1. Intro to Management Accounting Understanding Costs
Week 6

2. The role of the management accounting system
Control and prepare management accounts which captures and processes data for
formulating overall strategies and long range/short range plans
making resource allocation decisions
planning and control of operations & activities
evaluating of managers and operations
reporting information for use in external reports (annual accounts)

3. Evolving themes in management accounting
Customer focus
Key success factors: Cost, Quality, Time, Innovation
Total value chain analysis: Treating each business function as a valued contributor
Continuous improvement
Other concepts
Professional ethics
Cost benefit approach
Unstructured problem-solving

4. Functions performed by management accountant
Scorekeeping (preparing an income statement of a business unit)
Attention Directing (preparing budget report)
Problem solving (comparison of costs of two photocopiers)
The controller partnering with management
Decision support

5. Financial accounting –v- Management accounting
It ain’t what you do, it’s the way that you do it
Management
It ain’t what you got, it’s the way that you use it

6. If you got income, you gotta have… Costs
Many management accounting techniques developed in manufacturing
Many are applicable to service industries
Common feature is identification of costs
Understanding behaviour of costs
Controlling costs
Using this information to improve the organisation

7. Types of cost Variable costs Rise and fall with levels of output
Direct materials
Fixed costs
Exists irrespective in changes in output
Rent of factory
Stepped costs
Remain constant (fixed) until trigger event
Renting more factory space if production exceeds certain level
Semi-variable costs
Present fixed and variable elements
Telephone costs

8. Variable costs Variable costs can be further broken down into
Direct costs
Variable overheads
They generally can be related directly to a specific unit of production
Eg wood used for making chairs is a direct cost
If electricity consumed by a machine making chairs is known although there is no electricity in the product it can be directly related to the manufacture of the product – it is a variable overhead.

9. Fixed Costs Overheads of the organisation Some are production related
Some are not
Not directly related to the product but
The product (probably) couldn’t be made without incurring overhead costs

10. £s and units Whereas Financial accounting concerns itself with £s only
Management accounting has a place for £s and units
But activities can be reduced to £s as a common measure

11. Costing raw materials Direct Materials + Direct Labour +
Direct Expenses +
= Prime Cost

12. Direct Costs – Materials (Stock)
For high volume similar items purchased in batches need “broad” costing system
Can’t track individual items
First-in-First-out (FIFO)
Last-in-First-out (LIFO)
(Weighted) Average Cost (AVCO)

13. Stock costing example Day 1 buy 100 units @£5 each
Day 3 issue to production 50 units
What is the direct cost to production of Day 3 issue of material?

14. FIFO Cumulative Units £ 100 @ £5 100 500 100 @ £7 200 1200£ £
Issue £
Remaining
Charge to production = £250
Closing Stock value = £950

15. LIFO Cumulative Units £ 100 @ £5 100 500 100 @ £7 200 1200£ £
Issue £
Remaining
Charge to production = £350
Closing Stock value = £850

16. AVCO Cumulative Units £ av cost 100 @ £5 100 500 £5
£ £5
£ £6
Issue £
Remaining
Charge to production = £300
Closing Stock value = £900

17. Costs and Efficiency Cost Volume Profit Analysis
Understanding the behaviour allows
Control which is needed because..
Increased revenue generation without control of costs
Affects profitability
Decreases efficiency
Reduces margins

18. Graphical representation of fixed cost behaviour
Volume of activity (units of output) F

19. Graphical representation of variable cost behaviour
Volume of activity

20. Combination of fixed and variable costs
Volume of activity (units of output) F
Total cost
Fixed costs
Variable costs

21. Reason for combination
Assume Fixed Costs of £1,000
That is a cost irrespective of output
Assume Variable costs of £1 per unit
At 0 output costs = £1,000
At 1 unit output costs = £1,001
At 10 units output costs = £1,010 etc…

22. So does it matter? 1 There is a link between variable costs and income
Every time you make and sell a unit you
Gain income
Incur a cost
As income rises so do variable costs
But your fixed costs remain the same

23. So does it matter? 2
Hopefully you sell products at more than the costs of production
But you still have to cover the fixed costs
Until fixed costs are covered you won’t make a profit

24. Relationship of income and costs
Volume of activity (units of output) F
Total cost
Fixed costs
Variable costs
Break even point
Total sales revenue

25. An example…(a simple one)..
You plan to make and sell 10,000 units
Can sell for £3.00 per unit
Costs are..
Workshop rent £15,000 per annum
Raw materials 50p per unit
Electricity 20p per unit

26. How much profit? Income (10,000 X £3) £30,000 Costs Rent £15,000
“Direct costs” (70p X 10,000) £ 7,000
Profit £ 8,000

27. Sounds OK then… But what if only able to sell 6,500 units
Less units made = less variable costs
But fixed costs still have to be paid
Which means..

28. Cancel world cruise, then?
Income (6,500 X £3) £19,500
Costs
Rent [still to be paid] £15,000
“Direct costs” (70p X 6,500) £ 4,550
Loss £

29. Avoiding failure (probably)
Identify which costs are variable
And which are fixed
This is important
From this knowledge is it possible to predict how viable a business proposition is?
Yes. To an extent. Enter Cost Volume Profit Analysis (CVP analysis)

30. A bit of jargon
The difference between income (which exhibits variable behaviour) and
Variable costs is
Contribution
Every unit sold gives a contribution to profit
Each unit’s contribution erodes fixed costs until we “Break even”
Total Income = Total Costs (no profit or loss)

31. Finding the Break Even Point (BEP)
BEP in units
is where Total Income = Total VC + FC
So where Income – VC = FC
BEP (units) =
Fixed Costs
Contribution

32. Why do we want to know? Markets for goods are uncertain
Allocation of resources
Margin of safety
How duff can your sales predictions be without ending up making a loss

33. Practical Example Acme Dog Products Ltd
The “Clip-it” patent spaniel ear clip
Variable costs = £7 per clip
Fixed Costs = £350,000
Selling Price = £12 per clip
What is the Break Even Point (BEP)?

34. The “Clip-it” patent spaniel ear clip
Can be done by plotting simply on a graph or
Fixed Costs £350,000 = 70,000 units
Contribution (12 – 7)

35. Developing the scenario
Simple BEP tells us how many units we need to sell before we start to see a profit. Assume however..
Up to 50,000 units selling price = £15
Above 50, 000 units selling price = £10
New BEP = £350,000 = 43,750 units
(£15 – £7)= £8

36. Introducing stepped costs
But if sales are over 50,000 units need extra warehouse space at cost of £80,000 per annum
This is a fixed cost
At sales of 50,000 units contribution = 50,000 X 8 =£400,000
Fixed costs = (£350,000)
Profit = £ 50,000
At sales greater than 50,000,
then extra fixed costs = (£ 80,000)
So need to cover additional costs of £ 30,000
Therefore additional FC = £30,000 = 10,000 units
Contribution = (10 – 7)
BEP = 50, ,000 = 60,000 units

37. How does this help decision making?
Choices (assuming can sell at least 50,000 units)
Sell no more than 50,000 units and make maximum profit of £50,000
If sell more than 50,000 units
New BEP = 60,000
Every unit above BEP makes profit of £3
To make profit of £50,000 need to sell
60,000 units PLUS £50,000/£3 = 16,667 units
Therefore 76,667 units
Is this viable? Have we the resources? What is long term prospect for this product? Etc……

38. Using CVP analysis to improve profitability
Yorkies Ltd – produce specialised ear clips for Yorkshire terriers
Selling price = £8
Could make and sell 55,000 units
Last year output was 40,000 units
Variable costs
Direct materials £3.00
Direct labour £1.10
Overheads £0.70
Fixed costs
Production £65,000
Selling £28,000

39. BEP? Fixed costs = £93,000 = Contribution = (£8-£4.8) = £3.2
So BEP was 29,063 units

40. What was profit last year?
Total Revenue = 40,000 X £8 = £320,000
Total costs
Variable (£4.80 X 40,000) £192,000
Fixed £ 93,000
£285,000
Revenue = £320,000 - £285,000 = £35,000

41. More profit…
What price would have to be charged last year to have made a profit of £50,000?
Total Costs = £285,000
To cover costs and make £50,000 profit would need income of
£285,000 + £50,000 = £335,000
Unit price = £335,000 = £8.38
40,000

42. Modelling profit maximisation
Knowing the relationship between individual costs and income means
Prediction of profits
Develop models to improve efficiency
Incentive schemes
Provide benchmarks for success of plans

43. Management have an idea!
Management have suggested 2 scenarios to improve profits
Scenario A
Spend £20,000 on advertising and raise selling price by 5%
Expect to see sales rise by 15%
Scenario B
Salesperson is currently paid £13,850 per annum
Switch to paying them 30p for each unit sold up to the new BEP
Then 50p per unit over BEP
Expect sales to increase by 20%
What are the EXPECTED outcomes?

44. Scenario A Fixed costs now £113,000
Sales = (40, %) 46,000 units
Selling price = (£8 + 5%) £8.40
Contribution per unit = £ £4.80 = £3.60
Total revenue = 46,000 X £8.40 = £386,400
Less variable costs = £220,800
Less fixed costs = £113,000
Profit = £ 52,600

45. Scenario B Sales rise to 48,000 units
Fixed costs go down by £13,850 to £79,150
Up to BEP variable costs up by 30p to £5.10
Therefore contribution = £8 - £5.10 = £2.90
BEP = £79,150 = 27,293 units
£2.90
Up to BEP fixed costs are covered,
so after BEP units sold = 48,000 – 27,293 = 20,707
All revenue is profit less variable costs
Therefore 20,707 X £8 = £165,656
Less variable costs
Now (£ £0.50) X 20,707 = £109,747
Profit = £ 55,509

46. Scenario B Salesperson’s earnings 27,293 X 30p = £ 8,188
£18,542

47. Downsides to CVP analysis
Cost classification
It is not always that easy to identify cost behaviour
Variable costs
Don’t necessarily exhibit linear relationship with output (bulk discounts etc)
Time period
Does the relationship between costs/income hold true into the distant future?
Complementary products
CVP analysis assumes a one product mix. What if several products being made is there a spillover effect?
Estimates
Extrapolation to the future is based on best estimate. Obviously things could change
Non-cost factors
CVP analysis is number-only based