CHAPTER 1
ACTIVI A CTIVITY TY B A SED COSTING COSTING In F2, we have discussed two traditional costing methods: - absorption costing and marginal costing. What was the main difference? In absorption costing, both fixed and variab variable le production overheads overheads are a re charged charged to production. production. In marginal costing, only variable production overheads are charged to production. Abso Ab so rp tio ti o n Cost Co st ing in g In absorption costing, overheads are allocated to products using a three-stage procedure: Stage 1: 1: - Overheads are allocated or apportioned to cost centres (usually production and service departments) using suitable basis Stage 2: 2: - Service centre costs are reapportioned to production centres Stage 3: 3: - Overheads are absorbed into units of production using an overhead absorption rate
OAR OAR = Budg Bu dg eted ov erheads erheads Bud geted activity level The budgeted activity level is usually taken as direct labour hours, machine hours or number of units. Illustration 1 Budgeted overheads $70,500 Products Pro ducts Budgeted units units Direct Di rect Labour(hours) Labour(hours)
X
Y
Z
15,000
8,000
2,000
1
3
4
2
CHAPTER 1
ACTIVI A CTIVITY TY B A SED COSTING COSTING In F2, we have discussed two traditional costing methods: - absorption costing and marginal costing. What was the main difference? In absorption costing, both fixed and variab variable le production overheads overheads are a re charged charged to production. production. In marginal costing, only variable production overheads are charged to production. Abso Ab so rp tio ti o n Cost Co st ing in g In absorption costing, overheads are allocated to products using a three-stage procedure: Stage 1: 1: - Overheads are allocated or apportioned to cost centres (usually production and service departments) using suitable basis Stage 2: 2: - Service centre costs are reapportioned to production centres Stage 3: 3: - Overheads are absorbed into units of production using an overhead absorption rate
OAR OAR = Budg Bu dg eted ov erheads erheads Bud geted activity level The budgeted activity level is usually taken as direct labour hours, machine hours or number of units. Illustration 1 Budgeted overheads $70,500 Products Pro ducts Budgeted units units Direct Di rect Labour(hours) Labour(hours)
X
Y
Z
15,000
8,000
2,000
1
3
4
2
OAR = Budgeted overheads Total labour hours
=
$70,500 (15000 x 1) + (8000 x 3) + (2000 x 4)
=
$70,500 47,000
=
$1.50/labour $1.50/labour hour
The overhead cost charged per unit is:Products Pro ducts Overhead Overhead cost
X
Y
Z
(1.5 x 1)
(1.5 x 3)
(1.5 x 4)
$1.50
$4.50
$ 6.00
If either or both of the actual overhead cost or activity volume differ from budget, the use of this rate is likely to lead to what is known as underabsorption or over-absorption of overheads. Illustration 2 Budgeted overheads overheads
$70,500
Budgeted labour hours hours
47,000
Actual Actual labour labour hours hours
50,000
Actual Actual overh overheads eads
OAR = $1.50/labour hr
$85,000
Overheads Overheads absorbed = 50,000 x $1.50 =
75,000
Overheads Overheads incurred incurred
=
85,000
Overheads Overheads Under Under absorbed absorbe d
=
10,000
Finding the cost per unit – Absorption Absorption Costing Cost Card Direct Materials Materials Direct Labour Prime Cost Variable Vari able Overheads Overheads Fixed Overheads Overheads Full Production Cost Co st
15.00 18.00 33.00 2.00 3.00 38.00
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Marginal Costing Marginal costing is the accounting system in which variable costs are charged to cost units and fixed costs of the period are written off in full against the aggregate contribution. Contribution is the difference between sales value and the variable cost of sales. Contribution = Selling Selling price – ALL variable costs Total Total Contribution = con tribution per unit x sales sales vo lume Profit = Total Total contribution – Fixed overheads
Find the cost per unit – Marginal Costing Cost Card Direct Materials Materials Direct Labour Prime Cost Variable Vari able Overheads Overheads Marginal Production Cost
15.00 18.00 33.00 2.00 35.00
Abso Ab so rp tio ti o n vs Margin Marg inal al Cost Co stin ing g Pr o fit fi t Reported profit figures using marginal costing or absorption costing will differ if there is any change in the level of inventories in the period. If production is equal to sales, there will be no difference in calculated profits using the costing methods. If inventory levels increase between the beginning and end of a period, absorption costing will report the higher profit. Some of the fixed production overhead incurred during the period will be carried forward in closing inventory (which reduces cost of sales) to be set against sales revenue in the following period perio d instead instead of being bei ng written off o ff in ful fulll against agai nst profit in i n the period peri od concerned. concerned. If inventory levels decrease, absorption costing will report the lower profit because as well as the fixed overhead incurred, fixed production overhead which had been carried forward in opening inventory is released and is also included in cost of sales.
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Therefore, If inventory levels levels inc rease, rease, absorp absorp tion costing g ives the higher profit If inv entory levels decrease, decrease, marginal marginal co sting gives the higher profit If inv entory levels are cons tant, both methods give the same profit Profits generated using absorption & marginal costing can also be reconciled as follows: Difference Di fference in the the profi p rofitt = change in i n inventory in units units x FOAR per unit unit
Illustration 3 The The following budgeted b udgeted information informati on relates relate s to a manufacturing company comp any for next period: Production Sales
Units 14,000 12,000
Fixed production costs
$ 63,000
The normal level of activity is 14,000 units per period. Using absorption costing the profit for next period has been calculated as $36,000. What would the profit for next period be using marginal costing? Difference Di fference in profit profi t = change change in i n inventory x FOAR/unit = 2,000 x (63,000/14,000) = 2,000 x $4.50 = $9,000 Inventories nventories are increasing, hence absorption abso rption costing profit profi t is higher. Absorption costing costing profit Differen Di fference ce in profits Marginal costing profits
36,000 9,000 27,000
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1.1
ACCA SYLLABUS GUIDE OUTCOME 1: Identify appropriate cost drivers under Activity Based Costing (ABC)
1.1.1 Introdu ction to ABC Absorption costing focuses on the product in the costing process. Costs are traced to the product because each product item is assumed to consume the resources. However, in many modern-manufacturing operations, overheads are not homogeneous in terms of being primarily influenced by volume. In fact, the majority of overheads in a modern manufacturing operation are largely unaffected by changes in production volume. ABC is an alternative costing method to absorption costing. ABC links overhead costs to the products or services that cause them by absorbing overhead costs on the basis of activities that ‘drive’ costs (cost drivers) rather than on the basis of production volume. In ABC, activities are the focus of the costing process. Costs are traced from activities to products based on the products demands for these activities during the production process. Activities may include equipment preparation, order handling, quality control. 'Cost driver' is the term used for an activity which influences the amount of total expenditure on a particular cost. For some costs, volume will be the cost driver, but for many other costs, volume will be a very poor indicator. By grouping costs on the basis of cost drivers, we will be able to both manage costs better (by managing the activity) and to calculate the cost of production. Examples of cost drivers would be: Ordering costs – no. of orders Set-up costs – no. of set-ups Packing costs – no. of packing orders
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1.2
ACCA SYLLABUS GUIDE OUTCOME 2: Calculate costs per driver and per unit using ABC
1.2.1 Steps in establishing and applying AB C There are 5 main steps in establishing and applying ABC: 1. Identify activities that consume resources and incur overhead costs. 2. Allocate overhead costs to the activities that incur them. 3. Determine the cost driver for each activity or cost pool. Each group of costs which are influenced by a particular cost driver is referred to as a 'cost pool'. 4. Collect data about actual activity for the cost driver in each cost pool 5. Calculate the overhead cost of products or services. This is done by calculating an overhead cost per unit of the cost driver. Overhead costs are then charged to products or services on the basis of activities used for each product or service.
identify a cost
identify what causes/drives it
calculate the cost per driver
trace the cost into the units produced
Extracted from Article “Activity-Based Costing” by K. Garrett, Student Accountant February 2010 http://www.accaglobal.com/content/dam/acca/global/pdf/sa_jan10_garrett.pdf The following example looks at the different activities within a company, their cost and their cost driver. The cost per driver is found by dividing the total cost of the activity by the quantity of the cost drivers. Overhead costs are then charged to products or services on the basis of activities used for each product or service.
Activity
Cost Pool
Cost Driver 7
Cost/ Driv er
Process set up Material procurement Maintenance
$ 37,500 9,000
Volume 100 set ups 50 purchase orders
10,000
10 standard maintenance plans
Material handling
22,500
Quality control Order processing
20,500 13,000
2,000 material movements 250 inspections 300 customers
$ 375 / set up 180 / purchase order 1000/ maintenance plan 11.25 / material movement 82 / inspection 43.33 / customer
$112,500
1.3
ACCA SYLLABUS GUIDE OUTCOME 3: Compare ABC and traditional methods of overhead absorption based on production units, labour hours or machine hours
Traditional absorption costing assumes that overhead expenditure is related to direct labour hours, machine hours or production units. However, this assumption is no longer reliable in many companies. Using ABC to allocate overhead costs to products will lead to very different values of overheads allocated per unit. Lectur e Example 1 Kira manufactures three products: X, Y, and Z. Data for the period just ended is as follows: X 20,000 $18 1kg 2 hours
Production (units) Sales Price (per unit) Material (kg per unit) Labour Hours (per unit)
Y 25,000 $40 2kg 1 hour
Z 5,000 $60 3kg 1 hour
(Material cost is $5 per kg and labour is paid at the rate of $5 per hour)
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Total overheads for the period were as follows: Set-up costs Machining Receiving Ordering
$ 100,000 55,000 40,000 15,000 210,000
The following data is available: X 2 10 10 30
Machine hours per unit Number of set-ups Number of deliveries received Number of orders done
Product Y 2 13 8 30
Z 2 2 2 20
Required: (a) Calculate the cos t (and h ence pr ofit) per u nit, absor bing all the overheads on the basis of labour hou rs. (b) Calculate the co st (and hence th e pro fit) per unit abso rbing the overheads using an ABC approach. All calculations should be to 2 decimal p laces. 1.3.1 The Advantages of ABC 1. More accurate cost information is obtained. It identifies ways of reducing overhead costs in the longer-term. This will enable managers to make better decisions, particularly in respect of pricing and marketing activities. 2. In absorption costing, as the profitability of a product would be overstated, the company's marketing effort is likely to be directed towards maximising the sale of this product, with a lesser emphasis on the other products. In addition, as the resulting selling price will be less than is required to fully recover overheads and yield a satisfactory profit, the market will perceive the product to be particularly attractive. 3. It provides much better insights into what drives overhead costs. ABC recognises that overhead costs are not all related to volume. It also identifies activities and costs that do not add value. 4. ABC can be applied to all overhead costs, not just production overheads.
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1.3.2 Disadvantages of ABC ABC may not be universally beneficial. There are four major issues to be considered: 1. Cost vs benefit The need to analyse costs on a radically different basis will require resources, which will lead to additional costs. Clearly the benefits which will be obtained must exceed these costs. In general terms, an organisation which has little competition, a stable and standardised product range and for which overheads represent a small proportion of total cost, will not benefit from the introduction of ABC. 2. Need for informed application While ABC is likely to provide better information for decision makers, it must still be applied with care. ABC is not fully understood by many managers and therefore is not fully accepted as a means of cost control. 3. Difficulty in identifying cost drivers In a practical context, there are frequently difficulties in identifying the appropriate drivers. ABC costs are based on assumptions and simplifications. The choice of both activities and cost drivers might be inappropriate. 4. Lack of appropriate accounting records ABC needs a new set of accounting records, this is often not immediately available and therefore resistance to change is common. The setting up of new cost pools is needed which is time-consuming. Lecture Example 2 (extracted from the article “Activity-Based Costing” by K. Garrett, Student Accountant February 2010) http://www.accaglobal.com/content/dam/acca/global/pdf/sa_jan10_garrett.pdf A company offers two products: ordinary and deluxe. The company knows that demand for the deluxe range will be low, but hopes that the price premium it can charge will still allow it to make a good profit, even on a low volume item.
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The following data is available: Budget Units produced
Ordinary Units
Deluxe Units
20,000
2,000
Costs per unit
$
$
Material Labour (5 hours x $12/hr) Var overhead (5 hours x $1/hr) Marginal cos t
10 60 5 75
12 72 6 90
(6 hours x $12/hr) (6 hours x$1/hr)
Budgeted f ixed production overheads are $224,000. An analysis of the fixed overheads of $224,000 shows that they consist of: $ 90,000 92,000 42,000 224,000
Batch set-up costs Stores – material handling etc Other (rent, etc) Total
Ordinary units are produced in long production runs, with each batch consisting of 2,000 units. Deluxe units are produced in short production runs, with each batch consisting of 100 units. Each ordinary unit consists of 20 components, each deluxe unit of 30 components. Required: (a) Calculate the cost per unit, absorbing the overheads on the basis of labour hours. (b) Calculate the co st per u nit absorbing the o verheads u sing an Activity Based Co sting approach . (c) Explain how this company can benefit from using Activity-Based Costing in dealing with its fixed overheads.
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1.3.3 Service organisations Five key characteristics of service organisations are:
Simultaneity/spontaneity (production and consumption of the service coinciding); Perishability (the inability to store the service); Heterogeneity (variability in the standard of performance of the provision of the service); Intangibility (of what is provided to and valued by individual customers). No transfer of ownership.
ABC can be effectively applied to service organisations. Indeed, the fact that for most service organisations, indirect costs will represent the major proportion of total cost means that the technique is of particular relevance to service organisations. Further questions Question 1 Which ONE of the following is an advantage of Activity Based Costing? A. B. C. D.
It It It It
provides more accurate product costs is simple to apply is a form of marginal costing and so is relevant to decision making is particularly useful when fixed overheads are very low
Question 2 Which of the following are benefits of using activity based costing? (1) It recognises that overhead costs are not always driven by the volume of production. (2) It does not result in under or over absorption of fixed overheads. (3) It avoids all arbitrary cost apportionments. (4) It is particularly useful in single product businesses. A. B. C. D.
1 only 1 and 2 only 2 and 3 only 1 and 4 only
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Question 3 In which circumstance is activity based costing a more useful approach to product costing: A. B. C. D.
One product is produced Overheads form a high proportion of total costs Overhead expenditure is driven by the volume of output It is very difficult to identify the relevant cost drivers
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CHAPTER 2
TARGET COSTING 2.1
ACCA SYLLABUS GUIDE OUTCOME 1: Derive a target cost in manufacturing and service industries
A target cost is a cost estimate derived by subtracting a desired profit margin from a competitive market price. This market price is determined based on the expected price to be paid by the market to achieve a certain market share and sales volume. The required profit margin is then deducted from the anticipated selling price to arrive at the target product cost. A product of acceptable quality is then designed within that cost. The main focus of target costing is not finding what a new product does cost but what it should or needs to cost. The firm can then focus on the costs which can be reduced to achieve the target cost. Target costing is used by such companies as Sony, Toyota and Swatch. 2.1.1 Steps in target cos ting 1 1. Target costing begins by specifying a product an organisation wishes to sell. This will involve extensive customer analysis, considering which features customers value and which they do not. Ideally only those features valued by customers will be included in the product design. 2. The price at which the product can be sold at is then considered. This will take in to account the competitor s’ products and the market conditions expected at the time that the product will be launched. Hence a heavy emphasis is placed on external analysis before any consideration is made of the internal cost of the product. 3. From the above price a desi red margin is deducted. This can be a gross or a net margin. 4. This leaves the cost target. An organisation will need to meet this target if their desired margin is to be met. 5. Costs for the product are then calculated and compared to the cost target. If it appears that this cost cannot be achieved then the difference (shortfall) is called a cost gap. This gap would have to be 1 Examinabl e June
2012 Qs 2a , Sept/December 2015 Qs 1a
14
closed, by some form of cost reduction (for e.g. value engineering), while satisfying the needs of customers. 6. Before going ahead with the project, the company may hold negotiations with customers.
Illustration 1 Targeted selling price Gross profit margin Target cost =
$20 20% $ 20 (4) (20% of $20) 16
Selling Price Less margin Target Cost
Lectur e Example 1 Play plc is considering whether or not to launch a new product. It has targeted a selling price of $100 per unit. Play wants to earn a margin on selling price of 20%. Calculate the target co st.
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Lectur e Example 2 A company, ABC Ltd, could sell 100,000 units per annum of a new product at a competitive market price of $75 per unit. Capital investment of $10,000,000 would be required to manufacture the product. The company seeks to earn a return on initial capital employed of 20% per annum. Required: What is the target cost per unit of the new product? _________ 2.2
ACCA SYLLABUS GUIDE OUTCOME 2: Explain the difficulties of using target costing in service industries
Target costing was introduced by major Japanese manufacturing companies for use when: 1. a new product was to be designed to meet the target cost 2. a substantial part of the production cost consisted of bought-in materials Four key characteristics of service organisations are:
Simultaneity/spontaneity (production and consumption of the service coinciding); Perishability (the inability to store the service); Heterogeneity (variability in the standard of performance of the provision of the service); Intangibility (of what is provided to and valued by individual customers). No transfer of ownership.
Hence, although target costing can be used in service industries, it may face a number of problems: 1. it is very difficult to determine a market-driven price for services provided 2. the introduction of new services occurs far less frequently than in a manufacturing company. 3. the major cost in the service industry is salaries. Bought-in materials are usually low when compared to salaries. It is very difficult to reduce the cost of salaries!
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2.3
ACCA SYLLABUS GUIDE OUTCOME 3: Suggest how a target cost gap might be closed
Where a gap exists between the current estimated cost levels and the target cost, it is essential that this gap be closed. Efforts to close a target cost gap are most likely to be successful at the design stage. It is far easier to ‘design out’ cost during the pre-production phase than to ‘control out’ cost during the production phase. 2.3.1 Ways to reduce a cos t gap 1. Review the product’s features. 2. Remove features that add to cost but do not significantly add value to the product when viewed by the customer (non-value-added activities). This should reduce cost but not the achievable selling price (value engineering / value analysis). 3. Team approach - cost reduction works best when a team approach is adopted. The company should bring together members of the marketing, design, assembly and distribution teams to allow discussion of methods to reduce costs. Open discussion and brainstorming are useful approaches here. 4. Review the whole supplier chain - each step in the supply chain should be reviewed, possibly with the aid of staff questionnaires, to identify areas of likely cost savings. For example, the questionnaire might ask ‘are there more than five potential suppliers for this component?’ Clearly a ‘yes’ response to this question will mean that there is the potential for tendering or price competition. 5. Efficiency improvements should also be possible by reducing waste or idle time that might exist. Where possible, standardised components should be used in the design. Productivity gains may be possible by changing working practices or by de-skilling the process. Automation is increasingly common in assembly and manufacturing. Lectur e Example 3 Kingo is in the process of introducing a new product and has undertaken market research to find out more about competitors’ products. A target selling price of $60 has been established. The target profit margin for each unit is 30% of the proposed selling price. Cost estimates have also been prepared
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Production costs per unit
$
Direct material Direct labour Direct machinery costs Design Quality assurance
13.00 14.00 1.10 7.00 4.50
Non-production costs per unit Marketing Distribution After-sales service and warranty costs
3.20 3.50 1.10
Required: a. Calculate the target cost for each unit b. Identify any cost gap which may have arisen c. Suggest ways in which Kingo may reduce their unit cost 2.3.2 Difficulties in implementing target co sting 2 1. As has already been mentioned, it is often more difficult to use target costing in service organisations: for target costing to be useful, a service has to be clearly defined. 2. For one-off jobs, comparative data may not be available. Hence, it would be difficult to set a target cost. 3. For specialist jobs, it may be difficult to establish a market price. Hence target costing will be difficult to use. 2.3.3 Benefits of Target Costing 3 1. When should target costing be used? It is useful in competitive markets. Hence, the company has to accept the price set by the market for their products. This would help the company focus of the price of the goods and services offered by competitors. 2.
Target costing helps an organization to look into its internal processes and their costs more closely. It should find ways how to close the cost gap: focus on reducing costs and retaining customers.
Further Questions 2 Examined 3 Examined
Sept/Dec 2015 Qs 1b Sept/Dec 2015 Qs 1b
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Question 14 S Company is a manufacturer of multiple products and uses target costing. It has been noted that Product P currently has a target cost gap and the company wishes to close this gap. Which of the following may be used to close the target cost gap for product P? A. Use overtime to complete work ahead of schedule B. Substitute current raw materials with cheaper versions C. Raise the selling price of P D. Negotiate cheaper rent for S Company’s premises Question 25 The selling price of Product X is set at $550 for each unit and sales for the coming year are expected to be 800 units. A return of 30% on the investment of $500,000 in Product X will be required in the coming year. What is the target cost for each unit of Product X? A. $385 B. $165 C. $187·50 D. $362·50 Question 3 The selling price of product K is set at $450 for each unit. If the company requires a return of 20% in the coming year on product K, the target cost for each unit for the coming year is: A. B. C. D.
4 5
$300 $360 $400 $450
Specimen Exam Applicable from December 2014 Specimen Exam Applicable from December 2014
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Question 4 Which of the following BEST describe target costing? A. Setting market B. Setting C. Setting D. Setting
a cost by subtracting a desired profit margin from a competitive price a price by adding a desired profit margin to a production cost a cost for the use in the calculation of variances a selling price for the company to aim in the long run
Question 5 Which of the following describes target costing? A. A method of costing that sets a target cost by subtracting a desired profit margin from a competitive market price. B. A method of costing that sets a target price by adding a desired profit margin to actual cost. C. A method of costing that targets selected business departments and aims to minimize their costs. D. A method of costing whose target is to reduce unit cost without impairing value to the customer. Question 6 Edward Co assembles and sells many types of radio. It is considering extending its product range to include digital radios. These radios produce a better sound quality than traditional radios and have a large number of potential additional features not possible with the previous technologies (station scanning, more choice, one touch tuning, station identification text and song identification text etc). A radio is produced by assembly workers assembling a variety of components. Production overheads are currently absorbed into product costs on an assembly labour hour basis. Edward Co is considering a target costing approach for its new digital radio product. Required: (a) Briefly describe the target costing process that Edward Co should undertake. (3 marks)
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(b) Explain the benefits to Edward Co of adopting a target costing approach at such an early stage in the product development process. (4 marks) (c) Assuming a cost gap was identified in the process, outline possible steps Edward Co could take to reduce this gap. (5 marks) A selling price of $44 has been set in order to compete with a similar radio on the market that has comparable features to Edward Co’s intended product. The board have agreed that the acceptable margin (after allowing for all production costs) should be 20%. Cost information for the new radio is as follows: Component 1 (Circuit board) – these are bought in and cost $4·10 each. They are bought in batches of 4,000 and additional delivery costs are $2,400 per batch. Component 2 (Wiring) – in an ideal situation 25 cm of wiring is needed for each completed radio. However, there is some waste involved in the process as wire is occasionally cut to the wrong length or is damaged in the assembly process. Edward Co estimates that 2% of the purchased wire is lost in the assembly process. Wire costs $0·50 per metre to buy. Other material – other materials cost $8·10 per radio. Assembly labou r – these are skilled people who are difficult to recruit and retain. Edward Co has more staff of this type than needed but is prepared to carry this extra cost in return for the security it gives the business. It takes 30 minutes to assemble a radio and the assembly workers are paid $12·60 per hour. It is estimated that 10% of hours paid to the assembly workers is for idle time. Production Overheads – recent historic cost analysis has revealed the following production overhead data:
Month 1 Month 2
Total Production o/heads $ 620,000 700,000
Total assembly labour hrs 19,000 23,000
Fixed production overheads are absorbed on an assembly hour basis based on normal annual activity levels. In a typical year 240,000 assembly hours will be worked by Edward Co.
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Required: (d) Calculate the expected cost per unit for the radio and identify any cost gap that might exist. (13 marks) (Acca Paper December 2007 Question 1)
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CHAPTER 3
LIFE-CYCLE COSTING Life-cycle costing tracks and accumulates the actual costs and revenues attributable to each product from inception to abandonment. It enables a product’s true profitability to be determined at the end of the economic life. Traditional cost accounting systems do not accumulate costs over a product’s entire life but focus instead on (normally) twelve month accounting periods. As a result the total profitability of a product over its entire life becomes difficult to determine. 3.1
ACCA SYLLABUS GUIDE OUTCOME 1: Identify the costs involved at different stages of the life-cycle
As mentioned in Chapter 2, target costing places great emphasis on controlling any of the costs that relate to any part of the product’s life. Every product goes through a life cycle. 1. Development. The product has a research and development stage where costs are incurred but no revenue is generated. During this stage, a high level of setup costs will be incurred, including research and development, product design and building of production facilities. 2. Introduction. The product is introduced to the market. Potential customers will be unaware of the product or service, and the organisation may have to spend further on advertising to bring the product or service to the attention of the market. Therefore, this stage will involve extensive marketing and promotion costs. High prices may be changed to recoup these high development costs. 3. Growth. The product gains a bigger market as demand builds up. Sales revenues increase and the product begins to make a profit. Marketing and promotion will continue through this stage. Unit costs tend to fall as fixed costs are recovered over greater volumes. Competition also increases and the company may need to reduce prices to remain competitive. 4. Maturity. Eventually, the growth in demand for the product will slow down and it will enter a period of relative maturity. It will continue to be profitable. However, price competition and product differentiation will
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start to erode profitability. The product may be modified or improved, as a means of sustaining its demand. 5. Decline. At some stage, the market will have bought enough of the product and it will therefore reach 'saturation point'. Demand will start to fall and prices will also fall. Eventually it will become a loss maker and this is the time when the organisation should decide to stop selling the product or service. During this stage, the costs involved would be environmental clean-up, disposal and decommissioning. Meanwhile, a replacement product will need to have been developed, incurring new levels of research and development and other setup costs. The level of sales and profits earned over a life cycle can be illustrated diagrammatically as follows.
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3.2
ACC A SY ACCA SYLLAB LLABUS US GUI GUIDE DE OUT OUTCOME COME 2: Derive Deri ve a life cycle cycle cost in manuf manufacturin acturing g and service industr industries ies
Lectur e Example 1 Quick Ltd is launch launching ing a new product on o n the market. mar ket. The following followi ng costs have have been estimated for the whole life of the product: Research and development development (already incurred) incurred) Marketing costs Production cost per unit unit Selling and distribution distri bution costs
$30,000 $6,000 $5 $4,000
The expected expected number number of units units to be produced and and sold is 10,000. Required Calculate the life-cyc life-cyc le c ost per u nit. Lectur e Example 2 (extracted from the article “Target Costing and Life-Cycle Life-Cycle Costi Co sting” ng” by K. Garrett, Garrett, Student Accountant, March Ma rch 2010) http://www.accaglobal.com/content/dam/acca/global/pdf/Feb10_tarcosting_F5.pdf
A company company is plann planning a new product. product. Market research informat information ion suggests suggests that the product should sell 10,000 units at $21.00/unit. The company seeks to make a mark-up of 40% product cost. It is estimated that the lifetime costs of the product will be as follows: 1) Design Desi gn and development development costs $50,000 $50,0 00 2) Manufactu Manufacturing ring Costs $10/unit $10/unit 3) End of life costs $20,000 The company estimates that if it were to spend an additional $15,000 on design, desi gn, manufactu manufacturing ring costs/unit costs/unit could be reduced. Required a. What is the target target cost of the produ ct? b. What is the original lifecycle cost per unit and is the product worth making o n that basis? c. If the additional amount were spent on design, what is the maximum manufacturing cost per unit that could be tolerated if the company is to earn earn its required mark-up? mark-up?
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3.3
ACC A SY ACCA SYLLAB LLABUS US GUI GUIDE DE OUT OUTCOME COME 3: Identify the benefits of life cycle cycle costing cos ting
The benefits of product life cycle costing are summarised as follows: 1. All costs (production and non production) will will be traced to individual products over their complete life cycles and hence individual product profitability profitabi lity can be more accurately measured. mea sured. 2. The product life cycle costing results in earlier actions to generate revenue or to lower costs than otherwise might be considered. 3. Better decisions should follow from a more accurate and realistic assessment of revenues and costs, at least within a particular life cycle stage. 4. Product life cycle thinking thinking can promote long-term long-term rewarding rewarding in contrast to short-term profitability rewarding. 5. It helps management to understand the cost consequences of developing and making a product and to identify areas in which cost reduction efforts are likely to to be most effective. Very often, often, 90% of the the product’s life-cycle life-cycle costs are determined by decisions made in the development stage. Therefore, it is important to focus on these costs before the product enters the market. 6. Identifying the costs incurred during the different stages of a product’s product’ s life cycle provides an insight into understanding and managing the total costs incurred throughout its life cycle. Non production costs will become more visible and the potential for their control is increased. 7. More accurate feedback feedb ack on o n the the success or failure of new products will be available. To maximise maximise a product’s return over its lifecycle, a number of factors need to be considered: 1. Design costs: costs : - since approximately 90% of a product’s costs are often incurred at the design and development stages of its life, it is absolutely important that design teams work as part of a cross-functional team to minimize costs over the whole life cycle.
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2. Minimise the time to market: market: - since competition is harsh, it is vital to get any new product into the marketplace as quickly as possible. and make a profit before competition increases. 3. Maximise the length of the life cycle itself : - Generally, the longer the life cycle, the the greater greate r the the profit profi t that that will be generated. genera ted. How can the life cycle be maximised? a. Get the the product to the the market as quickly as possible possi ble b. Find Fi nd other uses uses or markets for the the product c. Market skimming (introduci (introducing ng the the product product at a high high price) will prolong prolong life and maximise the revenue over the product’s life. 4. Minimise break-even time: time: - The quicker costs are covered, the more funds funds the company comp any will have have to develop further further products. prod ucts.
Lectur e Example Example 3 Birtles plc is a manufacturer of small domestic electrical appliances. Its market is very competitive in terms of both price and new product innovation. As a result product life cycles are short. Birtles plc’s managers are concerned about the reliability of its product costing system. It currently uses an absorption costing system, and absorbs overheads on the basis of budgeted direct labour hours. On this basis the estimated cost of its latest product, a talking electric kettle, is as follows: $ per unit 4.50 0.50 5.00 10.00
Direct Materials Materials Direct Di rect Labour ($12 per hour) hour) Production overheads overheads ($120 per hour) hour) Production Cost
The firm’s management accountant has suggested that more accurate product costs would be obtained if an activity based costing (ABC) approach were used. He has collected the following information as a starting point for an ABC treatmen treatmentt of production production overhead overhead cost. Budgeted factory overhead per annum. Cost Pools Stores administration administrati on
Cost per annum $000 5,000
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Cost Driver Driver Number Number of different components
Production Line set ups Dispatch Di spatch Other Other overheads overheads Total production overhead overhead
3,000 1,000 3,000 12,000
Number Number of set ups Number Number of dispatches disp atches Direct Di rect labour hours hours
Estimated activity per annum Cost Driver Number Number of components components Number Number of set ups Number Number of dispatches dis patches Direct Di rect labour hours hours
Total Activity per annum 2,000 items 10,000 set ups 20,000 dispatches disp atches 100,000 hours hours
Each talking kettle uses 10 different components and kettle manufacture will involve six production line set ups per annum. Five hundred dispatches will be required per annum. annum. Budgeted production i s 10,000 kettles per pe r annum annum..
Required: Estimate Estimate the co st of a talking kettle using an ABC approach and the cost drivers sugg ested ested by the manageme management nt accoun tant.
Birtles plc’s Finance Director supports the proposal to introduce activity based costing but argues that the firm should consider all the costs involved in the development, production and marketing of the kettle. In addition to the above ABC costs, $30,000 has already been spent on research research and and developmen developmentt for the talking electric kettle and he estimates that a further $5,000 will be spent on marketing the new product. There are no other costs attributable to the new product. Total sales over its life will be 10,000 units per annum for the next two years. On past experience he knows that the firm will have to reduce the selling price of the kettle by 40% in its second year of sales in order to remain competitive. Required: Calculate the price to be charged per unit for the talking electric kettle in the first year of sales so that it will earn an OVERALL 20% margin on sales over its two year life after covering ALL attributable costs outlined above. (CAT Paper T7 December 2004 Qs n o 3)
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Further Questions Questions Question 1 Which of the following costs would be included to find the life-cycle cost of a product? (i) Research and development costs (ii) (ii ) Production costs (iii) Distribution costs (iv) Marketing costs A. B. C. D.
(i), (ii), (iv) (ii), (ii (iii), i), (iv) (i), (ii), (iii) (iii ) All of the the above
Question 26 The following costs arise in relation to production of a new product: (i) Research and development costs (ii) Design Desi gn costs costs (iii) (iii ) Testing Testing costs (iv) Advertising costs (v) Production costs In calculating the lifetime costs of the product, which of the above items would be EXCLUDED? A. (i), (ii), (ii ), and and (iii) (iii ) only only B. (ii) and (iii) only C. (iv) and (v) only D. None of the above Question 3 The following statements relate to life-cycle costing: (i) It helps forecast a product’s profitability over its entire life. (ii) It takes into account a product’s total costs over its entire life. (iii) (ii i) It focuses foc uses on o n the productio pro duction n of month mo nthly ly profit profi t statements throughout throughout a product’s entire life.
6
Specimen Exam Ex am Applicable from from December 2014
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Which of the statements are true? A. B. C. D.
(i) only (i) and (ii) only (i) and (iii) only (i), (ii) and (iii)
Question 4 In calculating the life cycle costs of a product, which of the following items would be excluded? i. ii. iii. iv. v.
Planning and concept design costs Preliminary and detailed design costs Testing costs Production costs Distribution and customer service costs A. (iii) B. (iv) C. (v) D. None of them
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CHAPTER 4
THROUGHPUT ACCOUNTING 4.1
ACCA SYLLABUS GUIDE OUTCOME 1: Calculate and interpret a throughput accounting ratio (TPAR)
4.1.1 What is thro ughpu t? Throughput is the rate of converting raw materials and purchased components into products sold to customers. In money terms, it is the extra money that is made for an organisation from selling its products. Throughp ut = Revenue – Raw material cos t 4.1.2 What is throug hput accounting? Throughput accounting (TA) is an approach to accounting which is largely in sympathy with the JIT philosophy. In essence, TA assumes that a manager has a given set of resources available. These comprise existing buildings, capital equipment and labour force. Using these resources, purchased materials and parts must be processed to generate sales revenue. Given this scenario the most appropriate financial objective to set for doing this is the maximisation of throughput which is defined as: sales revenue less direct material cost. 4.1.3 Main concepts in throug hpu t accounting 1. In the short run, most costs in the factory (with the exception of materials costs) are fixed. These fixed costs include direct labour. These fixed costs are called Total Factory Costs (TFC) (operating expenses). 2. In a JIT environment, the ideal inventory level is zero. Products should not be made unless a customer has ordered them. Work in progress should be valued at material cost only until the output is eventually sold, so that no value will be added and no profit earned until the sale takes place. 3. Profitability is determined by the rate at which sales are made and, in a JIT environment, this depends on how quickly goods can be produced to satisfy customer orders. Since the goal of a profit-orientated
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organisation is to make money, inventory must be sold for that goal to be achieved. 4.1.4 Traditional Cost Accou nting versus Throug hput Accounting Ratio Conventional cost accounting 1. Inventory is an asset.
Throughput accounting Inventory is not an asset. It is a result of unsynchronised manufacturing and is a barrier to making profit.
2. Costs can be classified either Such classifications as direct or indirect. useful.
are
no
longer
3. Product profitability can be Profitability is determined by the rate at determined by deducting a which money is earned. product cost from selling price. 4. Profit can be increased by Profit is a function of material cost, total reducing cost elements. factory cost and throughput.
Marginal costing and throughput accounting both determine a contribution by calculating the difference between sales revenue and variable costs. However this contribution figure will be higher under throughput accounting since only material costs are recognised as being variable costs. Under marginal costing, direct labour costs and certain overhead costs will also be deducted from sales revenues in order to calculate contribution. Throughput accounting regards such costs as fixed and this is true insofar as they cannot be avoided in the ‘immediate’ sense. Illustration 1
Sales revenue Material cost Labour cost (@ $3/hr) Variable overheads Fixed overheads Max demand
X
Y
25 5 3 2 1 10,000
30 8 6 2 4 15,000
Total labour hours available are 30,000 hours.
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How do we calculate contribution ? X $ Sales revenue Less all Variable costs Material Labour Variable cost Contribution / unit
Y $ 25
5 3 2
10 15
$ 8 6 2
$ 30
16 14
How do w e calculate return?
Sales Revenue Less Material Return / unit 4.2
X
Y
$ 25 5 20
$ 30 8 22
ACCA SYLLABUS GUIDE OUTCOME 2: Discuss and apply the theory of constraints
The theory of constraints is applied within an organization by following ‘the five focusing steps’ – a tool which was developed to help organisations deal with constraints. Step 1: Identify the system’s bottlenecks Step 2: Decide how to exploit the system’s bottlenecks This involves making sure that the bottleneck resource is actively being used as much as possible and is producing as many units as possible. Step 3: Subordinate everything else to the decisions made in Step 2 The production capacity of the bottleneck resource should determine the production schedule for the organization as a whole. Idle time is unavoidable and needs to be accepted if the theory of constraints is to be successfully applied. Step 4: Elevate the system’s bottlenecks This will normally require capital expenditure. Step 5: If a new constraints is broken in Step 4, go back to Step 1 The likely constraint in the system is likely to be market demand.
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Lecture Example 1 (extracted from the article “Throughput Accounting and Backflush Accounting” by K. Garrett, Student Accountant, March 2010) 7 A not-for-profit hospital performs a medical screening service in three sequential stages: 1) Take an x-ray 2) Interpret the result 3) Recall patients who need further investigation/tell others that all is fine Process
Time/patient (hours )
Total hou rs available/week
Take an X-ray
0.25
40
Interpret the result
0.10
20
Recall patients who need further investigation/ tell others that all is fine
0.20
30
Required: a. Find the bottleneck process b. How can we increase the throug hput of the process identified in part (a) as the bottleneck? Lectur e Example 28 Cat Co makes a product using three machines – X, Y and Z. The capacity of each machine is a s follows: Machine Capacity per week
X 800
Y 600
Z 500
The demand for the product is 1,000 units per week. For every additional unit sold per week, net present value increases by $50,000. Cat Co is considering the following possible purchases (they are not mutually exclusive): Purch ase 1 Replace machine X with a newer model. This will increase capacity to 1,100 units per week and costs $6m Purch ase 2 Invest in a second machine Y, increasing capacity by 550 units per week. The cost of this machine would be $6.8m. 7
http://www.accaglobal.com/content/dam/acca/global/pdf/Feb10_throughput_F5.pdf
8 I rons
A., “Throughput a ccounting and the theory of constraints”, November 2011 http://www.acca global .com/content/dam/acca/gl obal /pdf/sa _oct11_throughput.pdf
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Purch ase 3 Upgrade machine Z at a cost of $7.5m, thereby increasing capacity to 1,050 units. Required: Which is Cat Co’s best course of action? 4.2.1 The Throu ghp ut Acco untin g Ratio (TPAR) Where there is a bottleneck resource (limiting factor), performance can be measured in terms of throughput for each unit of bottleneck resource consumed. 4.2.1.1
Three important ratios
Throughput (return) p er factory hour = Throughput per unit Product’s time on the bottleneck resource
Cost per factory hou r = Total Factory Cost Total time available on bottleneck resource The cost per factory hour is across the whole factory and therefore only needs to be calculated once (not for each product). Throughp ut accounting ratio = Return per factory hour Cost per factory hour TPAR>1 would suggest that the rate at which the organisation is generating cash from sales of this product is greater than the rate at which it is incurring costs, so the product should make a profit. Priority should be given to the products generating the best ratios. TPAR<1 would suggest that throughput is insufficient to cover operating costs, resulting in a loss. Hence, changes need to be made quickly.
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Illustration 2 From the information given in Illustration 1, Return / factory hour X 20 1 20
Return / unit Labour Hours per unit Ret / factory hr
Y 22 2 11
Which product should b e produ ced first? X as it has the higher return / factory hour. Any remaining labour hours should be used on product Y. Cost / factory hour Factory costs are assumed to be fixed in the short term. Take all costs excluding material Product X Product Y
(3 + 2 + 1) = 6 x 10,000 (6 + 2 + 4) = 12 x 15,000
= =
60,000 180,000 240,000
i.e. Cost / factory hour = $240,000 30,000 = $8 / hr TPAR
X
Y
$20 $8 = 2.5
$11 $8 = 1.375
Both products have a TPA ratio greater than 1, i.e. worth producing. 4.2.1.2
Criticisms of TPAR
1. It concentrates on the short-term 2. It is more difficult to apply throughput accounting concepts to the longer term when all costs are variable 3. In the long run, ABC might be more appropriate for measuring and controlling performance
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4.3
ACCA SYLLABUS GUIDE OUTCOME 3: Suggest how a TPAR could be improved
Management should focus attention upon improving the throughput accounting ratio. If they can do this then higher levels of profit will be achieved. Options to improve the TPAR include: 1. increase the selling price – this will increase throughput per unit 2. reduce material costs per unit – this will also increase throughput per unit 3. reduce total operating expenses – this will reduce the total factory costs 4. improve the productivity of the assembly workforce. Therefore, the time required to make each unit will fall and throughput will increase. 4.4
ACCA SYLLABUS GUIDE OUTCOME 4: Apply throughput accounting to a multi-product decision-making problem
Four steps: 1. calculate the throughput per unit for each product (selling price – material cost) 2. identify the bottleneck constraint 3. calculate the throughput return per hour of bottleneck resource 4. rank the products in order of the priority in which they should be produced starting with the product that generates the highest return per hour first 5. calculate the optimum production plan, allocating the bottleneck resource to each one in order, being sure not to exceed the maximum demand for any of the products.
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Lectur e Example 3 GMX plc manufactures 2 types of games. Their cost cards are as follows: Game 1 $ Selling price Materials Labour Other Variable Costs Fixed Costs Profit
Game 2 $ 25
10 4 6 3
Machine hour per unit Maximum demand
23 $2
2 hrs 20,000 units
28 18 3 3 2
26 $2
1 hr 10,000 units
The total hours available are 40,000. Required: a.
Calculate the optimum produc tion plan and the maximum profit using conv entional key factor analysis.
b.
Calculate the optimum produc tion plan and the maximum profit, on the assump tion th at in the shor t-term o nly material costs are variable (i.e. using a thro ughpu t accou nting appro ach).
c.
Calculate the Through put Accounting ratios for both produ cts.
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Lectur e Example 4 Ride Ltd is engaged in the manufacturing and marketing of bicycles. Two bicycles are produced. These are the ‘Roadster’ which is designed for use on roads and the ‘Everest’ which is a bicycle designed for use in mountainous areas. The following information relates to the year ending 31 December 2005: (1) Unit selling price and cost data is as follows: Roadster $ 200 80 20
Selling price Material cost Variable production conversion costs
Everest $ 280 100 60
(2) Fixed production overheads attributable to the manufacture of the bicycles will amount to $4,050,000. (3) Expected demand is as follows: Roadster Everest
150,000 units 70,000 units
(4) Each bicycle is completed in the finishing department. The number of each type of bicycle that can be completed in one hour in the finishing department is as follows: Roadster Everest
6.25 5.00
There are a total of 30,000 hours available within the finishing department. (5) Ride Ltd operates a just in time (JIT) manufacturing system with regard to the manufacture of bicycles and aims to hold very little work-in-progress and no finished goods stocks whatsoever. Required: (a) Using marginal costing principles, calculate the mix (units) of each type of bicycle which will maximise net profit and state the value of that profit. (b) Calculate throughout accounting ratio for each type of bicycle and briefly discuss when it is worth producing a product where throughput accounting principles are in operation. Your answer should assume that the variable overhead cost amounting to
39
$4,800,000 incurred as a result of the chosen product mix in part (a) is fixed in the short term. (c) Using throughput accounting principles, advise management of the quantities of each ty pe of bicy cle that should be manufactured which will maximise net profit and prepare a projection of the net profit that wo uld b e earned by Ride Ltd in the year endin g 31 December 2005. (ACCA Paper 3.3 December 2004 Qs 2)
Further questions Question 19 A company manufactures a product which requires four hours per unit of machine time. Machine time is a bottleneck resource as there are only ten machines which are available for 12 hours per day, five days per week. The product has a selling price of $130 per unit, direct material costs of $50 per unit, labour costs of $40 per unit and factory overhead costs of $20 per unit. These costs are based on weekly production and sales of 150 units. What is the throughput accounting ratio (to 2 decimal places)? A. 1·33 B. 2·00 C. 0·75 D. 0·31
9
Specimen Exam Applicable from December 2014
40
Question 210 An organisation has market demand of 50,000 units for a product that goes through three processes: cutting, heating and assembly. The total time required in each process for each product and the total hours available are:
Process
Cutting
Heating
Assembly
Hrs per unit
2
3
4
Total hours available
100,000
120,000
220,000
Which is the bottleneck process? A. Cutting process B. Heating process C. Assembly process Question 3 Beta Co produces 3 products, E, F and G, details of which are shown below: Produ ct
E
F
G
$
$
$
Selling price per unit
120
110
130
Direct material cost per unit
60
70
85
Maximum demand (units)
30,000 25,000 40,000
Time required on the bottleneck resource (hours per unit)
5
4
3
There are 320,000 bottleneck hours available each month. Required: Calculate the optimum product mix each month. 1010
“Throughput Accounting and the Theory of Constrai nts – part 2”,
http://www.acca global .com/gb/en/student/acca -qual -student-journey/qual-resourc e/accaqual ifi cation/f5/technical-artic les/throughput-constraints2.html, Marc h 2013
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CHAPTER 5
ENVIRONMENTAL ACCOUNTING11 5.1
ACCA SYLLABUS GUIDE OUTCOME 1: Discuss the issues businesses face environmental costs
in
the
management
of
5.1.1 What is enviro nmental accou nting? Environmental accounting encompasses the provision of environment-related information both externally and internally. It focuses on reports required for shareholders and other stakeholders, as well of the provision of management information. 5.1.2 What is enviro nmental management accou nting ? Management accounts give us an analysis of the performance of a business and are ideally prepared on a timely basis so that we get up-to-date management information. They break down each of our different business segments (in a larger business) in a high level of detail. This information is then used to assess how the business’ historic performance has been and, moving forward, how it can be improved in the future. Environmental management accounting is simply a specialised part of the management accounts that focuses on things such as the cost of energy and water and the disposal of waste and effluent. It is a subset of environmental accounting. It focuses on information required for decision making within the organisation (internally focused), although much of the information it generates could also be used for external reporting. The focus of environmental management accounting is not all on purely financial costs. It includes consideration of other non-financial matters such as the costs vs. benefits of buying from suppliers who are more environmentally aware, or the effect on the public image of the company from failure to comply with environmental regulations. 11
Prepared using the two articles, “Environmental Management Accounting” by S. Johnson, Student
Accountant, June 2004 http://www.acca global .com/en/student/quali fica tion-res ources/acca-qualification/acca-exams/p5exams/exams-p54/environmenta-management.html and “Environmental Management Accounting” by A. I rons, Student Accountant, I ss ue 15/2004 http://www.accaglobal.com/content/dam/acca/global/pdf/SA_july2004_F5_EMA.pdf
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In 1998, the International Federation of Accountants (IFAC) originally defined environmental management accounting as: ‘The management of environmental and economic performance through the development and implementation of appropriate environment-related accounting systems and practices. While this may include reporting and auditing in some companies, environmental management accounting typically involves lifecycle costing, full cost accounting, benefits assessment, and strategic planning for environmental management.’ Environmental management accounting is Then, in 2001, The United Nations Division for Sustainable Development (UNDSD) emphasised their belief that environmental management accounting systems generate information for internal decision making rather than external decision making. The UNDSD make what became a widely accepted distinction between two types of information: physical information and monetary information. Hence, they broadly defined EMA to be the identification, collection, analysis and use of two types of information for internal decision making: physical information on the use, flows and destinies of energy, water and materials (including wastes) information on environment-related cost, earnings and monetary savings. 5.1.3 Defining environ mental cos ts Many organisations vary in their definition of environmental costs. A useful cost categorisation is that provided by the US Environmental Protection Agency in 1998. They stated that the definition of environmental costs depended on how an organisation intended on using the information. They made a distinction between four types of costs: 1. conventional costs: raw material and energy costs having environmental relevance 2. potentially hidden costs: costs captured by accounting systems but then losing their identity in ‘general overheads’ 3. contingent costs: costs to be incurred at a future date, e.g. clean up costs 4. image and relationship costs: costs that, by their nature, are intangible, for example, the costs of producing environmental reports. The UNDSD, on the other hand, described environmental costs as comprising of: 1. costs incurred to protect the environment, e.g. measures taken to prevent pollution and
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2. costs of wasted material, capital and labour , i.e. inefficiencies in the production process. Neither of these definitions contradict each other; they just look at the costs from slightly different angles. Hence, definitions of environmental costs vary greatly, with some being very narrow and some being far wider. 5.1.4 Managing environ mental cos ts – its importance Environmental risks cannot be ignored, they are now as much a part of running a successful business as product design, marketing, and sound financial management. There are three main reasons why the management of environmental costs is becoming increasingly important in organisations. 1. society as a whole has become more environmentally aware, with people becoming increasingly aware about the ‘carbon footprint’12 and recycling taking place now in many countries. Companies are finding that they can increase their appeal to customers by portraying themselves as environmentally responsible. 2. environmental costs are becoming huge for some companies, particularly those operating in highly industrialised sectors such as oil production. In some cases, these costs can amount to more than 20% of operating costs. Such significant costs need to be managed. 3. regulation is increasing worldwide at a rapid pace, with penalties for non-compliance also increasing accordingly. Penalties include fines, increased liability to environmental taxes, loss in value of land, destruction of brand values, loss of sales, consumer boycotts, inability to secure finance, loss of insurance cover, contingent liabilities, law suits and damage to corporate image. In the largest ever seizure related to an environmental conviction in the UK, a plant hire firm, John Craxford Plant Hire Ltd, had to not only pay £85,000 in costs and fines but also got £1.2m of its assets seized. This was because it had illegally buried waste and also breached its waste and pollution permits. And it’s not just the companies that need to worry. Officers of the company and even junior employees could find themselves facing criminal prosecution for knowingly breaching environmental regulations. In 2010, the failure of a 40-ft-tall blowout preventer has severely damaged BP’s image and wiped out more than $20 billion of the company’s stock A ‘carbon footprint’ (as defined by the Carbon Trust) measures the total greenhouse gas emissions caused directly and indirectly by a person, organisation, event or product 12
44
market value. BP claimed it was spending $6 million a day on the salvage effort. The spill cost BP more than $4.6 billion in containment and clean-up expenses. The oil spill also affected the Louisiana fishing industr and the tourism business along the Florida coast 13. By failing to incorporate environmental concerns, organisations are unaware of the impact on the income statement and statement of financial position of environment-related activities. Moreover, they miss out on identifying cost reduction and other improvement opportunities, employ incorrect product/service pricing, mix and development decisions. This leads to a failure to enhance customer value, while increasing the risk profile of investments and other decisions with long-term consequences. 5.1.5 How do organisations c ontrol these environmental costs? It is only after environmental costs have been defined, identified and allocated that a business can begin the task of trying to control them. Much of the prepare environmental management accounts Let us consider an organisation whose main environmental costs are as follows: 1. waste and effluent disposal 2. water consumption 3. energy 4. transport and travel 5. consumables and raw materials. 1. Waste and effluent dis pos al There are lots of environmental costs associated with waste. For example, the costs of unused raw materials and disposal; taxes for landfill; fines for compliance failures such as pollution. It is possible to identify how much material is wasted in production by using the ‘mass balance’ approach, whereby the weight of materials bought is compared to the product yield. From this process, potential cost savings may be identified. In addition to these monetary costs to the organisation, waste has environmental costs in terms of lost land resources (because waste has been buried) and the generation of greenhouse gases in the form of methane. 2. Water Businesses actually pay for water twice – first, to buy it and second, to dispose of it. If savings are to be made in terms of reduced water bills, it is 13 Articl e, “BP Oil
Spill Clean-Up to Cost Nearl y $5 Bil lion”, Environmental Leader, May 2010 http://www.environmentall eader.com/2010/05/03/bp-oil -spi ll -clean-up-to-cost-nearly-5-billion/
45
important for organisations to identify where water is used and how consumption can be decreased. 3. Energy A recent UK government publicity campaign reports that companies are spending, on average, an extra 30% on energy through inefficient practices. With good energy management, we could reduce the environmental impact of energy production by 30% and slash 30% of the organisations’ energy expenditure. For example, environmental management accounts may help to identify inefficiencies and wasteful practices and, therefore, opportunities for cost savings. 4. Transpo rt and travel Again, environmental management accounting can often help to identify savings in terms of business travel and transport of goods and materials. At a simple level, a business can invest in more fuel-efficient vehicles. 5. Consumables and raw materials These costs are usually easy to identify and discussions with senior managers may help to identify where savings can be made. For example, toner cartridges for printers could be refilled rather than replaced. This should produce a saving both in terms of the financial cost for the organisation and a waste saving for the environment (toner cartridges are difficult to dispose of and less waste is created this way). It is equally important to allocate environmental costs to the processes or products which give rise to them. Only by doing this can an organisation make well-informed business decisions. For example, a pharmaceutical company may be deciding whether to continue with the production of one of its drugs. In order to incorporate environmental aspects into its decision, it needs to know exactly how many products are input into the process compared to its outputs; how much waste is created during the process; how much labour and fuel is used in making the drug; how much packaging the drug uses and what percentage of that is recyclable etc. Only by identifying these costs and allocating them to the product can an informed decision be made about the environmental effects of continued production.
46
5.1.6 How shou ld environmental information be reported? Hansen and Mendoza (1999) stated that environmental costs are incurred because of poor quality controls. Therefore, they advocate the use of a periodical environmental cost report that is produced in the format of a cost of quality report, with each category of cost being expressed as a percentage of sales revenues or operating costs so that comparisons can be made between different periods and/or organisations. The categories of costs would be as follows: 1. Environmental prevention costs: the costs of activities undertaken to prevent the production of waste. 2. Environmental detection costs: costs incurred to ensure that the organisation complies with regulations and voluntary standards. 3. Environmental internal failure costs: costs incurred from performing activities that have produced contaminants and waste that have not been discharged into the environment. 4. Environmental external failure costs: costs incurred on activities performed after discharging waste into the environment. It is clear from the suggested format of this quality type report that Hansen and Mendoza’s definition of ‘environmental cost’ is relatively narrow. 5.1.7 Identify ing environ mental cos ts Much of the information that is needed to prepare environmental management accounts could actually be found in a business’ general ledger. A close review of it should reveal the costs of materials, utilities and waste disposal, at the least. The main problem is, however, that most of the costs will have to be found within the category of ‘general overheads’ if they are to be accurately identified. Identifying them could be a lengthy process, particularly in a large organisation. The management of environmental costs can be a difficult process. This is because: 1. just as EMA is difficult to define, so too are the actual costs involved. 2. having defined them, some of the costs are difficult to separate out and identify. 3. the costs can need to be controlled but this can only be done if they have been correctly identified in the first place.
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5.2
ACCA SYLLABUS GUIDE OUTCOME 2: Describe the different methods a business may use to account for its environmental costs 14
Environmental management accounting uses some standard accountancy techniques to identify, analyse, manage and hopefully reduce environmental costs in a way that provides mutual benefit to the company and the environment, although sometimes it is only possible to provide benefit to one of these parties. In 2003, the UNDSD identified four management accounting techniques for the identification and allocation of environmental costs: input/ outflow analysis, flow cost accounting, activity based costing and lifecycle costing. 1. Inpu t/outflow analysis This technique records material inflows and balances this with outflows on the basis that, what comes in, must go out.
Input/output analysis accord ing to Envirow ise The purchased input is regarded as 100% and balanced against the outputs – which are produced, sold and stored goods and the residual (regarded as waste). Materials are measured in physical unit and include energy and water. For example, if 100kg of materials have been bought and only 80kg of materials have been produced, then the 20kg difference must be accounted for in some way. It may be that 10% of it has been sold as scrap and 90% of it is waste. By accounting for outputs in this way, both in terms of physical
14 Examined
December 2013 Qs 1c
48
quantities and, at the end of the process, in monetary terms too, businesses are forced to focus on environmental costs. 2. Flow cost accounting This technique uses not only material flows but also the organisational structure. It makes material flows transparent by looking at the physical quantities involved, their costs and their value. It divides the material flows into three categories: material, system, and delivery and disposal. i. ii. iii.
The material values and costs apply to the materials which are involved in the various processes. The system values and costs are the in-house handling costs which are incurred to maintain and support material throughput e.g. personnel costs and depreciation. The delivery and disposal values and costs refer to the costs of flows leaving the company, e.g. transport costs or costs of disposing waste.
The values and costs of each of these three flows are then calculated. The aim of flow cost accounting is to reduce the quantity of materials which, as well as having a positive effect on the environment, should have a positive effect on a business’ total costs in the long run.
3. Activity -based costing ABC allocates internal costs to cost centres and cost drivers on the basis of the activities that give rise to the costs. In an environmental accounting context, it distinguishes between environment-related costs, which can be attributed to joint cost centres (e.g. incinerators and sewage plants), and
49
environment-driven costs, which tend to be hidden on general overheads, e.g. increased depreciation or higher cost of staff. For example, activity-based costing may be used to ascertain more accurately the costs of washing towels at a gym. The energy used to power the washing machine is an environmental cost; the cost driver is ‘washing’. Once the costs have been identified and information accumulated on how many customers are using the gym, it may actually be established that some customers are using more than one towel on a single visit to the gym. The gym could drive forward change by informing customers that they need to pay for a second towel if they need one. Given that this approach will be seen as ‘environmentally-friendly’, most customers would not argue with its introduction. Nor would most of them want to pay for the cost of a second towel. The costs to be saved by the company from this new policy would include both the energy savings from having to run fewer washing machines all the time and the staff costs of those people collecting the towels and operating the machines. Presumably, since the towels are being washed less frequently, they will need to be replaced by new ones less often as well. In addition to these savings to the company, however, are the all-important savings to the environment since less power and cotton (or whatever materials the towels are made from) is now being used, and the scarce resources of our planet are therefore being conserved. Lastly, the gym is also seen as an environmentally friendly organisation and this, in turn, may attract more customers and increase revenues. 4. Lifecycle costing Within the context of environmental accounting, lifecycle costing (full costing) is a technique which requires the full environmental consequences, and, therefore, costs, arising from production of a product to be taken account across its whole lifecycle, literally ‘from cradle to grave’. One example of the potential gains from using lifecycle costing can be seen in the case of Xerox Limited. Xerox Limited, a subsidiary of Xerox Corporation, introduced the concept of lifecycle costing for its logistic chain. The core business of Xerox Limited is manufacturing photocopiers, which are leased rather than sold. This means the machines are returned to Xerox Limited at the end of their lease. Previously, machines were shipped in a range of different types of packaging, which could rarely be re-used by customers to return the old copiers. The customer had to dispose of the original packaging and to provide new packaging to return the machine at the end of its lease, which in turn could not be used to re-ship other machines. This meant Xerox lost the original costs and had to bear the costs of disposal of the packaging.
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A new system was invented which used a standard pack (tote). Two types of totes were introduced to suit the entire range of products sold by Xerox. Totes can be used for both new machines delivery and return carcasses. The wholechain cost analysis showed the considerably lower cost of the tote system, compared to the previously existing system and the supply chain became more visible. The tote system resulted not only in cost savings but also in reduced ‘de-pack’ times and improved customer relations (Bennett and James, 1998b). The above –mentioned accounting techniques are useful for environmental management accounting to identify and allocate environmental costs. In addition, there are alternative techniques to estimate environmental costs such as the ‘environmental cost decision tree’. Also, the undertaking of environmental audits on a regular basis provides the platform for a successful programme of total quality management (TQM). Lectur e Example 1 British Petroleum’s Annual Review describes a number of activities aimed at reducing the environmental impact of the company’s operations. a. What are the advantages, for a company like BP, of reducing environmental costs? b. What are the disadvantages enco untered by these comp anies in trying to reduce these environmental costs? Lectur e Example 215 The following are types of management accounting techniques: (i) Flow cost accounting (ii) Input/output analysis (iii) Life-cycle costing (iv) Activity based costing Which of the above techniques could be used by a company to account for its environmental costs? A. (i) only B. (i) and (ii) only C. (i), (ii) and (iii) only D. All of the above
15
Specimen Exam Applicable from December 2014
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CHAPTER 6
Planning w ith Limiting Factors A limiting factor is the factor (aspect of business/resource) that limits an organisation’s activities. For many businesses, this may frequently be the level of sales that can be achieved but at other times a business may be limited by a shortage of a resource which prevents the business from achieving its sales potential. Other examples of limiting factors would include: - supply of skilled labour, supply of materials, factory space, finance, plant capacity and market demand. 6.1
ACCA SYLLABUS GUIDE OUTCOME 1: Identify limiting factors in a scarce resource situation and select an appropriate technique in a scarce resource situation Determine the optimal production plan where an organisation is restricted by a single limiting factor, including within the context of “make” or “buy” decisions
A business may face a single constraint situation; however, others may face a multi constraint scenario. Planning w ith one limiting factor When there is only one scarce resource, key factor analysis can be used to solve the problem. Options must be ranked using contribution earned per unit of the scarce resource. 6.1.1 Three steps in key factor analysis Step 1: - First determine the limiting factor (bottleneck resource) Step 2: - Rank the options using the contribution earned per unit of the scarce resource Step 3: - Allocate resources
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Illustration 1
SP / unit VC / unit FC / unit Skilled Labour / unit Demand (units)
Product A
Product B
100 80 10 0.5 hr 5000
120 75 12 0.75 hr 4000
Only 4,000 labour hours are available. How many labour h ours are required? Required:
Product A (0.5 x 5000) Product B (0.75 x 4000)
2500 3000 5500 4000 1500
Available Shortfall
Labour hours are a limiting factor Product A
SP / unit VC / unit Cont / unit Lab hrs / unit Cont / lab hr Ranking
100 80 20 0.5 40 2
Product B 120 75 45 0.75 60 1
Prod Plan Product Product B Product A
Units
Lab hrs / unit
4000
0.75
1000 = 2000 0.5
0.5
Produce 2000 units Product A 4000 units Product B
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Total lab hrs Available = 4000 (3000) 1000 (1000) 0__
6.1.2 Assumptions 1. A single quantifiable objective. In reality, there may be multiple objectives. 2. Each product always uses the same quantity of the scarce resource per unit. 3. The contribution per unit is constant. However, the selling price may have to be lowered to sell more; discounts may be available as the quantity of materials needed increases. 4. Products are independent. It may not be possible to prioritise product A at the expense of product B. 5. We focus on the short term, therefore ignoring fixed costs. Lectur e Example 1 Dave Ltd manufactures 3 products using the same machinery. Only 8,000 machine hours are available each month. The following information is available: -
SP / unit ($) VC / unit ($) Machining mins / unit Monthly demand
Product A
Product B
Product C
40 15 60 6,000
45 18 40 9,000
60 25 30 3,000
Required: a. Calculate the mont hly machine hour s required to meet all demand for produ cts A, B and C. Hence, calculate any surplus or sh ortfall in machine hours. b.
Calculate the number of units of each prod uct wh ich Dave Ltd shou ld produc e in order to maximize its pro fit.
c.
Calculate the monthly contribu tion that this produ ction mix shou ld yield.
6.2
ACCA SYLLABUS GUIDE OUTCOME 2: Formulate and solve a multiple scare resource problem both graphically and using simultaneous equations as appropriate
When there are two or more resources in short supply, linear programming is required to find the solution.
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Linear programming is used to: 1. maximise contribution and/or 2. minimise costs 6.2.1 Steps invo lved in linear pro gramming 1. 2. 3. 4.
Define the variables Define and formulate the objective Formulate the constraints Draw a graph identifying the feasible region. The constraints are represented as straight lines on the graph. The feasible region shows those combinations of variables which are possible given the resource constraints. 5. Solve for the optimal production plan. An iso-contribution line (an objective function for a particular value) must be drawn. All points on this line represent an equal contribution. This line must move to and from the origin in parallel. The objective is to get the highest contribution or the minimum cost within the binding constraints. A linear programming situation can be solved using simultaneous equations. However, this technique should be used after one has determined graphically the constraints and the feasible region. 6.2.2 Linear programming assump tions 1. a single quantifiable objective 2. each product always uses the same quantity of the scarce resource per unit. 3. the contribution (or cost) per unit is constant for each product, regardless of the level of activity. Therefore, the objective function is a straight line. 4. products are independent 5. the focus is short-term 6. all costs either vary with a single volume-related cost driver or they are fixed for the period under consideration. Illustration 2 A company manufactures two types of boxes, Box A and Box B. Contribution / box A = $20
Contribution / box B = $45
Two materials, X and Y are used in the manufacturing of each box. Each material is in short supply.
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Material X = 3,000 kg available
Material Y = 2,700 kg available
Each box A uses 20 kg of Material X and 15 kg of Material Y Each box B uses 30 kg of Material X and 50 kg of Material Y The objective of this company is to maximize profits. Variables Let A be the number of boxes of A produced and sold Let B be the number of boxes of B produced and sold Objective function Max C = 20A + 45B Constraints Mat X = 20A + 30B ≤ 3,000 Mat Y = 15A + 50B ≤ 2,700 Non-negativity = A,B ≥ 0 Material X 20A + 30B = 3,000 When A is 0, B = 100 When B is 0, A = 150 Material Y 15A + 50B = 2700 When A = 0, B = 54 When B = 0, A = 180 Product A
200
OPQR = feasible region
180 150
P
B Q
100 A 45
Material X Iso-cont. Line
0 O
Material Y 25
50 R
75
56
100
Product B
How can we draw the iso-contribution line? 20A + 45B = 900
take a number which is a multiple of both the 20 and the 45
when A is 0, B = 20 when B is 0, A = 45 Which is the optimal point? 1. Shift out the objective function. 2. We need to maximize profits. Hence the optimal point is the last point to reach in the feasible region, OPQR Therefore the optimal point in the above example is B. How can I find the optimal point using simultaneous equations? 1.
Find the contribution at each point on the feasible region.
At point O, contribution is 0 At point P, contribution is 20A + 45B 20(150) + 45(0) = 3,000 At point R, contribution is 20A + 45B 20(0) + 45(54) = 2430 At point Q – point of intersection of material X, material Y. Material X = 20A + 30B = 3,000 …………x5 Material Y = 15A + 50B = 2,700 …………x3 100A + 150B = 15,000 45A + 150B = 8,100 55A = 6,900 A = 125.45 100(125.45) + 150B = 15,000 B = 16.36 Contribution = 20A + 45B = 20(125.45) + 45(16.36) = 2509 + 736.2 = 3245.2 Therefore point Q is the optimal point where contribution is $3245.20
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Lectur e Example 2 – (Article by Mr Geoff Cordwell ‘Linear Programming’)16 A profit-seeking firm has two constraints: labour, limited to 16,000 hours, and materials, limited to 15,000kg. The firm manufactures and sells two products, X and Y. To make X, the firm uses 3kg of material and 4 hours of labour, whereas to make Y, the firm uses 5kg of material and 4 hours of labour. The contributions made by each product are $30 for X and $40 for Y. The cost of materials is normally $8 per kg, and the labour rate is $10 per hour. Required: a. Write dow n the objective function and the cons traints for this firm. b. Draw a graph to illu strate all the con straints, shadin g the feasible region. c. Find the optimal solution if the company aims to maximize contribution. Calculate the contribution gained at this optimal point. d. Find the optimal point using simultaneous equations. How muc h is co ntribution at each point on the feasible region? 6.3
ACCA SYLLABUS GUIDE OUTCOME 3: Explain and calculate shadow prices (dual prices) and discuss their implications on decision-making and performance management
Any scarce resource that is fully utilised in the optimal solution will have a shadow price. It would be worth paying more than the ‘normal’ price to obtain more of the scarce resource because of the contribution foregone by not being able to satisfy the sales demand. Therefore, if more critical (scarce) resource becomes available, then the feasible region would tend to expand and this means that the optimal point would tend to move outward away from the origin, thus earning more contribution. Hence the shadow price of a binding constraint is the amount by which the total contribution would increase if one more unit of the scarce resource became available. Management can use the shadow price as a measure of how much they would be willing to pay to gain more of a scarce resource over and above the normal price subject to any non-financial issues that may be present. If the availability of a non-critical scarce resource increased then the feasible region would not tend to expand and therefore no more contribution could be 16
http://www.accaglobal.com/content/dam/acca/global/pdf/sa_mar08_cordwell.pdf
58
earned. In this case, extra non-critical scarce resource has no value and a nil shadow price. 6.3.1 Calculating shadow prices 1. add one unit to the constraint concerned while leaving the other critical constraint unchanged 2. solve the revised simultaneous equations to derive a new optimal solution 3. calculate the revised optimal contribution and compare to the old contribution. The increase in contribution is the shadow price for the constraint under consideration. Illustration 3 Following from illustration 2, find the shadow price of Material X. 20A + 30B = 3001 (add 1 kg to Material X) 15A + 50B = 2700 20A + 30B = 3001 ….. x5 15A + 50B = 2700 ….. x3 100A + 150B = 15005 45A + 150B = 8100 55A / = 6905 A = 125.55 100 A + 150B = 15005 100(125.55) + 150B = 15005 B = 16.33 Therefore New Contribution = 20 (125.55) + 45 (16.33) = 2511+ 734.85 = 3245.85 Old Contribution = 3245.20 Shadow price = 0.65 Extra contribution / kg of Material X
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6.4
ACCA SYLLABUS GUIDE OUTCOME 4: Calculate slack and explain the implications of the existence of slack for decision-making and performance management (excluding simplex and sensitivity to changes in objective functions)
Slack occurs when the maximum availability of a resource is not used. Therefore, slack is the amount by which a resource is under-utilised. It will occur when the optimum point does not fall on the given resource line. If, at the optimal solution, the resource used equals the resource available, the constraint is binding and there is no slack. Hence, a shadow price has to be calculated. Lectur e Example 3 Using the information from lecture example 2, calculate the shadow price of both the materials and the labour. Lectur e Example 4 Using the information from lecture examples 2 and 3, calculate the amount of extra material which should be bought in. What happens if the o bjective is to minimize costs? 1. Same steps as above 2.
Check the constraints :- are they less than or greater than?
3.
If they are ‘greater than’, the region which you should consider is above the constraint.
4.
The optimal point will be the first point you reach on the feasible region when you shift out the iso-cost function.
Lectur e Example 5 A linear programming model has been formulated for two products, X and Y. The objective function is depicted by the formula C = 5X+6Y, where C = contribution, X = the number of product X to be produced and Y= the number of product Y to be produced. Each unit of X uses 2 kg of material Z and each unit of Y uses 3 kg of material Z. The standard cost of material Z is $2 per kg. The shadow price for material Z has been worked out and found to be $2.80 per kg.
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If an extra 20 kg of material Z becomes available at $2 per kg, what will the maximum increase in contribution be? A. B. C. D.
Increase of $96 Increase of $56 Increase of $16 No change
Further questions Question 1 Pegs plc manufactures 2 products, Pega and Pegi. The cost cards are as follows. Pega
Pegi
Selling price
25
28
Materials Labour Other variable costs Fixed costs
8 5 7 3 23
20 2 2 2 26
$2 2 hrs 20,000 units
$2 1 hr 10,000 units
Profit Machine hours per unit Maximum demand
The total hours available are 48,000. Calculate the optimum production plan and the maximum profit using conv entional key factor analysis. Question 2 A company manufactures and sells two products (X and Y) both of which utilize the same skilled labour. For the coming period, the supply of skilled labour is limited to 2,000 hours. Data relating to each product are as follows:
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Product Selling price per unit Variable cost per unit Skilled labour hours per unit Maximum demand (units) per period
X
Y
$20 $12 2
$40 $30 4
800
400
In order to maximize profit in the coming period, how many units of each product should the company manufacture and sell? A. B. C. D.
200 units of X and 400 units 400 units of X and 300 units 600 units of X and 200 units 800 units of X and 100 units
of Y of Y of Y of Y
Question 3 A company uses limiting factor analysis to calculate an optimal production plan given a scarce resource. The following applies to the three products of the company: Product Direct materials (@ $6/kg) Direct labour (@ $10/hour) Variable overheads (@ $2/hour)
Maximum demand (units) Optimal production plan
i $ 36 40 8
ii $ 24 25 5
iii $ 15 10 2
84
54
27
2,000 2,000
4,000 1,500
4,000 4,000
How many kg of material were available for use in production? A. B. C. D.
15,750 kg 28,000 kg 30,000 kg 38,000 kg
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Question 4 Which of the following is correct? A. When considering limiting factors the products should always be ranked according to contribution per unit sold. B. If there is only one scarce resource linear programming should be used C. In linear programming the point furthest from the origin will always be the point of profit maximization D. The slope of the objective function in profit maximization depends on the contributions of the products. Question 5 A company manufactures and sells two products (X and Y) which have a contribution per unit of $8 and $20 respectively. The company aims to maximize profit. Two materials (G and H) are used in the manufacture of each product. Each material is in short supply – 1,000 kg of G and 1,800 kg of H are available next period. The company holds no inventories and it can sell all the units produced. The management accountant has drawn the following graph accurately showing the constraints for materials G and H. Product Y (units)
100 90
Materi al G
Material H
0 125
150
Product X (units)
a. What is the amount (in kg) of material G and material H used in each unit of Product Y?
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A. B. C. D.
Material G 10 10 20 20
Material H 20 10 20 10
b. What is the optimal mix of production (in units) for the next period? A. B. C. D.
Product X 0 50 60 125
Product Y 90 60 50 0
Question 617 Highfly Co manufactures two products, X and Y, and any quantities produced can be sold for $60 per unit and $25 per unit respectively. Variable costs per unit of the two products are as follows:
Materials (at $5 per kg) Labour (at $6 per hour) Other variable costs Total
Product X $ 15 24 6 ––– 45 –––
Product Y $ 5 3 5 ––– 13 –––
Next month, only 4,200 kg of material and 3,000 labour hours will be available. The company aims to maximise its profits each month. The company wants to use the linear programming model to establish an optimum production plan. The model considers ‘x’ to be number of units of product X and ‘y’ to be the number of units of product Y. Which of the following objective functions and constraint statements (relating to material and labour respectively) is correct? A. B. C. D. 17
Objective fun ction 60x + 25y 15x + 12y 15x + 12y 60x + 25y
Material constraint Labour constraint 3x + y ≤ 4,200 4x + 0·5y ≤ 3,000 3x + y ≥ 4,200 4x + 0·5y ≥ 3,000 3x + y ≤ 4,200 4x + 0·5y ≤ 3,000 3x + y ≥ 4,200 4x + 0·5y ≥ 3,000
Specimen Exam Applicable from December 2014
64
CHAPTER 7
Relevant Costing, Make-or-buy and other short-term decisions 7.1
ACCA SYLLABUS GUIDE OUTCOME 1: Explain the concept of relevant costing
Companies and government bodies have increasingly tended to concentrate on their core competences – what they are really good at – and turn other functions over to specialist contractors. This is known as outsourcing or subcontracting. Any short term decisions should be approached using relevant costing principles. Relevant costs and revenues are future cash flows arising as a direct consequence of a decision. 1. Relevant costs are revenues are future costs and revenues 2. Relevant costs and revenues are cash flows 3. Relevant costs and revenues are incremental costs and revenues. Decision making should be based on relevant costs and revenues. 1. Relevant costs are future costs. A decision is about the future and it cannot alter what has been done already. Costs that have been incurred in the past are totally irrelevant to any decision that is being made 'now'. Such costs are called past costs or sunk costs and are irrelevant. 2. Relevant costs are cash flows. Only cash flow information is required. This means that costs or charges which do not reflect additional cash spending (such as depreciation and notional costs) should be ignored for the purpose of decision making. 3. Relevant costs are incremental costs and it is the increase in costs and revenues that occurs as a direct result of a decision taken that is relevant. Common costs can be ignored for the purpose of decision making. 4. Avoidable costs are costs which would not be incurred if the activity to which they relate did not exist. Therefore, they are relevant to a decision. 65
5. Committed costs are future costs that cannot be avoided because of decisions that have already been made. These are non-relevant costs. 7.2
ACCA SYLLABUS GUIDE OUTCOME 2: Explain and apply the concept of opportunity costs
Where the choice of one course of action requires that an alternative course of action is given up, the financial benefits that are forgone or sacrificed are known as opportunity costs. Opportunity costs represent the lost contribution to profits arising from the best use of the alternative forgone. Opportunity costs only arise when resources are scarce and have alternative uses. Lectur e Example 1 RCA which manufactures and sells one single product is currently operating at 85% of full capacity, producing 102,000 units per month. The current total monthly costs of production amount to $330,000, of which $75,000 are fixed and are expected to remain unchanged for all levels of activity up to full capacity. A new potential customer has expressed interest in taking regular monthly delivery of 12,000 units at a price of $2.80 per unit. All existing production is sold each month at a price of $3.25 per unit. If the new business is accepted, existing sales are expected to fall by 2 units for every 15 units sold to the new customer. Required: What is the overall increase in monthly profit which would result from accepting the new business? Relevant Cos ts for Materials The relevant cost of raw materials is generally their current replacement cost, unless the materials have already been purchased and would not be replaced once used. In this case the relevant cost of using them is the higher of:
Their current resale value The value they would obtain if they were put to an alternative use
If the materials have no resale value and no other possible use, then the relevant cost of using them for the opportunity under consideration would be nil.
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Not Not in in stock stock
In In stock stock Used Used regularly regularly
No No other other use use
Scarce Scarce
Buy Buyit! it!
Needs Needsto tobe be replaced replaced
Won Wontt be bereplaced replaced
Can Cantt replace replace
Current Current replacement replacement cost cost
Current Current replacement replacement cost cost
Current Current Resale Resale value value
Opportunity Opportunity Cost Cost
’
’
’
’
Illustration 1
Material
Qty needed for contract
Qty currently in inventory
Original Cost of qty in inv.
Current Purch price
Current Resale price
A B
400 kg 200 kg
200 kg 100 kg
$10 / kg $20 / kg
$15 / kg $22 / kg
$12 / kg $15 / kg
Material A is used regularly in the business. Material B is no longer used and has no alternative use in the business. The relevant cost of material is Material A – regularly used – replace 400kg x $15 = $6000 Material B – 100kgs in stock could have been sold if not used in the contract opportunity cost = 100kg x $15 = $1500 The other 100kg have to be purchased at $22 100kg x $22 = $2200 Therefore $1500+$2200 = $3700 Please note that the original cost is a sunk cost, therefore irrelevant. Relevant Costs for Labour 67
The key question here is: Is there spare capacity? If there is spare capacity within a department, additional work can be undertaken at no extra cost. Therefore, the relevant cost of labour is nil. If a department is working in full capacity, additional work can be undertaken only in two circumstances: a. Hire more employees – the relevant cost of labour will be the current rate of pay given to these employees b. Shift work from another department – in this case, the relevant cost of labour will be the lost contribution from not producing the alternative product/not working on the other work. This can be calculated by taking the sales value of the units of the product which will now be forgone and deduct the cost of producing them but excluding the labour cost. Workers will still have to be paid even if they are working on another product. Another method is: - calculate the lost contribution (selling price less all variable costs) plus the wages paid to the workers working on the new product/work.
Spare Spare Capacity Capacity
Full Full Capacity Capacity Additional Additionalwork workcannot cannot be beundertaken undertaken
Additional Additionalwork workcan can be undertaken at no extra be undertaken at no extracost cost
Hire Hiremore moreemployees employees
Nil Nil
Current Current rate rate of of pay pay given given
Illustration 2
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Shift Shiftwork workfrom fromanother anotherdept dept
Lost Lost Contribution Contribution ++ Variable Variable cost cost
