Presentation on theme: "Intro to Management Accounting Understanding Costs"— Presentation transcript:
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 forformulating overall strategies and long range/short range plansmaking resource allocation decisionsplanning and control of operations & activitiesevaluating of managers and operationsreporting information for use in external reports (annual accounts)
3 Evolving themes in management accounting Customer focusKey success factors: Cost, Quality, Time, InnovationTotal value chain analysis: Treating each business function as a valued contributorContinuous improvementOther conceptsProfessional ethicsCost benefit approachUnstructured 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 managementDecision support
5 Financial accounting –v- Management accounting It ain’t what you do, it’s the way that you do itManagementIt 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 manufacturingMany are applicable to service industriesCommon feature is identification of costsUnderstanding behaviour of costsControlling costsUsing this information to improve the organisation
7 Types of cost Variable costs Rise and fall with levels of output Direct materialsFixed costsExists irrespective in changes in outputRent of factoryStepped costsRemain constant (fixed) until trigger eventRenting more factory space if production exceeds certain levelSemi-variable costsPresent fixed and variable elementsTelephone costs
8 Variable costs Variable costs can be further broken down into Direct costsVariable overheadsThey generally can be related directly to a specific unit of productionEg wood used for making chairs is a direct costIf 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 notNot directly related to the product butThe 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 unitsBut 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 systemCan’t track individual itemsFirst-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 unitsWhat 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 £RemainingCharge to production = £250Closing Stock value = £950
15 LIFO Cumulative Units £ 100 @ £5 100 500 100 @ £7 200 1200 ££Issue £RemainingCharge to production = £350Closing Stock value = £850
16 AVCO Cumulative Units £ av cost 100 @ £5 100 500 £5 £ £5£ £6Issue £RemainingCharge to production = £300Closing Stock value = £900
17 Costs and Efficiency Cost Volume Profit Analysis Understanding the behaviour allowsControl which is needed because..Increased revenue generation without control of costsAffects profitabilityDecreases efficiencyReduces 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)FTotal costFixed costsVariable costs
21 Reason for combination Assume Fixed Costs of £1,000That is a cost irrespective of outputAssume Variable costs of £1 per unitAt 0 output costs = £1,000At 1 unit output costs = £1,001At 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 youGain incomeIncur a costAs income rises so do variable costsBut your fixed costs remain the same
23 So does it matter? 2Hopefully you sell products at more than the costs of productionBut you still have to cover the fixed costsUntil fixed costs are covered you won’t make a profit
24 Relationship of income and costs Volume of activity (units of output)FTotal costFixed costsVariable costsBreak even pointTotal sales revenue
25 An example…(a simple one).. You plan to make and sell 10,000 unitsCan sell for £3.00 per unitCosts are..Workshop rent £15,000 per annumRaw materials 50p per unitElectricity 20p per unit
26 How much profit? Income (10,000 X £3) £30,000 Costs Rent £15,000 “Direct costs” (70p X 10,000) £ 7,000Profit £ 8,000
27 Sounds OK then… But what if only able to sell 6,500 units Less units made = less variable costsBut fixed costs still have to be paidWhich means..
28 Cancel world cruise, then? Income (6,500 X £3) £19,500CostsRent [still to be paid] £15,000“Direct costs” (70p X 6,500) £ 4,550Loss £
29 Avoiding failure (probably) Identify which costs are variableAnd which are fixedThis is importantFrom 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 jargonThe difference between income (which exhibits variable behaviour) andVariable costs isContributionEvery unit sold gives a contribution to profitEach 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 unitsis where Total Income = Total VC + FCSo where Income – VC = FCBEP (units) =Fixed CostsContribution
32 Why do we want to know? Markets for goods are uncertain Allocation of resourcesMargin of safetyHow 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 clipVariable costs = £7 per clipFixed Costs = £350,000Selling Price = £12 per clipWhat is the Break Even Point (BEP)?
34 The “Clip-it” patent spaniel ear clip Can be done by plotting simply on a graph orFixed Costs £350,000 = 70,000 unitsContribution (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 = £15Above 50, 000 units selling price = £10New 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 annumThis is a fixed costAt sales of 50,000 units contribution = 50,000 X 8 =£400,000Fixed costs = (£350,000)Profit = £ 50,000At sales greater than 50,000,then extra fixed costs = (£ 80,000)So need to cover additional costs of £ 30,000Therefore additional FC = £30,000 = 10,000 unitsContribution = (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 £50,000If sell more than 50,000 unitsNew BEP = 60,000Every unit above BEP makes profit of £3To make profit of £50,000 need to sell60,000 units PLUS £50,000/£3 = 16,667 unitsTherefore 76,667 unitsIs 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 terriersSelling price = £8Could make and sell 55,000 unitsLast year output was 40,000 unitsVariable costsDirect materials £3.00Direct labour £1.10Overheads £0.70Fixed costsProduction £65,000Selling £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 = £320,000Total costsVariable (£4.80 X 40,000) £192,000Fixed £ 93,000£285,000Revenue = £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 = £285,000To cover costs and make £50,000 profit would need income of£285,000 + £50,000 = £335,000Unit price = £335,000 = £8.3840,000
42 Modelling profit maximisation Knowing the relationship between individual costs and income meansPrediction of profitsDevelop models to improve efficiencyIncentive schemesProvide benchmarks for success of plans
43 Management have an idea! Management have suggested 2 scenarios to improve profitsScenario ASpend £20,000 on advertising and raise selling price by 5%Expect to see sales rise by 15%Scenario BSalesperson is currently paid £13,850 per annumSwitch to paying them 30p for each unit sold up to the new BEPThen 50p per unit over BEPExpect sales to increase by 20%What are the EXPECTED outcomes?
44 Scenario A Fixed costs now £113,000 Sales = (40, %) 46,000 unitsSelling price = (£8 + 5%) £8.40Contribution per unit = £ £4.80 = £3.60Total revenue = 46,000 X £8.40 = £386,400Less variable costs = £220,800Less fixed costs = £113,000Profit = £ 52,600
45 Scenario B Sales rise to 48,000 units Fixed costs go down by £13,850 to £79,150Up to BEP variable costs up by 30p to £5.10Therefore contribution = £8 - £5.10 = £2.90BEP = £79,150 = 27,293 units£2.90Up to BEP fixed costs are covered,so after BEP units sold = 48,000 – 27,293 = 20,707All revenue is profit less variable costsTherefore 20,707 X £8 = £165,656Less variable costsNow (£ £0.50) X 20,707 = £109,747Profit = £ 55,509
46 Scenario B Salesperson’s earnings 27,293 X 30p = £ 8,188 £18,542
47 Downsides to CVP analysis Cost classificationIt is not always that easy to identify cost behaviourVariable costsDon’t necessarily exhibit linear relationship with output (bulk discounts etc)Time periodDoes the relationship between costs/income hold true into the distant future?Complementary productsCVP analysis assumes a one product mix. What if several products being made is there a spillover effect?EstimatesExtrapolation to the future is based on best estimate. Obviously things could changeNon-cost factorsCVP analysis is number-only based
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