Accounting Costing 2 Prof. Clive Vlieland-Boddy Academic Year 2009-2010

Activity Based Costing

Activity Based Costing Costs per service or activity. Costs are allocated to a service or activity Examples: Cost per sales enquiry Costs per warranty claim Costs per credit check

Cost Drivers There are two main types of cost driver: A resource driver, which refers to the contribution of the quantity of resources used to the cost of an activity. An activity driver, which refers to the costs incurred by the activities required to complete a particular task or project.

Activity-Based Costing A way to allocate as many costs as possible to a product Focuses on activities and cost of activities Each activity has its own cost driver Uses a separate allocation rate for each activity Activity based costing is a way to allocate indirect costs (overhead) to production. The focus is on activities and the cost of performing those activities. Each activity has its own cost driver and uses a separate allocation rate. 5

Other Costing Issues

Job Costing Measures individual costs of production or service to each sales unit. Example: A builder will charge to a job all the materials and labour so as to identify the results of that particular job.

Processing Costing Traces all direct an indirect costs of manufacturing often on a batch process. They eventually divide these costs up to calculate a per unit cost.

Conversion Costs

Equivalent Units When valuing ending inventories of WIP, there may well be many partly completed units. These have to be equated into completed units. Example: At the month end a cycle manufacture has 500 half completed cycles. That would equate to 250 equivalent units.

Cost Volume Profit Analysis (CVP) & Break Even

The principles of variable/marginal costing For any given period of time, fixed costs will be the same, for any volume of sales and production (provided that the level of activity is within the ‘relevant range’). Therefore, selling an extra item of product or service: Revenue will increase by the sales volume of the item sold Costs will increase by the variable cost per unit Profit will increase by the amount of contribution earned from the extra item

Cost-volume-profit analysis Systematic method of examining the relationship between changes in activity and changes in total sales revenue, expenses and net profit CVP analysis is subject to a number of underlying assumptions and limitations The objective of CVP analysis is to establish what will happen to the financial results if a specified level of activity or volume fluctuates

CVP analysis assumptions All other variables remain constant A single product or constant sales mix Total costs and total revenue are linear functions of output The analysis applies to the relevant range only Costs can be accurately divided into their fixed and variable elements The analysis applies only to a short-time horizon Complexity-related fixed costs do not change CVP analysis model simplifies the real-world conditions that firm faces. That’s why the analysis is subject to a number of underlying assumptions and limitations All other variables remain constant means that volume of production is the only factor which will cause the costs and revenue to change throughout the analysis. (changes in other variables such as production efficiency, sales mix, price level and production methods have an important influence on sales revenue and costs, so if it is significant the CVP analysis will be incorrect). A single product or constant sales mix means that either a single product is sold or, if range of products is sold that sales will be in accordance with a predetermined sales mix. If the sales mix is used than then volume of sales can be depicted in a graph of CVP-analysis measured using standard batch size Total costs and total revenue are linear functions of output means that unit variables and selling price are constant The analysis applies to the relevant range only means that the CVP-analysis is valid only for decision taken within the relevant production range (outside this range the unit selling price and the variable cost are no longer constant per unit) Costs can be accurately divided into their fixed and variable elements The analysis applies only to a short-time horizon. In short-time the costs of providing a firm’s operating capacity, such as property taxes and the salaries are likely to be fixed in relation to changes in activity and unaffected by changes in volume whereas other costs will vary with changes of production. In the short-run volume is he most important variable influencing total revenue, cost and profit. Complexity-related fixed costs do not change means that the changes in complexity-related costs arising from changes in the range of items produced are not captured

Break Even

CVP diagram Horizontal axis – unit of production Vertical axis – total cost and revenue Fixed costs (FC) are plotted as a single horizontal line at the one level. Variable costs (VC) are added to the fixed costs to enable the total cost to be plotted. For plotting total cost line there are need to be two points. At zero sales volume total cost will be equal to the fixed costs and at particular volume of production total costs will be sum of fixed costs and variable costs (VC per unit * number of units). The relevant range consisting of 2 horizontal lines are added to the graph: beyond these lines we have assurance that the CVP analysis is valid. This graph helps us estimate the proper volume of production. Break-even point is the point at which the total sales revenue line cuts the total cost line (the point where the production makes neither profit nor loss). The area between the total sales revenue line and the total cost line at a volume below the break-even point represents losses that will occur for various sales below break-even point. And the similar if the company operates at a sales volume above the break-even point, the difference between the total revenue and the total cost lines represents the profit that results from the sales level above break-even point.

Margin of safety The extent that the revenue exceeds total costs, is called the margin of safety. Indicates by how much sales may decrease before a loss occurs

Break Even Analysis Remember: A higher price or lower price does not mean that break even will never be reached! The break even point depends on the number of sales needed to generate revenue to cover costs – the break even chart is NOT time related!

Activity 18.4.1 Use the matrix on web site to do this

Budgets

Budgets

Budgets Estimates of the income and expenditure of a business or a part of a business over a time period Used extensively in planning Helps establish efficient use of resources Help monitor cash flow and identify departures from plans Maintains a focus and discipline for those involved

Budgets Flexible Budgets – budgets that take account of changing business conditions Static Budget – Based on pre determined level of activity

Flexible Budgets A budget prepared for a multiple levels of sales volume is called a flexible budget. Flexible budgets are prepared at the beginning of the year for planning purposes and at the end of the year for performance evaluation. Differences between actual results and the flexible budget are called flexible budget variances. One click is required for each bullet, including the first one. © John Wiley & Sons, 2005 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 1e Slide # 24

Acct 311 - Prof. Teresa Gordon 3/25/2017 Flexible Budget This is the budget we would have prepared HAD WE ONLY KNOWN the number of units that would be sold or produced 25 25

What is needed to do a flexible budget Acct 311 - Prof. Teresa Gordon 3/25/2017 What is needed to do a flexible budget To do a flexible budget we need to know the assumptions used to create the original budget Units expected to be sold Expected selling price per unit Variable cost per unit Fixed costs (in total) 26 26

Static Budgets A budget prepared for a single level of sales volume is called a static budget. Static budgets are prepared at the beginning of the year. Differences between actual results and the static budget are called static budget variances. One click is required for each bullet, including the first one. © John Wiley & Sons, 2005 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 1e Slide # 27

Performance Evaluation A static budget variance includes effects from output volume. A flexible budget variance removes these output volume effects. Other adjustments to the year-end flexible budget may be made for a fair performance evaluation, such as Input price changes outside the control of the manager under evaluation Fixed cost increases outside the control of the manager under evaluation One click is required for each bullet and sub-bullet, including the first primary bullet. © John Wiley & Sons, 2005 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 1e Slide # 28

Comparing Actual Results to Planned Results Acct 311 - Prof. Teresa Gordon 3/25/2017 Comparing Actual Results to Planned Results Budget comparisons and variances 29 29

Budget Variances Managers compare actual results to budgeted results in order to monitor operations, and motivate appropriate performance. Differences between budgeted and actual results are called budget variances. Variances are stated in absolute value terms, and labeled as Favorable or Unfavorable. The first bullet and sub-bullets are automated. The first click brings in the second primary bullet. The second click brings in its secondary bullet. © John Wiley & Sons, 2005 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 1e Slide # 30

Actual Vs Budget Actual Budget Variance Sales 540,000 520,000 20,000 F Purchases 350,000 340,000 10,000 U Because it is a positive variance the it is marked with a F. Unfavourable is marked with a U

Budgets Variance – the difference between planned values and actual values Positive or Favourable variance – actual figures less than planned Negative Unfavourable variance – actual figures above planned

Budget Variances Budget variances are investigated. The investigation may find: Inefficiencies in actual operations that can be corrected. Efficiencies in actual operations that can be replicated in other areas of the organization. Uncontrollable outside factors that require changes to the budgeting process. The first primary bullet is automated. One click is required for each remaining bullet and sub-bullet. © John Wiley & Sons, 2005 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 1e Slide # 33

Revenue or Cost Variance Analysis Standard variances Price variance Quantity variance The difference between the actual price and the standard price The difference between the actual quantity and the standard quantity

Easier than formulas? Sales volume variance Sales price variance Acct 311 - Prof. Teresa Gordon 3/25/2017 Easier than formulas? Sales volume variance (actual units – planned units) * planned selling price per unit Sales price variance (actual unit price – budgeted unit price) * units sold Note: Some companies use contribution margin per unit instead of selling price to compute these variances. 35 35

Acct 311 - Prof. Teresa Gordon 3/25/2017 Drilling down further . . . Sales volume variance can be further analyzed Are sales more or less than expected because we sold a different mix of products than we planned? The selling price for each product might also be different than we planned 36 36

Production Variances Direct materials Price variance Quantity variance Acct 311 - Prof. Teresa Gordon 3/25/2017 Production Variances Direct materials Price variance Quantity variance The computations are similar to what we illustrated for sales. You change one element at a time and, from the difference, determine the impact on costs (instead of sales) 37 37

Direct labor Rate variance Efficiency variance

Responsibility for Labour Variances Maybe I can attribute the labour and materials variances to personnel for hiring the wrong people and training them poorly.

Variable overhead Spending variance Efficiency variance

Fixed overhead Budget variance Volume variance

Performance Reports

Performance Reports Report financial performance of responsibility centers Cost center Difference between actual results and budget Changes in labour dollars or hours Changes in purchased price vs. quantity discount Revenue center Variance due to selling more or less units than expected Variance due to price changes Profit center Focus on both revenue and cost variances Responsibility accounting performance reports capture the financial performance of cost, revenue, and profit centers. Responsibility accounting performance reports compare actual results with budgeted amounts and display a variance, or difference, between the two amounts. Because cost centers are only responsible for controlling costs, their performance reports only include information on actual versus budgeted costs. Cost center performance reports typically focus on the flexible budget variance—the difference between actual results and the flexible budget. Likewise, performance reports for revenue centers only contain actual versus budgeted revenue. Revenue center performance reports often highlight both the flexible budget variance and the sales volume variance. The sales volume variance is due strictly to volume differences—selling more or fewer units than originally planned. The flexible budget variance, however, is due strictly to differences in the sales price—selling units for a higher or lower price than originally planned. Both the sales volume variance and the flexible budget variance help revenue center managers understand why they have exceeded or fallen short of budgeted revenue. However, profit centers are responsible for both controlling costs and generating revenue. Therefore, their performance reports contain actual and budgeted information on both their revenues and costs. Copyright (c) 2009 Prentice Hall. All rights reserved. 43

Performance Reports Management by exception Only material variances are investigated Should focus on information, not blame Some variances are uncontrollable Examples: increase in costs due to a natural disaster or macro economic issues Managers use management by exception to determine which variances in the performance report are worth investigating. For example, management may only investigate variances that exceed a certain dollar amount (for example, over $1,000) or a certain percentage of the budgeted figure (for example, over 10%). Smaller variances signal that operations are close to target and do not require management’s immediate attention. Regardless of the type of responsibility center, performance reports should focus on information, not blame. Analyzing budget variances helps managers understand the underlying reasons for the unit’s performance. Once management understands these reasons, it may be able to take corrective actions. But some variances are uncontrollable. Managers should not be held accountable for conditions they cannot control. Responsibility accounting can help management identify the causes of variances, thereby allowing them to determine what was controllable, and what was not. Copyright (c) 2009 Prentice Hall. All rights reserved. 44

Question 1 Activity Based Costing requires: Answer: Costs to be allocated to an activity Enables management to evaluate its services to customers Enables variances to be created on customer focused tasks. All of the above Answer: d. All of the above

Question 2 Job Costing is where: Answer: d. Costs are assigned to a particular job Often used by Accountants & Lawyers to charge their clients Enables accurate control of each job. All the above are correct Answer: d.

Question 3 Process costing is: Answer: c. Suitable for controlling costs in a manufacturing environment Usually allocates costs by batch then divides them up to get a per unit cost Both a and b are correct Answer: c.

Question 4 Equivalent Units: Answer: c. Are a method of assessing ending inventories Are calculated by establishing the extent that WIP is completed in terms of finished goods. A and B are correct Answer: c.

Question 5 CVP enables evaluation of: Answer: c The number of units to be sold to break even The relationship that total costs have to total revenues Both a and b are correct Answer: c

Question 6 Margin of Safety is: Answer: d. The extent that revenues exceed total costs Is the extent that profits are above Break Even Represent the level of activity that can be lost before losses are sustained All above are correct Answer: d.

Question 7 A flexible budget is: Answer: c. A static budget adjusted for volume activity Is prepared for several levels of expected activity. Both A and B are correct Answer: c.

Question 8 A variance is: Answer: d. The extent that actual has departed from forecast Is either Favourable or Unfavourable Enables management by exception All above are correct Answer: d.

Question 9 A Sales variance can be: Answer: a. Both because of price and quantity Can only be a price variance Can only be a quantity variance Answer: a. recast