Intro to Management Accounting Understanding Costs Week 6

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)

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

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

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

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

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

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.

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

£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

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

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)

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?

FIFO Cumulative Units £ 100 @ £5 100 500 100 @ £7 200 1200 100 @ £5 100 500 100 @ £7 200 1200 Issue 50 @ £5 -50 -250 Remaining 150 950 Charge to production = £250 Closing Stock value = £950

LIFO Cumulative Units £ 100 @ £5 100 500 100 @ £7 200 1200 100 @ £5 100 500 100 @ £7 200 1200 Issue 50 @ £7 -50 -350 Remaining 150 850 Charge to production = £350 Closing Stock value = £850

AVCO Cumulative Units £ av cost 100 @ £5 100 500 £5 100 @ £5 100 500 £5 100 @ £7 200 1200 £6 Issue 50 @ £6 -50 -300 Remaining 150 900 Charge to production = £300 Closing Stock value = £900

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

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

Graphical representation of variable cost behaviour Volume of activity

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

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…

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

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

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

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

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

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..

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 £ 50

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)

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)

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

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

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)?

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)

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

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 + 10,000 = 60,000 units

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……

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

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

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

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

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

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?

Scenario A Fixed costs now £113,000 Sales = (40,000 + 15%) 46,000 units Selling price = (£8 + 5%) £8.40 Contribution per unit = £8.40 - £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

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 (£4.80 + £0.50) X 20,707 = £109,747 Profit = £ 55,509

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

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