Accounting VI: Cost and Management Accounting
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Management accounting provides information for planning, control, and decision making. It is not governed by accounting standards, is forward-looking, and may be detailed to the unit, department, or product (Drury, 2018).
Cost Concepts and Classification
| Basis | Classes |
|---|---|
| By element | Materials, labour, expenses |
| By traceability | Direct costs (traced to the product) and indirect costs (overheads) |
| By function | Production, administration, selling and distribution |
| By behavior | Fixed, variable, semi-variable (mixed), stepped |
| For decisions | Relevant costs (future, differential); sunk costs (past, irrelevant); opportunity costs (benefit lost from the next best alternative) |
Prime cost = direct materials + direct labour + direct expenses. Total cost = production cost + non-production costs.
Materials, Labour, and Overheads
- Materials: issues priced by FIFO, weighted average, or standard price; reorder level, maximum and minimum levels; the economic order quantity (EOQ) = √(2DO/H), where D is annual demand, O the ordering cost per order, and H the holding cost per unit per year. Example: D = 12 000, O = 600, H = 24 gives EOQ = √(2 × 12 000 × 600 ÷ 24) = √600 000 ≈ 775 units.
- Labour: time-rate and piece-rate wages, overtime, labour turnover.
- Overheads: allocation, apportionment (sharing common costs by a basis such as floor area), and absorption into units using a predetermined rate (overhead ÷ activity base, such as labour hours). Under-absorbed or over-absorbed overheads are adjusted at the period end.
Costing Methods
Absorption costing includes fixed production overheads in inventory valuation; marginal costing treats fixed costs as period costs and values inventory at variable cost. Profit differs when inventory levels change. Job, batch, and process costing are used in different industries.
Cost-Volume-Profit (CVP) Analysis
- Contribution per unit = selling price − variable cost per unit.
- Break-even point (units) = fixed costs ÷ contribution per unit.
- Break-even point (sales value) = fixed costs ÷ contribution margin ratio.
- Margin of safety = (actual or budgeted sales − break-even sales) ÷ actual or budgeted sales.
- Target profit units = (fixed costs + target profit) ÷ contribution per unit.
Worked example. Selling price 500; variable cost 300; fixed costs 400 000. Contribution = 200 per unit. Break-even = 400 000 ÷ 200 = 2 000 units, or sales of 1 000 000. If sales are 3 000 units, the margin of safety = (3 000 − 2 000) ÷ 3 000 = 33.3 percent. To earn a profit of 100 000, sales needed = (400 000 + 100 000) ÷ 200 = 2 500 units.
Limitations: assumes linear costs and revenues, constant selling price, and a single product (or fixed mix).
Budgeting
A budget is a quantitative plan. Types: sales, production, cash, master budgets; flexible budgets adjust for activity; variance analysis compares actual with budget or standard (favourable and adverse variances). Budgets support planning, coordination, motivation, and control, but may cause budgetary slack.
Capital Investment Appraisal
| Method | Rule | Notes |
|---|---|---|
| Payback period | Accept if payback is shorter than the target | Simple; ignores cash flows after payback and the time value of money |
| Accounting rate of return (ARR) | Average annual profit ÷ average investment | Uses profit; ignores timing |
| Net present value (NPV) | Accept if NPV > 0 | Considers time value; the preferred method |
| Internal rate of return (IRR) | Accept if IRR exceeds the cost of capital | Discount rate at which NPV = 0 |
Worked example. Investment 1 000 000; cash inflows 400 000 a year for four years; cost of capital 10 percent. The annuity factor for four years at 10 percent is 3.170, so the PV of inflows = 400 000 × 3.170 = 1 268 000 and NPV = +268 000 (accept). Payback = 1 000 000 ÷ 400 000 = 2.5 years. ARR = average profit (1 600 000 − 1 000 000) ÷ 4 = 150 000 divided by average investment 500 000 = 30 percent.
Short-Term Decisions
Use relevant costs: accept a special order if the extra revenue exceeds the incremental costs; make-or-buy decisions compare the relevant cost of making with the price of buying; consider limiting factors; shut-down decisions consider avoidable costs.
Common Mistakes
- Including sunk costs in decisions.
- Confusing contribution with profit.
- Ignoring the time value of money in investment appraisal.
CHAPTER 9