
items. Items that are not significant for decision making should be ignored.
For example, the depreciation on trivial items like staples or certain
stationeries should be recognised as expenses instead of being depreciated.
(j) Accruals
The impact of transactions and different occasions are perceived when they
happen and they are recorded in the accounting records and reported in the
monetary proclamations of the periods to which they relate. Accrual
accounting portrays the impact of exchanges and different occasions and
circumstances on a reporting entityÊs financial assets and claims in the
periods in which those impacts happen, regardless that the subsequent
money receipts and payments happen in an alternate period. As opposed to
Cash-Basis, when a credit sale is made, the double entry is a debit to
Accounts Receivable account and a credit to Sales account, to record the
particular a sales, not when the cash is collected from the customer.
Other concepts and principles that can be of concern are, namely, separate entity
concept, historic cost assumption, monetary unit assumption, accounting period
assumption, revenue recognition principle and disclosure principle.
Revenue is assumed to be earned when the entity has handed over the goods or
service agreed to the legally binding customer. Generally, the invoice date is used
to determine the recognition of revenue. Disclosure principle is when business
entities have reported substantial information for external stakeholders to make
useful decisions on the organisation.
ACTIVITY 2.2
SELF-CHECK 2.2
Separate entity concept: The assumption that a business entity is separate and
distinct from its owners and from other business entities.
Prudence: Business entities should use the same accounting methods for
different periods.
Drury, C. (2015). Management and cost accounting (9th ed.). Cengage Learning.
Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J. O.
(2014). Introduction to management accounting (Global Edition 16th ed.).
Pearson Education Limited.
INTRODUCTION
The Financial Manager of an organisation uses ratios in making decisions related
to his/her responsibilities (internal use), and they are also used by creditors,
lenders and investors in evaluating an organisation (external use).
The prime purpose of each analytical method is to identify potential areas facing
financial distress. When the areas are established, detailed probing is necessary
to find out the reasons of all differences especially in the process of choosing new
ratios.
This topic introduces a few other methods to analyse other than the traditional
ratio analysis. The other methods are common size (vertical) analysis and
horizontal analysis. Ratios and its analysis are elaborated to establish compliance
to sharia and to establish borrowings in organisations.
ACTIVITY 3.1
Think about any financial ratio that you have come across before and
what it means.
We will start with profitability ratios, followed by the rest of the categories.
the cost elements to decide on the strategies to improve the net profit
margin and gross profit margin, besides looking at the selling price and
quantity levels. These are the formulas for both gross profit margin and net
profit margin:
Gross Profit
Gross Profit Margin 100%
Sales
PBIT
Net Profit Margin 100%
Sales
PBIT
ROCE 100%
Capital Employed
PBAT
ROE 100%
Equity Capital
Sales
Assets Turnover
Total Assets
Average Inventory
Inventory Turnover 365 days
Cost of Sales
Trade Payables
TPPP 365 days
Credit Purchases
Trade Receivables
TRCP 365 days
Credit Sales
This figure is useful for internal control, especially when a longer term
borrowing is incurred, specifically when a stated minimum level of net
working capital needs to be established by the organisation. This criterion is
used to force the organisation to establish enough operating liquidity and
helps protect the creditors.
When an organisationÊs current ratio is 1, its net working capital is nil, and
when an organisationÊs current ratio is less than 1, it will have a negative
net working capital. Therefore, the most ideal current ratio should be 2:1,
but again, it all depends on the industry to make a better comparison. The
formula for Current Ratio is as follows:
Current Assets
Current Ratio
Current Liabilities
measure the overall organisationÊs liquidity. The ideal quick ratio should be
1:1, but it depends on the industry to make a better comparison. The
formula used to find the Acid Test Ratio is as follows:
PBIT
Interest Cover
Interest Payable
Dividend
Dividend Yield 100%
Current Market Value of Share
This shows how safe the dividend payment is, or the extent of profit
retention, for example, profits being reinvested in the business. Variations
may be due to maintaining dividend when profits are declining.
PAIT
Earnings per Share (EPS) 100 cents
Number of Ordinary Shares
Market Price
Price Earnings Ratio (P/E)
EPS
Example 3.1
Given below are the financial statements of Syarikat Good Business Berhad for
the year ended 31 December 2015. Financial ratios for Syarikat Good Business
Berhad are calculated based on the formulas that have been discussed
previously.
Current Assets
Cash at Bank 25,000
Accounts Receivables 50,000
Inventories 75,000 150,000
Total Assets 350,000
RM RM
Equity and Liabilities:
Equity
Ordinary Shares 150,000
Retained Earnings 80,000
Liabilities:
Accounts Payables 70,000
Bank Notes 5,000 75,000
Given below are the financial ratio calculations for Syarikat Good Business
Berhad.
Current assets
(a) Current ratio
Current liabilities
RM150,000
RM75,000
2:1
This current ratio of 2 : 1 means that that the current assets are double the
current liabilities. Therefore, the liquidity of the entity is deemed to be
sufficient to cover its short-term obligations.
This quick ratio of 1 : 1 means that that the current assets (net of inventories)
are equal to the current liabilities. Therefore, as a more severe test of
liquidity, this entity is deemed to be sufficient to cover its short-term
obligations. This is not surprising looking at the favourable current ratio
above.
365 days
Average age of inventory
Inventory turnover
This inventory turnover of 1 time means that that the inventory turns over
in the entity, on average, once a year. Generally, a higher inventory
turnover is preferred as it means that the inventory is following the latest
trend and perhaps it will appeal to better sales. Average age of inventory
will be in days, and a lower figure in days is preferred.
Accounts receivable
(d) Average collection period 365 days
Credit sales
RM50,000
365 days
RM225,000
81 days
This average collection period of 81 days means that that the collection of
credit customers of the entity is, on average, collected every 81 days in a
year. Generally, a lower figure in days is preferred, which represents a
more efficient collection policy and practice.
Accounts payable
(e) Average payment period 365 days
Annual purchases
RM70,000
365 days
RM75,000
341 days
This average payment period of 341 days means that that the payment to
suppliers is, on average, made once in every 341 days in a year, which is
not an encouraging figure. Generally, a lower figure in days is preferred,
which represents a more efficient payment policy and practice.
Sales
(f) Total assets turnover
Total assets
RM225,000
RM350,000
0.64 times
This total assets turnover ratio of 0.64 times means that the total assets of
the entity is utilised 0.64 times to generate the sales of RM225,000.
Generally, a higher figure is preferred, which represents a more efficient
usage of assets.
The gearing ratio of 16.4% means that most of the assets of the entity is
funded by equity instead of debts. Generally, a gearing ratio of below 50%
is attractive.
PBIT
(h) Interest cover
Interest
RM65,000
RM5,000
13 times
The interest covers of 13 times means that the interest payable can be paid
from the available profits by as many as 13 times. Even though we know
that the entity will only pay once, this a test of the financial ability of the
entity. Generally, a higher interest cover ratio is preferred.
Sales COGS
(i) Gross profit margin
Sales
Gross profit
Sales
RM150,000
RM225,000
67%
The gross profit margin of 67% means that for every RM1 of sales the gross
profit is 67 cents, and generally, a higher gross profit margin ratio is
preferred.
Net income
(j) Net profit margin
Sales
RM52,500
RM225,000
23.3%
The net profit margin of 23.3% means that for every one ringgit of sales the
net profit is about 23 cents and generally, a higher net profit margin ratio is
preferred.
The ROE of 22.8% means that for every RM1 of shareholders investment in
the entity, the return is about 23 cents and generally, a higher ROE is
preferred to attract more investments.
An analysis should ensure that the time frames of the financial statements of an
organisation or organisations being compared are the same; otherwise, the effects
of seasonality may cause erroneous conclusions and decisions. It is best to use
audited financial statements for ratio analysis. If say, the financial statements of
the organisation are not verified, there is a possibility that the information is not
accurate, and we are unable to establish the organisationÊs true financial health.
(a) If the Bank figure is RM200,000 and total assets are RM500,000, the Bank
figure is presented as 40 (RM200,000 divided by RM500,000);
(b) Finally, let say that the ownerÊs equity is RM300,000, it will be presented as
60 (RM300,000 divided by RM500,000).
The restated amounts from the vertical analysis of the Statement of Financial
Position (Balance Sheet) will be presented as a „Common-size‰ Statement of
Financial Position (Balance Sheet), and a Common-size Balance Sheet allows you
to compare the organisationÊs Statement of Financial Position (Balance Sheet)
with another in the same industry.
For example, the amount of cash reported in the Statement of Financial Position
(Balance Sheet) at 31 December of the year 2015, 2014, 2013, 2012, and 2011 will
be expressed as a percentage of the amounts on 31 December 2011.
Let us assume that the cash amount in the year 2011 was RM100,000 and in the
year 2015 it was at RM135,000, therefore, the horizontal analysis will return a
result in a number 135, instead of a monetary value. This shows that the amount
of cash at the end of 2015 is 135% of the amount at the end of 2011.
The same analysis will be done for each item on the Statement of Financial
Position and for each item on the Statement of Income. This will allow you to see
how each item has changed in relationship to the changes in other items. The
term „Trend Analysis‰ is also referred to interchangeably replace Horizontal
Analysis.
SELF-CHECK 3.1
ACTIVITY 3.2
There are five main categories of ratios that can be used to do to compare
various performances of organisations, which includes:
ă Profitability ratios;
ă Liquidity ratios;
ă Efficiency ratios;
ă Investment ratios.
Horizontal and vertical (common size) analyses are also analyses that are
based on ratios, but instead of for only one particular year, it focuses on
multiple years or multiple business sizes.
Ratios are also subjected to certain limitations which make it difficult to make
comparisons between companies. The limitations are difficulties in
identifying a company in the same sector of a similar size, product and
service, different degrees of diversification, and finally different financing
policies.
Based on IOI BerhadÊs 2013 annual report calculate its financial ratios for the year
2013.
Drury, C. (2015). Management and cost accounting (9th ed.). Cengage Learning.
Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J. O.
(2014). Introduction to management accounting (Global Edition 16th ed.).
Pearson Education Limited.
INTRODUCTION
What does the term „Cost‰ mean? Costs are all payments of cash or cash
equivalents (or the commitment to pay cash in the future) for the purpose of
generating revenues for the organisation. For example, when goods are
purchased for cash or credit, the amount of the payment is the cost of the goods.
There can be multiple categories of costs or expenses for organisations, such as
administrative cost and distribution cost and costs can be classified in different
ways for different purposes.
This topic discusses on the basic cost concepts and itÊs classification. We will also
be looking into preparing the different costs methods which cover preparing
costs of manufacturing products and the various costs of behaviour. Lastly, we
will also be looking into preparing cost of goods manufactured, the cost of goods
sold and a simple income statement.
In the case of manufactured goods, these costs consist of direct materials (raw
materials), direct labour and direct manufacturing overheads (production
overheads).
Period costs are excluded from the product costs of a specific product. The period
costs are identified within a given specific time frame and these period costs are
generally not inventoried. This is because the period costs are expensed out from
the income statement, and incurred in the given specific period; this is done
based on the rules of accrual accounting.
Period costs are excluded from the costing of a purchased goods or goods that
are manufactured. For example, office rental and insurance expenses. Rent and
insurance are excluded from the cost of goods that are manufactured or
purchased. Actually, rent and insurance are recognised as expenses in the income
statement in the incurred time frame .
Figure 4.1
Information given is that half of the output for the year is sold and there is no
opening inventory.
RM
Production costs 100,000
Less: Ending inventory (50%) (50,000)
Cost of goods sold (50%) 50,000
Period costs (100%) 80,000
Total costs recorded as an expense for the period 130,000
Manufacturing costs can be classified into three major elements: Direct material,
Direct labour; and Manufacturing overheads. Direct materials consist of all those
materials that can be physically identified with specific products. For example,
the chip used for a microcomputer is a direct material or wood used to produce a
table.
Direct labour includes those labour costs that can be specifically traced to or
identified with a particular product. For example, the wages of operatives who
assemble parts into the finished products such as carpenters or welders.
However, the salary of factory supervisors cannot specifically be identified with
the product is known as indirect labour costs and also manufacturing overheads.
Loose tools, such as, nuts and bolts or welding rods are known to be indirect
material costs.
Manufacturing overheads are neither direct materials nor direct labour costs. It is
referred as indirect manufacturing costs. Manufacturing overheads include
expenses such as, depreciation, utilities, rent, maintenance, indirect materials and
indirect labour. It is difficult or not logical to trace indirect cost to manufacturing,
therefore indirect cost is generally allocated to the total cost of production. The
basis for allocation is using the direct machine hours or direct labour hours. A
more efficient method is applying activity based costing to allocate the
manufacturing overhead costs.
Therefore, it can be summarised (refer to Table 4.1) that direct material and direct
labour are direct costs and manufacturing overheads are all other indirect costs.
SELF-CHECK 4.1
List the possible direct and indirect costs for a university and a
manufacturing entity.
The different types of cost behaviour that we are going to explore and discuss are
namely: Fixed costs; Variable costs; Mixed costs or Semi-variable costs; Step
costs; Sunk costs; Avoidable costs; Unavoidable costs; and Opportunity costs.
As total fixed costs are constant, the fixed cost per unit will vary at different
levels of activity. The higher the activity level, the lower the fixed cost per unit;
therefore when a business entity produces a greater number of outputs, the fixed
cost per unit decreases. Figure 4.2 shows the behaviour of fixed cost plotted on a
graph, which is a flat straight line. The fixed cost is fixed at RM1,000 regardless
whether the activity or the output level is zero or 50 units.
Direct material costs are usually variable costs because it increases in proportion
to an increase in the number of units manufactured. To better understand this, let
us look at the example of a furniture manufacturer; if the number of chairs
produced doubles so will the cost of raw materials.
As variable cost moves in proportion to activity, the variable cost per unit will be
constant at different levels of activity. Whether the activity level is higher or
lower, the variable cost is a fixed amount per unit. Therefore, when a business
entity produces a greater number of outputs, the total variable cost will increase.
Figure 4.3 shows the behaviour of variable cost plotted on a graph, which is a
linear straight line. The variable cost is RM20 per unit and RM1,000 in total for 50
units of production.
Figure 4.5 shows the behaviour of step cost plotted on a graph, that is, a flat
straight line that shifts upwards based on a range of activity level. The
supervisory expense is at RM1,000 for five machine operators, and doubles up
when the machines operators are six to ten.
For example, assuming that you are thinking of registering for this MBA course
on a full-time basis, then the relevant cost of going to Open University Malaysia
(OUM) for a MBA degree is not only the cost of tuition fees, books and lodging,
but also the income forgone (opportunity cost) by studying full-time instead of
working.
ACTIVITY 4.1
1. You are required to establish the best possible classification for the
relevant cost data in the items below:
2. For all the costs that are discussed above, list and explain those
costs that are evident for a furniture manufacturer.
(e) If the machine in (a) can be sold for RM8000, and given that
the organisation decides to retain and use the machine, the
RM8000 is a _____________ cost.
(f) Given that the organisation decides to use the machine in the
future, it has to be repaired. For the decision to retain the
usage of the machine, the repair cost is a _____________ cost.
RM RM
Direct material xx
Direct labour xx
Prime costs xx
Manufacturing overheads xx
Total manufacturing costs xx
Non-manufacturing overheads xx
Total costs xx
ACTIVITY 4.2
This organisation manufactures and sells curtains. You are expected to
categorise the given costs listed below as (i) to (viii), and numbered (1)
to (20) into classifications of cost:
(Hint: each of the cost in (1) to (20) has one classification only)
Typically costs of various cost objects are determined in two basic stages;
Accumulation of costs into classified ledger accounts (cost pools), such as,
raw materials, wages, advertising or utility; and assigns cost to cost objects.
Cost drivers are observable casual factors that measure a cost objectÊs
resource consumption. They are factors that cause changes in resource usage
and thus have a cause-and-effect relationship with the costs associated with a
cost object.
Direct and indirect costs are determined by their traceability to a cost object.
Direct Costs are those costs that can be traced to a cost object in an
economically feasible way.
Indirect Costs are costs that cannot be traced to a given cost object in an
economically feasible way.
Cost behaviour refers to how a cost will react when there is a change in the
level of activity in a business function; as and when the level of activity goes
up or down, or a particular cost may fluctuate or remain static. Cost
behaviour patterns are important in costing, because decisions differ based
on these. Costs are often categorised as variable and fixed.
Variable cost will differ in total and in direct proportion to changes in the
level of activity. The activity can be expressed in units, such as units
produced or sold, miles driven or hours worked.
Fixed cost remains always constant for a given range, regardless of changes
in the level of activity. Examples of fixed costs are rental, salary, and
insurance.
The relevant range is a range of activity within which the assumptions about
variable and fixed costs are valid.
Normally, the decision makers should consider the costs in terms of total
rather than unit costs. However, in many decision contexts, considering unit
costs is useful. A unit cost, also called an average cost, is computed by
dividing total cost by the number of units. Accounting systems typically
report both total costs and average cost per unit.
Period costs are all costs that are excluded from manufacturing costs. These
costs are expensed in the income statement in the time frame in which they
are incurred. Examples of period costs include management salaries, office
rent, office insurance, administration costs, and marketing costs.
Question 1
Wonder Bakery manufactures two types of bread, which it sells as wholesale
products to various specialty retail bakeries. Each loaf of bread requires a three-
step process. The first step is mixing. The mixing department combines all of the
necessary ingredients to create the dough and processes it through high-speed
mixers. The dough is then left to rise before baking. The second step is baking,
which is an entirely automated process. The baking department moulds the
dough into its final shape and bakes each loaf of bread in a high-temperature
oven. The final step is finishing, which is an entirely manual process. The
finishing department coats each loaf of bread with a special glaze, allows the
bread to cool, and then carefully packages each loaf in a specialty carton for sale
in retail bakeries.
Question 2
If the Cost Object were the „mixing department‰ instead of units of production of
each kind of bread, which preceding costs would now be direct instead of
indirect costs?
Drury, C. (2015). Management and cost accounting (9th ed.). Cengage Learning.
Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J.
O. (2014). Introduction to management accounting (Global Edition 16th
ed.). Pearson Education Limited.
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Explain the assumptions and derivation of Cost-Volume-Profit
(CVP);
2. Apply and account for changes in CVP variables and calculate its
impacts; and
3. Apply multiple-product CVP and extension to the CVP.
INTRODUCTION
This topic discusses the concept of Cost-Volume-Profit (CVP). In this topic, we will
also be conducting analysis and also illustrate how decision makers will use the
CVP model to assist the „what-if‰ queries. The CVP analysis assists the
management to direct the decision makers to the possible risks and rewards of
decisions that are to be made, by looking at how changes in activity level affects
pricing or costs.
CM SP VC
SP Selling price per unit
VC Variable cost per unit
The contribution margin ratio can be computed either on a per unit basis or on a
total basis. The term contribution ratio is also referred to as the contribution
margin percentage.
CM per unit
CM Ratio
Sales per unit
or
Total CM
CM Ratio
Total Sales Revenue
SELF-CHECK 5.1
Figure 5.1: The three methods that can be used to derive the Break-even Point
Selling price
Operating income Quantity sold (in units)
Unit
Variable cost
Quantity sold (in units) Fixed costs
Unit
Given that the condition for the Break-even Point is that the revenue equals cost,
which means that the profit or loss will be nil. This is based on the formula above
where the operating income will be zero.
The formula is next obtained by substituting the contribution margin per unit for
„selling price per unit‰ minus „variable cost per unit‰ in the operating income
equation. The answer derived from the equation will be the Break-even in units.
SELF-CHECK 5.2
Which method is the best to compute the Break-even Point? Justify your
answer.
Listed are the most common and relevant limitations for Cost-Volume-Profit
Analysis. These five assumptions that follow are not exhaustive:
(a) Changes in the levels of revenues and costs arise only because of changes in
the number of units sold. The number of units sold is the only revenue and
given cost driver is the only cost driver;
(b) Total costs can be separated into fixed and variable components;
(c) The behaviours of total revenues and total costs are linear; that is, when
graphed they will be represented by a linear line in relation to units sold
within a given relevant range;
(e) Variable cost per unit and total fixed costs are known and are constant.
SELF-CHECK 5.3
ACTIVITY 5.1
Figure 5.3: The three main areas under BEP and target income
Example 5.1
Monica is planning to open a food stall at the campus cafeteria and the estimated
costs and revenues are given.
In addition to the above information, Monica decides that she must have a profit
of RM300 to motivate her to be in business.
The first thing that Monica needs to determine is the number of burgers that need
to be sold to earn her target profit. The solution may be attained directly from the
information in the example applied in a CVP graph, by an equation or by using
the contribution margin approach.
Equation Method
The contribution margin per unit is available to first recover fixed costs and then
to generate the target profit. In Example 5.1, the volume of burgers that must be
sold to earn a profit of RM300 can be calculated as follows:
Given the fixed cost as RM500 and based on the calculation below, the sales units
that are required are 250 units to break even. At this point there will be no profit
or loss incurred by Monica.
CM RM500
U RM2
250 burgers
Going back to the question above, if Monica desires to pocket a profit of RM300,
she needs to increase her sales volume and this is shown in the calculations
below.
CM RM500 RM300
U RM2
(with target profit) 400 burgers
Monica, as the business owner, can now evaluate the likelihood of the venture to
be successful with the desired profit by estimating the probability of selling at
least 400 burgers to the students. That is, she must determine whether there will
be sufficient demand for the burgers that she plans to sell.
If it is considered unlikely that 400 burgers could be sold, Monica can use Cost-
Volume-Profit analysis to evaluate numerous alternative strategies. Cost-
Volume-Profit (CVP) analysis can be used to ascertain the number of burger sales
required to break even under the original cost and price strategy, or under any
feasible combination of cost and price alternatives.
ACTIVITY 5.2
Given fixed operating costs is RM2500, the sales price per unit is RM10
and its variable operating cost per unit is RM5. Calculate the BEP.
Solution:
RM2500
BEP
RM10 RM5
500 units
Therefore, the organisation will have a profit for sales greater than 500 units and
a loss for sales less than 500 units.
ACTIVITY 5.3
For example, assume that Monica estimates the most likely sales volume for
the burgers will be 350 units, that after negotiations with the university facilities
management, cafeteria space rental will be lowered to RM400 and the burgersÊ
patties will be supplied at a cost of RM2.50 each. In addition, Monica decided
that RM300 is the minimum profit required to operate the stall.
Taking into consideration all the information, at what price must the burgers be
sold?
VC
TP * Sales Qty FC
SP
U
U Sales Qty
RM300 RM2.5*350 RM400
350
RM4.50
(a) If the product sold is increased by 5%, what should be the operating
income?; and
(b) If the variable cost per unit decreases by 3%, what will be the operating
income?
In other words, if the budgeted revenues are above a given Break-even and it
eventually drops, how far can the revenue drop below the budgeted figure
before the Break-even Point is reached.
Margin of safety can be described using three formulas as shown below. We have
to keep in mind that even though the denominations are different, these three
facets are talking about the same thing, the threshold level.
CVP analysis for an organisation that sells more than one product or service has
a four-step process (refer to Figure 5.4), which are:
Example 5.2
Determine the Break-even sales volume of Fan A1 and Light B2 at Ally Babas
Bhd.
Step 3:
Fixed Costs
Break-Even Point (BEP)
WACM
RM78,000
RM3.25
RM24,000
Step 4:
ACTIVITY 5.4
Break-even Points are sensitive to changes in fixed costs, the selling price of
the firmÊs product, and variable costs. As fixed costs increase, the Break-even
Point increases, and vice versa.
As the sale price per unit increases, the Break-even Point decrease, and vice
versa. Increase in the variable cost per unit increases the Break-even Point,
and again, vice versa.
The organisationÊs cost of goods sold and its operating expenses contain
components of fixed and variable operating costs. Using the algebraic
approach, such as:
FC
The formula for BEP is X
SP VC
U U
Total Fixed Cost
Units
Contribution Margin per Unit
Question 1
Garrett Manufacturing sold 410,000 units of its product for RM68 per unit in
2014. Variable cost per unit is RM60 and total fixed costs are RM1,640,000.
Required:
Question 2
Brilliant Travel Agency specialises in flights between Toronto and Jamaica. It
books passengers on Ontario Air. BrilliantÊs fixed costs are RM36,000 per month.
Ontario Air charges passengers RM1,300 per round-trip ticket.
(b) Make a target operating income (TOI) of RM12,000 per month in each of the
following independent cases.
Required:
1. BrilliantÊs variable costs are RM34 per ticket. Ontario Air pays Brilliant 10%
commission on ticket price.
2. BrilliantÊs variable costs are RM30 per ticket. Ontario Air pays Brilliant 10%
commission on ticket price.
3. BrilliantÊs variable costs are RM30 per ticket. Ontario Air pays RM46 fixed
commission per ticket to Brilliant. Comment on the results.
BrilliantÊs variable costs are RM30 per ticket. It receives RM46 commission per
ticket from Ontario Air. It charges its customers a delivery fee of RM8 per ticket.
Comment on the results.
Drury, C. (2015). Management and cost accounting (9th ed.). Cengage Learning.
Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J.
O. (2014). Introduction to management accounting (Global Edition 16th
ed.). Pearson Education Limited.
INTRODUCTION
This topic discusses the decision-making process and the concept of relevant
information. Short-term decision making is essential for the survival of an
organisation. We will begin with the step-by-step approach in decision making
and the application of the relevant cost concept, as well as, the relevant revenue
concept. The terms Sunk Cost and Opportunity Cost, from Topic 4, will also be
discussed in understanding the concept of relevance.
To ensure that the decision made is the most accurate possible, the information
provided should be filtered to the extent that all possible information is reliable
to predict or estimate the business needs in the future. In terms of demand from
customers, availability of materials from suppliers, availability of labour force,
and assets required for production. The other qualitative analysis will be the
quality of the materials, and also the efficiency of the work force to run the
production to the highest quality and standards possible.
This information is vital to ensure that objectives of the organisation are being
met with calculated risk taking and planning to achieve the desired quality of the
product, as well as, the desired quantity.
Sunk Costs are also irrelevant for decision-making as sunk costs are past,
historical expenditures with no relevance to present decisions. Decision makers
must focus on future incremental costs and revenues in making decisions.
When an organisation purchases, for example, a new machine, then the cost of
the old machine is recognised as a Sunk Cost for decision-making purpose.
Having said that, the cost of the new equipment is a future cost and thus
relevant; therefore, the incremental increase in future cost, such as, insurance
expenses (due to the increased value of the new machine compared to the old
machineÊs value) is relevant as it differs in the future.
ACTIVITY 6.1
Quantitative factors are factors with measurement in numeric terms and this may
encompass not only financial information, for example, the cost of direct
materials but also non-financial information, such as, percentage of down time in
a manufacturing entity.
ACTIVITY 6.2
Cost
(a) Allocated office overheads;
(b) Cost of an aged machine;
(c) Direct materials;
(d) Salary of human resource director;
(e) Washing machine and dryer installation;
(f) Fixed overheads which are unavoidable;
(g) Research expenditures for a latest product;
(h) RM3.8 million promotion programme; and
(i) Manufactured cost of existing inventory.
Decision
(a) Closing a money-losing department;
(b) Vehicle replacement;
(c) Make or buy a product;
(d) Project discontinuance; manager transferred elsewhere in the
organisation;
(e) Purchase of a new house;
(f) Plant closure;
(g) Product introduction to marketplace;
(h) Whether to promote product A or B with the RM3.8 million
programme; and
(i) Whether to dispose the inventory or sell to another party.
Required:
For all the costs above consider and determine whether the costs are
relevant or irrelevant, based on the decision cited. Explain why.
ACTIVITY 6.3
When Proton decided to use MitsubishiÊs engines for its cars, what was
the decision based on?
A catering chain has offered to buy 1,000 units at RM17.50 per unit which is
lower than the normal selling price. Should management accept the special offer
in the short-run?
Solution:
It is important to realise that the average cost per unit produced is irrelevant to
the decision as it includes a proportion of the total fixed costs. The fixed costs do
not change with the decision to accept or reject the order and therefore are not
relevant to the Bahulu Berhad decision making process for the example.
In the example, the new average cost to produce and distribute 9,000 units is
RM18.56 (down from RM19 at 8,000 units). The computation is as follows:
However, the special order is profitable at any price above RM15, the incremental
(relevant) cost to produce and distribute.
The relevant cost data for pricing this special order will be the variable costs. In
total, these costs will change with the decision to accept the order. Normal
long-term decisions require consideration of both variable and fixed costs. In the
longer term, both total fixed costs and total variable costs may change.
For example, a short-term decline in demand will reduce the total variable
distribution costs incurred by an organisation but will have no impact on the
fixed capacity costs, such as warehouse rates. In the longer term, if low-levels of
demand persist, a firm may downsize its warehouse capacity and hence reduce
its fixed capacity costs.
To decide whether to make or buy a product, a decision maker must focus on the
differential costs. That is, those costs which differ between the decision
alternatives. In some circumstances, the opportunity cost of revenues foregone
will also be relevant to the decision to make or buy. For example, it would be
important to consider as a cost, the lost rental revenue of production space
withdrawn to internally produce a component part.
Relevant Cost Analysis, such as a make versus buy decision should consider
strategic and qualitative factors, to minimise risk. If the opportunity to make the
product is outside of the strategic plan, the option to produce the product may
jeopardise the long-term strategic plan and decrease the opportunities for
increased profits.
Other factors to consider in decision making are Opportunity Costs. These costs
are foregone income as a result of choosing a particular alternative. Opportunity
costs are relevant to not only outsourcing decisions, but to all types of
management decisions. The key with opportunity cost is assessing the
alternatives available for excess capacity, with the related profits.
Card Berhad has offered to make the component for Ring Berhad at a price of
RM49 per unit. If the offer were accepted, Ring Berhad could save only 40% of its
fixed overheads as most of the facilities could not be used for other purposes.
(a) Should Ring Berhad accept CardÊs offer? What other factors should they
consider?; and
(b) Would your decision, in (a) above, change if Ring Berhad had the
opportunity to sublet its production facilities if it accepted CardÊs offer.
Rental revenue would amount to RM 50,000 per annum.
Solution:
Fixed Costs are treated in this way to avoid the implication that they vary
in relation to the number of units produced. Ring Berhad would be
spending RM30,000 more to buy the components than make the component
parts.
(b) The RM50,000 incremental revenue would change the decision. Ring
Berhad will be RM20,000 better off if it buys the component parts from
Card Berhad.
One major challenge faced by a decision maker is when each product or service
has more than one constraining resource. It may require minimum inventory
levels for some products and consideration of the resulting total contribution
margin from the mix chosen. Mathematical programmes, such as linear
programming support this type of complex decision. A bottleneck constraint can
arise in complex situations when the theory of constraints and throughput
contribution analysis assist in decision-making.
relevant revenues and costs including those that are incremental to assist in
decision-making. Focus on differences in total costs for the alternatives. Generally,
allocated overheads are ignored. Those costs that will not change are irrelevant to
the decision.
SELF-CHECK 6.1
Scenario 1
SKL Buses is considering the acquisition of two new buses. Because
of improved mileage, these vehicles are expected to have a lower
operating cost per kilometre than the buses the company plans to
replace. Management is studying whether the firm would be better-off
keeping the older vehicles or going ahead with the replacement, and
has identified the following decision factors to evaluate:
(b) Moving revenues, which are not expected to change with the
acquisition;
Required:
Classify the seven decision factors listed into the following categories
(Note: factors may be used more than once):
Scenario 2
Pandan Berhad recently discontinued the manufacture of product
PEC1. The standard costs for this product were:
(a) Dispose of as scrap. The proceeds from the sale will equal the cost
of transportation to the disposal site;
(b) Sell to an exporter for sale in a developing country. The sales price
to the exporter would be RM12 per unit; and
Required:
(a) Determine the current carrying value of the PEC1 inventory; and
Scenario 3
Rinnai Berhad manufactures cups. Several weeks ago, the firm received
a special-order inquiry from Fagor Berhad. Fagor desires to market a
special cup similar to RinnaiÊs model CUP35 and has offered to
purchase 3,000 units. The following data are available:
(a) Cost data for RinnaiÊs model CUP35 cup: Direct materials,
RM45; Direct labour, RM30 (2 hours at RM15 per hour); and
Manufacturing overheads, RM70 (2 hours at RM35 per hour);
(c) Fagor requires a modification of the design that will allow a RM4
reduction in direct-material cost;
(d) RinnaiÊs production supervisor notes that the company will incur
RM8,700 in additional set-up costs and will have to purchase a
RM3,300 special device to manufacture these units. The device
will be discarded once the special order is completed;
Required:
One of RinnaiÊs accountants wants to reject the special order because it
is not in favour of Rinnai. Do you agree with this conclusion if Rinnai
currently has excess capacity? Show calculations to support your answer.
Scenario 4
Rudy Berhad produces two switches: SW1 and SW2. Data regarding
these two swithes follow.
SW1 SW2
Machine hours required per unit 2hrs 2.5hrs
Standard cost per unit:
Direct material RM2.50 RM4
Direct labour 5 4
Manufacturing overhead:
Variable* 3 2.50
Fixed** 4 5
Total RM14.50 RM15.50
The company requires 8,000 units of SW1 and 11,000 units of SW2.
Recently, management decided to devote additional machine time to
other product lines, resulting in only 31,000 machine hours per year that
can be dedicated to production of the switches. Another company has
offered to sell to Rudy Berhad the switches at prices of RM13.50 for
SW1 and RM13.50 for SW2.
Required:
Assume that Rudy Berhad decided to produce all SW1 and purchase
SW2 only as needed. Determine the number of SW2s to be purchased.
(a) Compute the net benefit to the firm of manufacturing (rather than
purchasing) a unit of SW1. Repeat the calculation for a unit of
SW2; and
(b) Rudy lacks sufficient machine time to produce all of the SW1
and SW2 needed. Which component (SW1 or SW2) should Rudy
manufacture first with the limited machine hours available? Why?
Provide all supporting computations.
Sunk Costs are excluded because it cannot be changed by future actions, were
incurred in the past, and not recordable. Sunk costs are also irrelevant for
decision making as sunk costs are past, historical expenditures with no
relevance to present decisions. Decision makers must focus on future
incremental costs and revenues in making decisions.
Question 1
The Dalton Company manufactures slippers and sells them at RM12 a pair.
Variable manufacturing cost is RM5.00 a pair and allocated fixed manufacturing
cost is RM1.25 a pair. It has enough idle capacity available to accept a one-time-
only special order of 5,000 pairs of slippers at RM6.25 a pair. Dalton will not
incur any marketing costs as a result of the special order. What would the effect
on operating income be if the special order could be accepted without affecting
normal sales?:
(a) RM0;
Question 2
DeCesare Computers makes 5,200 units of a circuit board, CB76, at a cost of
RM280 each. Variable cost per unit is RM190 and fixed cost per unit is RM90.
Peach Electronics offers to supply 5,200 units of CB76 for RM260. If DeCesare
buys from Peach it will be able to save RM10 per unit in fixed costs but continue
to incur the remaining RM80 per unit. Should DeCesare accept PeachÊs offer?
Explain.
Drury, C. (2015). Management and cost accounting (9th ed.). Cengage Learning.
Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J.
O. (2014). Introduction to management accounting (Global Edition 16th
ed.). Pearson Education Limited.
INTRODUCTION
Budgeting is so universal that it covers all types of entities, be it manufacturing,
services, or governments. Majority of small, medium and large organisations
formalise their planning and control process using a budgetary control system.
Budgets and the Budgetary Control System have therefore become a primary
management accounting technique for the planning and controlling business
operations.
This topic discusses the budgeting process from the conception of the plan to its
expected execution. Budget is also known as a plan that shows the way we want
to use resources for a given time frame. The Budget System also includes control
using a system known as „feedback‰ on actual results, which is used to compare
with the budget. This is to assist us to evaluate the performance, especially
operating results in order to achieve the plan and goals. One of the goals to
compare the budget and actual is to understand the reasons for the differences,
and to make changes.
The business strategy of an organisation may set one or more objectives in terms
of a targeted profit level, sales volume or Return on Investment (ROI). Budgeting
becomes most useful when budgets are integrated with an organisationÊs
strategy. Whatever objectives are set, they should be quantifiable, verifiable,
achievable and understandable.
(b) Communicating the budget to all levels of the organisation, with a top
down approach (from the strategic management level to middle
management and operational);
(c) Investigating variances from the budget with reasons and corrective
actions; and
Master Budget is the final product of the planning function and the
comprehensive and complete financial planning for an organisation in total and
is generally for a one year period of the fiscal year of an organisation. A Master
Budget is made up of several other budgets. An organisation is made up of
several divisions and departments carrying out different functions. A typical
manufacturing business will usually have the following departments (refer to
Figure 7.1):
These departments or divisions have been set up to organise the activities of the
business in an orderly manner. These are organisational entities each with its
own decision maker or head of department, generally known as a manager, who
is responsible for functions within the organisation. These departments work
together to execute the organisationÊs mission, vision and budgets. Therefore
these important managers will have specific roles in the master plan and will
contribute to it via their departmental budgets.
Sales Budget is a detailed schedule that shows the duration of the Sales Budget,
and is given in both units and value. All other components of the master budget
are linked to the Sales Budget. Therefore, an accurate sales budget is vital to the
success of the entire budgeting process. The sales budget assists in determining
how many units will be produced, and other budgets will be prepared based on
this information.
The Sales Budget triggers a chain reaction that leads to the development of other
budgets. Therefore, the sales budget is the most important and crucial budget of
all and if the sales budget is inaccurate, then all of the other budgets will be
misleading. Several factors affect the sales forecast, including the historical data
on sales volume, future trends and global economic conditions, industry
variations, market research output, and government and pricing policies.
The Sales Budget leads to the preparation of the production budget, and it lists
the number of units that have to be produced during each budgeting timeframe
so that sales needs and desired ending inventory are met. The formula for
production quantity is as follows:
The required purchases of raw materials are calculated as follows (see Figure 7.4):
Direct Manufacturing Labour Cost Budget is used to plan the quantity and the
cost of direct labour is required to facilitate production during the budget period.
It also provides information for planning the cash required to pay direct wages.
The Manufacturing Overhead Expenses Budget is used to plan the total amount
of both variable and fixed manufacturing overheads. Manufacturing overheads
are normally classified into fixed manufacturing overheads and variable
manufacturing overheads for budgetary control purposes. Factory rent, rates and
salaries of factory managers and supervisors are examples of fixed
manufacturing overhead expenses.
Apart from the cost of Goods Sold Budget, the Selling and Administrative
Expenses budgets also show in detail the selling expenses and administration
expenses during the budget period. Combining the above budgets will give us
the Income Statement Budget, the end product of all the Operating Budgets,
which gives us the forecast of the overall revenue, expenses, and profit of an
organisation. This will be the first snapshot of the profit or loss of the operations
of the organisation.
The Cash Budget is an extremely important financial budget for any organisation
and its planning is vital for all organisations to ensure that sufficient liquidity is
maintained to meet cash obligations as and when they arise. Schedules such as
cash collections from sales made to customers, cash payments for materials
purchased from suppliers, cash payments for wages and among others are
required to assist in preparing the Cash Budget.
Capital Expenditure Budget can also be part of the Cash Budget, which is
inserted later into the Statement of Financial Position Budget (Balance Sheet).
This is a financial budget which is related to the long-range plan of the
organisation, and it explains the amount and the timing of the planned capital
expenditure of the organisation.
The Statement of Financial Position Budget shows the expected assets and
liabilities of the organisation at the end of the budget period and the Statement of
Cash Flows budget shows the expected changes in cash flows, the inflows and
outflows resulting from operations, investment activities and financing activities.
The components of the Master Budget and Financial Budget are as follows
(Figure 7.5):
Example 7.1 is a comprehensive example of Guard Berhad for its product G1 that
requires us to prepare all the budgets discussed previously.
Example 7.1
Guard Berhad manufactures and sells product G1 and is about to prepare
budgets for the months of April, May and June 2016. The following information
is available:
Product Data:
Depreciation
Month Units
April 9,000
May 12,000
June 11,000
July 10,000
August 12,000
Other Information:
Inventories:
Cash Payments:
Assets:
Cash RM52,000
Accounts Receivable, (net of bad debts) 940,000
Finished Goods Inventories:
Units 4,500
Unit Cost RM101
Amount 454,500
Raw Materials Inventories: Units Value
M1 33,600 RM67,200
M2 8,400 25,200
M3 16,800 84,000
RM176,400
Equities:
RM
Accounts Payable (Raw Materials) 150,000
Taxes Payable 140,000
Selling and Administration Costs-accrued 30,000
Production Costs-accrued 145,000
Paid up Capital 1,700,000
Retained Earnings 977,900
RM3,142,900
Required:
Prepare the following budgets for Guard Berhad for the months of April, May
and June 2016, and for the quarter:
Sales Budget
Production Budget (in units)
Materials Cost Budget
Wages Cost Budget
Production Overheads Cost Budget
Production Cost Budget
Raw Materials Purchases Budget
Marketing and Administration Cost Budget
Cash Receipts Budget
Cash Payments Budget
Summary Cash Budget
Budgeted Income Statement
Budgeted Financial Position
Guard Berhad
Comprehensive Budgets for April, May and June 2016
Unit
April May June Quarter
Cost
Budgeted production units
10,500 11,500 10,500 32,500
(Schedule B)
Material M1 RM8 RM84,000 RM92,000 RM84,000 RM260,000
M2 RM3 31,500 34,500 31,500 97,500
M3 RM10 105,000 115,000 105,000 RM325,000
RM21 RM220,500 RM241,500 RM220,500 RM682,500
Hours
April May June Quarter
per Unit
Budgeted production units
10,500 11,500 10,500 32,500
(Schedule B)
Manufacturing labour hours 2 21,000 23,000 21,000 65,000
Cost @ RM10/hour RM210,000 RM230,000 RM210,000 RM650,900
Assembly labour hours 1 10,500 11,500 10,500 32,500
Cost @ RM12/hour RM126,000 RM138,000 RM126,000 RM390,000
Total hours 31,500 34,500 31,500 97,500
Total wages cost RM336,000 RM368,000 RM336,000 RM1,040,000
Per
April May June Quarter
Unit
Budgeted production units
10,500 11,500 10,500 32,500
(Schedule B)
Variable overheads RM18 RM189,000 RM207,000 RM189,000 RM585,000
Fixed overhead 300,000 300,000 300,000 900,000
Total overhead costs RM489,000 RM507,000 RM489,000 RM1,485,000
Material M1
Per
April May June Quarter July
Unit
Budgeted production units
10,500 11,500 10,500 32,500 11,000
(Schedule B)
Production requirements 4 42,000 46,000 42,000 130,000 44,000
Add Ending inventories* 36,8000 33,600 35,200 35,200
Total units required 78,800 79,600 77,200 165,200
Less Beginning inventories** 33,600 36,800 33,600 33,600
Purchases units 45,200 42,800 43,600 131,600
Purchases cost @ RM2.00 RM90,400 RM85,600 RM87,200 RM263,200
Material: M2
Per
April May June Quarter July
Unit
Budgeted production units
10,500 11,500 10,500 32,500 11,000
(Schedule B)
Production requirements 1 10,500 11,500 10,500 32,500 11,000
Add Ending inventories 9,200 8,400 8,800 8,800
Total units required 19,700 19,900 19,300 41,300
Less Beginning inventories 8,400 9,200 8,400 8,400
Purchases units 11,300 10,700 10,900 32,900
Purchases cost @ RM3 RM33,900 RM32,100 RM32,700 RM98,700
Material: M3
Per
April May June Quarter July
Unit
Budgeted production units
10,500 11,500 10,500 32,500 11,000
(Schedule B)
Production requirements 2 21,000 23,000 21,000 65,000 22,000
Add Ending inventories 18,400 16,800 17,600 17,600
Total units required 39,400 39,800 38,600 82,600
Less Beginning inventories 16,800 18,400 16,800 16,800
Purchases units 22,600 21,400 21,800 65,800
Purchases cost @ RM5 RM113,000 RM107,000 RM109,000 RM329,000
Per
April May June Quarter
Unit
Budgeted sales units
9,000 12,000 11,000 32,000
(Schedule A)
Variable overheads RM3 RM27,000 RM36,000 RM33,000 RM96,000
Fixed overheads 80,000 80,000 80,000 240,000
Total overhead costs RM107,000 RM116,000 RM113,000 RM336,000
* Please see Statement of Financial Position (SFP) for Accounts Receivable in April
RM940,000.
Amounts paid in April for March ă Please see Statement of Financial Position (SFP).
Example 7.2:
Darix Berhad is a tea distributor and its Statement of Financial Position as at
31 March 2016 is given below:
Darix Berhad
Statement of Financial Position as at 31 March 2016
Assets RM
Property, Plant & Equipments 338,000
Inventory 42,000
Accounts receivable 75,000
Cash at Bank 11,000
466,000
Liabilities and Equity
Accounts payable 89,000
Bank Loan 35,000
OwnersÊ Capital 342,000
466,000
The company is in the process of preparing the Budget Data for April. A number
of budget items have already been prepared, as stated as follows:
(a) Sales are budgeted at RM300,000 for April. Of these sales, RM120,000 will
be for cash; the remainder will be credit sales. 35% of a monthÊs credit sales
are collected in the month the sales are made, and the remainder is
collected in the following month. All of the 31 March receivables will be
collected in April;
(b) Purchases of inventory are expected to total RM216,000 during April. These
purchases will all be on account. 60% of all purchases are paid in the month
of purchase; the remainder is paid in the following month. All of the 31
March accounts payable to supplier will be paid during April;
(c) Operating expenses for April are budgeted at RM71,000. These expenses
will be paid in cash;
(d) The loan on the 31 March Balance Sheet was taken up in December 2011,
with an interest commitment of 6% per annum and will be paid off in April,
together with its interest;
(e) In April a new brewing equipment costing RM10,000 will be purchased for
50% cash and the remainder borrowed from the bank at 5% annual interest.
The first interest payment is to be paid at the end of the month of purchase.
Depreciation of the brewing equipment is at 10% per annum and the life of
the equipment is five years. The borrowed amount will be paid back after
six months; and
(f) During April, the company will borrow RM70,000 from its bank at 5%
annual interest and the first interest payment is due in May.
You are required to prepare a cash budget for the month of April 2016.
CASH INFLOWS: RM
Cash Sales 120,000
Credit Sales 63,000
Accounts receivable 75,000
Bank Loan for Equipment purchase 5,000
Bank Loan at month end 70,000
TOTAL CASH INFLOW 333,000
CASH OUTFLOWS: RM
Purchases 129,600
Accounts Payables 89,000
Operating expenses 71,000
Loan repayment 35,000
Loan interest payment 875
Purchase brewing equipment 10,000
Interest paid for Equipment Loan 21
335,496
TOTAL CASH OUTFLOW
Surplus/Deficit (2,496)
Budgets do not automatically ensure success without the people that make it
work. All individuals affected by the budget, especially management at all levels
must support the budget to provide an organisational environment conducive to
the success of the budget.
Budgets are most effective with the application of participative budgets instead
of imposed budgets, whilst authoritative budgets are normally faced with
difficulties in implementation. A good budget is prepared and communicated to
all managers for its successful implementation. A participative budget is when
employees from all levels of the organisation take part in the preparation of the
budget by making decisions together. This process facilitates the communication
between the decision maker, the senior management, the middle management
and operations.
ACTIVITY 7.1
Use OUM as an organisation and plan its possible budgets and controls
for next year ending 31 December.
A budget may emphasise results but not the reasons, when both are important.
Therefore we need to do a variance analysis of all the differences between the
budgeted figures and the actual figures. The participative theme of budgeting
demands complete management support and involvement, and if managers are
not convinced of budgetingÊs benefits, they are not likely to cooperate in the
Budgeting Process.
SELF-CHECK 7.1
ACTIVITY 7.2
YAP Berhad provides the following budgeted sales for the next seven
months period:
5kg of materials are required for each unit produced. Each material
costs RM8 per kg. Inventory levels for materials are equal to 30% of the
needs for the next month and the materials inventory on January 1 was
15,000kg.
Required:
Prepare production budgets in units for the three months, from
February to April.
Budgets are a primary financial planning tool used by businesses and other
organisations. The chapter explains how businesses use and prepare budgets
as part of the management process.
Planning and Control are considered the primary functions of budgeting. The
process of budget preparation involves all the activities of formalised
business planning, and planning is considered a very important management
function in any business enterprise.
Master budget is then subdivided into shorter periods, such as, monthly or
quarterly to facilitate timely comparisons of actual and plan results. It
consists of two components, operating/functional budget and financial
budget.
Financial Budget shows the cash flows and financial position expected with
the planned operations.
Question 1
The Howell Company has prepared a sales budget of 43,000 finished units for a
3-month period. The company has an inventory of 11,000 units of finished goods
on hand at December 31 and has a target finished goods inventory of 19,000 units
at the end of the succeeding quarter.
It takes 4 gallons of direct materials to make one unit of finished product. The
company has an inventory of 66,000 gallons of direct materials at December 31
and has a target ending inventory of 56,000 gallons at the end of the succeeding
quarter. How many gallons of direct materials should Howell Company
purchase during the 3 months ending March 31?
Question 2
The Mochizuki Co. in Japan has a division that manufactures two-wheel
motorcycles. Its budgeted sales for Model G in 2015 are 915,000 units.
MochizukiÊs target ending inventory is 70,000 units, and its beginning inventory
is 115,000 units. The companyÊs budgeted selling price to its distributors and
dealers is 405,000 yen (æ) per motorcycle.
Mochizuki buys all its wheels from an outside supplier. No defective wheels are
accepted. (MochizukiÊs needs for extra wheels for replacement parts are ordered
by a separate division of the company.) The companyÊs target ending inventory
is 72,000 wheels, and its beginning inventory is 55,000 wheels. The budgeted
purchase price is 18,000 yen (æ) per wheel.
Required:
Drury, C. (2015). Management and cost accounting (9th ed.). Cengage Learning.
Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J.
O. (2014). Introduction to management accounting (Global Edition 16th
ed.). Pearson Education Limited.
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Describe the characteristics of a Flexible Budget;
2. Describe how a Flexible Budget works;
3. Prepare variances for Flexible Budgets; and
4. Prepare Flexible Budgets with multiple cost drivers.
INTRODUCTION
This topic will be the transition from budgets to the analysis of the budgets.
Starting from the Fixed Budgets and moving towards Flexible Budgets, we will
also be discussing variance analysis. Under a system of Budgetary Control and
Responsibility Accounting, actual costs and revenues are accumulated for each
responsibility centre and periodically compared with budgetary targets.
Variances from budgets are highlighted, and the person in charge of the
responsibility centre is held accountable for the deviations.
SELF-CHECK 8.1
Example 8.1
Based on the information below, you are required to calculate the level of output
that will be utilised for;
Solution:
The Static Budget would be based on the planned level of activity of 5,000 units,
while the flexible budget would be based on 4,700 units.
We have to keep in mind that we are to compare the actual figures (based on
4,700 units) with the Flexible Budget figures (based on 4,700 units). It is
important to note that, the Fixed Budget figures (based on 5,000 units) are not to
be used for comparative purposes, as it is meaningless to do so.
SELF-CHECK 8.2
There are three steps involved in developing a flexible budget, as follows (refer
to Figure 8.1):
A flexible budget gives an estimate of the costs that should be for a given level of
activity within a specified range. A flexible budget has 3 major uses depicted in
Figure 8.2:
The term „Standard‰ can represent a price, cost or quantity that is established as
a guide to estimate the performance of an entity, and is normally developed on a
per unit basis. A standard input is the quantity of input for a unit of production,
for example, a litre of material for a chemical product. A standard price is the
price expected to be paid for a unit of input, for example, the price to pay for one
litre of chemicals is RM5 per litre. Following this logic, a standard cost is the cost
of a finished unit of output and the budgeted amounts are based on these
standard prices, costs, and quantities. Example 8.2 shows Dia PostageÊs Fixed
Budget and Flexible Budget:
Example 8.2
DIA POSTAGE
Fixed Budget
For the month ended 31 December 2016
Budgeted Actual Variance
Budgeted number of clients 5,000 5,200 200F
DIA POSTAGE
Flexible Budget
For the month ended 31 December 2016
Budgeted number of
5,000
client-visits
DIA POSTAGE
Flexible Budget Performance Report
For the month ended 31 December 2016
SELF-CHECK 8.3
(b) Used for planning purposes ă as it (b) Used for control purposes
serves to define the general broad
objectives of the specific organisation.
(c) Prepared at the beginning of the (c) Prepared at the end of the period.
period
(d) Based upon one project level of (d) ÂFlexedÊ to accommodate actual level
activity of production
(e) To create a meaningful performance (e) Used to compute what costs should
report, actual costs and expected have been for the actual level of
costs must be compared at the same activity, so that meaningful
level of activity. comparison can be done.
(f) A single budget with no analysis of (f) Cost will be analysed based on fixed
cost. and variable elements, so that the
budget can be adjusted according to
the actual activity.
(g) Not very useful when it comes to (g) Helps managers to factor in any
preparing performance reports. uncertainty by allowing the manager
to look at the expected outcomes for
the given activity range.
ACTIVITY 8.1
ACTIVITY 8.2
Required
Show two budgetary control statements for January, one based on the
fixed budget for 5,000 units and one based on a flexible budget for the
actual level of production.
Flexible Budgets are detailed plans that are used for costs control valid for a
given range of activity levels, and it compares actual information with
budgeted data.
The Flexible Budget variance is the total variance for each cost item that is
commonly analysed from its price and quantity component.
The Price Variance is the difference between the actual cost incurred and the
budgeted cost for the actual input used.
The Quantity Variance is the difference between the budgeted cost and the
standard cost allowable for the actual outputs (of finished product).
Question 1
Based on the scenario below, prepare a static-budget-based variance analysis of
the September performance.
Scenario:
Bank Management Printers, Inc., produces luxury chequebooks with three
cheques and stubs per page. Each chequebook is designed for an individual
customer and is ordered through the customerÊs bank. The companyÊs operating
budget for September 2014 included these data:
RM
Number of chequebooks 15,000
Selling price per book 20
Variable cost per book 8
Fixed costs for the month 145,000
RM
Number of chequebooks produced and sold 12,000
Average selling price per book 21
Variable cost per book 7
Fixed costs for the month 150,000
The executive vice president of the company observed that the operating income
for September was much lower than anticipated, despite a higher-than-budgeted
selling price and a lower-than-budgeted variable cost per unit. As the companyÊs
management accountant, you have been asked to provide explanations for the
disappointing September results.
Bank Management develops its flexible budget on the basis of budgeted per-
output-unit revenue and per-output-unit variable costs, without detailed analysis
of budgeted inputs.
Question 2
Based on the scenario above, prepare a flexible-budget-based variance analysis of
the September performance, and explain why Bank Management might find the
flexible-budget-based variance analysis more informative than the static-budget-
based variance analysis.
Drury, C. (2015). Management and cost accounting (9th ed.). Cengage Learning.
Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J.
O. (2014). Introduction to management accounting (Global Edition 16th
ed.). Pearson Education Limited.
INTRODUCTION
This topic will be based on Flexible Budgets and will conduct multiple variance
analysis, such as, Materials, Labour and Overheads Variances. To be more
specific, variances, such as, Direct Materials Price and Efficiency Variances,
Direct Labour Price and Efficiency Variances, Variable Overheads Spending and
Efficiency Variance, and Fixed Overheads Spending and Production-volume
Variances. We will also be discussing the use of variances to the management of
an organisation. Lastly we will be discussing the importance of variance analysis
in benchmarking where the interrelationship of all the variances will be vital for
an organisationÊs efficiency and sustainability.
A Standard Cost is generally determined very tactfully as it looks into the price,
cost or quantity used as a benchmark for the purpose of performance evaluation
and is very commonly stated on the basis of per unit. For example, a standard
input can be the quantity of input, such as, 1kg of raw material or one direct
labour hour for the output. A standard input can also be the standard price that
an organisation pays for, perhaps, RM5 per direct labour hour. A standard cost is
a budget for one simple unit of product and it simplifies product costing.
SELF-CHECK 9.1
Do you think that the terms standard cost and budgets are the same?
Direct Material and Direct Labour Variances can be further divided into price
variance and efficiency variance. These two variances assist in explaining the
reasons why the actual cost will differ from the budgeted cost figures.
SELF-CHECK 9.2
The price variance reflects the difference between an actual input price and a
(standard) budgeted input price. The equation for the materials price variance is
as follows. The quantity of materials should be the actual purchased quantity.
Materials price Actual Price Standard Price Actual Quantity of
variance Input
Unit Unit
The efficiency variance shows the difference of the actual input quantity and the
standard quantity of input. At times, the Direct Material Variance is known as
the Usage Variance. The quantity of materials should be the actual used quantity.
The equation for the material efficiency variance is as shown:
ACTIVITY 9.1
The Rate Variance shows the difference between an actual input of labour rate
and a (standard) budgeted input of labour rate. The equation for the Labour Rate
Variance is as follows:
The Efficiency Variance shows the difference between an actual input of labour
hours and a standard input of labour hours. The equation for the Labour Price
Variance, also at times known as Labour Rate Variance, is:
ACTIVITY 9.2
Deciding on the appropriate level of capacity that benefits the organisation in the
long run, and timing is an important issue in this planning. Normally, most
decisions regarding fixed costs will have already been made at the beginning of
the budget time frame. But for variable costs, the daily operating decisions affect
the level of variable costs incurred in a given time frame. It is important to note
that the level of fixed costs must be determined in advance of the budget time
frame and this fixed cost is locked in for a medium to long term; therefore; the
decision making process may impact an organisationÊs profitability when fixed
cost is involved. A common definition for fixed overhead costs is total costs that
remain constant for a specific time frame even though there is a change in the
level of activity within a given relevant range. In other words, Fixed Costs are
fixed in the sense that they donÊt really increase or decrease in a straight line with
the activity level within a given relevant range.
The method of Standard Costing tracks the direct costs of a product to the output
of the product. This is achieved by multiplying the standard prices of the inputs
for the actual outputs produced, by the standard quantities for the actual outputs
produced.
Figure 9.4 shows the common steps to develop budgeted variable overheads
when information is available for standard quantities of inputs for actual
outputs.
Figure 9.4: The common steps to develop budgeted variable overheads when information
is available for standard quantities of inputs for actual outputs
Firstly, we need to decide the time frame for the budget, generally a 12 monthsÊ
time frame for budgeting, but a shorter time frame may also be applied. Then, we
need to determine the cost allocation of required based variable overhead costs to
produced output. It is also common to find a cause and effect relationship
between the cost and its base or the cost driver, when we are selecting the cost
allocation bases. The third step is to find the variable overhead costs linked to
each of the allocation bases. Finally, we need to calculate the per unit rate for all
cost allocation bases used to allocate the variable overhead costs to the produced
output.
This variance reveals how much variable overhead costs differ from the flexible
budget amount. However, it does little to explain why this difference has
occurred. To learn why the variance arose, it needs to be divided into two
components, namely variable overheads efficiency variance and the variable
overheads spending variance.
The equation (formula) for the fixed overheads spending variance is given as
follows:
The feedback received for the reasons for the variances can also assist the
knowledge of the organisation, the department and the specific decision maker in
improving future decision-making. This ability of knowing and acting on the
feedback will enable the organisation to continuously apply improvements in the
processes of buying and using materials, hiring and paying labour, as well as,
overheads planning.
As a more specific example, a Favourable Materials Price Variance may give rise
to an Unfavourable Efficiency Variance if the cheaper material of lower quality is
used. This may result in an Unfavourable Labour Efficiency Variance, as the
labour may find the lower quality material consumes more time and hence
higher usage of the material. A favourable Direct Materials Efficiency Variance
may be due to an experienced workforce but experienced workers are paid more
and there may be an Unfavourable Direct Labour Price Variance.
SELF-CHECK 9.3
ACTIVITY 9.3
RM
Direct materials ă 2 kilograms of plastic at RM5 per kilogramme 10
Direct labor ă 2 hours at RM12 per hour 24
Variable manufacturing overheads 12
Fixed manufacturing overheads 6
Total standard cost per unit 52
Actual costs for the month ending January 2016 in producing 7,400 units
were as follows.
RM
Direct materials (15,000 kilograms) 73,500
Direct labour (14,900 hours) 181,780
Variable overheads 88,990
Fixed overheads 44,000
Total manufacturing costs 388,270
Required:
Materials Price and Materials Usage Variances, and Labour Rate and
Labour Efficiency Variances.
Effectiveness is the level where planned objectives or targets are met, and
efficiency is when considerable amount of inputs are used to achieve a given
output level.
Variance and its analysis are formed for materials purchases, materials usage,
labour rate, labour efficiency, variable overheads and fixed overheads.
Question 1
Based on the scenario below, compute the price and efficiency variances for the
three categories of direct materials, and for direct manufacturing labour in July
2014.
Sunto Scientific manufactures GPS devices for a chain of retail stores. Its most
popular model, the Magellan XS, is assembled in a dedicated facility in
Savannah, Georgia. Sunto is keenly aware of the competitive threat from smart
phones that use Google Maps, and has put in a standard cost system to manage
production of the Magellan XS. It has also implemented a just-in-time system so
that the Savannah facility operates with no inventory of any kind.
The controller of the Savannah plant, Jim Williams, is disappointed with the
standard costing system in place. The standards were developed on the basis of a
study done by an outside consultant at the start of the year. Williams points out
that he has rarely seen a significant unfavourable variance under this system. He
observes that even at the present level of output, workers seem to have a
substantial amount of idle time. Moreover, he is concerned that the production
supervisor, John Kelso, is aware of the issue but is unwilling to tighten the
standards because the current lenient benchmarks make his performance look
good.
Question 2
Based on the scenario above describe the types of actions the employees at the
Savannah plant may have taken to reduce the accuracy of the standards set by
the outside consultant. Why would employees take those actions? Is this
behaviour ethical?
Drury, C. (2015). Management and cost accounting (9th ed.). Cengage Learning.
Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J.
O. (2014). Introduction to management accounting (Global Edition 16th
ed.). Pearson Education Limited.
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Describe the different types of responsibility centres;
2. Compute and evaluate performance measurement and reporting;
and
3. Discuss and evaluate the Balance Scorecard.
INTRODUCTION
This topic will be based on the responsibility accounting budgets that are common
and budgets created with responsibility accounting. Responsibility accounting is
the practice of holding managers or decision makers responsible for the activities
and performance of responsibility centres, for example, a department. Where there
are significant variations from the budget, the manager of the Responsibility
Centre is accountable for such variations. A responsibility accounting system is
built around a framework of responsibility centres and a responsibility centre is a
subunit in an organisation whose decision maker is responsible and accountable
for his or her activities and performance.
Cost Centre is a subunit where the decision maker is held accountable for any
costs incurred in that subunit. Most factory departments and the warehouse are
typical cost centres. Revenue Centre is a subunit where the decision maker is
held responsible for revenue generated by that subunit. Profit Centre is a subunit
where the decision maker is held responsible for the profit of that subunit. A
Profit Centre may have cost and revenue centres as subordinate divisions or
departments. Investment Centre is a subunit where the decision maker is held
responsible for any profit generated, and any capital invested to generate a
profit in that subunit of a large organisation. A division of an organisation is
responsible for manufacturing, pricing and marketing products, and making
decisions regarding purchase of equipment, expansion of capacity and
introducing new products.
The first is the mechanics of budgeting that is concerned with the methods
of preparing the budget, and the second is the behavioural implication of
the budgetary control system, which is concerned with how managers and
employees are affected by performance appraisal through budgets.
SELF-CHECK 10.1
Figure 10.2 shows the four perspectives with examples under the Balanced
Scorecard, namely:
By looking at the goals of the organisation and the predictors of achieving those
goals, customer perspective looks at the ability of the organisation to respond to
the needs of the customers, in a time line that is acceptable to the industry or the
organisationÊs standards. To satisfy the needs and demands of the customer, the
organisation might want to look into the reliability of the delivery network to
reach its customers within the agreed contract terms.
These positive responses will enhance the image of the organisation in its
customersÊ sphere, as well as, improving the demand for its products in the
market that the organisation serves, or create new markets when the quality of
the services and products surpass the normal standards.
It is not necessary to have four objectives for all of the perspectives, as the focus
is to manage the objectives and follow through to successfully attain them.
Balanced scorecards are supposed to be flexible and need to fit the organisation
using them. Duplication of indicators should be avoided; therefore no indicators
should be used more than once on the scorecard.
The goals listed should give a broad perspective of activities. Table 10.1 shows
the four perspectives of the balanced scorecard with examples of their possible
application.
Table 10.1: Four Perspectives of the Balanced Scorecard with Examples of Their Possible
Application
SELF-CHECK 10.2
ACTIVITY 10.1
List down two performance indicators for each of the four perspectives
of a Balanced Scorecard.
The Balanced Scorecard puts strong emphasis on financial objectives and its
measures. A Balanced Scorecard emphasises non-financial measures as part of a
program to achieve future financial performance. When financial and non-
financial performance measures are connected, it is able to measure the non-
financial attributes as the main indicators of future financial performance.
Only the most critical areas need to be focused on and used in the process of
implementing the organisationÊs strategies. The scorecard also highlights any
improper decisions that decision makers make if they were unsuccessful in
considering operational and financial measures coherently. Let us say, an
organisation, for which innovation is vital for its survival may attain desired
short-term financial performance by cutting down research and development
expenditure. Therefore, a good balanced scorecard will indicate that the short-
term financial performance is attained by implementing decisions that impacts
future financial performance negatively because a leading indicator of that
performance that is the research and development expenditure and research and
development output has reduced.
We are unable to expect improvements across all the measures all the time. This
approach may not be appropriate because trade-offs are required to be made
across many strategic goals. For example, emphasising quality and speed of
response beyond an expected target might not be needed, as greater
improvement in these objectives may not be consistent with maximising the
profit agenda.
Copyright © Open University Malaysia (OUM)
154 TOPIC 10 RESPONSIBILITY ACCOUNTING
The use of subjective measures are common in a balanced scorecard but the
management should also be concerned with the benefits trade-off of more
information in the decision-making process, as these measures might be
subjected to possible manipulation and mislead the users of the information.
If one is not careful, a Balanced Scorecard might not consider both costs and
benefits of initiatives, such as, spending on information technology and research
and development, as well as, the possibility that the balanced scorecard might
ignore the non-financial measures when evaluating managers and employees.
When non-financial measures are excluded, the decision makers will also give
lesser importance to non-financial scorecard measures when they evaluate the
performance of the organisation.
An average operating asset which is the denominator in the ROI formula should
be net of operating assets, such as, cash, accounts receivable, inventory, property,
plant and equipment and all other assets that are used for operations in an
organisation.
Based on the format, the ROI shows important information on the conduct of an
entity. On a general note, the ROI across a given industry should be similar in the
long term, as it will always reach equilibrium and even out. Whenever the ROI is
above the industry average, funding will flow in to that particular industry,
which will eventually equal the ROI of other industries. Commonly, margins of
an industry with huge turnovers are comparatively small, and vice versa.
Example 10.1 represents the results of operations for the most recent month.
Example 10.1
RM10,000 RM100,000
ROI
RM100,000 RM50,000
10% 2 times
20%
Example 10.2 shows an example of ROI and RI, as well as, Rate of Return.
Example 10.2
Selected sales and operating data of three divisions of the three different services
companies are given below:
(c) Assume that each division is given an investment opportunity that would
yield a 17% Rate of Return.
Division A:
RM300,000
ROI 100 20%
RM1,500,000
OR
RM300,000 RM6,000,000
5% 4 20%
RM6,000,000 RM1,500,000
Division B:
RM900,000
ROI 100 18%
RM6,000,000
OR
RM900,000 RM10,000,000
9% 2 18%
RM10,000,000 RM5,000,000
Division C:
RM180,000
ROI 100 9%
RM2,000,000
OR
RM180,000 RM8,000,000
2.25% 4 18%
RM8,000,000 RM2,000,000
(ii) On the other hand, division C most likely will accept the 17%
investment opportunity, as Division CÊs level of acceptance will
increase the DivisionÊs overall rate of return;
(iv) On the other hand, division B will most likely reject the opportunity,
as the return on the proposed investment of 17% is lower compared to
Division BÊs required rate of return of 18%.
ACTIVITY 10.1
LaRo Sdn Bhd has two offices in business that operate in Singapore and
HK. Given the data below, you are required to:
Offices
Singapore HK
Sales RM20,000,000 RM50,000,000
Average operating assets RM15,000,000 RM25,000,000
Net operating income RM1,300,000 RM1,500,000
(a) Compute the Return on Investment (ROI) for each office, clearly
showing the Margin and Turnover; and
In a Cost Centre the decision maker is only responsible for costs, and the
accounting department would be a cost centre.
In a Profit Centre the decision maker is only responsible for revenues and
costs.
ROI helps the manager to see if the divisionÊs need is to improve the return
on sales or if they need to work on the efficiency in using their assets.
Selected sales and operating data of three departments of the three different
services companies are given below:
(a) Compute the return on investment (ROI) for each department; and
Drury, C. (2015). Management and cost accounting (9th ed.). Cengage Learning.
Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J.
O. (2014). Introduction to management accounting (Global Edition 16th
ed.). Pearson Education Limited.
OR
Thank you.