<?page no="0"?> Carsten Berkau Carsten Berkau Management Accounting International Syllabus 7 th Edition <?page no="1"?> Management Accounting <?page no="2"?> Prof. Dr. Carsten Berkau teaches Accounting and Management Accounting at the University of Applied Sciences in Osnabrück, Germany. Other textbooks are Basics of Accounting, Financial Statements and Bilanzen. <?page no="3"?> Carsten Berkau Management Accounting International Syllabus 7 Edition UVK Verlag · München Translated by Keabetswe Sylvia Berkau <?page no="4"?> ISBN 978-3-7398-3194-7 (Print) ISBN 978-3-7398-8194-2 (ePDF) Umschlagmotiv: © iStockphoto · matdesign24 Bibliografische Information der Deutschen Nationalbibliothek Die Deutsche Nationalbibliothek verzeichnet diese Publikation in der Deutschen Nationalbibliografie; detaillierte bibliografische Daten sind im Internet über http: / / dnb.dnb.de abrufbar. 7 th Edition 2023 6 th Edition 2020 DOI: https: / / doi.org/ 10.24053/ 9783739881942 © UVK Verlag 2023 - ein Unternehmen der Narr Francke Attempto Verlag GmbH + Co. KG, Dischingerweg 5 · D-72070 Tübingen Das Werk einschließlich aller seiner Teile ist urheberrechtlich geschützt. Jede Verwertung außerhalb der engen Grenzen des Urheberrechtsgesetzes ist ohne Zustimmung des Verlages unzulässig und strafbar. Das gilt insbesondere für Vervielfältigungen, Übersetzungen, Mikroverfilmungen und die Einspeicherung und Verarbeitung in elektronischen Systemen. Alle Informationen in diesem Buch wurden mit großer Sorgfalt erstellt. Fehler können dennoch nicht völlig ausgeschlossen werden. Weder Verlag noch Autor: innen oder Herausgeber: innen übernehmen deshalb eine Gewährleistung für die Korrektheit des Inhaltes und haften nicht für fehlerhafte Angaben und deren Folgen. Diese Publikation enthält gegebenenfalls Links zu externen Inhalten Dritter, auf die weder Verlag noch Autor: innen oder Herausgeber: innen Einfluss haben. Für die Inhalte der verlinkten Seiten sind stets die jeweiligen Anbieter oder Betreibenden der Seiten verantwortlich. Internet: www.narr.de eMail: info@narr.de CPI books GmbH, Leck <?page no="5"?> Contents I. Contents ................................................................................................................... 1-5 II. Introduction ..........................................................................................................1-14 1. Conventions........................................................................................... 1-19 1.1. Accounting Periods........................................................................................1-19 1.2. Accounting Technical Terms .......................................................................1-19 1.3. Account Names..............................................................................................1-19 1.4. Alphabetic Order ...........................................................................................1-19 1.5. Basics ...............................................................................................................1-19 1.6. Bookkeeping Entries .....................................................................................1-19 1.7. Bookkeeping Entry Format ..........................................................................1-19 1.8. Calculations.....................................................................................................1-20 1.9. Case Studies ....................................................................................................1-20 1.10. Case Study Text..............................................................................................1-20 1.11. Cash Flow Separation ....................................................................................1-20 1.12. Companies ......................................................................................................1-20 1.13. Cost-Expense-Congruence ...........................................................................1-20 1.14. Country............................................................................................................1-20 1.15. Currency Unit .................................................................................................1-20 1.16. Data Format in Tables...................................................................................1-20 1.17. Data Sheets .....................................................................................................1-21 1.18. Prepayments of Income Taxes .....................................................................1-21 1.19. How it is Done ...............................................................................................1-21 1.20. Income Taxes .................................................................................................1-21 1.21. Financial Statements for Taxation ...............................................................1-21 1.22. Names..............................................................................................................1-21 1.23. Language .........................................................................................................1-21 1.24. Learning Objectives .......................................................................................1-21 1.25. Legal Forms of a Business ............................................................................1-21 1.26. Length of a Month/ Year ..............................................................................1-21 <?page no="6"?> Berkau: Management Accounting 7e 1-6 1.27. Level of Precision .......................................................................................... 1-21 1.28. Links ................................................................................................................ 1-22 1.29. Literature......................................................................................................... 1-22 1.30. Non-existing Items ........................................................................................ 1-22 1.31. Online Materials............................................................................................. 1-22 1.32. Payment Terms .............................................................................................. 1-22 1.33. Presentation of Accounts ............................................................................. 1-22 1.34. Pro-Rated Depreciation/ Interest Calculations .......................................... 1-22 1.35. Quotation of Law Texts/ Standards ............................................................ 1-23 1.36. Sequence of Bookkeeping Entries............................................................... 1-23 1.37. Tax on Capital Returns (Dividend Tax) ..................................................... 1-23 1.38. Transaction Costs .......................................................................................... 1-23 1.39. Value Added Tax, Goods and Service Tax ................................................ 1-23 1.40. VAT Reduction.............................................................................................. 1-23 1.41. Working Definitions...................................................................................... 1-23 1.42. Work-in-Process Account ............................................................................ 1-24 1.43. Writing Management Terms ........................................................................ 1-24 1.44. WWW.............................................................................................................. 1-24 1.45. YouTube Videos............................................................................................ 1-24 1.46. 10-20-30 Rule ................................................................................................. 1-24 2. Introduction to Managerial Accounting............................................... 2-25 2.1. Purpose of a Management Accounting System ......................................... 2-25 2.2. Management Accounting and Financial Accounting (Introduction) ...... 2-26 2.3. Management Accounting for General Management................................. 2-26 2.4. Cost Accounting ............................................................................................ 2-27 3. Case Study PENOR PLC - Financial Accounting............................... 3-30 3.1. What is in the Chapter? ................................................................................. 3-30 3.2. Leaning Objectives ........................................................................................ 3-30 3.3. C/ S PENOR PLC......................................................................................... 3-30 3.4. Inception (A) .................................................................................................. 3-31 3.5. Financial Accounting (B) .............................................................................. 3-33 <?page no="7"?> Berkau: Management Accounting 7e 1-7 3.6. Preparation of Financial Statements ............................................................3-34 3.7. Summary .........................................................................................................3-35 3.8. Working Definitions ......................................................................................3-35 3.9. Question Bank................................................................................................3-36 3.10. Solutions..........................................................................................................3-36 4. Case Study PENOR PLC - Managerial Accounting........................... 4-37 4.1. What is in the Chapter? .................................................................................4-37 4.2. Learning Objectives .......................................................................................4-37 4.3. Management Accounting (C)........................................................................4-37 4.4. Recording Profits without Bookkeeping.....................................................4-40 4.5. Reporting.........................................................................................................4-42 4.6. Preparing a Business Plan .............................................................................4-45 4.7. Summary .........................................................................................................4-50 4.8. Working Definitions ......................................................................................4-51 4.9. Question Bank................................................................................................4-51 4.10. Solutions..........................................................................................................4-52 5. Management Accounting vs. Financial Accounting............................ 5-53 5.1. What is in the Chapter? .................................................................................5-53 5.2. Learning Objectives .......................................................................................5-53 5.3. Management Accounting in General...........................................................5-53 5.4. Principles of Management Accounting .......................................................5-54 5.5. Features of Management Accounting .........................................................5-57 5.6. Difference between Management and Financial Accounting ..................5-59 5.7. Management Accounting Focusses on the Future ....................................5-59 5.8. Management Accounting is not Ruled by Laws.........................................5-59 5.9. Management Accounting is Based on Costs ..............................................5-60 5.10. Management Accounting is more in the Details........................................5-60 5.11. Management Accounting Allocates Costs to Cost Objects......................5-60 5.12. Management Accounting Applies for Periods Less than a Year .............5-61 5.13. Management Accounting Monitors Deviations .........................................5-61 5.14. Management Accounting Reports ...............................................................5-61 <?page no="8"?> Berkau: Management Accounting 7e 1-8 5.15. Summary ......................................................................................................... 5-62 5.16. Working Definitions...................................................................................... 5-62 5.17. Question Bank ............................................................................................... 5-62 5.18. Solutions ......................................................................................................... 5-63 6. Cost Planning / Business Plan............................................................. 6-65 6.1. What is in the Chapter? ................................................................................. 6-65 6.2. Learning Objectives....................................................................................... 6-65 6.3. Business Plan.................................................................................................. 6-65 6.4. C/ S KIRSTENBOSCH (Pty) Ltd............................................................... 6-66 6.5. Revenue Plan - C/ S KIRSTENBOSCH (Pty) Ltd................................... 6-67 6.6. Cost Plan - C/ S KIRSTENBOSCH (Pty) Ltd. ........................................ 6-67 6.7. Profit Plan - C/ S KIRSTENBOSCH (Pty) Ltd. ...................................... 6-68 6.8. Liquidity Plan - C/ S KIRSTENBOSCH (Pty) Ltd. ................................. 6.69 6.9. Budgeted Balance Sheet - C/ S KIRSTENBOSCH (Pty) Ltd................. 6-71 6.10. Cash Flow Statement - C/ S KIRSTENBOSCH (Pty) Ltd. .................... 6.72 6.11. C/ S BANTRY Ltd. ....................................................................................... 6.74 6.12. Revenue Plan - BANTRY Ltd. ................................................................... 6-77 6.13. Cost Plan - C/ S BANTRY Ltd................................................................... 6.77 6.14. Profit Plan - C/ S BANTRY Ltd................................................................. 6-79 6.15. Liquidity Plan - C/ S BANTRY Ltd. .......................................................... 6.81 6.16. Balance Sheet - C/ S BANTRY Ltd............................................................ 6-82 6.17. C/ S McTOY GmbH..................................................................................... 6-84 6.18. C/ S Schluchman ............................................................................................ 6-84 6.19. Summary ......................................................................................................... 6-84 6.20. Working Definitions...................................................................................... 6-85 6.21. Question Bank ............................................................................................... 6-85 6.22. Solutions ......................................................................................................... 6-86 7. Investment Decisions ........................................................................... 7-87 7.1. What is in the Chapter? ................................................................................. 7-87 7.2. Learning Objectives....................................................................................... 7-87 7.3. Investment Appraisal - Basic Approaches................................................. 7-87 <?page no="9"?> Berkau: Management Accounting 7e 1-9 7.4. Payback method .............................................................................................7-87 7.5. C/ S HOPEFIELD (Pty) Ltd. ......................................................................7-88 7.6. Additional Investments - Capital Structure Decisions .............................7-88 7.7. C/ S MESUM GmbH ....................................................................................7-90 7.8. Capital Budget Table CBT ............................................................................7-90 7.9. C/ S WALLINGFORD Ltd. - 1..................................................................7-91 7.10. Extended Capital Budget Table eCBT ........................................................7-91 7.11. C/ S WALLINGFORD Ltd. - 2...................................................................7-92 7.12. Decisions between Investments...................................................................7-92 7.13. C/ S WALLINGFORD Ltd. - 3...................................................................7-92 7.14. Present Value Calculation .............................................................................7-94 7.15. Present Value for Annuities..........................................................................7-94 7.16. C/ S WALLINGFORD Ltd. - 4...................................................................7-95 7.17. Yields from Investments ...............................................................................7-96 7.18. Internal Rate of Return .................................................................................7-96 7.19. C/ S WALLINGFORD Ltd. - 5...................................................................7-97 7.20. Investment Programme Decisions ..............................................................7-97 7.21. C/ S GATESVILLE AG. ..............................................................................7-98 7.22. Ongoing Investments ....................................................................................7-98 7.23. C/ S KORINGBERG (Pty) Ltd...................................................................7-99 7.24. Summary .........................................................................................................7-99 7.25. Working Definitions ................................................................................... 7-100 7.26. Question Bank............................................................................................. 7-100 7.27. Solutions....................................................................................................... 7-101 8. Cost Volume Profit Analysis (CVP-Analysis)..................................... 8-102 8.1. What is in the Chapter? .............................................................................. 8-102 8.2. Learning Objectives .................................................................................... 8-102 8.3. Basics of Cost-Volume-Profit Analysis .................................................... 8-102 8.4. C/ S Ameer - GRAB Driver...................................................................... 8-102 8.5. Benefit from CVP-Analysis ....................................................................... 8-103 8.6. C/ S DEERFIELD TOURS (Pty) Ltd. .................................................... 8-104 8.7. CVP-Analysis for Changing Business Model .......................................... 8-106 <?page no="10"?> Berkau: Management Accounting 7e 1-10 8.8. Online-Shop for DEERFIELD TOURS (Pty) Ltd. ............................... 8-106 8.9. Bungee Jumping - DEERFIELD TOURS (Pty) Ltd............................. 8-107 8.10. Revenue Calculation - DEERFIELD TOUR (Pty) Ltd. ....................... 8-108 8.11. What-if-Analysis .......................................................................................... 8-109 8.12. Statistics - DEERFIELD TOURS (Pty) Ltd. ......................................... 8-109 8.13. Multiple-Product CVP-Analysis ................................................................ 8-112 8.14. 2-Tour-Case - DEERFIELD TOURS (Pty) Ltd.................................... 8-113 8.15. Summary ....................................................................................................... 8-115 8.16. Working Definitions.................................................................................... 8-115 8.17. Question Bank ............................................................................................. 8-115 8.18. Solutions ....................................................................................................... 8-116 9. Degree of Operating Leverage (DOL) ................................................9-117 9.1. What is in the Chapter? ............................................................................... 9-117 9.2. Learning Objectives..................................................................................... 9-117 9.3. Profit and Output Relationship ................................................................. 9-117 9.4. C/ S DEERFIELD TOURS (Pty) Ltd...................................................... 9-118 9.5. DOL-Declining Effect................................................................................ 9-120 9.6. Fixed Costs Effect ....................................................................................... 9-120 9.7. C/ S EMS KAYAK GmbH........................................................................ 9-121 9.8. 3 Break-Even Points - EMS KAYAK GmbH........................................ 9-122 9.9. DOL-Studies - EMS KAYAK GmbH .................................................... 9-126 9.10. Fixed Cost Effect - EMS KAYAK GmbH............................................. 9-127 9.11. DOL for Cash Flows .................................................................................. 9-131 9.12. Summary ....................................................................................................... 9-131 9.13. Working Definitions.................................................................................... 9-131 9.14. Question Bank: ............................................................................................ 9-131 9.15. Solutions ....................................................................................................... 9-132 10. Performance Measurement............................................................. 10-133 10.1. What is in the Chapter? .............................................................................10-133 10.2. Learning Objectives...................................................................................10-133 10.3. What is Performance? ............................................................................... 10-133 <?page no="11"?> Berkau: Management Accounting 7e 1-11 10.4. C/ S VANHUIZEN BV........................................................................... 10-134 10.5. Short-run (Variable) Contribution Margin............................................. 10-136 10.6. Controllable Contribution Margin .......................................................... 10-136 10.7. Divisional Contribution Margin .............................................................. 10-137 10.8. Divisional Net Profit ................................................................................ 10-137 10.9. Return on Investment .............................................................................. 10-138 10.10. Return on Equity ................................................................................... 10-140 10.11. Residual Income .................................................................................... 10-141 10.12. Economic Value Added (EVA™) ...................................................... 10-141 10.13. Summary ................................................................................................. 10-143 10.14. Working Definitions ............................................................................. 10-143 10.15. Question Bank ....................................................................................... 10-143 10.16. Solutions ................................................................................................. 10-144 11. Accounting for Mergers and Acquisitions ..................................... 11-145 11.1. What is in the Chapter? ............................................................................ 11-145 11.2. Learning Objectives .................................................................................. 11-145 11.3. M&A - Overview ...................................................................................... 11-145 11.4. General Description of OHIO FRIED CHICKEN ........................... 11-145 11.5. Business Valuation .................................................................................... 11-146 11.6. Investment Appraisal................................................................................ 11-148 11.7. Financial Statements ................................................................................. 11-150 11.8. Private Purchase (4-1)............................................................................... 11-150 11.9. Acquisition by another Company (4-2) .................................................. 11-152 11.10. Merger (4-3)............................................................................................ 11-160 11.11. Financial Statement Analysis................................................................ 11-163 11.12. Risk Analysis .......................................................................................... 11-165 11.13. Summary ................................................................................................. 11-167 11.14. Working Definitions ............................................................................. 11-168 11.15. Question Bank ....................................................................................... 11-168 11.16. Solutions ................................................................................................. 11-169 <?page no="12"?> Berkau: Management Accounting 7e 1-12 12. Risk Valuation................................................................................. 12-170 12.1. What is in the Chapter? .............................................................................12-170 12.2. Leaning Objectives .................................................................................... 12-170 12.3. Bankruptcy due to Over-Indebtedness...................................................12-170 12.4. C/ S ROCKS PLC .....................................................................................12-170 12.5. Bankruptcy due to Illiquidity....................................................................12-172 12.6. Risks ............................................................................................................ 12-173 12.7. Risk Management ......................................................................................12-173 12.8. Multiple Risk Taking .................................................................................12-174 12.9. C/ S WEATHERMAN .............................................................................12-174 12.10. Simulation of Multiple Risks.................................................................12-176 12.11. C/ S NAMGURO Ltd. ..........................................................................12-177 12.12. Normal Distributions ............................................................................12-179 12.13. Bankruptcy Probability .......................................................................... 12-180 12.14. C/ S OHIO FRIED CHICKEN (Pty) Ltd. ........................................12-180 12.15. Summary.................................................................................................. 12-184 12.16. Working Definitions .............................................................................. 12-184 12.17. Question Bank........................................................................................12-184 12.18. Solutions..................................................................................................12-185 13. Full Cost Accounting Systems ........................................................ 13-187 13.1. What is in the Chapter? .............................................................................13-187 13.2. Learning Objectives...................................................................................13-187 13.3. Cost Concepts ............................................................................................ 13-187 13.4. Direct vs. Indirect Costs ........................................................................... 13-187 13.5. Manufacturing vs. non-Manufacturing Costs ........................................13-188 13.6. Product vs. Period Costs ..........................................................................13-188 13.7. C/ S STAFFORD (Pty) Ltd......................................................................13-189 13.8. Differential/ Sunk/ Opportunity Costs ...................................................13-194 13.9. Components of Cost Accounting Systems............................................. 13-195 13.10. Cost Category Accounting ....................................................................13-197 13.11. Cost Centre Accounting........................................................................13-197 13.12. Calculation ..............................................................................................13-198 <?page no="13"?> Berkau: Management Accounting 7e 1-13 13.13. Profitability Analysis.............................................................................. 13-198 13.14. C/ S GIULIO’s PIZZA&PASTA RISTORANTE........................... 13-199 13.15. Cost Category Accounting - C/ S........................................................ 13-202 13.16. Calculation - C/ S .................................................................................. 13-203 13.17. Cost Centre Accounting - C/ S............................................................ 13-204 13.18. Calculation - C/ S .................................................................................. 13-207 13.19. Profitability Analysis - C/ S.................................................................. 13-212 13.20. Summary ................................................................................................. 13-214 13.21. Working Definitions ............................................................................. 13-214 13.22. Question Bank ....................................................................................... 13-215 13.23. Solutions ................................................................................................. 13-216 14. Flexible Budgeting / Standard Costing ......................................... 14-217 14.1. What is in the Chapter? ............................................................................ 14-217 14.2. Learning Objectives .................................................................................. 14-217 14.3. Variable vs. Fixed Costs ........................................................................... 14-217 14.4. Cost Accounting Systems ........................................................................ 14-218 14.5. Standard Costing ....................................................................................... 14-218 14.6. Cost Separation ......................................................................................... 14-219 14.7. C/ S DANNING (Pty) Ltd. ..................................................................... 14-219 14.8. High-low Method - DANNING (Pty) Ltd........................................... 14-220 14.9. Scatter Graph - DANNING (Pty) Ltd.................................................. 14-220 14.10. Regression Method - DANNING (Pty) Ltd..................................... 14-221 14.11. Partial Cost Accounting Systems......................................................... 14-223 14.12. Allocation Principles ............................................................................. 14-223 14.13. C/ S GIULIO’s PIZZA&PASTA RISTORANTE........................... 14-224 14.14. Storing Goods that Include Fixed Costs ............................................ 14-230 14.15. C/ S LOGA (Pty) Ltd............................................................................ 14-231 14.16. Summary ................................................................................................. 14-234 14.17. Working Definitions ............................................................................. 14-234 14.18. Question Bank ....................................................................................... 14-234 14.19. Solutions ................................................................................................. 14-235 <?page no="14"?> Berkau: Management Accounting 7e 1-14 15. Cost Monitoring ..............................................................................15-236 15.1. What is in the Chapter? .............................................................................15-236 15.2. Learning Objectives...................................................................................15-236 15.3. Cost Deviations ......................................................................................... 15-236 15.4. C/ S CROXTON Ltd. ............................................................................... 15-236 15.5. Actual Volume Equals Budgeted Volume: April 20X6 ........................15-237 15.6. Actual Volume is below Budgeted Volume: May 20X6 ....................... 15-238 15.7. Actual Volume Exceeding Budgeted Volume: June 20X6...................15-240 15.8. Summary ..................................................................................................... 15-241 15.9. Working Definitions.................................................................................. 15-242 15.10. Question Bank........................................................................................15-242 15.11. Solutions..................................................................................................15-242 16. Cost Allocations ..............................................................................16-243 16.1. What is in the Chapter? .............................................................................16-243 16.2. Learning Objectives...................................................................................16-243 16.3. Cost Allocations......................................................................................... 16-243 16.4. The 1 st Allocation ......................................................................................16-243 16.5. The 2 nd Allocation......................................................................................16-243 16.6. The 3 rd Allocation ......................................................................................16-243 16.7. C/ S CLYDBANK Ltd.............................................................................. 16-244 16.8. The 1 st Allocation - C/ S...........................................................................16-245 16.9. The 3 rd Allocation - C/ S .......................................................................... 16-250 16.10. Technical Terms for Cost Allocations................................................. 16-251 16.11. Equation Method (1) .............................................................................16-252 16.12. C/ S TUSCAN (Pty) Ltd........................................................................ 16-252 16.13. C/ S HEISFELD Ltd. ............................................................................16-253 16.14. Iteration Method (2) ..............................................................................16-257 16.15. Summary.................................................................................................. 16-258 16.16. Working Definitions .............................................................................. 16-258 16.17. Question Bank........................................................................................16-259 16.18. Solutions..................................................................................................16-259 <?page no="15"?> Berkau: Management Accounting 7e 1-15 17. Reporting.........................................................................................17-260 17.1. What is in the Chapter? ............................................................................ 17-260 17.2. Learning Objectives .................................................................................. 17-260 17.3. Providing Information as an Accounting Task ..................................... 17-260 17.4. C/ S LEBUHRAYA Ltd........................................................................... 17-260 17.5. Calculation of Materials (1)...................................................................... 17-266 17.6. Calculation of Labour (2) ......................................................................... 17-266 17.7. Application of Overheads (3) .................................................................. 17-266 17.8. Adjustments (4) ......................................................................................... 17-266 17.9. COS-Report ............................................................................................... 17-266 17.10. Business Graphics ................................................................................. 17-267 17.11. Summary ................................................................................................. 17-268 17.12. Question Bank ....................................................................................... 17-268 17.13. Solutions ................................................................................................. 17-269 18. Job Order Costing (Manufacturing Accounting)...........................18-270 18.1. What is in the Chapter? ............................................................................ 18-270 18.2. Learning Objectives .................................................................................. 18-270 18.3. Calculations................................................................................................ 18-270 18.4. C/ S MAHKOTA (Pty) Ltd. .................................................................... 18-272 18.5. C/ S WEIXDORF Ltd. ............................................................................ 18-279 18.6. Summary .................................................................................................... 18-280 18.7. Working Definitions ................................................................................. 18-280 18.8. Question Bank........................................................................................... 18-280 18.9. Solutions..................................................................................................... 18-281 19. Process Costing (Manufacturing Accounting) ..............................19-282 19.1. What is in the Chapter? ............................................................................ 19-282 19.2. Learning Objectives .................................................................................. 19-282 19.3. Principle of Process Costing.................................................................... 19-282 19.4. C/ S EDEWECHT (Pty) Ltd................................................................... 19-284 19.5. Uncompleted Production Steps .............................................................. 19-288 19.6. Equivalent Units Calculation ................................................................... 19-288 <?page no="16"?> Berkau: Management Accounting 7e 1-16 19.7. Profit Calculation - C/ S ...........................................................................19-289 19.8. Summary ..................................................................................................... 19-291 19.9. Working Definition ................................................................................... 19-291 19.10. Question Bank........................................................................................19-291 19.11. Solutions..................................................................................................19-292 20. Contribution Margin Accounting.................................................. 20-293 20.1. What is in the Chapter? .............................................................................20-293 20.2. Learning Objectives...................................................................................20-293 20.3. The Structure of a Profitability Analysis System ...................................20-293 20.4. C/ S FLINDERS Ltd. ............................................................................... 20-294 20.5. Summary ..................................................................................................... 20-297 20.6. Question Bank ...........................................................................................20-297 20.7. Solutions .....................................................................................................20-298 21. Activity Based Costing and Target Costing...................................21-299 21.1. What is in the Chapter? .............................................................................21-299 21.2. Learning Objectives...................................................................................21-299 21.3. Background for ABC ................................................................................21-300 21.4. How does ABC Work? .............................................................................21-300 21.5. Activity Costs for a Professor .................................................................. 21-301 21.6. Business Process Calculation ...................................................................21-301 21.7. Case Study TORQUAY Ltd. ................................................................... 21-302 21.8. Traditional Cost-Accounting System - C/ S ..........................................21-303 21.9. Activity Based Costing (partial) - C/ S.................................................... 21-304 21.10. Activity-based Management.................................................................. 21-306 21.11. Target Costing ........................................................................................21-307 21.12. Design of a Business Class Service - C/ S ..........................................21-307 21.13. Summary.................................................................................................. 21-309 21.14. Working Definitions .............................................................................. 21-309 21.15. Question Bank........................................................................................21-310 21.16. Solutions..................................................................................................21-310 <?page no="17"?> Berkau: Management Accounting 7e 1-17 22. Abbreviations ..................................................................................22-311 23. Table of Figures ..............................................................................23-316 24. List of Links ................................................................................... 24-320 25. Literature .........................................................................................25-321 <?page no="18"?> Introduction to the 7 th Edition This 7 th edition of the textbook Management Accounting has been revised based on teaching experience with master students holding a bachelor’s in Engineering. We adjusted the contents for those of our readers who are not yet familiar with Bookkeeping and Financial Accounting. This way, you now can study Management Accounting from scratch on. The chapter (7) about methods in investment appraisal is new. Managers and engineers should understand how investments are evaluated and which criteria apply to compose investment programmes. We added target costing to the contents in chapter (21). For the 7 th edition, we further outsourced some aspects and calculations to the online materials which are available through QR-codes in the book. Managerial Accounting is a textbook for the bachelor’s and for the master’s degree level. It comes together with our textbooks ‘Berkau: Basics of Accounting’ for Bookkeeping and ‘Berkau: Financial Statements’ for IFRSs. For a ‘jump-start’ in Management Accounting we begin with a short and case-based presentation of Financial Accounting. We explain the basics of Bookkeeping and financial statement preparation by the case study PENOR PLC. This can be for you either a review of or an introduction to Financial Accounting. It also familiarises you with the formats of how we record business activities. The same case is discussed in the next following chapter from a Management Accounting perspective. Thus, we provide a practical overview of Managerial Accounting and can show in addition where it differs from Financial Accounting without discussing theory. Management Accounts support two fields of management, which we discuss from different angles in the major sections of this textbook: (1)Accounting for General Management. (2)Cost Accounting. We thank Dr. Jürgen Schechler from UVK Verlag in Munich for his valuable support and his motivational whatsapp messages. You can download online-study materials (exam tasks and exercises with detailed solutions and video links to our own video clips) from the link below: https: / / files.narr.digital/ 9783739831947/ cases.zip Enjoy your studies in Management Accounting! Cape Town, in July 2023 Prof. Dr. Carsten Berkau, Dipl.-Ing. Keabetswe Sylvia Berkau <?page no="19"?> Berkau: Management Accounting 7e 1-19 1. Conventions The conventions apply merely to simplify the case studies. These conventions are about legal forms, tax rates, formats etc. They apply for this textbook, for our Basics of Accounting, for our Financial Statements and for all online study materials. 1.1. Accounting Periods Accounting periods start on 1.01.20XX and end on 31.12.20XX. Furthermore, to keep the examples transferable to later years, we indicate decades by X, as in 20X4. X is followed by Y, then Z. 1.2. Accounting Technical Terms At the end of every chapter, we explain new technical terms. They help you to easily understand the content. These are simple explanations if you are beginners in Accounting. The Accounting technical terms are less formal and precise as the definitions provided by the IASB. 1.3. Account Names All account names are written with capital letters in the text, such as ‘Cash/ Bank account’. However, an account not subjected to our recordings is written in small letters. Assume there is a bank account with Deutsche Bank, and we refer thereto. The writing is with small letters: bank account. We do not make Bookkeeping entries therein, but Deutsche Bank AG does. However, the Cash/ Bank account applicable to calculate the item cash/ bank on the balance sheet is part of our Accounting work. 1.4. Alphabetic Order For all lists, we apply an alphabetic order. 1.5. Basics Our Basics refers to the textbook Berkau: Basics of Accounting. It introduces you to Bookkeeping and major Accounting concepts without consideration of International Accounting standards IFRSs. We frequently quote the Basics. 1.6. Bookkeeping Entries All Bookkeeping entries are printed in bold and cover a whole page’s width. 1.7. Bookkeeping Entry Format We write debit entries and credit entries. DR stands for debit recorded and CR for credit recorded. See, e.g., a Bookkeeping entry for the acquisition of a motor vehicle: DR Motor Vehicle................ 20,000.00 EUR DR VAT.......................... 4,000.00 EUR CR Cash/ Bank.................... 24,000.00 EUR <?page no="20"?> Berkau: Management Accounting 7e 1-20 The identifier for Bookkeeping entries in the text, like ‘Bookkeeping entry (1)’ can be found in the accounts as ‘(1)”, as well. 1.8. Calculations For calculations, we only show the units with the results. E.g., 10 + 20.50 = 30.50 EUR. Furthermore, the figures in calculations come without digits after the decimal point in case they equal zero. Results are printed in bold to find calculated figures easily. All calculations are exact to the EURcent or any other currency as 1/ 100amounts. 1.9. Case Studies We keep case studies in this textbook as easy as possible even as they might look unreal. Teaching Accounting is our priority. 1.10. Case Study Text We write case studies in a different text format than the normal text (Italic fonts). 1.11. Cash Flow Separation Interest payments in this textbook are always considered financing cash flows, even as IAS 7.33 allows their recognition as operating as well as financing cash flows. This applies for all case studies. 1.12. Companies For the textbook, the legal form of companies does not matter. Legal forms are not part of our Accounting syllabus. They are covered by our Basics. We only assure that companies prepare financial statements. This is the attitude of the IASB, too. In contrast to IFRSs, we do not refer to companies as ‘entities”. Once you read the expression entity in the standards, remember they are referring to companies. We apply the technical terms ‘business”, ‘firm” and ‘company”. Most companies are limited companies in this textbook, like GmbH, AG, Pty Ltd., PLC, Inc. etc. 1.13. Cost-Expense-Congruence By default, costs are expenses and vice versa. No imputed cost apply by default. 1.14. Country All cases take place in countries where IFRSs apply for single entity financial statements. For our teaching in Cape Town, many examples refer to South African companies. 1.15. Currency Unit For all examples, the reporting currency is based on the country of the case study. We use the common 3 letter codes for abbreviation, like ZAR for South African Rand or GBP for British Pound Sterling. 1.16. Data Format in Tables In tables, negative figures are shown in brackets. E.g., (7.50) equals -7.50 EUR. <?page no="21"?> Berkau: Management Accounting 7e 1-21 1.17. Data Sheets WWe show the most important data for case studies in their data sheets. 1.18. Prepayments of Income Taxes No provisional tax payments are made to the national revenue service in our case studies. Taxes are calculated at the yearend and added to short-term liabilities, mostly to the Income Tax Liabilities account. For German companies, § 249 HGB applies, and income taxes are shown as provisions. 1.19. How it is Done (1) You find How-it-is Done sections in this textbook. (2) They offer you very short and clear instructions for your Accounting work. 1.20. Income Taxes For our textbooks and the IFRSs, a simplified income tax model applies. Income taxes amount to 30 % of the pre-tax profit EBT. 1.21. Financial Statements for Taxation We do not cover tax calculations. Tax statements are relevant for us to determine income taxes (simplified calculation) and deferred taxes. 1.22. Names We name companies and mark them with capital letters. E.g., SCHULZE- BRAMMELKAMP Ltd. No links to actual existing persons or companies are intended. The names work as identifiers. 1.23. Language This textbook is written in South African English. 1.24. Learning Objectives Every chapter starts with the learning objectives and ends with a summary. We also give you a short overview in our What is in the Chapter? -paragraphs. 1.25. Legal Forms of a Business For this textbook, we use Ltd., (Pty) Ltd., Sdn. Bhd., Bhd., AG, GmbH, UG, PLC, Inc. etc. If no legal form has been mentioned, assume the company is in private ownership, such as SANDPIPER BOOKS for a privatelyowned bookstore. 1.26. Length of a Month/ Year 1 month = 21.5 days = 4.3 weeks. 1 year = 12 evenly long months = 365 days = 52 weeks. 1.27. Level of Precision We work exact to 2 digits after the decimal point. Results from workings are rounded, too. We calculate sometimes in MS-Excel; hence, calculations in the background are more precise than they appear. All financial statements show figures rounded to the nearest full currency unit. <?page no="22"?> Berkau: Management Accounting 7e 1-22 1.28. Links Links in the book direct you to further explanations and readings. 1.29. Literature The main source of preparing financial statements are the standards issued by the International Accounting Standard Board IASB. At the end of the textbook, we recommend further readings for you. 1.30. Non-existing Items In case something has not been mentioned it does not exist. E.g., if nothing has been said about a purchase on credit, it is on cash basis. 1.31. Online Materials The online materials are further considerations and exam tasks with solutions. Their names refer to the chapter and contain a counting figure, like Task_C6.17-REINIKENSTAD, which is linked to Management Accounting (C), chapter 6 and is the 16 th exam task. As higher the task count as newer the task is. 1.32. Payment Terms In this textbook, payments/ receipts for taxation and for dividends are made in the next following Accounting period. Per default, all cash flows are accounted on a cash/ bank basis. 1.33. Presentation of Accounts Accounts are displayed in the T-format. They have a 3-letter indicator column used for Bookkeeping entry identification or contra-entry references. Nominal accounts show the Accounting periods as a suffix, such as Depreciation-20X4. See the accounts for the car acquisition’s Bookkeeping entry: D C D C (1) 20,000.00 (1) 4,000.00 D C (1) 24,000.00 Cash/ Bank C/ B Property, plant, equipment PPE Value added tax VAT Figure 1.1: Accounts 1.34. Pro-Rated Depreciation/ Interest Calculations Although given as annual rates, depreciation and interest are calculated proportionally accurate to the full month. Monthly depreciation is calculated as annual depreciation divided by 12. In case a company owns an asset for a shorter period than a full year, a month will count for depreciation recognition if the asset is owned for the major duration thereof. Interest rates are given per annum (/ a) and compounded annually (no compounded interest calculation within a year). For loans taken out for shorter <?page no="23"?> Berkau: Management Accounting 7e 1-23 periods than a full year, interest is calculated per rate accurate to the month. For a bank loan of 100,000.00 EUR taken out on 9.06.20X4 with an annual rate of interest of 10 %/ a, the interest paid at the end of the year is: 7 × 100,000 × 10%/ 12 = 5,833.33 EUR. If dates are not at the beginning or end of the Accounting period, the month is underlined to direct your attention thereto, as in 11.06.20X4. By default, pay-off payments are made at the end of the Accounting period. Interest is only calculated for debts, such as bank loans, bonds etc. Overdrafts of bank account are ignored. An exception is chapter (37) in our Basics. 1.35. Quotation of Law Texts/ Standards Law texts/ standards are quoted like ‘§ 266 HGB’ or ‘IAS 1.68’. We use the original law names. Note, that IFRS paragraphs can be subjected to changes. 1.36. Sequence of Bookkeeping Entries The sequence of Bookkeeping entries comes along the logical process defined by the text. Bookkeeping identifiers, like ‘(1), (2), (3) …’ do not indicate nor prescribe a sequence of recording. 1.37. Tax on Capital Returns (Dividend Tax) The tax on capital returns is an income tax. The rate on capital returns is 25 % based on the capital gain for this textbook. Note, the tax on capital returns is no company tax, although it is owed by the company. It is a withholding tax in most countries levied from persons. 1.38. Transaction Costs We ignore transaction costs, like costs for selling goods/ services, taking and paying-off bank loans, issuing shares or bonds etc. 1.39. Value Added Tax, Goods and Service Tax VAT stands for value added tax and GST for Goods and Service Tax. Except in, e.g. United Arabic Emirates or some U.S. states like Delaware, Alaska etc., all consumers must pay VAT when buying goods or services. In some countries it is called a sales tax. In this textbook, we apply one single VAT account for input-VAT and output-VAT. The VAT rate in our textbooks is 20 %. We ignore reduced VAT rates as they apply in many countries for food, books etc. 1.40. VAT Reduction It is assumed that every company discussed in this textbook is acting as a VAT vendor. This means all companies are registered for VAT reduction. They prepare VAT refund statements and receive the paid input-VAT in the next following Accounting period. They also collect output-VAT from their customers. 1.41. Working Definitions At the end of every chapter, you find short and easily understandable definitions for new Accounting terms. They are merely a glossary and should support your understanding. For enforceable and more precise definitions study IFRSs! <?page no="24"?> Berkau: Management Accounting 7e 1-24 1.42. Work-in-Process Account We apply the Work-in-Process account as reconciliation account for all job orders and call it Work-in-Process WIP. We also apply a Work-in-Process account for single job orders but then add the job order ID thereto, like ‘Work-in-Process 4711” for job order 4711. 1.43. Writing Management Terms We write academic disciplines, like Accounting, Marketing, Management etc., with capital letters. 1.44. WWW We provide you with a lot of exercises and further materials. Pls., check the website mentioned in the introduction for access. Most of the exercises are our exam tasks from Hochschule Osnabrück or its partner universities, in South Africa, China, South Korea and Malaysia. 1.45. YouTube Videos On our YouTube channel (Carsten Berkau) we publish video materials which are based on the case studies on this textbook. Find their links on Twitter and on the UVK website. 1.46. 10-20-30 Rule In this textbook, the 10-20-30 rule applies. If not mentioned otherwise, the interest rate is 10 %/ a, the VAT rate is 20 % and the total income tax rate is 30 %/ a. <?page no="25"?> Berkau: Management Accounting 7e 2-25 2. Introduction to Managerial Accounting 2.1. Purpose of a Management Accounting System Managerial Accounting is Accounting for managers. Therefore, the design of Management Accounting systems mainly depends on the managers’ information requirements. In contrast to Financial Accounting, Management Accounting is not regulated by laws. Instead, it is based on production and cost theory. We divide this book in two major parts, Management Accounting for general management and cost Accounting starting with Accounting for general management. General management aims to the whole company. E.g., Management Accounting calculates and reports a return figure based on a company’s profit as percentage of its input of capital. Cost Accounting is about the calculation of products and the profit. It contains internal cost allocations, cost monitoring and management of fixed cost. The information managers need for controlling the business cannot be taken from financial statements. Only very few small businesses can be controlled by Financial Accounting data, but most companies install a Management Accounting system which supports managers with setting objectives, planning future activities, monitoring actual activities and calculating profitability and cash flows on a short-term (monthly) basis. Information in Management Accounting is allocated to periods shorter than 1 year to keep the response time low. Management Accounting works on a more detailed level. Therefore, companies are divided in small units, e.g., cost centres, which are controlled separately. In general, companies have hundreds of cost centres which are all subjected to budgeting and monitoring. Management Accountants operate as counsellors for managers. In an organisational chart, the chief financial officer CFO is the head of Accounting with responsibility for Financial Accounting (Bookkeeping, preparation of commercial and financial statements for tax purposes) and Management Accounting (maintenance of Accounting records, the planning (Budgeting) and monitoring of activities/ products, investment appraisal and reporting. Accountants take custody of the company’s funds and plan liquidity (Finance), too. Management Accounting must provide managers with true and relevant data which enables them to make good economic decisions for the company. We cover the below described chapters, allocated to three sections in the book: Section (1): Management Accounting and Financial Accounting. Section (2): Management Accounting for general management. Section (3): Cost Accounting. <?page no="26"?> Berkau: Management Accounting 7e 2-26 2.2. Management Accounting and Financial Accounting (Introduction) In the first section, we use the case study PENOR PLC for you to understand Financial Accounting. We demonstrate the differences between Management Accounting and Financial Accounting. Chapter (3) discusses how financial statements are prepared for the manufacturer PENOR PLC in compliance with IFRSs (International Financial Reporting Standards). The company is based in the UK and reports in British Pound Sterling GBP. In chapter (4), the same case study PENOR PLC introduces you to Management Accounting, such as cost planning, product calculation (job order costing), business plan preparation and reporting. After the case study, chapter (5) summarizes the characteristics of Management Accounting and points out the major differences to Financial Accounting. 2.3. Management Accounting for General Management In chapter (6), a business plan as already introduced for PENOR PLC is covered in more detail. Different cases from Hospitality Management and Industrial Management are discussed. After approval, the business plan is referred to as the (master) budget. It shows detailed plans for all departments. Chapter (6) covers business plans based on a full cost Accounting system. A full cost Accounting system considers all costs no matter whether they depend on the output or not. Output is known as what a company produces, which is its number of goods/ services. In contrast, partial cost Accounting systems do not refer to fixed costs and require fixed cost management as covered at the end of the textbook as either contribution margin Accounting or activity based costing. Chapter (7) introduces you to investment appraisal. The key measures as payback method, Accounting returns and present value concept are discussed. Long-term decisions in Accounting are based on those methods. The cost-volume-profit analysis is introduced in chapter (8). It determines the break-even-point which is the output of products the company earns a zero profit with. Passing through that performance threshold, a company earns profit. Then revenue exceeds costs. The chapter shows how a whatif analysis works to facilitate output volume and product mix decisions and how to calculate profitability if adjustments have been made to the business model. In chapter (9), we cover the degree of operational leverage (DOL) which tells managers how much the profit or cash flow increase in response to increasing outputs and/ or revenues. The chapter (10) describes methods of performance measurement. Major performance ratios are explained and demonstrated for the case study VANHUIZEN BV. This is discussed from a management/ reporting point of view. The next following chapters are linked to mergers and acquisitions. A merger applies if 2 or more companies are combined. An acquisition is the purchase of another company for holding. In chapter (11) we present Accounting <?page no="27"?> Berkau: Management Accounting 7e 2-27 due diligence work undertaken for company valuations in preparation for take-overs and/ or mergers. In chapter (12), we study risk valuation based on MonteCarloSimulation. The technical term value at risk (VaR) is introduced as well as the calculation of failure probabilities for companies. The latter one indicates how likely bankruptcy is for the business. 2.4. Cost Accounting Cost Accounting is mostly about methods of cost allocations within a company. The chapter is placed behind the Management Accounting for general management section to refer to the Accounting principles covered already then. In chapter (13), we introduce the structure of a cost Accounting system and show the features of its components, such as cost separation, cost centre Accounting, calculation and profitability analysis. We discuss the cost flow through a Management Accounting system. By the case study GIULIO’s PIZZA&PASTA RISTORANTE we explain each step in cost Accounting. The chapter (14) demonstrates the difference between full cost Accounting systems and flexible budgeting. For the purpose of comparison, we apply the same case study about the Italian restaurant. We cover monitoring in chapter (15) and show how to calculate and read cost deviations in order to detect their reasons. The chapter is based on standard costing. Chapter (16) is about cost allocations between cost centres. When departments exchange services, cost allocations are used for refunding the renderer and charge the recipient. In chapter (17), we introduce reporting in Industrial Management context and discuss the cost of sales report for a production firm. We show how to setup reports and discuss managers’ requirements to the format. Manufacturing Accounting is calculation and business profitability analysis for Industrial Management. It was shown by the PENOR PLC case study already and is subjected to the chapters (18) and (19) in more detail, which are linked to the job order costing for calculating batch costs - chapter (18), and process costing - chapter (19). In chapter (20), we study contribution margin Accounting for fixed cost management. The chapter (21) is about activity based costing (ABC). We’ll show the differences between a traditional cost Accounting system and ABC by an example from aviation. The upcoming chapters in this textbook are as follows: <?page no="28"?> Berkau: Management Accounting 7e 2-28 ( 0) Introduction. ( 1) Conventions. Section (1): Management Accounting and Financial Accounting ( 2) Introduction to Management Accounting. ( 3) Case Study PENOR PLC - Financial Accounting. ( 4) Case Study PENOR PLC - Managerial Accounting. ( 5) Characteristics of Management Accounting and Major Differences to Financial Accounting. Section (2): Accounting for General Management ( 6) Cost Planning / Business Plan. ( 7) Investment Appraisal. ( 8) Cost Volume Profit Analysis (CVP-Analysis). ( 9) Degree of Operating Leverage (DOL). (10) Performance Measurement. (11) Accounting for Mergers and Acquisitions. (12) Risk Valuation. Section (3): Cost Accounting (13) Full Cost Accounting Systems. (14) Flexible Budgeting / Standard Costing. (15) Cost Monitoring. (16) Cost Allocations. (17) Reporting. (18) Job Order Costing (Manufacturing Accounting). (19) Process Costing (Manufacturing Accounting). (20) Contribution Margin Accounting. (21) Activity Based Costing. <?page no="29"?> Berkau: Management Accounting 7e 2-29 Section (1): Management Accounting and Financial Accounting <?page no="30"?> Berkau: Management Accounting 7e 3-30 3. Case Study PENOR PLC - Financial Accounting 3.1. What is in the Chapter? In this chapter (3), we discuss a case study about a manufacturer for aluminium windows and doors in the UK. The chapter focusses on Financial Accounting. All financial statements are prepared in compliance with IFRSs. For this case study, we deliberately discuss aspects specific for Financial Accounting, e.g. changes in purchase prices, special payment terms and prepaid expenses. We also cover the disclosure of liabilities under IAS 1 and IFRS 9. The case study PENOR PLC repeats Financial Accounting and demonstrates how to prepare a full set of financial statements following IAS 1.10 that comprises a statement of financial position, a statement of comprehensive income, a statement of changes in equity and a statement of cash flows. 3.2. Leaning Objectives We show how companies prepare financial statements and what information can be derived therefrom for management. In real businesses, financial statements are available already and we can derive actual Managerial Accounting data from the Bookkeeping records. For budgeting we must plan and approve standard costs. 1 As the case-study-chapters (3) and (4) are much in the details, we recommend them for self-study. Best you do all calculations on your own by using a calculator or MS-Excel. After studying this chapter, you learned/ repeated Financial Accounting and you understand how its information can support controlling the business. You also achieved a good awareness of the differences between Financial Accounting and Management Accounting. 1 We start-off from Financial Accounting. Financial Accounting is required by national law and requires a company to report to its owners and to other parties about its financial position, profit and cash flows. All traders and all companies in the legal form of a limited company must prepare financial statements. 3.3. C/ S PENOR PLC We cover the case of PENOR PLC beginning with its establishment and discuss its activities during the first Accounting period. 2 The activities comprises the establishment of the business, its financing, all operations and the appropriation of profits. 3 As an overview of PENOR PLC’s activities, you’ll find below a data sheet. Data Sheet for PENOR PLC CClassification: Manufacturing; Issued capital: 400,000.00 GBP; Bank loan: 200,000.00 GBP; bank loan issue fees: 1,500.00 GBP, nominal rate of 2 In case you know how to prepare financial statements, skip the next pages and move to the financial statements. 3 For PENOR PLC, additional video material is provided on the website of UVK (www.uvk.de). <?page no="31"?> Berkau: Management Accounting 7e 3-31 iinterest: 3 %/ a, pay-off: 20,000.00 GBP/ a; effective interest method applies; Saws’ cost of acquisition: 5 × 30,000 GBP, Useful life: 5 years; Rent for factory building: 7,500.00 GBP/ m; Material prices: see exhibit Labour: 2,000,000.00 GBP/ a; Production: 5,000 windows/ a; 1,000 doors/ a; Sales in 20X1: 4,678 windows; 873 doors; Net selling prices: 800.00 GBP/ window; 1,500.00 GBP/ door; VAT rate: 20%. In this chapter and the next following one, we cover three aspects about PENOR PLC: (A) Inception. (B) Financial Accounting. (C) Management Accounting. 3.4. Inception (A) PENOR PLC is a privately-owned limited company that manufactures aluminium windows and doors in York, UK. PENOR PLC applies IFRSs for single-entity 4 financial statements because it is based in Great Britain. Limited companies are economically held responsible only to the extent of their equity. The equity contains the owners’ contribution at the time of establishment, which we call the issued capital. In the following Accounting periods, equity increases/ decreases by earnings from operations. Once a company’s equity becomes negative (due to losses) it must file for bankruptcy. PENOR PLC is in the legal form of a limited company to avoid that creditors can 4 Single entity financial statements are for one company. The opposite are group statements of consolidated statements for groups or joint ventures respectively. go after its owners’ personnel assets. This limits the risks for the owners. As creditors need to know about the company’s financial situation, all limited companies prepare financial statements. We discuss the financial statements at the time of incorporation. Thereafter we show the financial statements at the end of the first Accounting period 20X1. After the disclosure of the financial statements we discuss their preparation based on Bookkeeping. For the incorporation on 1.01.20X1, the 8 founding proprietors contribute 50,000.00 GBP/ p each. Hence, the issued capital is equal to: 50,000 × 8 = 400,000 GBP. All funds are paid into the company’s bank account. The memorandum of incorporation (MOI) 5 for PENOR PLC states that the owners’ equity is 400,000.00 GBP at the time of establishment. Each owner holds the same share in the company and receives an equal portion of its profit. The memorandum of incorporation is prepared by an attorney and submitted at the York courthouse for company registration. See below the opening balance sheet in Figure 3.1. The correct term for the balance sheet is statement of financial position. A balance sheet discloses all assets on the left hand side and all equity and liabilities on the right hand side. A reader of financial statements sees the assets of the company and the origin of the funds. If the funds come from the owners, we refer to them as equity. If financing is received from outside of the business, e.g. as a bank loan or as bonds, 5 In the US called ‘Articles’. <?page no="32"?> Berkau: Management Accounting 7e 3-32 the company must record a liability as it owes the bank to pay-off of the loan or the bondholders to redeem the bonds in the future. A C, L Non-current assets [GBP] Equity [GBP] P, P, E Share capital 400,000 Intangibles Reserves Financial assets Retained earnings Current assets Liabilities Inventory Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 400,000 Tax liabilities Total assets 400,000 Total equity and liab. 400,000 Penor PLC STATEMENT of FINANCIAL POSITION as at 1.01.20X1 Figure 3.1: PENOR PLC’s statement of financial position as at 1.01.20X1 Next, we explain how to prepare the opening balance sheet: Financial statements are prepared by recording all business activities in accounts. This is referred to as Bookkeeping. Bookkeeping entries are made in accounts. Real accounts are linked to the balance sheet and nominal ones to the income statement. Every account has a debit (left hand side) and a credit (right hand side) side. An entry made on the debit side is known as debit recorded (DR). Entries on the credit side are referred to as credit recorded (CR). In compliance with the double entry system, every Bookkeeping entry contains debit and credit entries to the same extent. That way, the balance sheet always disclose the same total on its debit as on its credit side. 6 All assets and their increases are recorded on the debit side of asset accounts, e.g. a cash receipt is a debit entry in the Cash/ Bank account: We write ‘DR Cash/ Bank’. All equity and all liabilities and their increases are recorded on the credit side of equity or liability accounts respectively. Therefore an issue of capital is a credit entry in the Issued Capital account: We write ‘CR Issued Capital account’. The Bookkeeping entry (1) for the establishment of PENOR PLC is shown below. DR Cash/ Bank.................... 400,000.00 GBP CR Issued Capital............... 400,000.00 GBP 6 Read for Bookkeeping our textbook Basics of Accounting. <?page no="33"?> Berkau: Management Accounting 7e 3-33 For incorporation, an opening balance sheet is part of the memorandum of incorporation. The opening balance sheet for PENOR PLC contains the company’s issued capital and shows that the proprietors paid their contributions in full (C/ B account 400,000.00 GBP). Therefore, PENOR PLC discloses one asset only: cash/ bank to the extent of 400,000.00 GBP. On a balance sheet, we do not disclose single items of assets, equity and liabilities but total values of groups thereof. E.g. a company that owns 3 cars, shows their total value under property, plant, equipment. 3.5. Financial Accounting (B) After the first Accounting period, PENOR PLC prepares and publishes (to court) a set of financial statements as below: A C, L Non-current assets [GBP] Equity [GBP] P, P, E 120,000 Share capital 400,000 Intangibles Reserves 34,844 Financial assets Retained earnings Current assets Liabilities Inventory 639,852 Interest bear liab 158,761 Accounts receivables 16,200 Accounts payables 1,544,380 Prepaid expenses 7,500 Provisions Cash/ Bank 1,455,080 Tax liabilities 100,647 Total assets 2,238,632 Total equity and liab. 2,238,632 PENOR PLC STATEMENT of FINANCIAL POSITION as at 31.12.20X1 Figure 3.2: Balance sheet <?page no="34"?> Berkau: Management Accounting 7e 3-34 [GBP] Revenue 5,051,900 Changes in FG inventory 332,252 5,384,152 Materials (2,922,400) Labour (2,000,000) Depreciation (30,000) Other expenses (90,000) Earnings before int. & taxes (EBIT) 341,752 Interest (6,261) Earnings before taxes (EBT) 335,491 Income tax expenses (100,647) Deferred taxes Earnings after taxes (EAT) 234,844 Penor PLC STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X1 Figure 3.3: Income statement The income statement tells us that PENOR PLC earned a profit of 234,843.62 GPB after tax. The values on the financial statements are disclosed accurate to the next British Pound Sterling (GBP). For the calculation of income taxes we apply an income tax rate of 30 %. 7 On the balance sheet, the total of assets amounts to 2,238,631.50 GBP. The company’s equity is 434,843.62 GBP after the company declared dividends to its shareholders to an extent of 200,000.00 GBP. PENOR PLC calculates a return of assets of: (335,490.89 + 6,260.61) / 2,238,631.50 = 1 15.27%. The return of assets is the profit before interest and taxation divided by the total of the assets. 7 This rate follows the convention in chapter (1). In general, the owners compare the efficiency of their company by return figures to alternative investments available to them on the capital market. 8 The further financial statements (statement of cash flows and statement of changes in equity) are discussed further below in the text after the explanation of PENOR PLC’s business activities and their Bookkeeping entries. 3.6. Preparation of Financial Statements Next, we study Bookkeeping at PENOR PLC in preparation for the financial statements. The following paragraphs are not required for an understanding of Management Accounting. We therefore placed them to the online materials 8 For the analysis of financial statements read our textbook Financial Statements, chapter (5). <?page no="35"?> Berkau: Management Accounting 7e 3-35 which you can download through Link 3.A. Link 3.A: Financial statement preparation PENOR PLC Financial Accounting is discussed in this textbook only to demonstrate the differences to Management Accounting. 3.7. Summary The case study PENOR PLC is about a British production firm. The company produces doors and windows. The company prepares financial statements along IFRSs which comprises a balance sheet, an income statement, a statement of cash flows and a statement of changes in equity. 3.8. Working Definitions 9 Appropriation of profits: A profit appropriation is the allocation of earnings after taxes to owners and/ or the company. Batch: A batch is the quantity of products produced by one internal job order. 9 The working definitions are a list of highlighted definitions in the text. They also include those from to online materials outsourced paragraphs. Bill of Materials: A bill of materials is a document that shows the part-structure of a product. Cash Flow Statement: A cash flow statements shows the total of payments and receipts over the Accounting period which is classified in cash flows from operations, investments and financing. Cost of Manufacturing COM: Costs of manufacturing comprise direct materials, direct labour and allocated manufacturing overheads. First-in-First-out Formula, FIFO formula: The first-in-first-out cost formula applies for inventory that cannot be distinguished and it pretends a stock release in the sequence of intakes. Lot size: The lot size is the number of goods produced in one batch. Nature of Expense Format: For profit calculation based on the nature of expense method we must consider all expenses and deduct the cost of manufacturing for additions to finished goods inventories Purchase: Purchases is buying goods which classify for inventory. Statement of Changes in Equity: The statement of changes in equity shows how each equity item on the balance sheet has changed based on the last Accounting period’s activities. Trading Account Calculation: A Trading account calculates the gross profit by deducting opening values for inventory and purchases from revenue and closing stock, adjusted for returns. VAT vendor: A VAT vendor is registered for input-VAT reduction and <?page no="36"?> Berkau: Management Accounting 7e 3-36 must collect output-VAT on behalf of the revenue service. 3.9. Question Bank (1) A company buys 50 hinges (materials) at 100.00 EUR/ u, then 70 hinges at 110.00 EUR/ u. During the Accounting period, 85 hinges are used for production. Weighted average method applies for inventory valuation. How much is the closing stock? (Round figures to the nearest EUR.) 1. 3,500 EUR . 2. 3,675 EUR . 3. 3,704 EUR . 4. 3,860 EUR . (2) A company pays rent 2 months in advance. The rent is 1,200.00 EUR/ m. Accordingly 2,400.00 EUR are added to the Rent account from prepaid expenses. From 1.07.20XX onwards, rent increases to 1,400.00 EUR/ m. How much is the balancing figure in the Rent account before adjustments? 1. 2,800.00 EUR . 2. 16,800.00 EUR . 3. 15,600.00 EUR . 4. 18,400.00 EUR . (3) On 1.01.20X2, a company takes out a bank loan which is an annuity. The principal is 100,000.00 EUR and the rate of interest is 2.5 %/ a. The annuity agreed on is amounting to 5,000.00 EUR. How much is interest to be paid on 31.12.20X4 rounded to the nearest EUR? 1. 2,500 EUR . 2. 2,373 EUR . 3. 2,737 EUR . 4. 5,000 EUR . (4) A company earns 100,000.00 EUR before taxes and carries forward a loss to the extent of 50,000.00 EUR. Half of the distributable amount is paid to the shareholders. How much would that be? 1. 50,000.00 EUR . 2. 25,000.00 EUR . 3. 20,000.00 EUR . 4. 10,000.00 EUR . (5) A bill of materials is… 1. … a price list of materials. 2. … a document that shows the production steps to manufacture a product. 3. … a document which shows how many parts of which kind belong to a product. 4. … an invoice for purchased parts of a product. 3.10. Solutions 1-3; 2-4; 3-2; 4-4; 5-3. <?page no="37"?> Berkau: Management Accounting 7e 4-37 4. Case Study PENOR PLC - Managerial Accounting 4.1. What is in the Chapter? In contrast to the previous chapter, we discuss the case PENOR PLC now from the point of view of Managerial Accounting. Chapter (4) shows where aspects of Financial Accounting can be neglected or simplified for business control and which new aspects become relevant. We demonstrate that a company cannot be controlled based on its financial statements as detailed data for departments and monthly periods are not available. We provide an overview of Management Accounting and explain budgeting, cost monitoring and the calculation of products and profit. As the case of PENOR PLC is from Industrial Management, calculations follow Manufacturing Accounting procedures. At the end of the chapter, we introduce reporting and show a statement of cost of goods manufactured and of cost of goods sold. We further set up a business plan for PENOR PLC. 4.2. Learning Objectives In this chapter, you will achieve an overview of Management Accounting. The chapter helps you to develop a complete understanding of Management Accounting based on the case study PENOR PLC. You will see the differences to Financial Accounting. After reading this chapter, you understand the major principles of Management Accounting and have seen how to apply them for a manufacturer. We 10 (A) is inception, (B) is Financial Accounting; compare to chapter (3). introduce technical terms for Management Accounting in this chapter and mention the concepts they apply for. This chapter prepares you for detailed studies coming later in this textbook. 4.3. Management Accounting (C) Management Accounting is Accounting for managers. In contrast to Financial Accounting, it serves the information needs of managers who are in control of the business. In Germany, the expression Controlling is widely used as a substitute for Management Accounting. As this word sounds similar to ‘kontrollieren’ in German, it becomes misleading because it emphasis monitoring aspects to much. We rather apply the term Management Accounting or Managerial Accounting. They both mean the same and are used interchangeable in this textbook. We discuss the company PENOR PLC as introduced in the previous chapter (3) but now from a management Accounting perspective. We continue the case study PENOR PLC at step (C) with reference to the sequence announced in chapter (3). 10 Financial Accounting and Managerial Accounting are similar regarding recording and making calculations - formulas and Bookkeeping entries look alike, although both Accounting concepts follow different purposes. Managerial Accounting provides information about profitability to facilitate managers to control the business. For <?page no="38"?> Berkau: Management Accounting 7e 4-38 that reason, Management Accounting must be more in the details. Accordingly, we split the company into smaller organisational units and calculate shorter periods, in general on a monthly basis. A question you might ask yourself is: ‘Can we not just control a business by financial statements only? ’ The answer surprisingly is: Yes, but only if the company is small and the owner maintains a good overview to make her/ his management decisions on her/ his own. For controlling a business, managers must exactly understand how the business operates. They need precise information about all activities and their implications to costs; and they must have them early to react on deviations from the plans. We study PENOR PLC again. Now, we simplify aspects which are relevant for Financial Accounting (IFRSs) but do not matter for business control. We call them here Accounting cuts. They simplify the calculations. At PENOR PLC these are: EEquity: The recording of the owners’ contribution to issued capital is not relevant. It is subjected to Finance. 11 Bank loan recognition: In compliance with IFRSs, interest is accounted for based on the effective interest method (at amortised costs). Business control is short-term based and does not focus on the disclosure of financial instruments. For PENOR PLC, we can ignore the fees for the bank loan upon issue. Therefore, interest is a cost as paid for. PENOR PLC’s bank loan payments are displayed for Management Accounting purpose in Figure 4.1. We always disclose loans at settlement values. No discounting for present value disclosure applies except of for lease liabilities 12 . The separation between long-term and short-term liabilities as required under IAS 1.60 is irrelevant for Management Accounting and can be ignored. 11 Finance is part of Management Accounting. It is taught as a separate subject and not covered by this textbook. 12 Study leases in chapter (7) of our textbook Financial Statements. <?page no="39"?> Berkau: Management Accounting 7e 4-39 0.03 rate of interest Year Opening amount Interest Pay-off Rest [GBP] [GBP] [GBP] [GBP] 20X1 200,000 6,000 20,000 180,000 20X2 180,000 5,400 20,000 160,000 20X3 160,000 4,800 20,000 140,000 20X4 140,000 4,200 20,000 120,000 20X5 120,000 3,600 20,000 100,000 20X6 100,000 3,000 20,000 80,000 20X7 80,000 2,400 20,000 60,000 20X8 60,000 1,800 20,000 40,000 20X9 40,000 1,200 20,000 20,000 20Y0 20,000 600 20,000 0 Penor PLC INTEREST and PAY-OFF PLAN Figure 4.1: PENOR PLC’s bank loan Interest: interest is equal to 5,400.00 GBP/ a at PENOR PLC for 20X2. For the calculation of a monthly rate of interest we divide the annual interest by 12. No compound interest calculation applies within a year. Expense-cost distinction: We pretend all costs are expenses and vice versa. This is consistent with the conventions in chapter (1). This leads to ignorance of unreal costs. We only break with this rule in chapter (6) for the business plan preparation for the SCHLUCHMAN case. Prepaid Expenses Recognition: We ignore prepayments, except of for liquidity planning. Payments made in prior periods matter only once they become costs. Hence, prepaid expenses can be ignored. The accrual principle is fundamental for Accounting. Therefore, we always assign costs to the period they belong to. E.g., PENOR PLC’s rent is considered for the months January to December. Therefore, we adjust the payment discussed in the previous chapter (3) and record rent to an extent of: 12 × 7,500 = 90,000.00 GBP/ a only. Volatile Prices for Purchases and Discount Considerations: For IFRSs, the discount received on the sealing strips is relevant and got recorded in the Discount Received account. Also, the different prices for the aluminium sheets are recorded at 50.00 GBP/ u and 52.00 GBP/ u as paid. The return of the 90°-fasteners is relevant for inventory valuation, too. For the purpose of Management Accounting, none of those above mentioned purchase details matters. Therefore, we simplify Bookkeeping entries and consider average costs for material costs, see below: - Aluminium profiles at 600,000.00 GBP. - Hinges at 450,000.00 GBP. - Glass panes at 600,000.00 GBP. - Aluminium sheets at an average unit cost of 50.77 GBP/ u which gives 50.77 × 1,300 = 6 66,001.00 GBP. - Sealing strips at 270,000 × (1 - 5%) = 256,500.00 GBP. - 90°-fasteners at: (50,000 - 500) × 25 = 1,237,500.00 GBP. - Self-tapping-screws at 20,000.00 GBP. Payment Terms: Except of for liquidity planning, payment methods are irrelevant. We pretend all payments are made <?page no="40"?> Berkau: Management Accounting 7e 4-40 directly and accounted for them on a cash/ bank basis. Labour Costs without Taxes and Social Security Contribution Details: Regarding labour, only the total labour costs matter. As Management Accounting requires cost allocation to products and services, we only distinguish between manufacturing and non-manufacturing labour which results in an alternative classification of costs. No Relevance of the Appropriation of Profits: For Management Accounting, the appropriation of profits is irrelevant, except of for the business plan. 4.4. Recording Profits without Bookkeeping In the next following paragraph, we prepare PENOR PLC’s profitability analysis. The profit is calculated as the difference between revenue and all costs for the Accounting period. Besides of the costs of goods sold, we also consider costs for interest and administration in this case study. For the profitability analysis at PENOR PLC, we prepare a profitability statement as shown in Figure 4.2. PENOR PLC 13 To calculate income taxes we must prepare the income statement in compliance with the British tax law what we did not do here. applies now the cost of sales format for Management Accounting. With the cost of sales format, a company deducts product costs for goods that have been sold. Therefore, the approach requires a product calculation for all batches and stock releases. The latter one becomes relevant, if the company sells goods that have been manufactured in prior Accounting periods. At PENOR PLC, this is not the case as we study the first Accounting period. The revenue is calculated based on the net selling prices and is the same as in chapter (3): 4,678 × 800 + 873 × 1,500 = 5,051,900.00 GBP. Interest of 6,000.00 GBP and the administration to the extent of 800,000.00 GBP are non-manufacturing costs and must be considered on the profitability analysis as shown in Figure 4.2 already. Find below the first version of the profitability analysis. As a profitability analysis sheet does not support income tax calculations, it ends with the pre-tax profit (earnings before taxation). 13 Note, the cost of goods sold are omitted yet on the profitability analysis in Figure 4.2. You find at its place an empty cell. Accordingly, the profit is way too high. <?page no="41"?> Berkau: Management Accounting 7e 4-41 [GBP] Revenue 5,051,900.00 5,051,900.00 Cost of goods sold Other expenses (800,000.00) Earnings before int. & taxes (EBIT) 4,251,900.00 Interest (6,000.00) Earnings before taxes (EBT) 4,245,900.00 Penor PLC PROFITABILITY ANALYSIS for the year ended 31.12.20X1 Figure 4.2: Profitability analysis (1) Next, we calculate the costs for 4,678 windows and 873 doors as sold in 20X1. Same as in chapter (3), we distinguish direct costs and overheads. Direct costs are assigned to products without allocations whereas overheads are added to job orders by applying predetermined allocation rates. Direct costs for PENOR PLC’s products are materials only - no direct labour applies. The allocation is based on 3 batches, see below: unit costs Job order 1 (5000 windows) Job order 2 (800 doors) Job order 3 (200 doors) 5000 800 200 Aluminium profile [kg] 20.00 GBP/ kg 400,000.00 96,000.00 24,000.00 Hinge [u] 30.00 GBP/ u 300,000.00 72,000.00 18,000.00 Glass pane [u] 100.00 GBP/ u 500,000.00 Alu slab [u] 50.77 GBP/ u 40,616.00 10,154.00 Sealing strip [m] 9.50 GBP/ u 190,000.00 45,600.00 11,400.00 90°-Fastener [u] 25.00 GBP/ u 1,000,000.00 160,000.00 40,000.00 2,390,000.00 414,216.00 103,554.00 Materials per unit 478.00 517.77 517.77 Screws per unit 2.50 2.50 2.50 Labour per unit 160.00 400.00 400.00 Depreciation per unit 5.00 5.00 5.00 Rent per unit 15.00 15.00 15.00 Unit cost of manuf. 660.50 940.27 940.27 Calculation of Unit Costs per Batch Figure 4.3: Unit costs of manufacturing per batch With the unit costs of manufacturing known we calculate the cost of goods sold. They add up to: 4,678 × 660.50 + 873 × 940.27 = 3 3,910,674.71 GBP. <?page no="42"?> Berkau: Management Accounting 7e 4-42 We deduct the cost of goods sold from revenues and then prepare the final version of the profitability analysis. It shows on its bottom line the pre-tax profit for PENOR PLC. [GBP] Revenue 5,051,900.00 5,051,900.00 Cost of goods sold (3,910,674.71) Other expenses (800,000.00) Earnings before int. & taxes (EBIT) 341,225.29 Interest (6,000.00) Earnings before taxes (EBT) 335,225.29 Penor PLC PROFITABLITY ANALYSIS for the year ended 31.12.20X1 Figure 4.4: Profitability analysis (2) 4.5. Reporting As Management Accounting supports managers, the findings of Accounting need to be presented to the recipients. This part of Management Accounting is referred to as Reporting. Reports can be prepared regularly as standard reports, or they come as exceptional report. We here only introduce some standard reports for manufacturers and refer to chapter (17) for further studies. One common standard report for production firms is the cost of manufacturing report. It shows how much the production of goods costs. The report starts-off with material costs. Material expenses are accounted for on a periodic basis. This requires to calculate materials as the difference of closing stock and the total of opening value (zero) and purchases. Under a periodic system (for inventory movements) we only record inputs but make no Bookkeeping entries for stock releases. We only take stock at the end of the Accounting period. At PENOR PLC, we also exclude screws from direct materials as they are considered manufacturing overheads - same as in chapter (3). This means instead of recording the actual screw consumption by window/ door, we pretend that PENOR PLC provides screws in a box that is placed in the factory. Once the box is empty, it is replaced by the next one. That way, screw consumption is treated as manufacturing overheads although a direct tracking would be possible. PENOR PLC’s reason to do so is to spare the administration effort for screw tracing. In general, cost of manufacturing also include direct labour, however, this does not apply for PENOR PLC. The prime costs are the total of direct costs (direct materials and direct labour), here they only contain direct materials. All production related overheads at PENOR PLC this is rent, depreciation, labour and screws are allocated to the products <?page no="43"?> Berkau: Management Accounting 7e 4-43 via allocations. This results in adding 1,335,000.00 GBP to finished goods. As we discuss PENOR PLC’s first Accounting period, no finished goods are on stock at the beginning of the year. Hence, we only consider cost of manufacturing from the Accounting period 20X1. No finished goods from prior periods are available for sale. See PENOR PLC’s COM-report in Figure 4.5. Item Amount [GBP] OV Raw materials 0 Purchases 3,230,001 3,230,001 Closing stock raw materials (307,231) indirect materials (15,000) Total direct materials 2,907,770 Direct labor 0 Prime cost 2,907,770 Applied overheads 1,335,000 4,242,770 OV Work in process WIP 0 4,242,770 Closing stock work in process WIP 0 COST of MANUFACTURING 4,242,770 Penor PLC REPORT on COST of MANUFACTURING as for the period ended 31.12.20X1 Figure 4.5: Cost of manufacturing COM report The report of cost of manufacturing becomes more meaningful once split in columns representing single products or product groups, here once we distinguish revenue and costs of manufacturing for windows and doors. We also add sales information and enhance the report. For the cost of sales report, direct materials are assigned to products following stock releases. This requires the application of a perpetual inventory movement system 14 . At PENOR PLC, we assign aluminium profiles, hinges, glass panes, seal strips and 90°-fasteners to the windows and aluminium profiles, hinges, aluminium slabs, seal strips and 90°-fasteners to the doors. Allocations are made for the distribution of manufacturing overheads. Labour is split between all doors and all windows at a 1 : 2 ratio. The remainder of the overheads, which is depreciation, rent and screws, are accounted for on a piece count basis (referred to the number of doors and windows). 14 Read about inventory movement systems the case study GREENACRES Ltd. in the textbook Financial Statements, chapter (9). <?page no="44"?> Berkau: Management Accounting 7e 4-44 Item for windows for doors [GBP] [GBP] Alu profiles 400,000 120,000 Hinges 300,000 90,000 Glass panes 500,000 Aluminium slabs 50,770 Seal strips 190,000 57,000 Fasterners 1,000,000 200,000 Total direct materials 2,390,000 517,770 Direct labor 0 0 Prime cost 2,390,000 517,770 Applied overheads 912,500 422,500 3,302,500 940,270 OV Work in process WIP 0 0 3,302,500 940,270 Closing stock work in process WIP 0 0 COST of MANUFACTURING 3,302,500 940,270 OV FG inventory 0 0 Closing stock of FG inventory (212,681) (119,414) COST of GOODS SOLD 3,089,819 820,856 Penor PLC REPORT on COST of GOODS SOLD as for the period ended 31.12.20X1 Figure 4.6: Cost of goods sold report Another standard report for Management Accounting is the business profitability analysis. In contrast to an income statement in Financial Accounting, the profitability analysis is prepared more in the details. This is why we record it as a product related (windows, doors) profitability analysis. In Financial Accounting the term profit and loss statement applies 15 . We prepare in Management Accounting a more detailed report to support informed product mix decisions. A product mix decision is here about how many windows and how many doors should be manufactured. To support 15 Following IFRSs the statements name is ‘statement of profit or loss and other comprehensive income’. This includes also gains, e.g. earned by disposal of assets. such decisions, reports on unit costs are helpful. Here the margin 16 per window is: 652,581 / 4,678 = 1 139.50 GBP/ u and the one for a door equals: 488,644.29 / 873 = 5 559.73 GBP/ u. This could be a strong argument to focus on door manufacturing rather than to produce windows. However, PENOR PLC must consult its Marketing department to answer the question of how many windows and doors can be sold. It should consider that a normal house has more windows than doors. On the profitability analysis, we deduct product costs, admin costs and interest 16 As the cost of sales contain fixed costs for rent, depreciation and labour, we are not supposed to call the margin a contribution margin. It is just a sales margin. <?page no="45"?> Berkau: Management Accounting 7e 4-45 from revenues to calculate the net operating profit. Window Door [GBP] [GBP] Revenue 3,742,400.00 1,309,500.00 Cost of goods sold (3,089,819.00) (820,855.71) 652,581.00 488,644.29 Margin Other expenses Earnings before int. & taxes (EBIT) Interest Earnings before taxes (EBT) 335,225.29 Penor PLC PROFITABILITY ANALYSIS for the year ended 31.12.20X1 1,141,225.29 (800,000.00) (6,000.00) 341,225.29 Figure 4.7: Profitability analysis for Management Accounting 4.6. Preparing a Business Plan A business plan contains a revenue plan, a cost plan, a profit plan, a liquidity plan and a budgeted balance sheet. For the budgeted balance sheet as at 31.12.20X4 we prepare a pro forma balance sheet for 20X1 as we are in need of the opening values for the balance sheet items. In the below paragraphs, we describe the development of the pro-forma balance sheet for PENOR PLC at first. We call it pro-forma as we break for Management Accounting purposes with some IFRSs regulations. Find the adjusted balance sheet for 20X1 in Figure 4.8. A C, L Non-current assets [GBP] Equity [GBP] P, P, E 120,000 Share capital 400,000 Intangibles Reserves Financial assets Retained earnings 335,225 Current assets Liabilities Inventory 639,326 Interest bear liab 180,000 Accounts receivables Accounts payables 1,324,380 Prepaid expenses Provisions Cash/ Bank 1,480,279 Tax liabilities Total assets 2,239,605 Total equity and liab. 2,239,605 Penor PLC STATEMENT of FINANCIAL POSITION (for Management Accounting) as at 31.12.20X1 Figure 4.8: Pro-forma balance sheet <?page no="46"?> Berkau: Management Accounting 7e 4-46 The balance sheet in Figure 4.8 ignores the disclosure of income tax as well as the appropriation of profits. Furthermore, we calculate the interest based on its nominal rate and ignore the distinction between short-term and long-term liabilities for PENOR PLC’s bank loan. No prepaid rent has been recorded nor did we consider the discount on seal strips as we already calculate with the discounted price. The closing stock of raw materials differs from Financial Accounting, because we calculate the aluminium slabs on an average price basis instead applying the first-in-first-out cost formula as in chapter (3). For the detailed preparation of the balance sheet download the complete Bookkeeping records from the link below. Link 4.A: Bookkeeping entries With the balance sheet prepared, we can plan activities for PENOR PLC in 20X2 and 20X3. Management Accountants refer to this calculations as budgeting or the preparation of the business plan. We stick to the expression business plan. A A business plan is the result of the annual planning of all activities of the company. The planning takes place every year. We define the technical terms more straight: A cost plan is the result of performance planning and calculating departmental and unit costs. It can be prepared in different versions (for different stages or for different scenarios). In contrast, a budget is the cost plan that has been approved by management. It is binding and used for calculations, e.g. for the allocation rates, or for detecting deviations which are the differences of actual to standard costs. Deviations are subjected to chapter (15) where we explain monitoring in the details. The cost structure of a business plan is frequently less detailed than actual costs. The itemisation decides about the monitoring quality in the future. A business plan refers to time periods shorter than a year, mostly it is prepared for monthly periods. To keep the PENOR PLC case study simple in this textbook, we plan only for 6-months-periods. The business plan is prepared for 2 years hence, we work on 4 planning periods. The business plan consists of: - Revenue plan. - Cost plan. - Profit plan. - Liquidity plan (omitted for PENOR PLC). - Budgeted balance sheet. The complete business plan shows in Figure 4.14. We start with the revenue plan below: For 20X2, PENOR PLC plans price increases for windows and doors every year by 100.00 GBP/ u for both products. Accordingly, in 20X2, it sells windows at: 800 + 100 = 9 900.00 GBP/ u and doors at: 1,500 + 100 = 1 1,600.00 GBP/ u and in the next year windows at: 900 + 100 = <?page no="47"?> Berkau: Management Accounting 7e 4-47 11,000.00 GBP/ u and doors at: 1,600 + 100 = 1 1,700.00 GBP/ u. PENOR PLC expects to increase its sales volume by 10 % every year and rounds the amounts to the nearest 10 units. Regarding the windows, the actual number is 4,678. In 20X2, the number is: 4,678 × (1 + 10%) = 5,145.80 units which according to the rounding rule gives 5,150 windows. In the next year, it is: 4,678 × (1 + 10%) 2 = 5,660.38 units which gives 5,660 windows for 20X3. The doors’ volume is: 873 × (1 + 10%) = 9 960.3 units which gives 960 doors in 20X2 and: 873 × (1 + 10%) 2 = 1,056.33 units which makes us plan 1,060 windows in 20X3. The revenue plan is displayed in Figure 4.9: [GBP] REVENUE PLAN I-VI 20X2 VII-XII 20X2 I-VI 20X3 VII - XII 20X3 amount of windows [#] 2,575 2,575 2,830 2,830 amount of doors [#] 480 480 530 530 revenue windows [GBP] 2,317,500 2,317,500 2,830,000 2,830,000 revenue doors [GBP] 768,000 768,000 901,000 901,000 Total revenue 3,085,500 3,085,500 3,731,000 3,731,000 Figure 4.9: Revenue plan For its cost plan, PENOR PLC considers an increase of costs of manufacturing every year by 2 % on average. The calculation is based on the unit cost of manufacturing rounded to the nearest GBP. Hence, the windows’ costs are: 661 × (1 + 2%) = 6674.22 GBP/ u which gives 674.00 GBP/ u and: 661 × (1 + 2%) 2 = 687.70 GBP/ u which gives 688.00 GBP/ u. The doors’ costs are: 940 × (1 + 2%) = 9 958.80 GBP/ u which gives 959.00 GBP/ u and: 940 × (1 + 2%) 2 = 9977.98 GBP/ u which gives 978.00 GBP/ u. The costs for administration do not change in the nearby future. Interest is calculated based on the interest and pay-off schedule. See below the interest and pay-off schedule for the business plan periods in Figure 4.10: Year Opening amount Interest Pay-off Rest [GBP] [GBP] [GBP] [GBP] 20X1 200,000 6,000 20,000 180,000 20X2 180,000 5,400 20,000 160,000 20X3 160,000 4,800 20,000 140,000 Penor PLC INTEREST and PAY-OFF PLAN Figure 4.10: Interest and pay-off schedule To simplify the case, we pretend selling exactly the same numbers of products as produced. As a consequence, PENOR PLC does not sell the finished products manufactured in 20X1. This means that the closing stock of finished goods remains constant at all times. To avoid calculations for the valuation of stock releases we apply the last-in-first-out cost formula. This way, the 322 windows and <?page no="48"?> Berkau: Management Accounting 7e 4-48 the 127 doors from 20X1 remain on stock for the entire planning horizon. 17 [GBP] COST PLAN I-VI 20X2 VII-XII 20X2 I-VI 20X3 VII - XII 20X3 COM windows 1,735,550 1,735,550 1,947,040 1,947,040 COM doors 460,320 460,320 518,340 518,340 Administration 400,000 400,000 400,000 400,000 Interest 2,700 2,700 2,400 2,400 Total costs 2,598,570 2,598,570 2,867,780 2,867,780 Figure 4.11: Cost plan The tax planning is made annually as taxes are due at the yearend. See below the profitability plan, which discloses the difference between revenue and costs as the operating profit. The earnings before taxes are the sum of the half-year net operating profits and are relevant for tax calculations. We apply the total income tax rate of 30 % (conventions). As no appropriation of profits is considered for PENOR PLC’s business plan, the earnings after taxes are carried forward to the next Accounting period. [GBP] PROFITABILITY PLAN I-VI 20X2 VII-XII 20X2 I-VI 20X3 VII - XII 20X3 Revenue 3,085,500 3,085,500 3,731,000 3,731,000 less Total of costs (2,598,570) (2,598,570) (2,867,780) (2,867,780) Operating profit 486,930 486,930 863,220 863,220 Earnings before tax 973,860 1,726,440 Income taxes (292,158) (517,932) Earnings after taxes 681,702 1,208,508 -> reserves -> dividend -> carried forward 681,702 1,208,508 Figure 4.12: Profitability plan To check the calculations, we prepare a budgeted balance sheet based on the balance sheet in Figure 4.8.. For planning purpose, we pretend to have paid VAT already. Therefore, 334,379.80 GBP 18 have been deducted from payables and from cash/ bank. Accordingly the balancing figure in cash/ bank is: 1,480,278.80 - 17 In real business it is more common to calculate with the first-in-first-out cost formula. That means for this case study to replace the value of doors and windows on stock with the actual cost of manufacturing. As the difference is only 2% we refrain 334,379.80 = 1,145,899.00 GBP in Figure 4.13. Furthermore, we calculate income taxes based on Manufacturing Accounting data. With the application of average costs for aluminium slabs, the profit is 335,225.29 GBP and the income taxes are: 335,225.29 × 30% = 1100,567.59 GBP on the budgeted balance sheet. from this calculations here. However, we make them for the case study BANTRY Ltd. in chapter (6). 18 The value is the credit balance of the VAT account as at 31.12.20X1. <?page no="49"?> Berkau: Management Accounting 7e 4-49 For the next Accounting periods, we assume the pre-tax profit (979,970.00 GBP) is equal to cash inflows, except of depreciation to the extent of 30,000.00 GBP. The income taxes of the previous year and the pay-off for the bank loan (20,000.00 GBP) are paid. Hence, the calculation of cash in 20X2 gives: 1,145,899 + 973,860 + 30,000 - 100,567.59 - 20,000 = 2 2,029,191.41 GBP. Note, that to simplify the case study, the opening value for cash/ bank is the value on the balance sheet less output-VAT liabilities: 1,480,278.80 - 334,379.80 = 1,145,899.00 GBP. Hence, payables are amounts PENOR (Pty) Ltd. owes only its suppliers (= 990,000.00 GBP). See the entire budgeted balance sheet as modified for the business plan calculations below in Figure 4.13. [GBP] BUDGETED BALANCE SHEET 20X1 (actual) 20X2 20X3 P, P, E 120,000 90,000 60,000 Intangibles Financial assets Inventory 639,326 639,326 639,326 Accounts receivables Prepaid expenses Cash/ Bank 1,145,899 2,029,191 3,473,473 Total assets 1,905,225 2,758,518 4,172,800 Share capital 400,000 400,000 400,000 Reserves Retained earnings 234,658 916,360 2,124,868 Interest bear liab 180,000 160,000 140,000 Accounts payables 990,000 990,000 990,000 Provisions Tax liabilities 100,568 292,158 517,932 Total equity and liab. 1,905,225 2,758,518 4,172,800 Figure 4.13: Budgeted balance sheet (annual) The figures for the Accounting period 20X1 are displayed to show the adjustments made for the actual period. The business plan covers the periods 20X2 and 20X3. The entire business plan for the periods 20X2 and 20X3 is disclosed in Figure 4.14. To keep the intro-case simple we omitted the preparation of the liquidity plan. You find liquidity plans in chapter (6). <?page no="50"?> Berkau: Management Accounting 7e 4-50 [GBP] REVENUE PLAN I-VI 20X2 VII-XII 20X2 I-VI 20X3 VII - XII 20X3 amount of windows [#] 2,575 2,575 2,830 2,830 amount of doors [#] 480 480 530 530 revenue windows [GBP] 2,317,500 2,317,500 2,830,000 2,830,000 revenue doors [GBP] 768,000 768,000 901,000 901,000 Total revenue 3,085,500 3,085,500 3,731,000 3,731,000 [GBP] COST PLAN I-VI 20X2 VII-XII 20X2 I-VI 20X3 VII - XII 20X3 COM windows 1,735,550 1,735,550 1,947,040 1,947,040 COM doors 460,320 460,320 518,340 518,340 Administration 400,000 400,000 400,000 400,000 Interest 2,700 2,700 2,400 2,400 Total costs 2,598,570 2,598,570 2,867,780 2,867,780 [GBP] PROFITABILITY PLAN I-VI 20X2 VII-XII 20X2 I-VI 20X3 VII - XII 20X3 Revenue 3,085,500 3,085,500 3,731,000 3,731,000 less Total of costs (2,598,570) (2,598,570) (2,867,780) (2,867,780) Operating profit 486,930 486,930 863,220 863,220 Earnings before tax 973,860 1,726,440 Income taxes (292,158) (517,932) Earnings after taxes 681,702 1,208,508 -> reserves -> dividend -> carried forward 681,702 1,208,508 [GBP] BUDGETED BALANCE SHEET I-VI 20X2 VII-XII 20X2 I-VI 20X3 VII - XII 20X3 P, P, E n/ a 90,000 n/ a 60,000 Intangibles Financial assets Inventory n/ a 639,326 n/ a 639,326 Accounts receivables Prepaid expenses Cash/ Bank n/ a 2,029,191 n/ a 3,473,473 Total assets n/ a 2,758,518 n/ a 4,172,800 Share capital n/ a 400,000 n/ a 400,000 Reserves Retained earnings n/ a 916,360 n/ a 2,124,868 Interest bear liab n/ a 160,000 n/ a 140,000 Accounts payables n/ a 990,000 n/ a 990,000 Provisions Tax liabilities n/ a 292,158 n/ a 517,932 Total equity and liab. n/ a 2,758,518 n/ a 4,172,800 Figure 4.14: Business plan for PENOR PLC For detecting deviations from budget, it is necessary to record actual data for the period 20X2 and 20X3. Thereafter, the actual data can be compared to budget (monitoring). 4.7. Summary This chapter introduces the basic features of Managerial Accounting. In contrast to the previous chapter (3), IFRSs are ignored. Data from Financial Accounting are ‘cleared’ from legal requirements. After data simplification (cut), product costs are calculated based on Manufacturing Accounting <?page no="51"?> Berkau: Management Accounting 7e 4-51 data. To keep this chapter clear of Bookkeeping entries the records of the Accounting period 20X1 have been placed to the online teaching materials. The business plan is prepared based on cost planning. The business plan for PENOR PLC contains an approved revenue plan, a cost plan and profitability analysis. A budgeted balance sheet can be added to the business plan, as well as a liquidity plan. Management Accounting is designed to support managers with Accounting information disclosed as reports. Managers need to know ‘What does the product cost? ’, ‘Is the business successful/ profitable? ’, ‘How much are future costs? ’, ‘Does the company generate cash? ’ and: ‘Are there substantial deviations from the budget? ’. 4.8. Working Definitions Business Plan: A business plan is the result of the annual planning of all activities of the company. Cost: A cost is a reduction of resources by operations intended by the company. Cost of Manufacturing: The cost of manufacturing are all costs that are directly or indirectly attributable to the product. Direct Costs: Direct costs are those costs that can be assigned straight to the product, e.g., based on the bill of materials documents or working sheets. Indirect costs occur for different products and require cost allocations. Manufacturing Accounting: The part of Management Accounting that deals with product calculation in an industrial environment is called Manufacturing Accounting. Net Operating Profit: A net operating profit NOP is the profit before taxation that results from normal operations which are continued. Overheads: Overhead costs are costs that apply for more than one product. Overhead Application: The application of overheads is the transfer of costs from the Manufacturing Overheads account to the Workin-Process account(s). Profitability Analysis: A profitability analysis is the income statement for Management Accounting. 4.9. Question Bank (1) A company holds a bank loan at a principal of 300,000.00 EUR taken out on 2.01.20X2 and got paid 298,000.00 EUR due to a once-off bank fee credited against the issue payment. The annuity is 15,000.00 EUR and the rate of interest is 2 %/ a. It discloses the loan for Management Accounting on 31.12.20X5 at: 1. 240,000 EUR . 2. 298,000 EUR . 3. 262,905 EUR . 4. 300,000 EUR . (2) Cost of Manufacturing are: 1. Direct costs and overheads. 2. Batch costs plus interest. 3. Direct and indirect cost of production. 4. Net purchase costs. (3) A company records 120,000.00 EUR in the Work-in-Process account. Half of the goods are fin- <?page no="52"?> Berkau: Management Accounting 7e 4-52 ished, and the other half is completed to an extent of 50%. How much costs are added to the Finished Goods Inventory account? 1. Nil . 2. 60,000 EUR . 3. 120,000 EUR . 4. 80,000 EUR . (4) In Managerial Accounting, a business plan comprises of: 1. Revenue plan, cost plan, liquidity plan, balance sheet. 2. Balance sheet, cash flow statement, profit plan, register of non-current assets. 3. Revenue plan, plan of cost of manufacturing, profitability plan, budgeted balance sheet. 4. Payment schedule, overhead plan, profitability plan, balance sheet. (5) A production firm got an opening value of raw materials of 100,000.00 EUR. It buys raw material at 400,000.00 EUR and records a closing stock of raw materials of 200,000.00 EUR. Direct labour is amounting to 750,000.00 EUR. Overhead application is 250,000.00 EUR. How much are its prime costs? 1. 950,000.00 EUR . 2. 1,050,000.00 EUR . 3. 1,300,000.00 EUR . 4. 1,450,000.00 EUR . 4.10. Solutions 1-3; 2-3; 3-4; 4-1; 5-2. <?page no="53"?> Berkau: Management Accounting 7e 5-53 5. Management Accounting vs. Financial Accounting 5.1. What is in the Chapter? This chapter explains the Management Accounting concept in general. We cover the major principles of cost management and describe features of Management Accounting systems. We further define basic technical terms. Thereafter, we distinguish Financial Accounting and Management Accounting. 5.2. Learning Objectives After studying this chapter, you know the purpose und major characteristics of Management Accounting and can compare them to Financial Accounting. You understand the basics concepts of Management Accounting and are familiarised with its technical terms. You know how a Management Accounting system works to support management. 5.3. Management Accounting in General The owners of a company trust managers to run all business processes efficiently and to make the right decisions in their interest. The interest of investors is a high return, meaning the capital input (investment) should be rewarded by a high profit earned (dividend, proceeds from selling shares). The relationship between capital input and profit is known as a return. 19 Check Laine/ Tregidga/ Unerman: Sustainability Accounting and Accountability and Hahn: Sustainability Management. The way how owners can maximise their capital is by (1) receiving dividends and by (2) selling their shares with a profit. (1) A dividend is a portion of the profit(s) paid to the owners of the business. The distributed profit can result from the last Accounting period’s earnings, or it has been carried forward from prior Accounting periods. The decision about declaring dividends is made on the annual general meeting AGM by the shareholders. (2) If the owners intend to earn profit by selling their shares, they watch the shareholder value. The value per share can be derived from a stock exchange as fair market value if shares are traded publically. The share price mostly depends on the real value of the business but also follows expectations of potential investors about the future development of the business. With regard to the share value, we focus in this textbook on book values which is equity as disclosed on the balance sheet divided by the number of shares. Equity includes the total of issued capital, reserves and retained earnings. Owners compare their investment to alternative investment opportunities on the capital market. They must consider risks taken with their investments. More and more, investors also consider aspects of sustainability for decision making. 19 <?page no="54"?> Berkau: Management Accounting 7e 5-54 For long-term decisions, companies consider the efficiency of their resource input which is measured by the present value of investments. In contrast to Financial Accounting which is a report based on financial statements, Management Accounting follows a wider approach. Management Accounting focusses on the profit for the period, shareholder value, efficiency of investments and sustainability aspects. The comparison between Financial Accounting and Management Accounting below helps you to understand the concept better. Below, we discuss at first some basic principles about Accounting 20 and define the major technical terms thereof. Thereafter we study features of Management Accounting systems. 5.4. Principles of Management Accounting Find next some concepts that require support from Management Accounting. Profit maximisation: The profit earned is the difference between revenue and all costs. Revenue and costs are always net values. This means that they are free of value added tax VAT. Revenue is the receipt of money for products sold or services rendered. The revenue does not require that customers make a payment, it also can be agreed that a customer pays later, e.g. if the sale is on credit. Costs are defined as the consumption of resources linked to the business model of the 20 Read our textbook Basics of Accounting. 21 The expression ‘on credit’ applies for sales and purchases, although a sale on credit gives a debit entry in A/ R. company. The existence of costs does not depend on payments either. A payment can occur later, e.g. when materials are bought on credit 21 . A company that only buys materials must not record a cost. Only the use of materials is cost relevant. In general, costs require the consumption of a resource. If we look at bank loans the same concept applies: The interest is a cost but the pay-off is not. Interest represents the price for borrowing whereas a payoff is only a cash flow - money is exchanged between the borrower and its bank. Companies strive to maximise their profits. The profit is the basis for the calculation of income taxes and once taxes have been deducted a company can declare the remainder as dividends to its shareholders. In this textbook, the total income tax rate is per default 30 % of the profit before taxes. The dividend is subjected to the decision of the shareholders on the AGM. Shareholders can decide to carry forward a profit/ loss to the next Accounting period(s) which affects the future dividends. Return maximisation: Returns measure the efficiency of input provided. The major return ratios are the return on assets and the return on equity. A return on assets is the pre-tax profit before interest 22 divided by the total of assets. It shows how efficient a company works on its resources. E.g., in a production firm the performance of the division managers is assessed 22 This is called the EBIT = earnings before interest and tax. <?page no="55"?> Berkau: Management Accounting 7e 5-55 based on return on assets. In contrast, the return on equity points to the interest of the owners. It divides the profit after taxes 23 (available for distribution), by the total of equity. 24 Meeting liquidity requirements: Liquidity represents the funds a company can spend. A cash flow is purely a change in cash/ bank. A cash inflow, e.g. as money is paid to the company or paid per bank transfer is known as a receipt. A cash outflow occurs if money is given to other parties. That will be called a payment. The cash flows are recorded on a cash flow statement which classifies receipts and payments into the 3 categories: operations, investments and finance. In Management Accounting, we plan the liquidity of a business which is the sum of the opening value of cash/ bank and all cash flows. The liquidity can increase further if, e.g. a bank offers an additional loan (extension of credit line). Hence, the liquidity represents the company’s ability to make payments in the next period. A company must fulfil liquidity minimum requirements to not go out of business. A company that is illiquid must file for bankruptcy. Maximisation of asset efficiency: Efficiency is measured as the amount of which the total and discounted cash inflows exceed the total and discounted cash outflows. This is the present value of an investment. To support investment decisions, we apply 23 This is EAT = earnings after tax 24 To put it more precisely, the distributable amount is defined as the profit after taxes of the actual Accounting period and the profit carried forward from methods of investment appraisal. Besides very simple calculations, we focus on dynamic methods which are based on the time value of money. With the time value of money concept we discount future payments/ receipts at a discount rate. The concept considers that 100 EUR today are worth more than a receipt of 100 EUR in 2 years. The reason is that the 100 EUR today can earn an interest over the next 2 years whereas the expected 100 EUR cannot. A discount factor reduces the value for a future cash flow to its present value. As more a cash flow is in the future as less of its value is considered for today. For the calculation we multiplied the amount with a discount factor. A cash flow of 100.00 EUR in 2 years has a present value of: 100 × (1 + 10%) -2 = 82.64 EUR. Here, we calculated at a discount rate of 10 %. The discount factor depends on returns for alternative investment opportunities on the capital market. In general we consider the weighted average cost of capital WACC. 25 Investments are long-term decisions and therefore require the consideration of compound interest calculations. Investments are expressed by a cash flow vector over the time. A cash flow vector looks like {-100; 80; 70}. The first cash flow (t = 0) is for the acquisition of an investment whereas the next following ones (t = 1; t = 2) are for cash flows received in return of its operations. The present value of the prior Accounting period(s) less losses carried forward. 25 Read for its calculation our textbook Financial Statements, chapter (5). <?page no="56"?> Berkau: Management Accounting 7e 5-56 above cash flows calculated at a discount rate of 10 % is: -100 + 80 / (1 + 10%) + 70 / (1 + 10%) 2 = 30.58 EUR. Another widely used indicator for efficiency is the internal rate of return. This is the rate of interest for which the present value becomes zero. We can say it is the discount rate for all cash flows to break-even. Then the discounted cash inflows meet the discounted cash outflows. For the above discussed vector the internal rate of return is 32.74 %. We use the MS-Excel function IRR() or linear interpolation for its calculation. Growth of shareholder value: The shareholder value is the value of all shares of a company. It is not based on the share prices as traded at a stock exchange but calculated by discounting future, free cash flows. A free cash flow is the cash flow that is available to owners and/ or creditors, e.g. as dividends and/ or bond redemption. It is calculated as the cash flow from operations after capital expenditures (investments and maintenance of noncurrent assets) have been deducted. If no dividend is declared, the free cash flow increases a company’s equity. To calculate the shareholder value, future free cash flows are discounted (at weighted cost of capital). A high shareholder value makes it likely for an investor to sell her/ his shares with a profit. Efficient risk management: Companies take risks to obtain chances. We apply a symmetrical risk definition. Any deviation from the expected 26 Read the textbook Sailer, U.: Nachhaltigkeitscontrolling. profit and from the expected cash flow is considered a risk. We discuss Risk Management in chapter (12). Risk Management is essential for Management Accounting because failing profit and liquidity minimums most likely results in bankruptcy. E.g., a profit that exceeds equity (equity becoming negative) leads to over-indebtedness. A negative cash flow that is so high in value that the company cannot fulfil its future payment obligations is known as illiquidity. Both, over-indebtedness and/ or illiquidity requires a limited company to file for bankruptcy. This is in protection of the creditors. Risk Management calculates the probability for a company to go out of business. As companies always take risks the probability cannot become zero but should be low. Investors in a company consider risks that way: If the investor can achieve the same return by different risks she/ he goes for the opportunity with the lower risk involved. Adhering to sustainability reporting standards: Aspects of environment, of social justice and corporate government become important factors for decisions in business and management. ESG ratings (environment, social and governance) are issued and measure the quality of how companies report information along ESG dimensions. Sustainability becomes more and more important for making decisions and needs to be addressed next to profit, cash flow, shareholder value and risk aspects. 26 <?page no="57"?> Berkau: Management Accounting 7e 5-57 5.5. Features of Management Accounting Management Accounting comprises of the below shown features. We describe Management Accounting procedures in the company: Budgeting: Management Accounting plans costs, profits and liquidity based on the output of finished goods or the number of services rendered. Management Accounting supports the coordination of partial budgets, e.g. budgets for various divisions within a company. Profitability analysis: Management Accounting calculates the profit of the company/ division by deducting costs from revenues. If the profitability analysis is based on cost objects, e.g. products, distribution channels, it is referred to as contribution margin analysis and supports, e.g. customer relationship management decisions. A contribution margin analysis can identify the most profitable customers or distribution channels. For contribution margin Accounting, a company must apply a partial cost Accounting system. Cost category Accounting: Management Accounting transforms expenses derived from Financial Accounting to costs. Under our conventions in this textbook, all costs are expenses already and vice versa. Therefore, no distinction between costs and expenses applies. Management Accounting analyses cost behaviour depending on various performance scenarios and splits 27 This is referred to as cost separation and is subjected to chapter (7). costs into variable and fixed cost. 27 For cost monitoring standard costs apply. Cost centre Accounting: Management Accounting splits the company into cost centres. Cost centres are organisational units with one person responsible for their costs. The costs of a cost centre must depend on one single reference unit which is also proportionally depending on the cost centre performance. A company can have hundreds of cost centres. Management Accounting calculates predetermined overhead allocation rates POR for the application of overheads to products. The overhead allocation rate is the total of manufacturing overheads in a cost centre divided by its planned performance measured in reference units. For applying overheads the actual performance is multiplied with the predetermined overhead allocation rate POR. Overor under-applied manufacturing overheads are closed-off to profit or loss. Cost centres are structured in hierarchies. In contrast to an organigram, the top node in a cost centre hierarchy represents the entire company. To judge about the efficiency of the cost centres, Management Accounting monitors cost centre costs. If the budgeted values are not met, deviations are reported in proficiency report. An analysis of the reasons for significant deviations follows. Calculation: Manufacturing Accounting calculates goods/ services. Product costs are direct costs and applied overheads from the cost centres involved <?page no="58"?> Berkau: Management Accounting 7e 5-58 in manufacturing/ performing. Costs of conversion include direct labour and applied overheads. Cost of manufacturing consist of material expenses and costs of conversion together. Cost of sales are the cost of manufacturing of those goods that have been sold. As the sale of goods can partially be based on stock releases, the cost of sales most likely differ from the manufacturing cost of products produced during the actual Accounting period. Reporting and ratio determination: Based on the information needs of managers, Management Accounting prepares reports for cost centres, products or business processes. Reports are provided to managers on a regular basis as standard reports or are issued exceptionally, meaning once specific threshold values are exceeded. Together with reports, Management Accounting provides ratios, e.g. efficiency ratios or turnaround figures. Fixed cost management: Management Accounting supports the budgeting of fixed costs. This includes activity based costing and/ or contribution margin Accounting. To streamline the product costs, Management Accounting supports the product design by providing engineers with cost information. Management Accounting also supports product mix decisions based on contribution margin Accounting. The control of current assets and short-term debts is referred to as working capital management. It aims to keep capital costs low by reducing inventory levels. Investment appraisal and M&A Accounting: M&A stands for mergers and acquisitions. Both refers to the purchase of companies. With a merger, two or more companies are combined to one firm resulting. With an acquisition, a group is established. This means one company (parent) gains control over another one (subsidiary). Management Accounting supports investment and mergers and acquisition decisions by methods of investment appraisal. The methods in use are based on the time value of money concept. Management Accounting supports M&A with calculations of the company-to-buy’s value, e.g. based on the discounted cash flow method. Long-term decisions in management are based on present values too, e.g. Management Accountants help to identify the best investments by calculating their net present values. For investment programme building net present value rates or internal rate of returns apply. The above list is incomplete as Management Accounting can fulfil further requirements to support management decisions, e.g. regarding project management. We consider the list of Management Accounting features sufficient to provide here an overview of the subject. Further details are discussed in the following chapters of this textbook. Next, we describe the major differences between Financial Accounting and Management Accounting. The comparison should be helpful to you if you studied Financial Accounting already. <?page no="59"?> Berkau: Management Accounting 7e 5-59 5.6. Difference between Management and Financial Accounting The major differences between Financial Accounting and Management Accounting are discussed following the statements below: - Management Accounting focusses on the future (planning/ budgeting). - Management Accounting is not ruled by laws. - Management Accounting is based on costs. - Management Accounting is in the details. - Management Accounting allocates costs to cost objects. - Management Accounting applies for periods of less than a year. - Management Accounting monitors cost deviations. - Management Accounting reports (to managers). 5.7. Management Accounting Focusses on the Future Financial Accounting reports to owners, creditors and the authorities about the last Accounting period. It is focussed on the past. In contrast, Management Accounting’s view is forward to the future. It plans business activities. A major portion of Management Accounting work is spent on the preparation of cost and profitability plans and the coordination of the budgeting process. Management Accountants calculate future profit and cash flows figures based on planned business operations, as derived from production/ service 28 Read further details about Marketing Research in Grunwald/ Hempelmann: Angewandte Marketinganalyse, Praxisbezogene Konzepte und volume. A budget or a business plan is no forecast but the result of a detailed planning and negotiation procedure. The number of products are determined by product mix decisions which are supported by Marketing Research 28 . The volume of goods/ services, their resource consumptions and costs of operations depend on the planned output and provided capacities. A business plan also can include capital expenditures resulting from investment decisions. The budgeting process goes through many plan versions before the final budget is approved. The master budget contains partial plans, such as the purchase budget, production budget, cash budget, inventory budget etc. A business plan is frequently presented by the CEO (chief executive officer) or CFO (chief financial officer) on the annual general meeting. Companies must plan their costs as low as possible to compete on the market. Hence, a good budget is one which meets the company’s performance goals at lowest costs. Managers are not supposed to overspend the budgets as this directly reduces the business profitability. To keep costs at bay, actual costs are monitored. We cover Budgeting in chapter (6) and in chapter (14) for flexible budgets. 5.8. Management Accounting is not Ruled by Laws In contrast to Financial Accounting, Management Accounting does not follow legal regulations. It is a discipline Methoden zur betrieblichen Entscheidungsunterstützung. <?page no="60"?> Berkau: Management Accounting 7e 5-60 of Business and Management focussing on the internal support of managers. Management Accounting is based on production and cost theory. As there are no legal reporting requirements, all data from Management Accounting is privileged information. In contrast, the financial statements of a company are published. 5.9. Management Accounting is Based on Costs An expense is a consumption of resources which leads to an outflow of economic benefits. Expenses are reported by the financial statements. A cost is a consumption of resources too, however costs must be linked to the business model. This means, any expense not linked to business operations or to administration, is no cost. E.g., the support of the local soccer team by a bakery is no cost but an expense. Management Accounting is based on cost information only. Planning, monitoring and profit and product calculations are based on costs. Therefore, no income tax or dividend calculations can be derived from Management Accounting data. 29 There can also be costs which are no expenses. We refer to them as imputed costs. Imputed costs normally are not related to payments. E.g., a B&B’s owner does not report her/ his own work as labour on the financial statements. However, for the calculation of the room rates, her/ his service must be considered as labour costs. Other examples are imputed interest, if the 29 Read for the calculation of company taxes Schneeloch/ Meyering/ Patek: Betriebswirtschaftliche Steuerlehre. company borrows from its owners, or imputed rent, if the company resides in the owner’s property without paying rent. In this textbook, we pretend all expenses are equal to costs by default. No imputed costs are covered. 5.10. Management Accounting is more in the Details The level of precision differs between Financial Accounting and Management Accounting. Financial Accounting reports on legal entity (company) level. In contrast, Management Accountants plan costs and analyse actual cost information for organisational units (cost centres) and/ or other cost objects, like single products, product groups or activities. 5.11. Management Accounting Allocates Costs to Cost Objects Management decisions are made for divisions, departments, cost centres, products etc. As a result, Management Accounting information must follow the structure of those cost objects. To prepare cost data linked to cost objects costs must be allocated. Frequently allocations are carried out based on rates, e.g. the predetermined overhead allocation rate POR for product calculations. In general, costs are allocated at first to cost centres, thereafter mutually between cost centres (internal cost allocations) and then to products. Under activity based costing ABC, costs are allocated to cost pools, to activities and <?page no="61"?> Berkau: Management Accounting 7e 5-61 thereafter to business processes. By the last step costs are allocated to products. In contrast, Financial Accounting rarely allocates costs. A product calculation of finished goods is only necessary when goods are added to stock and must be disclosed on the balance sheet. Otherwise, expenses in Financial Accounting apply for the entire company. 5.12. Management Accounting Applies for Periods Less than a Year Management Accountants provide information for controlling the business. To adjust business activities or to counteract unwanted cost developments, cost information must be available on time or at least on short notice. For this reason, Management Accountants plan, monitor and report costs for monthly periods. This allows managers to take immediate corrective actions once monitoring reveals that operational costs get out of proportions. Knowing about cost deviations as soon as possible is important for mitigating the damages. The analysis of cost deviations is merely a mass data problem. As companies monitor hundreds of cost centres on detailed cost category levels they apply artificial intelligence for filtering variances and background deviation analysis. A further reason for on-time cost data availability in Management Accounting is product calculation. For decisions about net selling prices, a company must know the cost of sales as soon as possible and cannot await the end of the Accounting period (year). In contrast, Financial Accounting in general prepares annual financial statements. Public companies which are listed at a stock exchange provide quarterly statements in addition to their annual ones. 5.13. Management Accounting Monitors Deviations A performance deviation is detected as a cost difference of actual costs from the budgeted. An approved budget should consider the most efficient resource deployment and therefore lead to the lowest costs of production or service rendering. If all actual costs are equal to standard costs, a company becomes as profitable as budgeted. Any deviation leads to an under-achievement of financial goals and needs to be addressed. As managers are responsible for costs, they must compare actual costs to budget every month. Management Accountants support them by monitoring (detection of variances) and regular proficiency reports. Monitoring is followed by a deviation analysis. In contrast, Financial Accounting does not monitor costs but reports the actual expenses on the income statement as they have been recorded in the books. 5.14. Management Accounting Reports The standard communication in Management Accounting is via reports. A Management Accounting report is a structured information sent to managers regularly or triggered by exceptions which should meet their information needs to control their <?page no="62"?> Berkau: Management Accounting 7e 5-62 unit’s operations and helps to make economic decisions in the interest of the entire business. Reports are based on budgeted and/ or actual data, the latter ones derived from the Bookkeeping records. A report can adhere to a standard format or is prepared on demand. In cases, when reported cost information is not sufficient for controlling the business and more detailed data are required an in-depth analysis is carried out. This is called a drill-down analysis and forms an add-on to monthly standard reports. Reports are designed on a profound information requirement analysis. Therefor managers are interviewed to determine what information they need and how their reports should look like. The report format depends on the knowledge and preferences of its recipients. In contrast, Financial Accounting is a single report on the entire company and on annual basis. The reports in Financial Accounting are the balance sheet, the income statement, the cash flow statement, the statement of changes in equity and the notes. 5.15. Summary In this chapter, we discussed the characteristics of Management Accounting. Management Accounting calculates profit for the company as well as for goods/ services, plans future activities, monitors costs, reports and calculates return figures and ratios. We acknowledged basic differences to Financial Accounting as follows: Management Accounting plans future activities, it is not ruled by laws, it calculates on a cost bases and not with expenses, it works on a more detailed level as Financial Accounting with regard to organisational units (cost centres) and time periods. Management Accounting allocates costs to cost objects of interest, which are cost centres, products, activities, customers etc. Management Accounting supports the controlling of the business by cost monitoring and reporting. 5.16. Working Definitions Budget/ Business Plan: A budget is the like a business plan. It contains at least the approved revenue planning, cost planning, profit planning and liquidity planning. Cost Centre: A cost centre is an organisational unit where costs are allocated to. The cost centre is controlled by a cost centre manager. Expense: An expense is a consumption of resources which leads to an outflow of economic benefits. Management Accounting Report: A Management Accounting report is a structured information file sent to managers regularly or triggered by exceptions which should meet their information needs to control their unit’s operations and helps to make economic decisions in the interest of the entire business. 5.17. Question Bank (1) In Managerial Accounting … 1. … budgeting is required to compare actual and planned costs. 2. … a cost centre is checked monthly for cost deviations. 3. … a cost centre manager must prepare an efficiency report regularly <?page no="63"?> Berkau: Management Accounting 7e 5-63 and disclose consumption and volume variance. 4. … no budgeting nor reporting of deviations is mandatory. (2) Management Accounting calculates materials based on … 1. … always net purchase costs. 2. … based on standard costs. 3. … based on budgeted net purchase prices. 4. … based on budgeted gross purchase prices. (3) In Managerial Accounting, the Profit and Loss account is the basis for … 1. … the income statement. 2. … the statement of comprehensive income. 3. … the profitability analysis. 4. … the calculation. (4) Costs are defined as … 1. … consumption of resources for business purpose. 2. … the equivalent to expenses. 3. … the equivalent to expenditures. 4. … the equivalent to payments. (5) A company that buys materials at 100.00 EUR; 110.00 EUR and 120.00 EUR to the amounts of 100 / 200 / 300 units discloses the standard costs per item based on weighted average cost as: 1. 100.00 EUR . 2. 111.00 EUR . 3. 113.33 EUR . 4. 120.00 EUR . 5.18. Solutions 1-4; 2-2; 3-3; 4-1; 5-3. <?page no="64"?> Berkau: Management Accounting 7e 5-64 Section (2): Accounting for General Management <?page no="65"?> Berkau: Management Accounting 7e 6-65 6. Cost Planning / Business Plan 6.1. What is in the Chapter? This chapter covers the planning of a company’s operations. We prepare various business plans for different industries. The case study KIRSTENBOSCH (Pty) Ltd. is a service provider in the fast-food industry. We demonstrate how to plan business activities and prepare a revenue plan, a cost plan, a profitability plan and a liquidity plan for 3 Accounting periods. The next case study BANTRY Ltd. is an Australian book printing company and demonstrates how to prepare a business plan if different stock levels of materials and finished goods apply. The profitability analysis is based on the nature of expense method. By the next case study McTOY GmbH, we cover a more complex case of a toy manufacturer. McTOY GmbH produces three kinds of toys, and we study the budgeting process for their products and consider price increases over the planning horizon. The last business plan SCHLUCHMAN covers a change in the legal form of a company. SCHLUCHMAN is a case study linked to Hospitality Management; the firm is a caterer. At the beginning, the company is in the legal form of a sole proprietor and is transformed into a public company after 2 years of its operations. 6.2. Learning Objectives In this chapter, you learn performance and cost planning for various businesses. After studying this chapter, you understand the planning procedures for different industries based on various methods in Managerial Accounting. You can prepare business plans and understand the differences between profitability and liquidity planning: Profitability is based on revenue and costs - liquidity on cash flows (receipts and payments). 6.3. Business Plan To plan performance, we anticipate and decide about the operations in the next periods. In Managerial Accounting, the term budgeting for the preparation of a business plan is common. The core elements of a business plan are cost and profit planning as well as liquidity calculations. A common structure for a business plan is: (1) Revenue plan. (2) Cost plan. (3) Profit plan. (4) Liquidity plan and/ or cash flow statement. (5) Budgeted balance sheet. For production firms, the cost plan can be extended for the consideration of materials requirements and resource planning. We follow the above structure and study below the company KIRSTENBOSCH (Pty) Ltd. At first, we introduce the case and thereafter we cover the elements of its business plan. <?page no="66"?> Berkau: Management Accounting 7e 6-66 6.4. C/ S KIRSTENBOSCH (Pty) Ltd. KIRSTENBOSCH (Pty) Ltd. is a fast-food restaurant. KIRSTENBOSCH (Pty) Ltd. is established on 2.01.20X0 by its owners contributing 500,000.00 EUR (face value). For its financing, KIRSTENBOSCH (Pty) Ltd. takes out a bank loan for 400,000.00 EUR. The bank loan comes with an annual rate of interest to be paid at the yearends and amounting to 5 %/ a. The pay-off amount is constant and is equal to 10 %/ a based on the principal, which is 400,000.00 EUR. The payoff payments at the end of each period are: 10% × 400,000 = 4 40,000.00 EUR/ a. As the pay-off is paid at the end of the Accounting periods, the pay-off amount is interest bearing. On 2.01.20X0, KIRSTENBOSCH (Pty) Ltd. furnishes the interior of the restaurant and spends 600,000.00 EUR thereon. To keep this first case study as simple as possible, no VAT applies. KIRSTENBOSCH (Pty) Ltd. pays for the interior by bank transfer. After 3 years, the interior must be replaced. No salvage value is considered for the furniture. KIRSTENBOSCH (Pty) Ltd. depreciates the interior of the restaurant over three Accounting periods based on straight-line method. No residual value applies. For the rent of the restaurant building, KIRSTENBOSCH (Pty) Ltd. pays 5,000.00 EUR/ m and one month in advance. In the first month it pays for rent on 2.01.20X0 and thereafter rent is paid on the 25 th of the preceding month. Hence, in January 20X0, it makes two payments for rent. KIRSTENBOSCH (Pty) Ltd. buys materials (meat patties, chicken parts, burger buns, green salad, sauces etc.) for 1,000,000.00 EUR per year. Materials are paid to an extent of 90 % in the Accounting period they are for. The remainder is due in the next following year. KIRSTENBOSCH (Pty) Ltd. pays for labour 300,000.00 EUR/ a. All workers are paid by bank transfer. For administration, KIRSTENBOSCH (Pty) Ltd. spends every year 240,000.00 EUR/ a. KIRSTENBOSCH (Pty) Ltd. earns every year a revenue of 2,200,000.00 EUR/ a. Income taxes are paid in the next following Accounting period under the conventions in this textbook. KIRSTENBOSCH (Pty) Ltd. plans every year to add the entire profit to its earnings reserves. We prepare a business plan for KIRSTENBOSCH (Pty) Ltd. which includes a revenue plan, a cost plan, a profit plan, a liquidity plan, a cash flow plan with reconciliation of profits with operating cash flows and set up a budgeted balance sheet as at 31.12.20X2. The business plan covers three Accounting periods and will therefore contain three columns: 20X0, 20X1 and 20X2. The budgeted balance sheet only is required as at the end of the budgeting period. Date Sheet for KIRSTENBOSCH (Pty) Ltd. Classification: Hospitality Management; Accounting periods: 20X0; 20X1; 20X2; Issued capital: 500,000.00 EUR; Bank loan: 400,000.00 EUR, annual payoff: 40,000.00 EUR, 5%/ a interest; P, P, E: 600,000.00 EUR, straight-line method over 3 Accounting periods; Rent: 5,000.00 EUR/ m; one month in advance; <?page no="67"?> Berkau: Management Accounting 7e 6-67 MMaterials: 1,000,000.00 EUR/ a; 90% paid instantly the remainder in the next Accounting period; Labour: 300,000.00 EUR/ a per bank transfer; Administration: 240,000.00 EUR/ a per bank transfer; Proceeds/ revenue: 2,200,000.00 EUR/ a; Income tax: 30%; Appropriation of profits: 100 % towards earnings reserves; VAT ignored. 6.5. Revenue Plan - C/ S KIRSTENBOSCH (Pty) Ltd. At first, we set up the revenue plan for KIRSTENBOSCH (Pty) Ltd. A revenue plan is an aggregated list of planned revenues on product group level for an Accounting period. Companies plan their revenue on various aggregation levels. E.g., a restaurant plans its revenue and costs based on product groups, like beef burgers, chicken meals, salads, beverage. To estimate annual revenues, companies carry out a Marketing analysis and compare the demand to their own production capacity. For KIRSTENBOSCH (Pty) Ltd., the revenue is given to be 2,200,000.00 EUR every year. REVENUE PLAN 20X0 20X1 20X2 Revenue 2,200,000 2,200,000 2,200,000 Figure 6.1: KIRSTENBOSCH (Pty) Ltd.’s revenue plan 6.6. Cost Plan - C/ S KIRSTENBOSCH (Pty) Ltd. Future costs are disclosed in a cost plan. A cost plan is a list of budgeted costs for a business displayed on costs or cost group levels for every Accounting period. KIRSTENBOSCH (Pty) Ltd.’s costs are for materials, rent, labour, depreciation, administration and interest. The value for the material consumption is constantly 1,000,000.00 EUR/ a. It does not matter for the cost plan when KIRSTENBOSCH (Pty) Ltd. actually pays for its materials. The rent is: 12 × 5,000 = 60,000.00 EUR/ a. The aspect of making prepayments does not matter for the cost plan. Depreciation is recognised as the cost of acquisition divided by the useful life following straight-line method. That gives: 600,000 / 3 = 2 200,000.00 EUR/ a. Labour amounts every year to 300,000.00 EUR/ a and administration costs to 240,000.00 EUR/ a. For interest calculation, we prepare an interest and pay-off schedule. Pay-off always is 10 %/ a of the bank loan’s principal: 40,000 EUR/ a. Interest is based on the rate of interest (= 5 %/ a) and the value of the loan at the beginning of the Accounting period. E.g., in the Accounting period 20X1, KIRSTENBOSCH (Pty) Ltd. owes the bank 360,000.00 EUR after paying-off 40,000.00 EUR in the first Accounting period. Hence, interest is: 360,000 × 5% = 1 18,000.00 EUR. Observe <?page no="68"?> Berkau: Management Accounting 7e 6-68 the interest and pay-off schedule in Figure 6.2. 0.05 Y e ar O p e nin g am o u nt Inte re s t P ayoff Re st 20X 0 400,000 20,000 40,000 360,000 20X 1 360,000 18,000 40,000 320,000 20X 2 320,000 16,000 40,000 280,000 Figure 6.2: KIRSTENBOSCH (Pty) Ltd.’s interest and pay-off schedule Interest is a cost and a payment at the same time. In contrast, pay-off is a cash flow only. Therefore, the pay-off is relevant for liquidity but does not count for the costs. Observe the cost plan in Figure 6.3: COST PLAN 20X0 20X1 20X2 Materials 1,000,000 1,000,000 1,000,000 Rent 60,000 60,000 60,000 Depreciation 200,000 200,000 200,000 Labour 300,000 300,000 300,000 Administration 240,000 240,000 240,000 Interest 20,000 18,000 16,000 Total 1,820,000 1,818,000 1,816,000 Figure 6.3: KIRSTENBOSCH (Pty) Ltd.’s cost plan 6.7. Profit Plan - C/ S KIRSTENBOSCH (Pty) Ltd. For profit calculation, we deduct the total of costs from annual revenues. A profit plan is a schedule where budgeted costs are deducted from the revenues for every Accounting period. In Management Accounting, the profit calculation if disclosed as a statement is called profitability analysis. As income taxes depend on the profit for the period, tax expenses are disclosed on the profit plan, too. In this textbook, income taxes are calculated by multiplying the total income tax rate of 30 % with the pre-tax profit. Note, that a proper income tax calculation requires to prepare the revenue and cost plan adhering to the tax law regulations, e.g. KIRSTENBOSCH (Pty) Ltd. must follow rules for depreciation which dictate depreciation method and depreciation parameters. The appropriation of profits is part of the profit planning and is shown at the bottom lines of the profit plan. This replaces a statement of changes in equity on the business plan. For the case study KIRSTENBOSCH (Pty) Ltd., the profit after taxes for 20X0 is: (2,200,000 - 1,820,000) × (1 - 30%) = 266,000.00 EUR. <?page no="69"?> Berkau: Management Accounting 7e 6-69 The income taxes are due in the next following Accounting period but they count as expenses regardless of when payments are made. Following the intention of KIRSTENBOSCH (Pty) Ltd., all profits after taxes are added to earnings reserves (appropriation of profits). Observe the profit plan in Figure 6.4. PROFITABILITY PLAN 20X0 20X1 20X2 Revenue 2,200,000 2,200,000 2,200,000 less costs (1,820,000) (1,818,000) (1,816,000) EBT 380,000 382,000 384,000 Income Tax (30%) (114,000) (114,600) (115,200) EAT 266,000 267,400 268,800 to: Earnings Reserves: 266,000 267,400 268,800 to: Dividend 0 0 0 carried forward 0 0 0 Figure 6.4: KIRSTENBOSCH (Pty) Ltd.’s profitability plan 6.8. Liquidity Plan - C/ S KIRSTENBOSCH (Pty) Ltd. Besides of profit maximisation, companies strive to generate cash with their operations. The liquidity plan considers future cash flows (payments and receipts). We measure the liquidity of a business by its cash/ bank item at the end of every Accounting period (we ignore further loan offers to the company). If the operations result in an insufficient liquidity, we must revise the business plan, e.g. by changing operations or adjusting the financing of the company (another bank loan). Liquidity needs to be planned because profitability can differ from cash flows. E.g., a company sells goods and get paid in the next period or it pays for an investment and recognises depreciation in the next following periods. A liquidity plan is a list that shows the opening value of cash/ bank and adds cash inflows and deducts cash outflows for every period. KIRSTENBOSCH (Pty) Ltd. plans all payments and receipts on its liquidity plan. The plan starts-off from the opening value of cash/ bank and adds/ deducts all cash flows. In 20X0, the opening value for cash/ bank is zero. This means the establishment of the company falls under receipts during the Accounting period 20X0. 30 Observe Figure 6.5: 30 The establishment of a company takes place either before the business plan’s periods or therein. If before, an opening value for the share issue must be considered. If the company is established during the business plan periods, the opening value is zero. <?page no="70"?> Berkau: Management Accounting 7e 6-70 LIQUIDITY PLAN 20X0 20X1 20X2 Opening balance 935,000 1,363,000 Issue of shares 500,000 Bank loan issue 400,000 Interest paid (20,000) (18,000) (16,000) Pay-off (40,000) (40,000) (40,000) Interior (600,000) Rent (65,000) (60,000) (60,000) Labour (300,000) (300,000) (300,000) Administration (240,000) (240,000) (240,000) Material expenses paid (900,000) (1,000,000) (1,000,000) Proceeds 2,200,000 2,200,000 2,200,000 Income tax paid 0 (114,000) (114,600) Closing amount cash/ bank 935,000 1,363,000 1,792,400 Figure 6.5: KIRSTENBOSCH (Pty) Ltd.’s liquidity plan For KIRSTENBOSCH (Pty) Ltd. the first receipt is: 500,000.00 EUR owners’ contribution. The next cash inflow results from the issue of the bank loan. The payment from the bank is 400,000.00 EUR which is the nominal value known as principal. Both receipts (share issue and bank loan receipt) are once-off payments. They do not repeat in future Accounting periods. The interest and pay-offs are paid at yearends and equal in 20X0: 20,000 + 40,000 = 6 60,000.00 EUR. The cash flows are negative as KIRSTENBOSCH (Pty) Ltd. pays its bank. The payment for the investment is negative, too. The full costs of acquisition are paid in 20X0 and are equal to 600,000.00 EUR. Rent is paid in advance. Therefore the payments differ from costs. The monthly payment is 5,000.00 EUR/ m. The rent for January 20X0 is due in 20X0 and the payment for January 20X1 is made in 20X0, too, hence, the total rent payments are adding up to: 13 × 5,000 = 65,000.00 EUR in 20X0. The amounts paid for labour and administration are the same as costs. Every Accounting period, KIRSTENBOSCH (Pty) Ltd. pays 300,000.00 EUR/ a for labour and 240,000.00 EUR/ a for administration. In the case of KIRSTENBOSCH (Pty) Ltd., the company pays only 90 % of its material costs during the actual Accounting period. The remainder of: 10% × 1,000,000 = 1 100,000.00 EUR is paid one year later. As this goes on, the payments for purchases are 900,000.00 EUR in 20X0 - but: 100,000 + 900,000 = 1,000,000.00 EUR in 20X1 and 20X2. According to deferred purchase payments, KIRSTENBOSCH (Pty) Ltd. must recognise on its balance sheet 100,000.00 EUR/ a in payables over all three Accounting periods. The revenue of KIRSTENBOSCH (Pty) Ltd. is paid on time. Therefore, the proceeds for all Accounting periods are equal to 2,200,000.00 EUR/ a. For the case study, we pretend that all receipts are cashed in once in the middle of the Accounting periods. Below, we explain the difference between revenue and proceeds. <?page no="71"?> Berkau: Management Accounting 7e 6-71 PProceeds are payments to be received in exchange of selling products or services. If VAT is considered the value for proceeds is the gross amount. In contrast, revenue is a term derived from the profit or loss calculation and is always the net amount. As we ignore VAT for this case study, the values for proceeds and revenues are the same. Tax payments for income taxes are delayed one Accounting period. Hence, the income tax payment in 20X0 is zero and in 20X1 it is: 30% × 380,000 = 114,000.00 EUR. The income taxes are payments into the revenue service’s bank account. The total value as at the end of Accounting period 20X0 in the Cash/ Bank account is: 500,000 + 400,000 - 60,000 - 600,000 - 65,000 - 300,000 - 240,000 - 900,000 + 2,200,000 = 9 935,000.00 EUR. Compare the result to the closing balancing figure recognised on the liquidity plan in Figure 6.5. It also shows on the balance sheet for 20X0 as item cash/ bank. Companies strive to keep liquidity positive but also try to keep it low. Cash reserves do not earn revenue and therefore do not contribute to a company’s profit. High cash reserves would prevent a company from earning profit and dilute return rates. A planned liquidity reserve is a trade-off between risk avoidance and business profitability. 6.9. Budgeted Balance Sheet - C/ S KIRSTENBOSCH (Pty) Ltd. To analyse a business’s future financial position, companies prepare a budgeted balance sheet. A budgeted balance sheet is a pro-forma statement of financial position at a future balance sheet date. The budgeted balance sheet is prepared as at the last day of the last Accounting period covered in the business plan. The budgeted balance sheet does not adhere to the formal IFRS requirements. 31 BUDGETED BALANCE SHEET 20X0 20X1 20X2 P, P, E 400,000 200,000 0 Prepaid expenses 5,000 5,000 5,000 Cash/ Bank 935,000 1,363,000 1,792,400 1,340,000 1,568,000 1,797,400 Issued capital 500,000 500,000 500,000 Reserves 266,000 533,400 802,200 Interest bearing liab. 360,000 320,000 280,000 Payables 100,000 100,000 100,000 Income tax liabilities 114,000 114,600 115,200 1,340,000 1,568,000 1,797,400 Figure 6.6: KIRSTENBOSCH (Pty) Ltd.’s pro-forma balance sheet 31 In academia, we recommend preparing a budgeted balance sheet to check the consistency of the business plan. <?page no="72"?> Berkau: Management Accounting 7e 6-72 The value of P, P, E represents the store equipment bought in 20X0 and is planned to be 600,000.00 EUR. The valuation shown on the balance sheet is reduced for depreciation in 20X0 already: 600,000 - 200,000 = 4 400,000.00 EUR. The prepaid expenses represent the January’s rent for the next Accounting period. The value displayed in 20X0 is for January 20X1, the value in the 20X1 column is for January 20X2 and the last one is prepaid expenses for 20X3. The value of cash/ bank is consistent with the bottom line on the liquidity plan in Figure 6.5. The issued capital is 500,000.00 EUR and remains unchanged. The reserves are earnings reserves and contain the after tax profit based on the appropriation of profits. The value in 20X0 is equal to the earnings after taxes. The value in 20X1 is the total of the previous profit and the actual one: 266,000 + 267,400 = 5 533,400.00 EUR. The last retained earnings are: 266,000 + 267,400 + 268,800 = 8 802,200.00 EUR. The value for the bank loan can be copied from the interest and pay-off schedule. The payables represent short-term liabilities from purchases. The income tax liabilities and recognised as a liability because they are paid in the next following Accounting period. 6.10. Cash Flow Statement - C/ S KIRSTENBOSCH (Pty) Ltd. Below, we discuss liquidity again. The reason is that a company that follows IFRSs for Financial Accounting must prepare a statement of cash flows. Its information is very similar to the liquidity plan. Therefore, companies either plan liquidity or their cash flows. A planned cash flow statement is a list of future operating cash flows, investing cash flows and financial cash flows. Most companies calculate their operating cash flows by reconciliation of their profits with the operating cash flow. In contrast to the liquidity plan, the structure of cash flows follows its triggers: operations, investing activities and financial activities. A cash flow statements discloses payments and receipts but no opening or closing balance. Besides these two differences, the cash flow statement provides the same information as a liquidity plan. <?page no="73"?> Berkau: Management Accounting 7e 6-73 CASH FLOW PLAN 20X0 20X1 20X2 CF operating activities EAT 266,000 267,400 268,800 Adj for depreciation 200,000 200,000 200,000 Adj for interest 20,000 18,000 16,000 Changes in payables 100,000 Changes in income tax liab. 114,000 600 600 Changes in A/ R & prepays (5,000) 695,000 486,000 485,400 CF investing activities Acquisition (600,000) (600,000) 0 0 CF financing activities Share issue 500,000 Interest & pay-off (60,000) (58,000) (56,000) Bank loan issue 400,000 840,000 (58,000) (56,000) Total cash flow 935,000 428,000 429,400 Figure 6.7: KIRSTENBOSCH (Pty) Ltd.’s statement of cash flows To check the figures for KIRSTENBOSCH (Pty) Ltd., we calculate the total cash flow for 20X1. It is the sum of cash flows from operating activities, cash flows from investing activities and cash flows from financing activities: 695,000 - 600,000 + 840,000 = 9 935,000.00 EUR. As there is no opening value for the Cash/ Bank account, the liquidity is equal to the total of cash flows 935,000.00 EUR in 20X0. Compare the calculation to Figure 6.5. In the next Accounting period 20X1, according to KIRSTENBOSCH (Pty) Ltd.’s cash flow statement in Figure 6.7, the total cash flow is: 486,000 + 0 - 58,000 = 4428,000.00 EUR. Based on the cash flow calculation, the liquidity is the sum of the opening value (same as the closing balance of the previous period) and the cash flows: 935,000 + 428,000 = 1,363,000.00 EUR. This is the figure you can read from the table in Figure 6.5 (bottom line). Accordingly, the liquidity in the last Accounting period 20X2 is equal to: 1,363,000 + 429,400 = 1,792,400.00 EUR. The value is disclosed in the liquidity plan in Figure 6.5 as well as balancing figure of the Cash/ Bank account on the balance sheet - such as shown as the cash/ bank item in Figure 6.6. How it is Done (Business Plan) (1) Determine the number of goods/ services that are intended to be sold. (2) Determine net selling prices by Marketing Research. (3) Calculate the revenue by multiplying sales volume with net selling prices. <?page no="74"?> Berkau: Management Accounting 7e 6-74 (4) Determine costs to produce goods or render services. (5) Calculate costs that are not linked to production, such as Marketing, Human Resources or Accounting costs. (6) Deduct costs from revenues to calculate earnings before taxes. (7) Assume income tax expenses occur in the period they are for. Deduct income tax expenses from earnings before taxes by multiplying the earnings before taxes with the total income tax rate (in the textbook always 30 %). (8) Consider the appropriation of earnings after taxes as either (a) profit carried forward, (b) dividend or (c) reserves. Follow the policy of the company about the appropriation of its profits. (9) Prepare a liquidity plan by direct method or reconciliation of profits with operating cash flows. (10) Deduct cash outflows from opening cash/ bank item and add cash inflows to calculate the cash/ bank closing value. (11) Prepare a balance sheet as at the end of the last Accounting period of the business plan. (12) Run a financial statement analysis for future financial statements to assess the business. (13) If the result of the business plan is unsatisfying change the business model or its parameters and rework from step (1). After studying a business plan for a service provider, we take our studies a step further. A business plan for a production firm must consider materials requirements and inventory movements. We discuss the case of BANTRY Ltd. which is a book printing firm. See below the case description: 6.11. C/ S BANTRY Ltd. BANTRY Ltd. is an Australian public, limited company based on shares. It was established by a share issue of 100,000.00 AUD. As we do not prepare the business plan for the first Accounting periods, we study BANTRY Ltd.’s balance sheet as at 31.12.20X2. This is the balance sheet as at the beginning of the period the business plan is prepared for. We plan 2 annual Accounting periods: 20X3 and 20X4. <?page no="75"?> Berkau: Management Accounting 7e 6-75 A C, L Non-current assets [AUD] Equity [AUD] P, P, E 180,000 Share capital 100,000 Intangibles Reserves Financial assets Retained earnings Current assets Liabilities (liab.) Inventory 15,000 Long-term liab. IBL 180,273 Acc. receivables A/ R Short-term liab. A/ P Prepaid expenses 45,000 Provisions Cash/ Bank 40,273 Income tax liab. Total assets 280,273 Total equity and liab. 280,273 BANTRY Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X2 Figure 6.8: BANTRY Ltd.’s balance sheet (20X2) BANTRY Ltd. produces textbooks in a printing and binding process. The book authors provide the contents as PDFfiles. BANTRY Ltd. does not recognise the contents as intangible asset on their financial statements as they do not pay for it. BANTRY Ltd. buys paper and card box for the covers in advance. For binding books, glue is applied. BANTRY employs 5 printing specialists who earn 120,000.00 AUD/ p each. The manager earns an annual salary of 200,000.00 AUD. The manager’s salary is a non-manufacturing cost. Therefore, the manager’s salary is not included in the costs of manufacturing but counts as general administration costs. BANTRY Ltd. operates 3 printing machines which were acquired on 3.07.20X1 at 80,000.00 AUD/ u each. Depreciation is accounted for on straight-line method over 6 years. Below, we confirm BANTRY Ltd.’s item of property, plant and equipment as disclosed on its balance sheet. It represents the printers’ value after 1.5 years of depreciation: 3 × (80,000 - 18 × 80,000/ 72) = 1160,000.00 AUD. For financing BANTRY Ltd. took out a bank loan for 200,000.00 AUD. The loan is an annuity. Its annual payments contain 3.5 %/ a interest and pay-off. The annual payments are 20,000.00 AUD/ a in total. In the first Accounting period 20X1, the annuity was 10,000.00 AUD according to the date of the bank loan issue on 1.07.20X1. In order to confirm the opening value of the bank loan as disclosed on the balance sheet we prepare an interest and pay-off plan. It is disclosed in Figure 6.9. As Management Accounting does not follow IFRSs, BANTRY Ltd. does not discloses shortterm and long-term liabilities separately. <?page no="76"?> Berkau: Management Accounting 7e 6-76 Year Opening amount Interest Pay-off Annuity Rest [AUD] [AUD] [AUD] [AUD] [AUD] 20X1 200,000.00 3,500.00 6,500.00 10,000.00 193,500.00 20X2 193,500.00 6,772.50 13,227.50 20,000.00 180,272.50 20X3 180,272.50 6,309.54 13,690.46 20,000.00 166,582.04 20X4 166,582.04 5,830.37 14,169.63 20,000.00 152,412.41 20X5 152,412.41 5,334.43 14,665.57 20,000.00 137,746.84 Bantry Ltd. INTEREST and PAY-OFF PLAN Figure 6.9: BANTRY Ltd.’s interest and pay-off plan The principal of the loan is 200,000.00 AUD. The first year’s interest is for 6 months: 200,000 × 3.5%/ 2 = 3 3,500.00 AUD. As half of the annuity applies in 20X2, pay-off is: 10,000 - 3,500 = 6,500.00 AUD. The value of the loan as at 31.12.20X2 is 180,272.50 AUD, check Figure 6.9. Interest is an expense but not considered as manufacturing related. BANTRY Ltd. pays monthly rent for the factory building 15,000 AUD/ m. The payments are made for one quarter in advance. Therefore, BANTRY Ltd. discloses on its balance sheet 45,000.00 AUD prepaid expenses. Rent is production-related and must be considered for the calculation of the books’ cost of manufacturing. We continue with the inventories as disclosed on the balance sheet. They represent 15 tons paper at purchase costs of 1.00 AUD/ kg. The planned production volume at BANTRY Ltd. is 48,000 books in 20X3; it increases in 20X4 by 10 %. The paper weight per book is 400 g/ book. No waste applies. BANTRY Ltd. plans to sell 45,000 books in 20X3 and 50,000 books in 20X4. The net selling price per book is 50.00 AUD/ u. According to the difference between production and sales volume, changes in inventories apply. The material expenses are expected to increase during the budget period. In previous years the paper price was 1.00 AUD/ kg (opening value). The paper price is 1.10 AUD/ kg in 20X3 and becomes 1.25 AUD/ kg in 20X4. BANTRY Ltd. intends to increases to and maintain safety paper stock at 25 tons. As a constraint, paper purchases are only available in full tons. This means that BANTRY might buy more paper than needed which will increase its stock level of raw materials above safety stock. BANTRY Ltd. has no other opening inventories (no covers, no glue). For inventory valuation, BABTRY Ltd. applies the cost formula first-in-first-out for all kinds of stock. This includes finished goods as well. The cover and the glue per book cost 2.00 AUD/ book and 0.30 AUD/ book respectively. Book covers and glue are bought on demand during the Accounting periods. During both Accounting periods, BANTRY Ltd. declares a dividend of 50 % of its distributable amount and adds the remainder to earnings reserves. Consider dividends and income tax liabilities payments in the next following Accounting periods. We prepare the revenue plan for BANTRY Ltd below. <?page no="77"?> Berkau: Management Accounting 7e 6-77 6.12. Revenue Plan - BANTRY Ltd. The revenue is based on a constant book price. All books sell at 50.00 AUD/ u. The revenue plan is disclosed in Figure 6.10. Revenue plan 20X3 20X4 Sales amount 45,000 50,000 Book revenue [AUD] 2,250,000.00 2,500,000.00 Total revenue 2,250,000.00 2,500,000.00 Figure 6.10: BANTRY’s revenue plan 6.13. Cost Plan - C/ S BANTRY Ltd. The cost plan for BANTRY Ltd. is more complex than for a service provider because of various materials (paper, card box and glue) and increasing purchase prices. This forces us to determine the material requirements, the costs and in preparation of the liquidity plan the purchase volumes and purchase costs 32 . BANTRY Ltd. prepares a material requirements plan as in Figure 6.11. Material requirements 20X3 20X4 Opening amount [kg] 15,000 25,800 Production requirement [kg] 19,200 21,120 Purchase paper [kg] 30,000 21,000 Rest paper [kg] 25,800 25,680 Production volume (books) 48,000 52,800 Purchase value [AUD] 33,000.00 26,250.00 Paper expenses [AUD] 19,620.00 23,232.00 Cover costs [AUD] 96,000.00 105,600.00 Glue costs 14,400.00 15,840.00 Figure 6.11: BANTRY Ltd.’s material requirements plan All material amounts are measured in kilogram. In the business plan, figures that represent amounts (no currency units) are disclosed in the centre of the cell. The opening amount for the paper is 15 tons in 20X3. In the next year, the opening amount is the closing amount from 20X3. The number of paper required for 32 Cost of purchase and cost of acquisition are technical term from Financial Accounting. They are not related to costs but to expenses. To avoid misunderstandings we prefer for purchase values the the production of 48,000 books depends on their unit weight of 400 g/ u. Hence, the paper requirement for the first Accounting period is: 48,000 × 0.4 = 1 19,200 kg. BANTRY Ltd. intends to increase its safety stock to 25 tons. Therefore, the amount of paper to be ordered is at least: 19,200 + 25,000 - 15,000 = 2 29,200 kg. As paper only can be ordered in full expression ‘purchases [EUR]’ over ‘purchase costs’. <?page no="78"?> Berkau: Management Accounting 7e 6-78 tons, BANTRY must order 30 tons. Therefore, the closing stock is 25.8 tons. The cost of purchases is: 30,000 × 1.1 = 333,000.00 AUD. For the paper costs in 20X3, different purchase prices apply. The opening value cost 1.00 AUD/ kg and the next purchase is valued at 1.10 AUD/ kg. The paper costs are: 15,000 × 1 + (19,200 - 15,000) × 1.1 = 1 19,620.00 AUD. For the next year, we must consider an increase of the production volume at 10 %. Thus, the number of books manufactured is: 48,000 × (1 + 10%) = 5 52,800 books. The calculation of the paper costs is similar to the previous year. BANTRY Ltd. needs: 52,800 × 0.4 = 2 21,120 kg of paper. To maintain a stock level of at least 25 tons, the minimum order amount is: 21,120 + 25,000 - 25,800 = 20,320 kg. BANTRY Ltd. orders 21 tons of paper at a price of 1.25 AUD/ kg. The costs of purchase are: 21,000 × 1.25 = 26,250.00 AUD. The material costs are based on the opening stock price only: 21,120 × 1.1 = 2 23,232.00 AUD. For the other materials, we consider the production volume in 20X3 and calculate book-cover costs of: 48,000 × 2 = 96,000.00 AUD and glue costs of: 48,000 × 0.30 = 1 14,400.00 AUD. In the next period 20X4, these costs are: 52,800 × 2 = 105,600.00 AUD and: 52,800 × 0.30 = 15,840.00 AUD respectively. Below, we complete the cost calculation for BANTRY Ltd. The cost plan is disclosed in Figure 6.12. Cost plan 20X3 20X4 Labour printer 600,000.00 600,000.00 Labour manager 200,000.00 200,000.00 Depreciation 40,000.00 40,000.00 Interest 6,309.54 5,830.37 Paper costs 19,620.00 23,232.00 Cover costs 96,000.00 105,600.00 Glue costs 14,400.00 15,840.00 Rent 180,000.00 180,000.00 Total costs 1,156,329.54 1,170,502.37 Figure 6.12: BANTRY Ltd.’s cost plan The cost plan covers all costs, no matter whether they are related to production. The labour costs are for the printer specialists: 5 × 120,000 = 6 600,000.00 AUD/ a in both Accounting periods. The manager’s salary is given: 200,000.00 AUD. Depreciation on the printers follows straight-line method. The annual depreciation is: 3 × 80,000 / 6 = 4 40,000.00 AUD/ a. We read the interest from the interest and pay-off table in Figure 6.9. Material costs are as discussed above. For the rent calculation, the payment terms are irrelevant. The annual rent is: 12 × 15,000 = 1 180,000.00 AUD/ a. We arrive at the total annual costs of 1,156,329.54 AUD for 20X3 and 1,170,502.37 AUD for 20X4. <?page no="79"?> Berkau: Management Accounting 7e 6-79 6.14. Profit Plan - C/ S BANTRY Ltd. For a profit calculation, a company can apply the nature of expense method or the cost of sales format. We here follow the nature of expense method. A profit calculation under the nature of expense method considers all costs of the period (as calculated above) and deducts the costs of changes of finished goods. In the first Accounting period, these are the cost of manufacturing for the books added to stock. As BANTRY Ltd. follows the first-in-first-out cost formula, the books on stock at the end of the Accounting period are the last ones produced. In the next year, the books sold first are the ones released from stock. This is relevant for the calculation of changes of finished goods inventories. In preparation of the profit calculation, we calculate the costs per book. We calculate the closing stock in the table below in Figure 6.13. Product calculation closing Stock Number of closing stock [books] 3,000 5,800 Paper costs of closing stock [AUD] 1,320.00 2,552.00 Cover costs of closing stock [AUD] 6,000.00 11,600.00 Glue costs of closing stock [AUD] 900.00 1,740.00 average OH (labour, depr., rent) 51,250.00 90,075.76 Total costs 59,470.00 105,967.76 Figure 6.13: BANTRY Ltd.’s closing stock valuation The number of books left on stock is the difference between the production volume and sales. It is: 48,000 - 45,000 = 33,000 books in 20X3 and 52,800 + 3,000 - 50,000 = 5 5,800 books in 20X4. Keeping in mind that the books printed last are the ones on stock, we know that the paper costs of these books are the ones from the last order in 20X3. Hence, paper costs are: 3,000 × 0.4 × 1.1 = 1,320.00 AUD. In the next period, the paper costs for closing stock of books are: 5,800 × 0.4 × 1.1 = 2 2,552.00 AUD. Because BANTRY Ltd. ordered 21 tons paper in 20X4 and the closing stock of raw materials is 25 tons, the total paper purchases from 20X4 are still on stock (inventories of raw materials). Therefore, the paper consumptions for books printed in 20X4 is completely at 1.10 AUD/ kg. As the cover costs and glue costs are constant, we only multiply the production volume with the material prices. Furthermore, the books’ costs of manufacturing include all overheads linked to production. These are all costs except of interest and manager’s salary. All other overheads are considered for the book calculation. For 20X3 we calculate the total manufacturing overheads for the 3,000 books on stock as the labour costs (printing experts only), depreciation and rent, divided by the volume and multiplied with 3,000. BANTRY Ltd. does not apply overheads in its produc- <?page no="80"?> Berkau: Management Accounting 7e 6-80 tion department based on predetermined overhead allocation rates POR 33 but in full and on product count (numbers of books). In 20X3, the applied manufacturing overheads are: 3,000 × (600,000 + 40,000 + 180,000) / 48,000 = 5 51,250.00 AUD. In the next period applied overheads are: 5,800 × (600,000 + 40,000 + 180,000) / 52,800 = 9 90,075.76 AUD. The valuation of closing stock completed, we calculate profits for the 2 Accounting periods. The profit plan is disclosed in Figure 6.14. Profitability plan 20X3 20X4 Revenue 2,250,000.00 2,500,000.00 Changes in books inventory 59,470.00 46,497.76 Total costs (1,156,329.54) (1,170,502.37) Earnings before taxation 1,153,140.46 1,375,995.39 Income tax (345,942.14) (412,798.62) Earnings after taxation 807,198.32 963,196.77 -> reserves (403,599.16) (481,598.39) -> dividend (403,599.16) (481,598.39) -> carried forward 0.00 0.00 Figure 6.14: BANTRY Ltd.’s profit plan In BANTRY Ltd.’s profit plan in Figure 6.14, the revenue and the total costs are taken from the revenue plan and the cost plan respectively. The changes in inventory of finished goods is the closing stock of books in 20X3. In 20X4, we must consider stock releases of 59,470.00 AUD because inventory movements are calculated on the first-in-first-out basis. The increase in closing stock of books for 20X4 is: 105,967.76 - 59,470 = 46,497.76 AUD. The value of 105,967.76 results from the inventory valuations in Figure 6.13. Although both valuations consider paper costs at a purchase price of 1.10 AUD/ kg the allocated overheads in 20X4 are lower as the production volume increased by 10 % in 20X4. 33 Manufacturing Accounting including the overhead application is discussed in chapters (18) and (19). Therefore, we simplify the case study here. After the profit calculation, we deduct income taxes at the total income tax rate of 30 % and consider the appropriation of profits at a dividend-reserves ratio of 50 : 50. The appropriation of profits is based on the distributable amount. It includes the profit carried forward from a previous period. In the case of BANTRY Ltd. no profit is carried forward. Hence, the dividend and the addition to reserves is half of the profit after taxes. It is: 807,198.32 / 2 = 4 403,599.16 AUD for 20X3 and 963,196.77 / 2 = 481,598.39 AUD for 20X4. <?page no="81"?> Berkau: Management Accounting 7e 6.81 6.15. Liquidity Plan - C/ S BANTRY Ltd. For the case study BANTRY Ltd. VAT is considered at a VAT rate of 20 %. Therefore, payments differ from costs. Paid input-VAT is refunded one period later by the revenue service. The liquidity plan starts-off from the opening balance in the Cash/ Bank account. At BANTRY Ltd. the opening value is 40,272.50 AUD as taken from the balance sheet in Figure 6.8. The liquidity plan discloses receipts on top. They are followed by the payments. The total is the closing balance of cash/ bank. Find the liquidity plan for BANTRY Ltd in Figure 6.15. Liquidity plan 20X3 20X4 OV cash/ bank 40,272.50 1,568,192.50 Revenue (net value) 2,250,000.00 2,500,000.00 Output-VAT 450,000.00 500,000.00 Purchase paper (net value) (33,000.00) (26,250.00) Purchase cover (net value) (96,000.00) (105,600.00) Purchase glue (net value) (14,400.00) (15,840.00) input-VAT from Purchases (28,680.00) (29,538.00) VAT receipt from revenue service (421,320.00) Labour printing experts (600,000.00) (600,000.00) Labour manager (200,000.00) (200,000.00) Rent payments (180,000.00) (180,000.00) Interestand pay-off payments (20,000.00) (20,000.00) Dividends (403,599.16) Payment of income tax (345,942.14) Liquidity 1,568,192.50 2,220,103.20 Figure 6.15: BANTRY Ltd.’s liquidity plan At BANTRY Ltd. proceeds is the money received from customers for the books. We copy the value from the profit plan. As the company is registered for VAT reduction, it collects output-VAT from its customers. The output-VAT is 20 % based on the revenue. Hence, BANTRY Ltd. receives: 2,250,000 × 20% = 4450,000.00 AUD in output-VAT. The proceeds are: 2,250,000 + 450,000 = 2,700,000.00 AUD. Next, we consider all purchases from the cost plan. Again, BANTRY Ltd. must consider input-VAT to be refunded in the next Accounting period. The 20X3’s input-VAT is: 20% × (33,000 + 96,000 + 14,400) = 2 28,680.00 AUD. The input-VAT is paid together with the costs of purchase in full. In the next Accounting period, BANTRY Ltd. pays the difference between outputand input-VAT to the revenue service. The resulting VAT liability to be settled in 20X3 is: 450,000 - 28,680 = 4 421,320.00 AUD. The payment is made in 20X4 as shown on the liquidity plan. BANTRY Ltd. makes payments for labour and for rent. As the bank loan is an annuity, a payment of 20,000.00 AUD is <?page no="82"?> Berkau: Management Accounting 7e 6-82 considered for both Accounting periods. The payment is for interest and pay-off. The lines at the bottom on the liquidity plan show payments of dividends and income tax liabilities. Under the conventions of this textbook the payments are made in the next following Accounting period. The dividends declared in 20X3 based on the profit earned during that Accounting period are paid in 20X4. Furthermore, BANTRY Ltd. pays income taxes for 20X3 in 20X4. The balance sheet in Figure 6.8 does not show profit nor income tax liabilities. Therefore, no payments are planned in 20X3 for dividends and income tax. The total of the opening value plus receipts and less payments gives the liquidity. In 20X3, the liquidity at BANTRY Ltd. is 1,568,192.50 AUD. This is also the value to be disclosed as item cash/ bank on the budgeted balance sheet. 6.16. Balance Sheet - C/ S BANTRY Ltd. The balance sheet is required as at the end of the budgeting period which is as at 31.12.20X4. However, the balance sheet is prepared for both periods on the business plan as we need to know the opening values for the 20X4-balance sheet. We plan the budgeted balance sheet in the format of a list. It is shown in Figure 6.16. Budgeted balance sheet 20X3 20X4 P, P, E 140,000.00 100,000.00 Intangibles Financial assets Inventory 87,850.00 137,365.76 Receivables Prepaid expenses 45,000.00 45,000.00 Cash/ Bank 1,568,192.50 2,220,103.20 Total assets 1,841,042.50 2,502,468.96 Share capital 100,000.00 100,000.00 Reserves 403,599.16 885,197.55 Retained earnings 0.00 0.00 Interest bear liabilities 166,582.04 152,412.41 Payables (dividends) 824,919.16 952,060.39 Provisions Tax liabilities 345,942.14 412,798.62 Total equity and liab. 1,841,042.50 2,502,468.96 Figure 6.16: BANTRY Ltd.’s budgeted balance sheet For the discussion of the balance sheets’ items we follow a top down approach and cover the value for both Accounting periods together. PProperty, plant, equipment: The item property, plant, equipment at BANTRY Ltd. shows the value of the printers. They <?page no="83"?> Berkau: Management Accounting 7e 6-83 were acquired in the middle of 20X1 at cost of acquisition (net value) of 240,000.00 AUD. On 31.12.20X3 the machines are depreciated over 2.5 years. The value is: 240,000 - 2.5 × 40,000 = 1 140,000.00 AUD. For the next Accounting period, we deduct another 40,000.00 AUD for depreciation. Hence, the value is: 140,000 - 40,000 = 100,000.00 AUD. Intangibles and financial assets: Intangibles and financial assets do not apply for BANTRY Ltd. Inventories: The inventories are calculated for paper and books. Covers and glue are ordered on demand. The paper’s value in 20X3 is: 25,800 kg × 1.1 = 28,380.00 AUD. In the next Accounting period, the closing stock of paper is 25,680 kg as shown in Figure 6.11. The last input was 21 tons at 1.25 AUD/ kg. Therefore, the value of the closing stock of paper is: 21,000 × 1.25 + (25,680 - 21,000) × 1.1 = 3 31,398.00 AUD. The valuation of finished goods is copied from Figure 6.13. The total of inventories which include paper and books in 20X3 amounts to: 28,380 + 59,470 = 87,850.00 AUD. In 20X4 the inventory valuation for paper and books gives: 31,398 + 105,967.76 = 1 137,365.76 AUD. Receivables: There are no claims against customer nor other business partners at BANTRY Ltd. Prepaid expenses: The prepaid expenses are constantly 45,000.00 AUD. BANTRY Ltd. pays quarterly rent in advance. The rent does not change over the budgeting period. Cash/ bank: The balancing figure for cash/ bank is taken from the bottom line of the liquidity plan in Figure 6.15. Issued capital: The issued capital is 100,000.00 AUD and does not change during the budgeting period. Reserves: BANTRY Ltd.’s reserves are earnings reserves only. The value in 20X3 is half of the distributable amount as calculated in the profit plan in Figure 6.14. No opening value is considered as the balance sheet in Figure 6.8 does not show reserves. In 20X4, BANTRY Ltd. adds half of the distributable amount to the already existing reserves. The sum is: 403,599.16 + 481,598.39 = 8 885,197.55 AUD. Interest bearing liabilities: The interest bearing liabilities result from the bank loan. It shows how much BANTRY Ltd. owes its bank at the end of each Accounting period. The value is taken from the interest and pay-off schedule in Figure 6.9. Payables: The short-term liabilities are the total of liabilities towards the owners (dividends) and VAT liabilities. The dividends declared by BANTRY Ltd. are equal to half of the distributable amounts as disclosed in the profit plan in Figure 6.14. Dividends declared in 20X3 are amounting to 403,599.16 and in 20X4 they are 481,598.39 AUD. The VAT liabilities are calculated as difference between outputand input VAT. In 20X3 the residual VAT liabilities are: 450,000 - 28,680 = 4 421,320.00 AUD. In the next Accounting period, BANTRY Ltd. owes the revenue service: 500,000 - <?page no="84"?> Berkau: Management Accounting 7e 6-84 29,538 = 4 470,462.00 AUD. Hence, the total of short term liabilities that include dividends to owners and VAT liabilities to the revenue service are in 20X3: 403,559.16 + 421,320 = 8 824,879.16 AUD and in 20X4: 481,598.39 + 470,462 = 952,060.39 AUD. Provisions: No Provisions apply at BANTRY Ltd. Income tax liabilities: The tax liabilities result from the tax payments scheduled for the next following Accounting period. No prepayments apply at BANTRY Ltd. The income taxes for 20X3 which are paid in 20X4 must be disclosed on the balance sheet as income tax liability. They are amounting to 345,942.14 AUD as copied from the profit plan in Figure 6.14. Accordingly to the previous period, the tax liabilities in 20X4 are 412,798.62 AUD. Note, that income taxes have been accounted for on cost basis for the business plan only. The budgeted balance sheet can be used to check of the business plan. We compare the total on both sides and acknowledge the sum of assets is equal to the total of equity and liability. 6.17. C/ S McTOY GmbH In contrast to the BANTRY Ltd. case study, the production process at McTOY GmbH is more complex and the number of materials is higher. Prices are increasing over the budgeting period. We recommend to selfstudy the case by preparing the business plan on MS-Excel. For the sake of textbook space, the case study McTOY GmbH has been placed to the online materials accessible through the link below: Link 6.A: C/ S McTOY GmbH 6.18. C/ S Schluchman Our next business plan is for a company that changes its legal form. The case study SCHLUCHMAN is linked to Hospitality Management. The company is a caterer. It covers a business plan with change of legal form. Download the case through the link below. Link 6.B: C/ S SCHLUCHMAN 6.19. Summary Companies plan their operations and non-operating activities like finance and investments for the next upcoming Accounting periods and prepare a business plan. The business plan contains the revenue plan, the cost plan, <?page no="85"?> Berkau: Management Accounting 7e 6-85 the profitability plan, the liquidity plan, the pro-forma budgeted balance sheet and future cash flow plan. In this chapter we explained detailed business plans for 4 different case studies. 6.20. Working Definitions Budgeted Balance Sheet: A budgeted balance sheet is a pro-forma statement of financial position at a future balance sheet date. Budgeted Cash Flow Statement: A planned cash flow statement is a list of future operating cash flows, investing cash flows and financial cash flows. Cost Plan: A cost plan is a list of budgeted costs for a business displayed on costs or cost group levels for every Accounting period. Liquidity Plan: A liquidity plan is a list that shows the opening value for cash/ bank, adds cash inflows and deducts cash outflows for every period. Proceeds: Proceeds are payments to be received in exchange of selling products or services. Profit Plan: A profit plan is a schedule where budgeted costs are deducted from the revenues for every Accounting period. Revenue Plan: A revenue plan is a list of planned revenues displayed on product group level for the Accounting periods. 6.21. Question Bank (1) A company (registered for VAT reduction) buys goods at purchase costs of 10,000.00 EUR every year and pays 80 % thereof and the remainder in the next year. You are to prepare the liquidity plan. How much are payments in the first 3 years? 1. 8,000.00 EUR / 8,000.00 EUR / 8,000.00 EUR . 2. 9,600.00 EUR / 10,000.00 EUR/ 10,000.00 EUR . 3. 9,600.00 EUR / 12,000.00 EUR / 12,000.00 EUR . 4. 9,600.00 EUR / 10,400.00 EUR / 10,000.00 EUR . (2) A company pays 250.00 EUR/ m rent. Rent is not subjected to VAT. The payment is 2 months in advance. On a 3 years business plan the rent shows in the cost plan as: 1. 3,500.00 EUR / 3,000.00 EUR / 3,000.00 EUR . 2. 3,500.00 EUR / 3,500.00 EUR / 3,500.00 EUR . 3. 3,500.00 EUR / 2,500.00 EUR / 3,000.00 EUR . 4. 3,000.00 EUR / 3,000.00 EUR / 3,000.00 EUR . (3) A business plan contains … 1. … a revenue plan, a cost plan, a profit plan and a cash flow statement. 2. … a revenue plan, a cost plan, a budgeted balance sheet and a liquidity plan. 3. … a profit plan, a product calculation and a liquidity plan. 4. … a cost plan, a profit plan, an asset plan and a budgeted balance sheet. (4) A company prepares a profit plan and discloses the appropriation of profits therein. The appropriation of profits is at an 80 : 20 ratio as dividends : R/ E. How much <?page no="86"?> Berkau: Management Accounting 7e 6-86 are dividends if the pre-tax profit is in every year 100,000.00 EUR? 1. 80,000.00 EUR / 96,000.00 EUR / 99,200.00 EUR . 2. 80,000.00 EUR / 80,000.00 EUR / 80,000.00 EUR . 3. 56,000.00 EUR / 67,200.00 EUR / 69,440.00 EUR . 4. 56,000.00 EUR / 56,000.00 EUR / 56,000.00 EUR . (5) A company buys a non-current asset at 150,000.00 EUR cost of acquisition. The dealer offers a discount of 5 %. VAT is to be considered at a rate of 20 %. Depreciation is accounted for on straight-line method over 10 years. How does the asset show on the budgeted balance sheet? 1. 128,250.00 EUR / 114,000.00 EUR / 99,750.00 EUR . 2. 142,000.00 EUR / 128,000.00 EUR / 114,000.00 EUR . 3. 153,000.00 EUR / 136,900.00 EUR / 119,700.00 EUR . 4. 171,000.00 EUR / 153,900.00 EUR / 136,900.00 EUR . 6.22. Solutions 1-2; 2-4; 3-2; 4-3; 5-1. <?page no="87"?> Berkau: Management Accounting 7e 7-87 7. Investment Decisions 7.1. What is in the Chapter? In this chapter we demonstrate how Management Accounting supports investment decisions and prepares capital budgets. We introduce the major investment appraisal techniques and explain the capital budget table. We also introduce the capital budget table with its extended version and discuss combinations of investments as investment programmes and investment series. 7.2. Learning Objectives After studying this chapter, you can apply the most common methods of investment appraisal and you know their differences. You also learn which method should be applied in particular situations and what are their advantages and weaknesses. 7.3. Investment Appraisal - Basic Approaches Investments are long-term decisions about the acquisition of non-current assets as well as of financial instruments and rights. E.g., a company that is a manufacturer decides whether to buy a new machine to increase its production volume or to acquire a license under which it produces goods or to invest money in shares of another company. As investment decisions are for longer periods, compound interest calculations need to be considered. The efficiency of investments is measured by cash flows. It cannot be calculated on profitability figures as not all costs are relevant for interest, e.g. depreciation is not. To make good investment decisions, Management Accounting supports mangers with valuations based on investment appraisal methods. Information whether an investment is worthwhile helps managers to decide between investment opportunities and to identify the best investment programme for the company. Furthermore, Management Accounting provides information for investment and finance planning. The latter one is to foresee whether planned investments and their cash flows will cause shortages in terms of a company’s liquidity in the future. The most common methods to support investment decisions are the (1) payback method, (2) Accounting return figures and valuations based on the time value of money concept which we refer to as (3) present value method. 7.4. Payback method The payback method is very simple and ignores compound interest calculations. It simply determines the time it takes to repay the initial payment for an investment. We only need to accumulate the cash flows of an investment and check after how many periods the cumulative cash flows break-even. The method does not calculate profitability or efficiency <?page no="88"?> Berkau: Management Accounting 7e 7-88 but a time span. Therefore, it reflects the liquidity risk investors take with the investment. Another weakness is that the payback method only considers periods until the investment breaks-even but ignores what happens thereafter. 7.5. C/ S HOPEFIELD (Pty) Ltd. HOPEFIELD (Pty) Ltd. invests 120,000.00 AUD in shares of a fast-food restaurant chain which pay an annual dividend of 7 %/ a. We calculate the time until the investment is paid back. The annual dividend is: 7% × 120,000 = 8 8,400.00 AUD. Therefore, it takes: 120,000 / 8,400 = 14.29 years for the money invested to be returned. We might be more interested in the date of when the investment’s cash flows break-even. Therefore, we calculate how much days is 29 % out of 365 days. It gives us 106 days, which means the investment pays back on the 16 th of April in the 15 th year (no leap day). 7.6. Additional Investments - Capital Structure Decisions Companies measure the business profitability by Accounting return figures. A return is the output, e.g. the profit, divided by the input, e.g. capital invested. Returns are measured as percentages. Although average returns consider the entire period of an investment (better than payback method) they ignore the time value of money (no compound interest calculation). The relationship between the return on assets and the return on equity is known as leverage effect. The leverage effect states that the return on equity increases/ decreases with the indebtedness of a business. Before we discuss the outcome of the effect, we derive the formula. We ignore income tax. The return on equity is: ROE = EBT/ E and the return on assets or return on capital employed is: ROA = ROCE = EBIT/ (E + D) with: E = equity and D = debts. Note, that in case D = 0 no interest is paid and ROA is equal to ROE. For further discussions, we intend to restructure the ROE-formula so that it shows how the return on equity depends on D/ E which is a factor that indicates how much a company is in debts. As the following steps of rearranging the equation are based on our intention to apply a specific format, we explain them step by step. At first we show the return on equity which is the EBT/ E. We replace EBT by EBIT - i × D. Next, we replace EBIT by ROA × (E+D): This is the same as: We factor out D/ E from the last 2 terms and arrive at the final format for the ROE-equation: <?page no="89"?> Berkau: Management Accounting 7e 7-89 The restructuring of the formula gives the return on equity as it depends on the relationship between the D and E which is the capital structure. We refer to it as the indebtedness rate, also known as the debt to equity ratio (D2E). Investors can take advantage of the leverage effect. If a company invests by increasing its D2E ratio and the Return on the employed capital ROA exceeds the interest rate, returns for the investors ROE increase. Therefore, the D2E ratio also is called financial leverage or gearing. We assume the EBIT is 12,000.00 EUR, 2,000.00 EUR thereof are for interest. Hence, the EBT equals: 12,000 - 2,000 = 10,000.00 EUR. The equity is 100,000.00 EUR and the D2E ratio is 50% which means the company took out loans for 50,000.00 EUR. The rate of interest is: 2,000 / 50,000 = 4%. The calculation of ROE gives: 10,000 / 100,000 = 10%. The ROA is: 12,000 / 150,000 = 8%. We put the figures into the equation for the leverage effect: For the next scenario (II), we assume the company invests 50,000.00 EUR which is takes out as a loan, too. The ROA remains 8 %. The Return on equity increases to 12%: We recalculate the returns: The EBIT is now: 8% × 200,000 = 16,000.00 EUR. Therefrom, 4% × 100,000 = 4,000.00 EUR is interest. The return on equity ROE is equal to: (16,000 - 4,000)/ 100,000 = 12%. The leverage effect depends on the capital structure and is also discussed under the name capital structure theory or M/ M-theory 34 . In the first approach the theory assumed that interest and ROA are constant. In this case, the leverage effect could be exploited without limitations. However, the ROA is not constant over D/ E. Investors rank their investment opportunities and accept those with high returns 34 M/ M = Modigilany/ Miller first. Therefore by expanding the business, the average ROA diminishes. The interest is not constant either. Investors who are highly in debts pay higher rates of interest than those with a low D2E ratio. Being much in debts might even lead to credit downgrades and no loan is offered at all. Therefore, investors cannot benefit from the leverage effect without limits. Furthermore, it needs to be taken into account that the leverage effect also reverses. In the above discussed example (II) a decrease of the ROA below the rate of interest, say 3 % results in a lower ROE as if the D2E is only 50%. It then would become 2.5 %. <?page no="90"?> Berkau: Management Accounting 7e 7-90 Below, we discuss the case of MESUM GmbH. The company considers to extend its operations by investing in an additional production line. The project needs to be financed by a loan completely. 7.7. C/ S MESUM GmbH MESUM GmbH runs a production line with an annual rate of return (= profit before interest and tax divided by the investment) of 9.8 %. MESUM GmbH invested 340,000.00 EUR and sells the production line after 3 years at 28,000.00 EUR. Hence, the average investment is: (340,000 - 28,000)/ 2 = 1 156,000.00 EUR. This follows the assumption of straight-line method for depreciation. Across the 3 periods, earnings before interest and tax are: 15,500.00 EUR, 15,250.00 EUR and 15,000.00 EUR. This is on average 15,250.00 EUR. Therefore, the average annual return is: 15,250 / 156,000 = 9 9.8 %/ a (rounded). For financing, MESUM GmbH took a bank loan of 240,000.00 EUR that comes with a rate of interest of 3.9 %/ a. The reminder of the investment (= 100,000.00 EUR) has been financed with equity. MESUM GmbH’s return on equity is: (9.8% × 340,000 - 3.9% × 240,000) × (1 - 30%) / 100,000 = 1 16.77 %/ a. MESUM GmbH wants to know whether to accept an investment offer in an additional production line. In particular, it wonders whether the project will increase its return of equity. The additional production line requires an investment of 45,000.00 EUR and the estimated average annual rate of return is 8 %/ a. The investment must be financed completely by a further bank loan. Unfortunately, the loan issue is only available for 50,000.00 EUR and its rate of interest is 4.2 %/ a. We calculate the return on equity for acceptance of the investment project. It is: (9.8% × 340,000 + 8% × 45,000 - 3.9% × 240,000 - 4.2% × 50,000) × (1 - 30%) / 100,000 = 1 17.82 %/ a. Hence, the additional investment is in favour of MESUM GmbH’s owners. The leverage effect works in both directions. In case the average annual return falls below the rate of interest, the higher indebtedness leads to an overproportional decrease of return of equity. We assume the new project fails and its average annual return is only 3 %. Now, the return on equity is 16.25 % which means the investment project should have been rejected if known before. 7.8. Capital Budget Table CBT Investments and their financing are best evaluated based on cash flows that take place over the investment’s life time. To calculate the investor’s future wealth (= capital) we apply cash flow vectors as introduced in chapter (5). This excludes non-financial factors from our decisions which is why we should evaluate our analysis based on <?page no="91"?> Berkau: Management Accounting 7e 7-91 further aspects, e.g. sustainability or market share achievements. The vectors represent cash flows for the periods 0 … T. To gain an overview of the calculations, we put all cash flows on a capital budget table. It shows columns for the periods and lines for the cash flow vectors of the investment, its financing and further payments/ receipts. Below, we introduce the case study WALLINGFORD Ltd. which is a car wash service. 7.9. C/ S WALLINGFORD Ltd. - 1 WALLINGFORD Ltd. is a gas station in South Africa. It plans an investment project in a car wash facility. The useful life of the car wash facility is 3 years. The investment is 2,000,000.00 ZAR. After 3 years, the car wash facility can be sold at 800,000.00 ZAR (after tax on capital gain). During the periods 1 … 3 WALLINGFORD Ltd. plans an annual cash inflow of 700,000.00 ZAR and in the last period 650,000.00 ZAR. The investment vector is: E(t) = {-2,000,000; 700,000; 700,000; 1,450,000}. For financing, WALLINGFORD Ltd. takes out a bank loan for 2,000,000.00 ZAR in t = 0 with an interest rate of 7.5 %/ a and pays-off 200,000.00 ZAR/ a. Interest and pay-off are due in t = 1 … T. In the last period T, WALLINGFORD Ltd. must payoff the bank loan completely. The finance vector is: F(t) = {2,000,000; - 350,000; -335,000; -1,720,000}. The basic payment vector B(t) covers administration and rent for the building. It is constantly 100,000.00 ZAR beginning with t = 1. We prepare the capital budget table for WALLINGFORD Ltd. in Figure 7.1 t=0 t=1 t=2 t=3 Investment E(t) (2,000,000.00) 700,000.00 700,000.00 1,450,000.00 Finance F(t) 2,000,000.00 (350,000.00) (335,000.00) (1,720,000.00) Basic Pay B(t) (100,000.00) (100,000.00) (100,000.00) Total 0.00 250,000.00 265,000.00 (370,000.00) Wallingford Ltd. Capital Budget Table Figure 7.1: Capital budget table WALLINGFORD Ltd. 7.10. Extended Capital Budget Table eCBT For investment appraisal, we want to calculate the future value of the investor’s capital C T . Therefore we extend the capital budget table by adding the opening capital to the equation. We further consider drawings as a yield vector and 35 Pretending d-i = c-i avoids the distinction of different cases. That simplified the application of formulas. follow the assumption that remaining cash flows (after drawings) will be reinvested at a credit interest rate c-i. In case of a shortage of funds, extra finance is based on a debit interest rate d-i. Sometimes, we (must) 35 simplify the interest calculations by a standard interest rate i which represents the debit <?page no="92"?> Berkau: Management Accounting 7e 7-92 interest as well as the credit interest rate. The capital C t at any time t is then: We put the cash flows on an extended capital budget table. At the bottom, we consider the re-investments/ additional financing. Therefore, the total on the bottom line always becomes zero, except of in the last period because C T is not reinvested. Below, we prepare the extended capital budget table for WALLINGFORD Ltd. 7.11. C/ S WALLINGFORD Ltd. - 2 For the case study WALLINGFORD Ltd. we add the below information: - The initial capital is 500,000.00 ZAR. - The annual drawing are 250,000.00 ZAR. In the first period t = 1 the drawing is only 50 %. That gives a yield structure vector f(t) = {0; 0.5; 1; 1} and a yield of Y = 250,000.00 ZAR. - The credit interest rate c-i is 3 % and the debit interest rate d-i is 12 %. Find the extended capital budget table in Figure 7.2. It is marked (I) which stands for the first version. t=0 t=1 t=2 t=3 Opening capital 500,000.00 Investment E(t) (2,000,000.00) 700,000.00 700,000.00 1,450,000.00 Finance F(t) 2,000,000.00 (350,000.00) (335,000.00) (1,720,000.00) Basic Pay B(t) (100,000.00) (100,000.00) (100,000.00) Drawing f t × Y (125,000.00) (250,000.00) (250,000.00) Re-inv/ Add fin (500,000.00) 515,000.00 Re-inv/ Add fin (640,000.00) 659,200.00 Re-inv/ Add fin (674,200.00) 694,426.00 0.00 0.00 0.00 74,426.00 Wallingford Ltd. extended Capital Budget Table (I) Figure 7.2: eCBT for WALLINGFORD Ltd. (I) 7.12. Decisions between Investments With the extended capital budget table we can easily support decisions about investments and financing. We replace the cash flows of the investment with the ones for an alternative one and check the future value for capital C T . The investment that results in the highest capital C T at t = T is favourable. 7.13. C/ S WALLINGFORD Ltd. - 3 We discuss an alternative car wash investment for WALLINGFORD Ltd. The alternative investment is lower and the receipts during the periods of operation are constantly 650,000.00 ZAR. The capital gain after taxes in the last period when the facility is disposed is lower: <?page no="93"?> Berkau: Management Accounting 7e 7-93 700,000.00 ZAR. The alternative investment vector is: E II (t) = {-1,800,000; 650,000; 650,000; 1,350,000}. Study below the alternative extended capital budget table in Figure 7.3. t=0 t=1 t=2 t=3 Opening capital 500,000.00 Investment E(t) (1,900,000.00) 650,000.00 650,000.00 1,350,000.00 Finance F(t) 2,000,000.00 (350,000.00) (335,000.00) (1,720,000.00) Basic Pay B(t) (100,000.00) (100,000.00) (100,000.00) Drawing f t × Y (125,000.00) (250,000.00) (250,000.00) Re-inv/ Add fin (600,000.00) 618,000.00 Re-inv/ Add fin (693,000.00) 713,790.00 Re-inv/ Add fin (678,790.00) 699,153.70 0.00 0.00 0.00 (20,846.30) Wallingford Ltd. extended Capital Budget Table (II) Figure 7.3: eCBT WALLINGFORD Ltd. (II) The future value for capital is lower and even became negative. However, we notice that the loan is too high as WALLINGFORD Ltd. does not use its funds. To remedy this waste of funds, we adjust the loan and prepare a 3 rd version of the extended capital budget table in Figure 7.4. t=0 t=1 t=2 t=3 Opening capital 500,000.00 Investment E(t) (1,900,000.00) 650,000.00 650,000.00 1,350,000.00 Finance F(t) 1,400,000.00 (305,000.00) (290,000.00) (1,075,000.00) Basic Pay B(t) (100,000.00) (100,000.00) (100,000.00) Drawing f t × Y (125,000.00) (250,000.00) (250,000.00) Re-inv/ Add fin 0.00 0.00 Re-inv/ Add fin (120,000.00) 123,600.00 Re-inv/ Add fin (133,600.00) 137,608.00 0.00 0.00 0.00 62,608.00 Wallingford Ltd. extended Capital Budget Table (III) Figure 7.4: eCBT for WALLINGFORD Ltd. (III) With the 3 rd version, the future value of the capital becomes positive but does not exceed the capital C T of the 1 st version. We can even double on the first extended capital budget table the capital C T by reducing the loan to the vector F(t) = {1,500,000; -312,500; -297500; - 1,182,500}. This gives a future capital C T (4 th version) of 143,971.25 ZAR. <?page no="94"?> Berkau: Management Accounting 7e 7-94 The approach to determine the best combination of investments and financing follows ‘trial and error’. The model works out but it does not take us straight to the best solution. Next, we simplify the technique for investment appraisal and eliminate factors which are not directly linked to investments. 7.14. Present Value Calculation To prepare a comparison of investment based on present values we determine the formula for the future value of the capital C T . It requires us to calculate C 0 based on the formula for C t and insert it in the formula for C 1 . Thereafter we take C 1 and insert it in the formula for C 2 until we arrive at C T . This way we come up with the formula as shown below. For simplification we pretend a standard rate of interest i (debit interest is equal to credit interest rate) applies: Next, we discount the future value for the capital C T by dividing the entire equation by (1 + i) T . It gives us the net present value. For the decision between investment alternatives the basic vector B(t), the drawings f t × Y and the financing cash flows F(t) can be assumed to be the same. Therefore, they do not matter and we exclude them from the comparison. The formula simplifies significantly. Observe the result of the simplifications below: There are some assumptions which come together with the formula. - The rate of interest is the standard rate, with d-i = c-i = i. - Financing is to the value which is needed. Hence, loans must be available at any amounts. - Reinvestments and additional loans are resettled in the next following period. - Investors can take loans without limits. 7.15. Present Value for Annuities Annuities are cash flows with the same value over a specific time period, e.g. {100; 100; 100; 100}. They apply frequently, e.g. for bank loans if the payment to the bank is constant. Other examples are rent or lease payments. The present value calculation for annuities allows us to simplify the present value calculation because the constant value of the cash flows can be <?page no="95"?> Berkau: Management Accounting 7e 7-95 factored out. The formula for an annuity is: In the formula A is the constant payment’s value, i stands for the rate of interest and T is the number of periods for the cash flows. In case the rate of interest varies over the time of constant payments, the cash flow calculation must be separated in multiple annuities. Each of them is than calculated based on the annuity formula. The present value for the above example at a discount rate of 10 % is: 100 × ((1 + 10%) 4 - 1) / (10% × (1 + 10%) 4 ) = 316.99. As the formula applies for cash flows in arrears, the present value is calculated for the period before the cash flow vector starts. If in the above example the payments are made in t = 1 …4, its present value is calculated for t = 0. 7.16. C/ S WALLINGFORD Ltd. - 4 We calculate the present values for the alternative investments. The discount factor should be based on the cost of capital but we apply the standard textbook rate of 10 %/ a. The present value for the first one is: - 2,000,000 + 700,000 × (1 + 10%) -1 + 700,000 × (1 + 10%) -2 + 1,450,000 × (1 + 10%) -3 = 3304,282.49 ZAR. We arrive at the same net present value if we calculate the future value for the capital under consideration of the above assumptions in an eCBT and discount the resulting C T 3 times at a discount rate of 10 %. See the calculation in Figure 7.5. t=0 t=1 t=2 t=3 Investment E(t) (2,000,000.00) 700,000.00 700,000.00 1,450,000.00 Re-inv/ Add fin 2,000,000.00 (2,200,000.00) Re-inv/ Add fin 1,500,000.00 (1,650,000.00) Re-inv/ Add fin 950,000.00 (1,045,000.00) 0.00 0.00 0.00 405,000.00 NPV 304,282.49 Wallingford Ltd. extended Capital Budget Table Figure 7.5: NPV calculation for the 1 st investment alternative The second investment object gives a net present value of: -1,900,000 + 650,000 × (1 + 10%) -1 + 650,000 × (1 + 10%) -2 + 1,350,000 × (1 + 10%) -3 = 242,374.15 ZAR. Alternatively, we can apply the present value formula for an annuity. This requires to consider the acquisition of 1,900,000.00 ZAR and the disposal cash flow of 700,000.00 ZAR extra: - 1,900,000 + 650,000 × ((1 + 10%) 3 -1) / (10% × (1 + 10%) 3 ) + 700,000 / (1 + 10%) 3 = -1,900,000 + 1,616,453.79 + 525,920.36 = 2 242,374.15 ZAR. <?page no="96"?> Berkau: Management Accounting 7e 7-96 Decisions making on the present value method is simple. If the present value is negative, reject the investment. If it is positive the investment leads to a higher discounted cash inflow than outflow and should be accepted. If alternative investments are available, accept the investment that gives the highest, positive net present value. Be aware of the assumptions made for the present value calculation. In particular, the effect of changes of the discount factor might be significant. To apply the present value method, investors must know their costs of capital 36 . 7.17. Yields from Investments For investment decisions the value of regular drawings is an important measure, e.g. for someone who plans to open her/ his own business. She/ he compares regular withdrawals to her/ his previous earned salary. To solve the equation for C T to the yield we express drawings by the yield structure vector multiplied with the yield level Y. With some basic mathematical steps we solve the formula for Y. That will result in the below formula which is valid under the made assumptions. The maximum for the yield level is reached for C T to be zero. This means, the drawings are that high that the investor’s capital is fully consumed. A negative C T would stand for a situation where the investor’s capital at the time T becomes negative. Neither do we increase the finance of the business to pay higher drawings. For the finance of the business we must guarantee that debts are payed off completely during the periods of the investment. That is the reason why on the eCTBs loans are settled in the period t = T at latest. If the assumptions do not apply because e.g. the debit interest rate differs from the credit interest rate, we must use linear interpolation to calculate the yield. 7.18. Internal Rate of Return The internal rate of return is no Accounting rate of return. An internal rate of return of e.g. 12 % does not give you a return of 12 %. The internal rate of return is the discount 36 The calculation of the weighted average cost of capital WACC is covered in out textbook Financial Statements. rate at which discounted cash flows meet a net present value of zero for the investment. There are 3 techniques to calculate the internal rate of return and avoiding solving complex mathematical equations. (1) MS-Excel provides you with the IRR() function. (2) Apply the goal seek function in MS-Excel and require the future value for the capital C T to become zero on the extended capital budget table. (3) Apply linear interpolation to calculate the internal rate of <?page no="97"?> Berkau: Management Accounting 7e 7-97 return between two rates which are either given or assumed. 7.19. C/ S WALLINGFORD Ltd. - 5 For WALLINGFORD Ltd.’s first investment the function IRR() returns a rate of 17.41 %/ a. Find below the result of the goal seek function for WALLINGFORD Ltd.’s investment (II). Before, the interest calculations for the reinvestments and additional finance have been made dependent on the rate of interest which is in the shaded cell B2. The goal seek function refers to that cell. The cell which is calculated to become zero is F8. Figure 7.6: Calculating IRR by goal seek function The internal rate of return comparison leads to the same investment decision (here: accept alternative I) as the present value technique. The advantage of the method is that the investor does not need to know the cost of capital. 7.20. Investment Programme Decisions Investment programmes are investments realised together. Because there are in general no unlimited funds available, investments on the shortlist are ranked by 2 alternative ratios: (1) present value rate and (2) internal rate of return. Thereafter the investments are added to the programme in the sequence of their rank. Further criteria might apply, too, e.g., sustainability aspects. The present value rate (NPV-rate) is the present value divided by the investment. The present value calculation requires discounting at a rate that reflects the company’s cost of capital. The internal rate of return is calculated as described above. The question which method is to apply depends on the investor’s decision about reinvestments of free cash flows. If the investor intends to re-invest on the capital market we use the NPV rate. If the investor tends to extend an investment the application of the internal rate of return is preferable. <?page no="98"?> Berkau: Management Accounting 7e 7-98 An extension of investments is more likely for investments in financial instruments as they are can be divided (a digging machine cannot). For investment programmes further non-Accounting restriction might apply as demonstrated by the case study GATESVILLE AG. 7.21. C/ S GATESVILLE AG. GATESVILLE AG is in the transportation industry. To extent its service, it plans to acquire pre-owned trucks and trailers. Investments A … C are trucks and the investment D is a truck trailer. The total number of truck trailers cannot exceed the number of trucks. The investment A … C can be realised only once. The investment in trailers is limited to the number of trucks. Investments cannot be divided. The cash flow vectors are given below. The receipts depend on the truck size (in tons) and are derived from GATESVILLE AG’s business experience. GATESVILLE AG’s cost of capital are 8.25 %/ a. - A(t) = {-80,000; 50,000; 63,000}. - B(t) = {-60,000; 45,000; 45,000}. - C(t) = {-100,000; 70,000; 70,000}. - D(t) = {-35,000; 25,000; 25,000}. For the investments, GATESVILLE AG has 65,000.00 EUR in equity and can take a bank loan up to 150,000.00 EUR. The present values, present value rates and internal rate of returns for the investments are: - NPV A = 19,952.53 EUR; NPV-rate A = 24.94%; IRR A = 25.33%/ a. - NPV B = 19,972.69 EUR; NPV-rate B = 33.29%; IRR B = 31.87%/ a. - NPV C = 24,401.96 EUR; NPV-rate C = 24.40%; IRR C = 25.69%/ a. - NPV D = 18,315.13 EUR; NPV-rate D = 52.33%; IRR D = 44.88%/ a. If GATESVILLE AG makes its decision based on the net present value rate, the programme is AB2D, meaning it accepts the investment in the 2 trucks A and B as well as in 2 truck trailers D. If the decision is based on the internal rate of return the programme becomes BCD. The investment programme vectors are: AB2D(t) = {-210,000; 145,000; 158,000} with a present value rate of 27.99% and an internal rate of return of 27.88%/ a and BCD(t) = {-195,000; 140,000; 140,000} with a present value rate of 27.59% and an internal rate of return of 27.92%/ a. We acknowledge that the programme based on present value rates achieves a higher present value rate and that the programme based on internal rate of returns has a higher internal rate of return as the alternative. 7.22. Ongoing Investments Investment series are multiple investments in a row, e.g. an Uberdriver who acquires the same car every 3 years. The formula to calculate the net present value for series of (m+1) investments is: <?page no="99"?> Berkau: Management Accounting 7e 7-99 The formula considers an overlap of one period. The acquisition of the next investment takes place during the last active period of the previous one. For the use of the formula without overlap, a zero-cash flow can be added at the end of the vector which increases T by 1 period. NPV (m) is the net present value of a series of m single investments. (m-1) is the number of repetitions. In contrast, NPV is the net present value of a onetime execution of an investment. If an investment is repeated indefinitely, the nominator becomes shorter as its second term is zero and can be omitted: For decisions between series of investments with different lifetimes, we determine the lowest common multiple for the number of active periods. Study the case study KORINGBERG (Pty) Ltd. below. 7.23. C/ S KORINGBERG (Pty) Ltd. KORINGBERG (Pty) Ltd. is a taxi company. Its owner wants to make a decision between investing in a used taxi car (UC) or a new one (NC). The used car option comes with a cash flow vector: UC(t) = {-20,000; 15,000; 15,000}. The new car has higher cash inflows because maintenance is lower. The vector is: {-45,000; 30,000; 25,000; 20,000; 15,000; 15,000}. The discount rate for this case study is 10 %. The number of active periods for UC is 2 and the one for NC is 5. To decide between the alternatives, we refer to a 10 period time span. Therein, the UC is repeated 4 times and the NC only once. The net present values for a one-time executions are: NPV UC = 6,033.06 AUD and NPV NC = 37,519.20 AUD. The series of 5 UC investments gives a net present value UC-NPV (5) = 6,033.06 × ((1 + 10%) 2 - (1 + 10%) -4×2 )/ ((1 + 10%) 2 - 1) = 221,359.69 AUD. A series of 2 NC investments gives: NC-NPV (2) = 37,519.20 × ((1 + 10%) 5 - (1 + 10%) -1×5 )/ ((1 + 10%) 5 - 1) = 660,815.67 AUD. This means the new car option is preferable. If the taxi company makes the decision for an unlimited row of investments, it calculates: UC-NPV (∞) = 6,033.06 × (1 + 10%) 2 / ((1 + 10%) 2 - 1) = 334,761.92 AUD and: NC-NPV (∞) = 37,519.20 × (1 + 10%) 5 / ((1 + 10%) 5 - 1) = 9 98,974.70 AUD. The result indicates to accept the investment in a new car if no other aspects are considered. 7.24. Summary Management Accounting supplies managers by making investment decisions. In this chapter we introduced common techniques of investment appraisal based on the payback method, the average annual return technique and valuations based on the time value of money concept. We discussed the net present value, yield and internal rate of return based on the latter concept. Furthermore, we covered aspects of investment decisions for investment <?page no="100"?> Berkau: Management Accounting 7e 7-100 programmes and series. To disclose investment figures we introduced the capital budget table format. 7.25. Working Definitions Annuities: Annuities are cash flows with the same value over a specific time period. Capital Budget Table: The CBT shows columns for the periods and lines for the cash flow vectors of the investment, its financing and further payments/ receipts. Internal Rate of Return: The internal rate of return is the discount rate at which discounted cash flows meet a net present value of zero for the investment. Investment Programmes: Investment programmes are investments realised together. Investment Series: Investment series are multiple investments in a row. Leverage Effect: The leverage effect states that the return on equity increases/ decreases with the indebtedness of a business. Payback Method: It determines the time it takes to repay the initial payment for an investment. 7.26. Question Bank (1) An investor got a capital opening balance of 300,000.00 EUR and receives 50,000.00 EUR/ period from other sources (consider B(t)) during t = 0 … 4. The investment has a cash flow vector E(t) = {- 800,000; 500,000; 400,000; 400,000; 380,000}. Debit-interest equals credit-interest at a rate of 4.5 %/ a. How much is the highest yield per period if drawings are made in t = 3 and t = 4 and the closing balance of capital is zero? 1. 713,932.83 EUR . 2. 0.00 EUR . 3. 725,021.65 EUR . 4. 676,121.88 EUR . (2) A company pays during the periods t = 1 … 10 an annuity of 1,200.00 EUR/ p. At the beginning, the rate of interest is 8 %/ a and increases from the 6 th period onwards to 10 %/ a. How much is the present value (in t = 0) of the cash flows? 1. 1,000.00 EUR . 2. 7,994.52 EUR . 3. 7,887.19 EUR . 4. 7,816.05 EUR . (3) A company is established with equity 25,000.00 EUR. It took out a loan for 80,000.00 EUR with an annual rate of interest of 6.5 %/ a. So far, the company invested 105,000.00 EUR with an average annual return of 11 %/ a. For a further investment of 40,000.00 EUR with an average annual rate of return of 12 %/ a it can take out a bank loan with an interest rate of 7 %/ a. How much is the return on equity if the additional investment and the loan are accepted? 1. 12.00 %. 2. 18.95 %. 3. 11.50 %. 4. 15.10 %. (4) An investment of 30,000.00 EUR gives an annual cash flow of 8,000.00 EUR/ a in t = 1 … 5. When is the loan paid back? <?page no="101"?> Berkau: Management Accounting 7e 7-101 1. 1.10.[t=4] . 2. 30.09.[t=4] . 3. 1.10.[t=3] . 4. 30.09.[t=3] . (5) An investment programme is to set-up based on present value rates. The total programme cannot exceed 1,000.00 EUR. The rate of interest is 10 %/ a. The cash flow vectors are: E A (t) = {-200; 150; 85; 70}, E B (t) = {-300; 150; 150; 150} und E C (t) = {-250; 190; 100; 50}. Each investment can be added twice to the programme. How much is the present value of the investment programme? 1. 22.08 % . 2. 26.45 % . 3. 29.60 % . 4. 21.99 % . 7.27. Solutions 1-3; 2-3; 3-2; 4-1; 5-2. <?page no="102"?> Berkau: Management Accounting 7e 8-102 8. Cost Volume Profit Analysis (CVP-Analysis) 8.1. What is in the Chapter? This chapter discusses how many products a business must produce and sell to break-even profit. This is the volume where revenue meets costs. E.g., a passenger flight’s load factor tells the airline how many revenue tickets must be sold to earn a zero profit. We demonstrate that the CVP-analysis is a more powerful tool than only to determine the critical number of products to break-even. It is widely used to make decisions about the launch of new products or changes in the service/ product mix. In this chapter, we study the case of DEERFIELD TOURS (Pty) Ltd. a tourist tour company that offers trips to South Africa and to Kuala Lumpur from Frankfurt/ Main. We also discuss the calculation of the probability for profits if various factors are unknown but can be assumed to be normally distributed around the best estimate. 8.2. Learning Objectives After studying this chapter, you understand that cost volume profit analysis requires a cost separation. A cost separation is dividing costs in variable and fixed costs. You further understand how a CVP-Analysis helps managers to find the right volume to earn and maximise profits. Based on selling prices and costs, you can calculate from which volume on the company earns profit. You will be able to apply and discuss the outcome of a CVP- 37 A break-even analysis differs from the payback method in Investment Appraisal which is based on cash flows. Compare to chapter (7). analysis and are able to find the product volume and/ or product mix to earn profit. You also can apply the CVP-Analysis to determine what happens if changes to the business model are made by carrying out a what-if analysis. 8.3. Basics of Cost-Volume-Profit Analysis The CVP-Analysis 37 is also known as break-even analysis. When a company starts operations, at first fixed costs apply, e.g. depreciation on the investments. Fixed costs do not change with the volume. In CVP-Analysis, the first units of production must cover the fixed costs. Only after the business produces/ sells enough goods/ services to covers fixed costs, revenue exceeds costs, and the company earn profits. 8.4. C/ S Ameer - GRAB Driver We observe Ameer, who runs a GRAB taxi service. He applies for a GRAB license and buys a car, which is a 5 year old Mercedes-Benz. The car costs 80,000.00 MYR without VAT 38 . The car has still a useful life of 5 years, but he intends to sell it after 2 years at 50,000.00 MYR (net amount). The depreciable value is: 80,000 - 50,000 = 3 30,000.00 MYR. Annual depreciation is: (80,000 - 50,000) / 2 = 1 15,000.00 MYR/ a. For financing his business, Ameer takes out a bank loan for 50,000.00 MYR at a rate 38 Consider an exchange rate of 5.00 MYR = 1.00 EUR. <?page no="103"?> Berkau: Management Accounting 7e 8-103 of interest of 3.5 %/ a and borrows the rest from his family. Interest expenses are: 50,000 × 3.5% = 1 1,750.00 MYR/ a. Ameer earns 20.00 MYR/ ride in revenue. The revenue includes a commission of 20 % to GRAB. He calculates petrol costs per ride to be 5.00 MYR/ ride. He ‘earns’ a margin of: 20 × (1 - 20%) - 5 = 1 11.00 MYR/ ride before interest, depreciation and taxation. The CVP-Analysis answers the question ‘How many rides does Ameer need per working day (Monday to Friday) to break-even? ’ The answer is: (15,000 + 1,750) / (5 × 52 × 11) = 5 5.86 rides 39 . With this number of rides, Ameer does not pay income taxes, as taxation only applies if a profit is earned. We acknowledge, he breaks-even with 6 rides per working day, as we round the rides to the nearest integer. 8.5. Benefit from CVP-Analysis Management Accountants strive to find the right volume that makes their companies most profitable. At first, we study the profit after breaking-even to understand what happens once the company operations exceed the break-even volume. We assume, there is a company selling goods at 115.00 EUR/ u with variable unit cost of manufacturing of 65.00 EUR/ u. If the fixed costs amount to 1,000.00 EUR, the 50.00 EUR difference between revenue und variable unit costs: 115 - 65 = 5 50.00 EUR/ u (= contribution margin) must cover all fixed costs. Hence, after 20 products have been sold, the contribution margin covers all fixed costs: 20 × 50 = 1 1,000.00 EUR. Further coverage is not required. At this stage, the company earns zero profit: 20 × (115 - 65) - 1,000 = 0 0.00 EUR. From the 21 st product sold onwards the business is profitable. If the company sells 21 products the profit is: 21 × (115 - 65) - 1,000 = 5 50.00 EUR. Beyond breaking-even, the profit is equal to the contribution margin per unit, here: 50 EUR/ u. The below assumptions apply to study a CVP-Analysis: (1) The selling prices per unit are constant. No discounts apply. (2) The unit cost function is constant. A cost separation must be possible. Furthermore, no jump costs apply, which implies there are no step-fixed costs as the existing resources facilitate the production of all goods/ services. (3) Companies that are selling different products must sell a constant mix. This requires that the goods ratio is constant, like ‘for 3 oranges we sell 2 bananas’. 40 (4) There are no changes in inventories of finished goods. Hence, production volume is equal to sales volume. No finished goods are added to inventories or released from stock. How it is Done (CVP calculation) (1) Check the requirements for a CVP analysis as above. 39 We rather consider Ameer’s labour as imputed costs here. If labour amounts to 100,000 MYR/ a he needs more than 40 rides. 40 Without a fixed mix you can calculate where to break-even, but you must know one quantity in order to calculate the corresponding one. <?page no="104"?> Berkau: Management Accounting 7e 8-104 (2) Determine standard costs for the planned output (planned costs). (3) Calculate/ plan the portion of fixed costs. If only total costs are available run a cost separation. (4) Determine the cost function that depends on the product volume. (5) Plan the budgeted revenue per unit(s) or consider actual revenues derived from Financial Accounting. (6) In case the company produces/ renders more than one type of goods/ services determine the sales ratio among products. (7) Prepare the revenue function that depends on the product volume (to be) sold. (8) Determine the product volume where the revenue curve intersects the cost curve. 8.6. C/ S DEERFIELD TOURS (Pty) Ltd. Next, we study the CVP-Analysis for DEERFIELD TOURS (Pty) Ltd. Data Sheet for DEERFIELD TOURS (Pty) Ltd. (Base Case) CClassification: Tourism; SA-tour: 10 … 25 t/ tour; base case: 19 trips; flight: 1,500.00 EUR/ t; hotel: 700.00 EUR/ t; meals: 400.00 EUR/ t; Fixed costs: administration: 3,400.00 EUR/ tour; bus: 7,000.00 EUR/ tour; Net selling price: 3,900.00 EUR/ t; VAT ignored. DEERFIELD TOURS (Pty) Ltd. is a tour provider that offers 1-week trips to the Garden Route in South Africa. The tours start and end in Frankfurt (Main) airport. Variable costs per traveller-trip (/ t) are the flight fare at 1,500.00 EUR/ t, the hotel stay-over-costs: 7 × 100 = 7 700.00 EUR/ t and costs for meals at: 8 × 50 = 400.00 EUR/ t. In total, the variable costs add up to: 1,500 + 700 + 400 = 2 2,600.00 EUR/ t. The fixed costs are for the tour planning and administration costs of 3,400.00 EUR/ tour and transportation in South Africa in a rented 25-seater bus at 7,000.00 EUR/ tour, in total: 3,400 + 7,000 = 1 10,400.00 EUR/ tour. DEERFIELD TOURS (Pty) Ltd. sells a trip at 3,900.00 EUR/ t. The maximum traveller volume is limited by the bus capacity to 25 passengers. DEERFIELD TOURS (Pty) Ltd. reserves the right to cancel a tour if less than 10 bookings are made. Cancellations by a traveller are considered noshows and do not get refunded. To calculate costs to break-even, DEERFIELD TOURS (Pty) Ltd. prepares a MS-Excel sheet we call contribution income statement CIS. It tells us how much profit is earned based on the number of trips. We enter the number of trips in the shaded field to calculate profit. We call the MS-Excel sheet contribution income statement, as a contribution margin is calculated by deducting variable costs from revenues. The calculation is presented in Figure 8.1. With the link below, you can download the spreadsheet from the online-materials. <?page no="105"?> Berkau: Management Accounting 7e 8-105 Link 8.A: Spreadsheet for CIS We define two variables for DEERFIELD TOURS (Pty) Ltd.: tours and trips t. The latter one is the number of travellers per tour. A tour is a service for 10 … 25 travellers (no abbreviation in use). For our break-even analysis, the trip is the primary volume unit. Sales of 1 trips Item Total Per unit Sales 3,900.00 3,900.00 Variable expenses (2,600.00) (2,600.00) Contribution margin 1,300.00 1,300.00 less: Fixed expenses (10,400.00) Net profit (9,100.00) CONTRIBUTION INCOME STATEMENT Figure 8.1: DEERFIELD TOURS (Pty) Ltd.’s CIS (1) If DEERFIELD TOURS (Pty) Ltd. sells 10 trips the contribution income statement (CIS) looks as in Figure 8.2. Sales of 10 trips Item Total Per unit Sales 39,000.00 3,900.00 Variable expenses (26,000.00) (2,600.00) Contribution margin 13,000.00 1,300.00 less: Fixed expenses (10,400.00) Net profit 2,600.00 CONTRIBUTION INCOME STATEMENT Figure 8.2: DEERFIELD TOURS (Pty) Ltd.’s CIS (2) To find the volume of trips to breakeven, we use the profit equation. The revenue is the number of trips multiplied with the selling price per trip. We call X the number of trips. X × 3,900 = 10,400 + X × 2,600. We isolate X and solve the equation to the number of trips: X = 10,400 / (3,900 - 2,600) = 10,400 / 1,300 = 8 8 trips. For checking, we calculate the profit for 8 trips: 8 × (3,900 - 2,600) - 10,400 = 0.00 EUR/ tour. The break-even point in a CVP analysis is the volume of goods or <?page no="106"?> Berkau: Management Accounting 7e 8-106 the activity level where the company earns a zero profit. In case DEERFIELD TOURS (Pty) Ltd. runs the tour at 10 trips, the tour profit becomes: 10 × (3,900 - 2,600) - 10,400 = 22,600.00 EUR/ tour. Compare the result to Figure 8.2. After breaking-even with 8 travellers, DEERFIELD TOURS (Pty) Ltd. earns the contribution margin for every trip exceeding the break-even volume as a profit. T The contribution margin is sales less variable costs. We check the profit for 20 trips in Figure 8.3. Sales of 20 trips Item Total Per unit Sales 78,000.00 3,900.00 Variable expenses (52,000.00) (2,600.00) Contribution margin 26,000.00 1,300.00 less: Fixed expenses (10,400.00) Net profit 15,600.00 CONTRIBUTION INCOME STATEMENT Figure 8.3: DEERFIELD TOURS (Pty) Ltd.’s CIS (3) DEERFIELD TOURS (Pty) Ltd.’s profit is now 15,600.00 EUR/ tour. We analyse the result: 20 trips mean: 12 trips beyond breaking-even. The profit is 12 times their contribution margin: 12 × 1,300 = 1 15,600.00 EUR/ tour. 8.7. CVP-Analysis for Changing Business Model A CVP-Analysis also supports managers making decisions about adjustments to the business concept and to analyse whether those changes result in profit improvements. We continue studying DEERFIELD TOURS (Pty) Ltd. Now, we analyse some possible changes regarding its business model: 8.8. Online-Shop for DEERFIELD TOURS (Pty) Ltd. DEERFIELD TOURS (Pty) Ltd. sells on average 19 trips per tour. The business plans to sell trips online to increase the volume. The website costs increase the fixed costs by 1,500.00 EUR/ tour. DEERFIELD TOURS (Pty) Ltd. expects to increase the average number of trips by 2 trips due to the convenient sales method. We analyse, whether the online shop increases the profit per tour with: 19 + 2 = 2 21 trips. For analysis we adjust DEERFIELD TOURS (Pty) Ltd.’s contribution income statement on MS-Excel. We add 1,500.00 EUR/ tour to the fixed costs and add 2 trips. Compare the base case in Figure 8.4 to the adjusted online-shopversion in Figure 8.5. <?page no="107"?> Berkau: Management Accounting 7e 8-107 Sales of 19 trips Item Total Per unit Sales 74,100.00 3,900.00 Variable expenses (49,400.00) (2,600.00) Contribution margin 24,700.00 1,300.00 less: Fixed expenses (10,400.00) Net profit 14,300.00 CONTRIBUTION INCOME STATEMENT Figure 8.4: DEERFIELD TOURS (Pty) Ltd.’s CIS (base case) The fixed cost for the alternative (onlineshop-version) tour concept are: 10,400 + 1,500 = 1 11,900.00 EUR/ tour. The number of trips has been increased based on the estimated volume. Sales of 21 trips Item Total Per unit Sales 81,900.00 3,900.00 Variable expenses (54,600.00) (2,600.00) Contribution margin 27,300.00 1,300.00 less: Fixed expenses (11,900.00) Net profit 15,400.00 CONTRIBUTION INCOME STATEMENT Figure 8.5: DEERFIELD TOURS (Pty) Ltd.’s CIS (online-shop) The internet shop increases the tour profit by: 15,400 - 14,300 = 1 1,100.00 EUR/ tour. The advice is: Go for the online-shop! 41 We return to the base case with 19 passengers without online-shop to discuss other changes: 8.9. Bungee Jumping - DEERFIELD TOURS (Pty) Ltd. As a further alternative, we discuss increasing the customer’s value of a trip by adding a bungee jumping option. The 41 DEERFIELD TOURS (Pty) Ltd. pays for the internet shop per tour. bungee jump costs 100 EUR per traveller, who accepts the offer. DEERFIELD TOURS (Pty) Ltd. estimates that every second traveller takes a bungee jump. DEERFIELD TOURS (Pty) Ltd. adds 50.00 EUR/ t to the sales price and to the variable costs per trip. This keeps the bungee jump option neutral to travellers. Due to the more attractive trip, the number of trips per tour is estimated to increase by 1 trip per tour. The administration costs per tour increase by 500.00 EUR compared to the base case scenario. Hence, the fixed costs are now: 10,400 + 500 = 1 10,900.00 EUR/ tour. <?page no="108"?> Berkau: Management Accounting 7e 8-108 Sales of 20 trips Item Total Per unit Sales 79,000.00 3,950.00 Variable expenses (53,000.00) (2,650.00) Contribution margin 26,000.00 1,300.00 less: Fixed expenses (10,900.00) Net profit 15,100.00 CONTRIBUTION INCOME STATEMENT Figure 8.6: DEERFIELD TOURS (Pty) Ltd.’s CIS (bungee jumping) With the bungee jumping option, the profit increases by: 15,100 - 14,300 = 800.00 EUR/ tour. The advice is to include the bungee jumping. 8.10. Revenue Calculation - DEERFIELD TOUR (Pty) Ltd. Another kind of analysis aims to revenue calculations if the profit per tour is given. We refer to the base case again for our calculations. Now, DEERFIELD TOURS (Pty) Ltd. plans to run the tour in a more luxury bus. The costs for the fancy bus are 11,000.00 EUR/ tour. The bus is a 35-seater which allows an increase of trip volume per tour. The Marketing department claims that the fancy bus will attract 6 more travellers. The question for DEERFIELD TOURS (Pty) Ltd. is: How do we change the net selling price (NSP) per trip to earn the same profit with: 19 + 6 = 2 25 trips as in the base case? For revenue calculation, there are 2 options. (1) The first one is academically elegant: We prepare the equation for the profit of the base case (= 14,300.00 EUR/ tour) and solve it for the net selling price NSP: (19 + 6) × NSP - (19 + 6) × 2,600 - (10,400 + 4,000) = 14,300 EUR/ tour. The NSP is: NSP = (14,300 + 25 × 2,600 + 14,400) / 25 = 3 3,748.00 EUR/ trip. (2) The second one is more Accountantlike: We use the goal seek function in MS-Excel: <?page no="109"?> Berkau: Management Accounting 7e 8-109 Figure 8.7: DEERFIELD TOURS (Pty) Ltd.’s calculation of adj. NSP The net selling price drops with the newbus-option because of the assumption of 6 additional trips. The advice is to go for the new bus if sure about the trip volume increase. 8.11. What-if-Analysis A CVP analysis can be used for what if-analysis. A what-if analysis is an alternative calculation of the outcome by changing particular parameters. A what-if analysis is useful for budgeting. The CVP-analysis can help us to combine changes regarding the business plan, such as DEERFIELD TOURS (Pty) Ltd. deploying an alternative bus and including the bungeejumping option together. One question for budgeting is still unanswered: How does DEERFIELD TOURS (Pty) Ltd. know, what happens to the volume in response of product parameter changes? The answer is: They don’t know. However, most companies carry out Marketing Research studies. We next study probabilities and distributions to predict customers’ decisions based on observations made in the past. 8.12. Statistics - DEERFIELD TOURS (Pty) Ltd. We refer to the DEERFIELD TOURS (Pty) Ltd. case again: We assume, that the Marketing department estimates the number of trips per tour based on the online-shop-option. The Marketing department claims the number of the travellers is 21 on average (as above). We pretend, the Marketing experts claim the number of trips is normally distributed and the standard deviation is 4.37 t (= trips). See Figure 8.8: A normal distribution depends on two variables: on the mean and the standard deviation. Once we know them, we can calculate the probabilities for values exceeding a particular threshold value, here the <?page no="110"?> Berkau: Management Accounting 7e 8-110 probability for the trip volume. This supports us in answering the following question: ‘How likely are 20+ trips per tour? ’, ‘How likely is a low number of travellers at which DEERFIELD TOURS (Pty) Ltd. only breaks-even? ’ or ‘How likely is a loss? ’ To give the answers, we transform the normal distribution towards a standard normal distribution. Then we can read out the probabilities from tables in textbooks of Mathematics or from the internet. In case of DEERFIELD TOURS (Pty) Ltd. we know the estimate (= 21 t/ tour) as well as the standard deviation (= 4.37 t/ tour). We demonstrate how to calculate the probability to break-even. The contra-probability gives us the likelihood for a loss. From 20 similar observations, Marketing experts derive that on average 21 trips per tour are booked through the online shop. Despite the low observation quantity, experts only assume the values are normally distributed. N Normal distributed figures result in a bell-shaped curve in case you draw a frequency-over-value-diagram. The technical term is probability density function. The peak of the curve is where the mean is. Observation Amount (t) Diff to mean (Diff) 2 1 20 -1 1 2 17 -4 16 3 21 0 0 4 18 -3 9 5 16 -5 25 6 24 3 9 7 20 -1 1 8 26 5 25 9 23 2 4 10 30 9 81 11 30 9 81 12 21 0 0 13 21 0 0 14 11 -10 100 15 21 0 0 16 19 -2 4 17 24 3 9 18 17 -4 16 19 21 0 0 20 20 -1 1 average: 21 standard dev.: 4.37 Figure 8.8: Observations To determine the distribution of trip numbers, we refer to mean and standard deviation. We can calculate standard deviations by MS-Excel or for the sake of teaching we calculate them ‘manually” in Figure 8.8. <?page no="111"?> Berkau: Management Accounting 7e 8-111 The distribution of observations in Figure 8.8 can be transformed to a standard normal distribution. A standard normal distribution is normally distributed and the mean equals 0 and the standard deviation is 1. Tables for standard normal distributions provide us with the probabilities for each value. You find a table for the normal standard distribution in Figure 8.10. DEERFIELD TOURS (Pty) Ltd. follows the Marketing campaign (online-shop) idea as discussed above. The mean of 21 trips per tour promises an increase in profit of 1,100.00 EUR/ tour. However, DEERFIELD TOURS (Pty) Ltd. needs to calculate, how risky the tour becomes in terms of making a loss due to less bookings. The probability for a loss is the contra probability for breaking-even. By the next step, we calculate the breakeven point. We determine the number of trips to break-even based on the onlineshop option. We use MS-Excel’s goal seek function. Find the result in Figure 8.9. Sales of 9.154 trips Item Total Per unit Sales 35,700.00 3,900.00 Variable expenses (23,800.00) (2,600.00) Contribution margin 11,900.00 1,300.00 less: Fixed expenses (11,900.00) Net profit 0.00 CONTRIBUTION INCOME STATEMENT Figure 8.9: DEERFIELD TOURS (Pty) Ltd.’s CIS (internet campaign) The number of trips must be integer. Based on the result of 9.15 travellers per tour to break-even, we consider 0 to 9 travellers a loss. If DEERFIELD TOURS (Pty) Ltd. sells 10+ trips per tour, it earns a profit. In order to determine the probability for the worst case(s) of making a loss - no matter how big the loss is - we want to know how likely less than 10 travellers/ tour are. We transform the normal distribution into a standard normal distribution and call the values for the standard normal distribution zamounts. The values of the normal distribution represent the trips per tour. We call them ‘t’ as in trips. We apply the transformation formula, which transforms t-values to z-values: z(t) = (t - mean)/ standard deviation = (9 - 21) / 4.37 = - -2.746. In short: z(t = 9) = - - 2.746. The z-value is negative because it is lower than the mean. By the next step, we read the probability for z < -2.746 from the tables for a standard normal distribution. The table in Figure 8.10 lists the probabilities for an event based on the interval 0 … z. However, we need the probability for an event below the z amount of - 2.746. As a standard normal distribution is symmetrical, we calculate the probability in question via its contra probability. At first, we read the probability for +2.746 from the table: The probability for +2.74 to be exceeded is 49.69 % and the probability for 2.75 is 49.70 %. The value we want to know is in between. By <?page no="112"?> Berkau: Management Accounting 7e 8-112 linear interpolation, we find a z-value for 2.746 being 49.696 % which gives 49.70 % after rounding. Next, we determine the probability in question via its contra probability, which equals: 50% - 49.70% = 0 0.30 %. With the given Marketing data in Figure 8.8, the probability for DEERFIELD TOURS (Pty) Ltd. of making a loss is 0.30 %. This green-lights the online-shop as DEERFIELD TOURS (Pty) Ltd. tolerates that low risk. Anyway, DEERFIELD TOURS (Pty) Ltd. is risk-free thanks to its cancellation policy which we consider a good risk avoidance. z 0 1 2 3 4 5 6 7 8 9 0 0.0000 0.0040 0.0080 0.0120 0.0160 0.0199 0.0239 0.0279 0.0319 0.0359 0.1 0.0398 0.0438 0.0478 0.0517 0.0557 0.0596 0.0636 0.0675 0.0714 0.0753 0.2 0.0793 0.8320 0.0871 0.0910 0.0948 0.0987 0.1626 0.1064 0.1103 0.1141 0.3 0.1179 0.1217 0.1255 0.1293 0.1331 0.1334 0.1406 0.1443 0.1480 0.1517 0.4 0.1554 0.1591 0.1628 0.1664 0.1700 0.1736 0.1772 0.1808 0.1844 0.1879 0.5 0.1913 0.1950 0.1985 0.2019 0.2054 0.2088 0.2123 0.2157 0.2190 0.2224 0.6 0.2257 0.2291 0.2324 0.2357 0.2389 0.2422 0.2454 0.2486 0.2517 0.2549 0.7 0.2580 0.2611 0.2642 0.2673 0.2704 0.2734 0.2764 0.2794 0.2823 0.2852 0.8 0.2881 0.2910 0.2929 0.2967 0.2995 0.3023 0.3051 0.3078 0.3106 0.3133 0.9 0.3159 0.3186 0.3212 0.3238 0.3264 0.3289 0.3315 0.3340 0.3365 0.3389 1 0.3413 0.3438 0.3461 0.3485 0.3508 0.3531 0.3554 0.3577 0.3599 0.3621 1.1 0.3643 0.3665 0.3686 0.3708 0.3729 0.3749 0.3770 0.3790 0.3810 0.3830 1.2 0.3849 0.3869 0.3888 0.3907 0.3925 0.3944 0.3962 0.3980 0.3997 0.4015 1.3 0.4032 0.4049 0.4066 0.4082 0.4099 0.4115 0.4131 0.4147 0.4162 0.4177 1.4 0.4192 0.4207 0.4222 0.4236 0.4251 0.4265 0.4279 0.4292 0.4306 0.4319 1.5 0.4332 0.4345 0.4357 0.4370 0.4382 0.4394 0.4406 0.4418 0.4429 0.4441 1.6 0.4452 0.4463 0.4474 0.4484 0.4495 0.4505 0.4515 0.4525 0.4535 0.4545 1.7 0.4554 0.4564 0.4573 0.4582 0.4591 0.4599 0.4608 0.4618 0.4625 0.4633 1.8 0.4641 0.4649 0.4656 0.4664 0.4671 0.4678 0.4686 0.4693 0.4699 0.4706 1.9 0.4713 0.4719 0.4726 0.4732 0.4738 0.4744 0.4750 0.4756 0.4761 0.4767 2 0.4772 0.4778 0.4783 0.4788 0.4793 0.4798 0.4803 0.4808 0.4812 0.4817 2.1 0.4821 0.4826 0.4830 0.4834 0.4838 0.4844 0.4846 0.4850 0.4854 0.4857 2.2 0.4861 0.4864 0.4868 0.4871 0.4875 0.4878 0.4881 0.4884 0.4887 0.4890 2.3 0.4893 0.4896 0.4898 0.4901 0.4904 0.4906 0.4909 0.4911 0.4913 0.4916 2.4 0.4918 0.4920 0.0492 0.4925 0.4927 0.4929 0.4931 0.4932 0.4934 0.4936 2.5 0.4938 0.4940 0.4941 0.4943 0.4945 0.4946 0.4948 0.4949 0.4951 0.4952 2.6 0.4953 0.4955 0.4956 0.4957 0.4959 0.4960 0.4961 0.4962 0.4963 0.4964 2.7 0.4965 0.4966 0.4967 0.4968 0.4969 0.4970 0.4971 0.4972 0.4973 0.4974 2.8 0.4974 0.4975 0.4976 0.4977 0.4977 0.4978 0.4979 0.4979 0.4980 0.4981 2.9 0.4981 0.4982 0.4982 0.4983 0.4984 0.4984 0.4985 0.4985 0.4986 0.4986 3 0.4987 0.4987 0.4987 0.4988 0.4988 0.4989 0.4989 0.4989 0.4990 0.4990 Figure 8.10: Standard normal distribution table 8.13. Multiple-Product CVP-Analysis CVP-Analysis also applies when a company produces and sells more than one product. In case of 2 products the break-even point becomes a breakeven line. For 3 products we get an area etc. To determine a break-even ‘point’ with a particular combination of products (product mix), Accountants assume a fixed ratio for the product volume. This narrows the number of solutions down to only one. A ratio of product volumes gives for a particular number of one product the quantity for the <?page no="113"?> Berkau: Management Accounting 7e 8-113 other one. We apply the method for DEERFIELD TOURS (Pty) Ltd. and enhance its business model. The company now offers 2 tours. 8.14. 2-Tour-Case - DEERFIELD TOURS (Pty) Ltd. DEERFIELD TOURS (Pty) Ltd. offers besides of tours to South Africa city trips to Kuala Lumpur. Find below the data sheet for the Kuala Lumpur trips at DEERFIELD TOURS (Pty) Ltd.: Data Sheet for KL-Tour CClassification: Tourism; KL-tour: 10 … 30 trips/ tour; base case: 1/ 5 of the Strips; flight: 1,400.00 EUR/ t; hotel: 560.00 EUR/ t; meals: 320.00 EUR/ t; Fixed costs: administration: 3,400.00 EUR/ tour; bus: 5,000.00 EUR/ tour. Selling price: 3,500.00 EUR/ t; VAT ignored. The tours to Malaysia start and end in Frankfurt (Main). The variable costs per trip are: the flight expenses at 1,400.00 EUR/ t, the hotel costs of: 7 × 80 = 5 560.00 EUR/ t and meals at: 8 × 40 = 3 320.00 EUR/ t. In total, the variable costs are: 1,400 + 560 + 320 = 2 2,280.00 EUR/ t. The fixed costs for tour planning and administration are 3,400.00 EUR/ tour and for the transport in a rented 30-seater bus 5,000.00 EUR/ tour. DEERFIELD TOURS (Pty) Ltd. sells a trip at 3,500.00 EUR/ t. The maximum number of travellers is 30 t per tour. DEERFIELD TOURS (Pty) Ltd. reserves the right to cancel a trip if less than 10 bookings are made. Based on its business plan, for 5 tours to the Garden Route there is 1 tour to Kuala Lumpur. As the traveller numbers can spread, we calculate a traveller ratio of: (5 × 25) : 30, as: 1125 : 30. Observe the adjusted contribution income statement depicted in Figure 8.11. 125 30 trips Item Garden Route Kuala Lumpur Sum Per unit Sales 487,500.00 105,000.00 592,500.00 100.0% Variable expenses (325,000.00) (68,400.00) (393,400.00) -66.4% Contribution margin 162,500.00 36,600.00 199,100.00 33.6% less: Fixed expenses (60,400.00) Net profit 138,700.00 CONTRIBUTION INCOME STATEMENT Figure 8.11: DEERFIELD TOURS (Pty) Ltd. 2-product CIS The calculation in the 2-product contribution income statement contains the items below: (1) The amount of Kuala Lumpur trips is calculated as: t KL = 30 × t GR / 125. (2) The sales for the Garden Route tour are: S GR = t GR × 3,900. (3) The sales for the Kuala Lumpur tour are: S KL = t KL × 3,500. (4) The variable costs for the Garden Route tour are: VC GR = t GR × 2,600. (5) The variable costs for the Kuala Lumpur tour are: VC KL = t KL × 2,280. (6) The contribution margin ratio is calculated as: (S GR + S KL ) - (VC GR + VC KL ) / <?page no="114"?> Berkau: Management Accounting 7e 8-114 (S GR + S KL ). The contribution margin ratio does not depend on the volume of trips as long equation (1) is valid: t KL = 30 × t GR / 125. (7) The fixed costs are: 5 × (3,400 + 7,000) + (3,400 + 5,000) = 6 60,400.00 EUR. For t GR = 100 and t KL = 24, the contribution margin ratio is: (100 × 3,900 + 24 × 3,500 - (100 × 2,600 + 24 × 2,280)) / (100 × 3,900 + 24 × 3,500) = 0.34 = 3 33.60 %. Compare the result to the MS-Excel calculation as demonstrated in Figure 8.12. 100 24 trips Item Garden Route Kuala Lumpur Sum Per cent Sales 390,000.00 84,000.00 474,000.00 100.0% Variable expenses (260,000.00) (54,720.00) (314,720.00) -66.4% Contribution margin 130,000.00 29,280.00 159,280.00 33.6% less: Fixed expenses (60,400.00) Net profit 98,880.00 CONTRIBUTION INCOME STATEMENT Figure 8.12: DEERFIELD TOURS (Pty) Ltd.’s 2-product CIS (2) Once we study the enhanced contribution income statement, we see that the contribution margin for both tours must cover all fixed costs to break-even. Cross product support is possible (fixed costs are added). To calculate the trip volumes for breaking-even, we look for trip numbers based on the given ratio that are that high that all trips together result in a contribution margin of 60,400.00 EUR. Accordingly, we can calculate sales of: 60,400 / 33.6% = 1 179,761.90 EUR. The formula for the total sales depending on t GR is: 179,761.90 = t GR × 3,900 + 30 × (t GR / 125) × 3,500. t GR = 179,761.90 / (3,900 + (30 × 3,500) / 125) = 337.92. This means the travellers to Kuala Lumpur are: t KL = 30 × 39.92 / 125 = 9 9.1. Figure 8.13: Goal seek function for break-even point <?page no="115"?> Berkau: Management Accounting 7e 8-115 Rounding to the next integer for the trip volume, gives a loss of 20.00 EUR if DEERFIELD TOURS (Pty) Ltd. sells 38 trips for the Garden Route and 9 trips for the Kuala Lumpur tour. This value only is obtained by 5 tours to South Africa and one to Malaysia. If 38 trips result only in 4 tours to the Garden Route, fixed costs would change. 38 9 trips Item Garden Route Kuala Lumpur Sum Per cent Sales 148,200.00 31,500.00 179,700.00 100.0% Variable expenses (98,800.00) (20,520.00) (119,320.00) -66.4% Contribution margin 49,400.00 10,980.00 60,380.00 33.6% less: Fixed expenses (60,400.00) Net profit (20.00) CONTRIBUTION INCOME STATEMENT Figure 8.14: DEERFIELD TOURS 2-product CIS (3) 8.15. Summary The CVP-Analysis calculates profits for different good/ service/ activity volumes. Frequently, the CVP analysis is applied to determine the break-even point. This is the volume where the company does not earn a profit (zeroprofit). A good use of the CVP- Analysis is to study alterations of the business concept and test for the most profitable alternative. We recommend carrying out CVP-Analysis on a spreadsheet program. In this chapter, we studied the application of the CVP- Analysis for various scenarios for the case study DEERFIELD TOURS (Pty) Ltd. 8.16. Working Definitions Break-Even Point: The break-even point in a CVP analysis is the volume of goods or the activity level, where the profit is zero. Contribution Margin: The contribution margin is sales less variable costs. Cost Separation: A cost separation is dividing costs in variable and fixed costs. Normal Distribution: Normal distributed figures result in a bell-shaped curve in case you draw a frequencyover-value-diagram. Standard Normal Distribution: A standard normal distribution is normally distributed and the mean is equal to 0 and the standard deviation is equal to 1. What-if Analysis: A what-if analysis is an alternative calculation of the outcome by changing particular parameters. 8.17. Question Bank (1) A standard normal distribution is … 1. … a probability density function with the mean 1 and the standard deviation 0. <?page no="116"?> Berkau: Management Accounting 7e 8-116 2. … a probability density function with the mean 0 and the standard deviation 1. 3. … a probability for the mean to be 1 and the standard deviation 0. 4. … a probability for the mean to be 0 and the standard deviation 0. (2) A company produces goods at proportional costs of 125.00 EUR/ u. The non-manufacturing costs per good produced are 20.00 EUR/ u. There are fixed costs of 11,600.00 EUR. How many products must be manufactured to earn a positive profit? 1. 92 units . 2. 93 units . 3. 80 units . 4. 81 units . (3) The equation to calculate the break-even point, which is based on the revenue per unit ‘rev’, the unit costs ‘pc’, the fixed costs ‘FC’ and the product quantity ‘X’ is: 1. X = FC/ (rev +pc). 2. rev +x = pc × X + FC. 3. 0 = rev × X - (FC + pc × X). 4. 0 = rev × X - (FC pc × X). (4) The requirements for the application of the CVP-analysis are: 1. Constant product prices, cost separation possible, no discounts. 2. Inclining cost function, cost separation possible, no changes in inventory. 3. Constant product prices, only integer figures applicable for quantities, no discounts. 4. Cost separation positive, no discounts, no inventory increases. (5) A company produces goods with the following costs: materials 80.00 EUR/ u, direct labour 35.00 EUR/ u and depreciation on production facilities 20,000.00 EUR. Administration is amounting to 10,000.00 EUR. How much must be the revenue to break-even with 500 products? 1. 175.00 EUR/ u . 2. 155.00 EUR/ u . 3. 135.00 EUR/ u . 4. 115.00 EUR/ u . 8.18. Solutions 1-2; 2-4; 3-3; 4-1; 5-1. <?page no="117"?> Berkau: Management Accounting 7e 9-117 9. Degree of Operating Leverage (DOL) 9.1. What is in the Chapter? This chapter covers a concept for making decision about fixed (non-current) assets. In contrast to chapter (7), we discuss here the impact on the company’s profit/ cash flows from a general management perspective. We consider that investments reduce the flexibility of a business as they diminish the liquidation options. They also move the break-even point towards higher volumes (more depreciation). The degree of operating leverage DOL indicates how much a profit or a cash flow change in response of changes in volume. We demonstrate, that investments (fixed costs) work as leverage. A company with high fixed costs will increase/ decrease its profit due to volume changes more than a company with low fixed costs. At first, we introduce the DOL concept with the case study DEERFIELD TOURS (Pty) Ltd. Later we use another case study of a production firm to explain more details. EMS KAYAK GmbH produces kayaks. 9.2. Learning Objectives A company operating beyond breakeven point, earns with every additional product a profit to the extent of its contribution margin. The reason is, that with fixed costs covered, profit increases by the net operating income. The Degree of Operating Leverage (DOL) is a concept that tells managers how profit will change in respond of variations in volume (measured in sales). After studying this chapter, you will be able to understand the DOL concept and can calculate DOL for alternative business scenarios. You also understand the limitation of the concept. 9.3. Profit and Output Relationship Managers must to understand, how a business responds to changes in demand. E.g., they need to know how profit grows as the result of one additional unit of output. For making economic decisions, managers must consider that investments amplify the effect output has on profits. If a business is uncertain about its sales number, the DOL effect can lead to a decision to reduce fixed costs, e.g., by outsourcing or by selling and leasing back its assets. For this chapter, we assume that net selling prices per unit are constant. We also pretend that the sales volume is equal to the production volume, therefore, no changes in finished goods can apply. How it is Done (Calculation of DOL) (1) Determine the revenue for a particular output that is the reference case. Call the scenario A or base case. (2) Determine the revenue for an alternative output. Call the scenario B. <?page no="118"?> Berkau: Management Accounting 7e 9-118 (3) Determine the percentage of changes in output. The percentage increase/ decrease is: Δ Output A,B = Output B / Output A - 1. (4) Calculate the percentage of changes in profit. The percentage increase/ decrease is: Δ EBIT A,B = EBIT B / EBIT A - 1. (5) Calculate the Degree of Operating Leverage. It is equal to: DOL A,B = Δ EBIT A,B / Δ Output A,B 9.4. C/ S DEERFIELD TOURS (Pty) Ltd. We start with the example from the previous chapter, DEERFIELD TOURS (Pty) Ltd. The company DEERFIELD TOURS (Pty) Ltd. offers tours to the South African Garden Route and identifies variable and fixed costs thereof. It breaks-even with 8 trips (= number of travellers for one tour). Observe Figure 9.1: Sales of 8 trips Item Total Per unit Sales 31,200.00 3,900.00 Variable expenses (20,800.00) (2,600.00) Contribution margin 10,400.00 1,300.00 less: Fixed expenses (10,400.00) Net profit 0.00 CONTRIBUTION INCOME STATEMENT Figure 9.1: DEERFIELD TOURS (Pty) Ltd. break-even point We repeat the data sheet for DEERFIELD TOURS (Pty) Ltd. below: Data Sheet for DEERFIELD TOURS (Pty) Ltd. Classification: Tourism; SA-tour: 10 … 25 t/ tour; base case: 19 trips (t); flight: 1,500.00 EUR/ t; hotel: 700.00 EUR/ t; meals: 400.00 EUR/ t; Fixed costs: administration: 3,400.00 EUR/ tour; bus: 7,000.00 EUR/ tour; Net selling price: 3,900.00 EUR/ t; VAT ignored. 42 The difference to a contribution margin is that fixed costs can be considered for the net operating income, too. In the case of DEERFIELD With selling 8 trips for a tour DEERFIELD TOURS (Pty) Ltd. covers all its fixed costs. The company earns zero profit then. Any additional traveller will contribute to the profit by the margin of revenue less proportional costs. We also refer to that margin as the net operating income NOI. 42 The net operating income is the profit that remains after all operational costs are paid. We explain NOI with a case where a landlord/ landlady rents out property. The TOURS (Pty) Ltd. net operating costs are always proportional costs and the contribution margin is equal to the NOI. <?page no="119"?> Berkau: Management Accounting 7e 9-119 net operating income is amounting to rental income less all costs to be paid as covered as agreed on the rental contract, like maintenance, municipality rates or gardening service. In contrast, no overheads like administration or depreciation, are deducted for NOI calculation. Once all fixed costs are covered at DEERFIELD TOURS (Pty) Ltd. every additional trip increases its profit by its operating income of: 3,900 - 2,600 = 1 1,300.00 EUR/ t. If DEERFIELD TOURS (Pty) Ltd. sells 9 trips per tour, its profit becomes 1,300.00 EUR/ tour. Observe the calculation in Figure 9.2: Sales of 9 trips Item Total Per unit Sales 35,100.00 3,900.00 Variable expenses (23,400.00) (2,600.00) Contribution margin 11,700.00 1,300.00 less: Fixed expenses (10,400.00) Net profit 1,300.00 CONTRIBUTION INCOME STATEMENT Figure 9.2: DEERFIELD TOURS (Pty) Ltd.’s/ profit calculation (1 additional traveller) The next additional trip makes DEERFIELD TOURS (Pty) Ltd. earn a profit of 2,600.00 EUR/ tour. We check 11 trips. This will be 3 travellers beyond break-even. All 3 travellers add 1,300.00 EUR/ t to DEERFIELD TOURS (Pty) Ltd.’s profit. Observe Figure 9.3 for confirmation. Sales of 11 trips Item Total Per unit Sales 42,900.00 3,900.00 Variable expenses (28,600.00) (2,600.00) Contribution margin 14,300.00 1,300.00 less: Fixed expenses (10,400.00) Net profit 3,900.00 CONTRIBUTION INCOME STATEMENT Figure 9.3: DEERFIELD TOURS (Pty) Ltd.’s CIS (11 travellers) As our intention is to analyse relative changes in profit caused by increases/ decreases of sales, we compare the calculations in Figure 9.2 to those displayed in Figure 9.3: The sales volume, measured in trips, increases from 9 to 11. This results in an: 11 / 9 - 1 = 2 22.22 % increase of sales. In response of this change in output, profit increases by: (3,900 - 1,300) / 1,300 = 2 200 %. We acknowledge a 200 % increase in profits is caused by 22.22 % more sales. <?page no="120"?> Berkau: Management Accounting 7e 9-120 The amplifier between these percentages is called the Degree or Operating Leverage (DOL). The factor between the changes in EBIT and in sales is called the degree of operating leverage DOL. The DOL is equal to changes in terms of EBIT over changes in sales volume. Sales EBIT DOL At DEERFIELD TOURS (Pty) Ltd., the degree of operating leverage DOL is: 200 % / 22.22 % = 9 9.00. The DOL is high as the company’s profit works close to the break-even point. Companies with a high DOL will experience high changes in profit due to sales deviations. To make the effect more precedent, we write the equation again but now we solve it for ∆EBIT: Sales DOL EBIT This notation demonstrates that DOL works as an amplifier of changes in sales. We consider companies with high DOL as risky. E.g., DEERFIELD TOURS (Pty) Ltd. will half its profit if losing 2 customers out of 11. There are two factors that affect the degree of operating leverage DOL. (1) DOL-declining effect. (2) Fixed costs effect. 9.5. DOL-Declining Effect As the profit is equal to zero at the break-even point and we measure relative changes in percentages, profit changes nearest to the break-even point are higher than more distant thereto.. This effect becomes clearer once we observe an increase of 5 trips on a current situation of 20 trips. It causes an output increase of: 25/ 20 - 1 = 2 20.00 %. The profit will change by: (((25 - 8) × 1,300) - ((20 - 8) × 1,300))) / ((20 - 8) × 1,300)) = (17 - 12) / 12 = 4 41.67 %. The degree of operating leverage is: 41.67 % / 20 % = 2.08. The profit is now less sensitive to changes in volume. We call this effect ‘DOL-decline’. 9.6. Fixed Costs Effect The degree of operating leverage depends on fixed costs. Fixed costs reductions move the break-even point to lower volumes. Therefore, companies trade-off between enjoying the DOL to increase their profits at high rates and suffering from risks due to investing in more machinery. Managers who alter their cost structures towards fixed costs, must tolerate a loss in flexibility. The situation is like a decision whether you buy a bicycle to ride it to the university instead of coming with an UBER. The bicycle acquisition results in fixed costs which only pay-out if you ride your bicycle frequently. For a onetime ride the UBER alternative is better as no fixed costs occur. Your investment decision makes transportation cheaper but in terms of the cost structure you lost flexibility. We study the case EMS KAYAK GmbH where a company reduces its fixed costs by outsourcing production steps. This way, the company benefits <?page no="121"?> Berkau: Management Accounting 7e 9-121 from the effects of a high DOL if certain about selling above break-even. Next, we introduce the case study and some technical terms of break-even points and DOLs. Later, we also study the impact of outputs on cash flows. This is known as DOL(CF). 9.7. C/ S EMS KAYAK GmbH In contrast to DEERFIELD TOURS (Pty) Ltd., EMS KAYAK GmbH is a manufacturer which operates at higher fixed costs. The company invests in production facilities with a 5-years life. This determines its cost structure for the upcoming Accounting periods. Depreciation is a constant fixed cost as straightline method applies. In preparation for DOL analysis, we prepare an income statement and a cash flow statement in MS-Excel. We then calculate the company’s Accounting break-even point, the cash break-even point and the financial break-even point. The Accounting break-even point is at zero-profit. The cash break-even point is where the resulting operating cash flow becomes zero. The financial break-even point is where the investment’s net present value is amounting to zero. We need the knowledge about the breakeven points concepts to study DOLs for profit as well as for cash flows. Below we show the data sheet for EMS KAYAK GmbH: Data Sheet for EMS KAYAK GmbH CClassification: Production; Net selling price: 400.00 EUR/ u; Variable costs per unit: 200.00 EUR/ u; Fixed costs: 5,000.00 EUR; Investment in machinery: 35,000.00 EUR fully depreciable over 5 years; Periods: 20X3 … 20X7; Boat quantity: 525 u/ a; Discount rate: 10 %; VAT ignored . EMS KAYAK GmbH is a kayak manufacturer and sells a kayak at 400.00 EUR/ u. The proportional costs per kayak are 200.00 EUR/ u. The fixed costs at EMS KAYAK GmbH are 5,000.00 EUR and are linked to labour in production and to administration. The investment in manufacturing facilities is for the boat hull production and costs 35,000.00 EUR, payable in 20X2. The depreciable value is written-off over 5 years based on straight-line method with no residual value. During the Accounting periods 20X3 … 20X7, EMS KAYAK GmbH estimates to manufacture and sell 525 kayaks. The rate of interest is 10 %/ a and applies for discounting cash flows. No financing by loan applies. The present value calculation is based on the investing cash flow in 20X2 (acquisition) and the operating cash flows (returns) during the following 5 years. Returns are earned from 20X3 to 20X7. An income tax rate of 30 % applies. For calculation of net present values, EMS KAYAK GmbH prepares a cash flow vector for investing and operating cash flows. The investing cash flow is equal to the cost of acquisition: -35,000.00 EUR. The operating cash flow includes proceeds of: 525 × 400 = 2 210,000.00 EUR. The negative operating cash flows represent proportional costs: 525 × 200 = 105,000.00 EUR/ a and for other fixed costs (labour and administration) which are 5,000.00 EUR/ a. The operating cash flows over the years 20X3 … 20X7 are: <?page no="122"?> Berkau: Management Accounting 7e 9-122 210,000 - 105,000 - 5,000 = 1 100,000.00 EUR/ a. Furthermore, income taxes are paid during the year they are for. After deduction of income taxes, the operating cash flow is: 100,000 - 27,900 = 72,100.00 EUR. For manufacturing another kayak volume (#ky), expect cash flows to adjust. The payment vector is based on 525 kayaks: CF 525 (t) = { {-35,000; 72,100.00; 72,100.00; 72,100.00; 72,100.00; 72,100.00}. To check whether the kayak production is adding value to the company, EMS KAYAK GmbH calculates the net present value of its kayak production project. It is: -35,000 + 72,100 × ((1 + 10%) 5 - 1) / (10% × (1 + 10%) 5 ) = 2 238,315.73 EUR. Figure 9.4 shows the profit and cash flow calculation and the net present value for an output of 525 kayaks. For your studies you can download the excel sheet through Link 9.A. Link 9.A: Excel sheet EMS KAYAK GmbH / u [EUR] [EUR] Sales 400.00 210,000.00 Proceeds 210,000.00 Var. Costs 200.00 (105,000.00) Var. Costs (105,000.00) Fixed costs (5,000.00) Fixed costs (5,000.00) Depreciation (7,000.00) Tax (27,900.00) EBT 93,000.00 OCF 72,100.00 less: tax (27,900.00) EAT 65,100.00 Output = 525 NPV 20X2 = 238,315.73 (35,000.00) + 72,100.00 × 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.4: EMS KAYAK GmbH’s profit and cash flow calculation (1) 9.8. 3 Break-Even Points - EMS KAYAK GmbH Next, we calculate break-even points. ‘How many kayaks (#ky) must EMS KAYAK GmbH sell to break-even? ’ The solution is based on a profit calculation: EBT(#ky) = #ky × 200 + 5,000 + 7,000. It gives: #ky BE = 12,000 / 200 = 6 60 kayaks (no income tax considered). Figure 9.5 proves the Accounting break-even point calculation. The Accounting break-even point is based on the output which makes the company earn a profit of zero. For EMS KAYAK GmbH, the number of kayaks #ky for the Accounting breakeven point is 60 kayaks. <?page no="123"?> Berkau: Management Accounting 7e 9-123 / u [EUR] [EUR] Sales 400.00 24,000.00 Proceeds 24,000.00 Var. Costs 200.00 (12,000.00) Var. Costs (12,000.00) Fixed costs (5,000.00) Fixed costs (5,000.00) Depreciation (7,000.00) Tax 0.00 EBT 0.00 OCF 7,000.00 less: tax 0.00 EAT 0.00 Output = 60 NPV 20X2 = (8,464.49) (35,000.00) + 7,000.00 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.5: EMS KAYAK GmbH’s Accounting break-even point (2a) For the cash break-even point, the number of kayaks #ky C-BE must meet the point, where EMS KAYAK GmbH’s operating cash flow becomes zero. Beyond that kayak volume #ky C-BE , the project generates cash from its operating activities. The cash break-even point is based on the output that makes the operating cash flow become zero. The cash breakeven point only matters in Accounting periods when EMS KAYAK GmbH manufactures kayaks and receives returns from operations, which is in 20X3 … 20X7. For the calculation of the cash breakeven point, we must consider income taxes. They depend on the profit calculation. If EMS KAYAK GmbH earns a loss, its taxes become zero. We must avoid negative income tax expenses in the formula and make an adjustment where the * * is (see below). The provisional cash flow equation without adjustment is (tax consideration in bold letters/ figures): OCF(#ky C-BE ) = #ky C-BE × 400 - #ky C-BE × 200 - 5,000 - 3 30% × (#ky C-BE × 400 - #ky C-BE × 200 - 5,000 - 7,000) = #ky C-BE × 140 - 1,400 = 0. After solving the equation for #ky C-BE , we determine the provisional cash breakeven volume: #ky C-BE = 1,400 / 140 = 1 10 kayaks. * Here comes the re-working for our calculation: Due to a loss with only 10 kayaks sold, the taxes become zero. Hence, the operating cash flow of 10 kayaks is: -3,000.00 EUR but not zero as calculated. Therefore, the cash break-even point is only reached at a higher than 10 kayaks volume. We adjust the formula accordingly. <?page no="124"?> Berkau: Management Accounting 7e 9-124 / u [EUR] [EUR] Sales 400.00 4,000.00 Proceeds 4,000.00 Var. Costs 200.00 (2,000.00) Var. Costs (2,000.00) Fixed costs (5,000.00) Fixed costs (5,000.00) Depreciation (7,000.00) Tax 0.00 EBT (10,000.00) OCF (3,000.00) less: tax 0.00 EAT (10,000.00) Output = 10 NPV 20X2 = (46,372.36) (35,000.00) + (3,000.00) * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.6: EMS KAYAK GmbH’s profit and cash flow calculation (2b) Once the EBT is negative, the tax expenses must be zero. In case we calculate the cash break-even point with MS- Excel, on the MS-Excel sheet the tax cell reads: ‘=if(EBT>0,-0.3×EBT,0)”. Therefore, you spreadsheet can handle different profit scenarios, but the above presented formula cannot. We adjust the equation for sections of negative EBTs by (manually) erasing the terms for taxation 43 and now re-calculate: OCF(#ky C- BE ) = #ky C-BE × 400 - #ky C-BE × 200 - 5,000 = #ky C-BE × 200 - 5,000 = 0. The cash break-even point is at: #ky C-BE = 5,000 / 200 = 2 25 kayaks. / u [EUR] [EUR] Sales 400.00 10,000.00 Proceeds 10,000.00 Var. Costs 200.00 (5,000.00) Var. Costs (5,000.00) Fixed costs (5,000.00) Fixed costs (5,000.00) Depreciation (7,000.00) Tax 0.00 EBT (7,000.00) OCF 0.00 less: tax 0.00 EAT (7,000.00) Output = 25 NPV 20X2 = (35,000.00) (35,000.00) + 0.00 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.7: EMS KAYAK GmbH’s cash break-even point (2b) Next, we want to know whether a project generates cash flows. The answer lies in the financial break-even point. It 43 The more convenient approach to ascertain the financial break-even point is by the goal seek function provided by MS-Excel. That way, the if-function considers zero taxation for loss and zero profit is relevant for investment decisions. The question is: ‘How many cases automatically and we do not have to adjust tax-relevant terms manually for the loss cases. <?page no="125"?> Berkau: Management Accounting 7e 9-125 goods/ services must be produced/ rendered, to take economically advantage of the investment? ’ In contrast to the previous break-even point considerations, the financial cash flow considers cash flows over the project life. Calculations consider the time value of money for the entire duration (useful life) of the investment. The financial break-even point is at the output where the net present value is zero. For the calculation, we use the goal seek function in MS-Excel. Observe the result in Figure 9.8. / u [EUR] [EUR] Sales 400.00 30,379.75 Proceeds 30,379.75 Var. Costs 200.00 (15,189.87) Var. Costs (15,189.87) Fixed costs (5,000.00) Fixed costs (5,000.00) Depreciation (7,000.00) Tax (956.96) EBT 3,189.87 OCF 9,232.91 less: tax (956.96) EAT 2,232.91 Output = 75.9493702 NPV 20X2 = 0.00 (35,000.00) + 9,232.91 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.8: EMS KAYAK GmbH’s financial break-even point (2c) We round the kayak volume #ky F-BE to its next integer and acknowledge that at 76 kayaks a positive net present value of 26.87 EUR for the kayak production project is achieved. Observe Figure 9.9. / u [EUR] [EUR] Sales 400.00 30,400.00 Proceeds 30,400.00 Var. Costs 200.00 (15,200.00) Var. Costs (15,200.00) Fixed costs (5,000.00) Fixed costs (5,000.00) Depreciation (7,000.00) Tax (960.00) EBT 3,200.00 OCF 9,240.00 less: tax (960.00) EAT 2,240.00 Output = 76 NPV 20X2 = 26.87 (35,000.00) + 9,240.00 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.9: EMS KAYAK GmbH’s financial break-even point (2c) <?page no="126"?> Berkau: Management Accounting 7e 9-126 9.9. DOL-Studies - EMS KAYAK GmbH After we calculated the break-even points, we can analyse the degree of operating leverage DOL for alternative volumes. The base case (1) is about 525 kayaks. Coming from 525 kayaks, EMS KAYAK GmbH increases production and sales volume by 200 kayaks 44 . (The profit and cash flows for 525 kayaks can be taken from Figure 9.4.) The distance to the break-even point is high enough to ignore the DOL-declining effect. The scenario of EMS KAYAK GmbH producing and selling 725 kayaks is shown in Figure 9.10: / u [EUR] [EUR] Sales 400.00 290,000.00 Proceeds 290,000.00 Var. Costs 200.00 (145,000.00) Var. Costs (145,000.00) Fixed costs (5,000.00) Fixed costs (5,000.00) Depreciation (7,000.00) Tax (39,900.00) EBT 133,000.00 OCF 100,100.00 less: tax (39,900.00) EAT 93,100.00 Output = 725 NPV 20X2 = 344,457.76 (35,000.00) + 100,100.00 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.10: EMS KAYAK GmbH’s profit and cash flow calculation (3) We calculate the degree of operating leverage for EMS KAYAK GmbH for increasing its volume from 525 to 725 kayaks: The degree of operating leverage for an increase of 200 kayaks based on the 525 kayak-situation gives: DOL (1)-(3) = ((133,000/ 93,000) -1) / ((725/ 525) - 1) = 11.13. We say: a 1%-change in sales leads to a 1.13% change of profit (here: EBIT). Hence, EBIT increase by 13 % more than sales. For checking the DOL-declining effect, we study another output. We analyse what means an increase of volume by 100 further kayaks, from 725 to 825. The situation of EMS KAYAK GmbH producing and selling 825 kayaks is shown by Figure 9.11 and is indicated as scenario (4). 44 We mark that case by (3). <?page no="127"?> Berkau: Management Accounting 7e 9-127 / u [EUR] [EUR] Sales 400.00 330,000.00 Proceeds 330,000.00 Var. Costs 200.00 (165,000.00) Var. Costs (165,000.00) Fixed costs (5,000.00) Fixed costs (5,000.00) Depreciation (7,000.00) Tax (45,900.00) EBT 153,000.00 OCF 114,100.00 less: tax (45,900.00) EAT 107,100.00 Output = 825 NPV 20X2 = 397,528.77 (35,000.00) + 114,100.00 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.11: EMS KAYAK GmbH’s profit and cash flow calculation (4) The DOL now changes a bit; this only is caused by the DOL-declining effect: DOL (3)-(4) = ((153,000/ 133,000) - 1)/ ((825/ 725) - 1) = 11.09. A 1 % change in sales causes a 1.09% change in profit. As more the figures are distant to the break-even point, as lower the DOL becomes. We can neglect the decline to 9 % because EMS KAYAK GmbH operates far beyond its break-even point of 60 kayaks. Furthermore, EMS KAYAK GmbH’s ability to change volume is limited as it cannot increase production significantly without investing. 9.10. Fixed Cost Effect - EMS KAYAK GmbH We study what happens if EMS KAYAK GmbH changes its cost structure towards more variable costs. We expect a lower DOL and more flexibility. EMS KAYAK GmbH outsources production steps and thus avoids the investments in machinery. We assume, that EMS KAYAK GmbH farms out the hull production to a supplier. Now, EMS KAYAK GmbH pays for every kayak 15.00 EUR/ ky proportional costs more but the investment in the hull production machinery is obsolete. Figure 9.12 discloses the financial situation of EMS KAYAK GmbH producing 525 kayaks. No depreciation applies but the proportional costs increase by 15.00 EUR/ ky and now are: 200 + 15 = 2 215.00 EUR/ ky. The fixed costs for labour and administration remain 5,000.00 EUR. <?page no="128"?> Berkau: Management Accounting 7e 9-128 / u [EUR] [EUR] Sales 400.00 210,000.00 Proceeds 210,000.00 Var. Costs 215.00 (112,875.00) Var. Costs (112,875.00) Fixed costs (5,000.00) Fixed costs (5,000.00) Depreciation 0.00 Tax (27,637.50) EBT 92,125.00 OCF 64,487.50 less: tax (27,637.50) EAT 64,487.50 Output = 525 NPV 20X2 = 209,458.36 (35,000.00) + 64,487.50 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.12: EMS KAYAK GmbH’s profit and cash flow calculation (5) With the hull production outsourced, EMS KAYAK GmbH earns a pre-tax profit of 92,135.00 EUR. We mark this scenario by (5). The profit decreases in contrast to scenario (1) by: 93,000 - 92,125 = 8 875.00 EUR. Although, EMS KAYAK GmbH is now better off as its DOL has decreased. We check an increase by 200 kayaks in Figure 9.13, marked as scenario (6). / u [EUR] [EUR] Sales 400.00 290,000.00 Proceeds 290,000.00 Var. Costs 215.00 (155,875.00) Var. Costs (155,875.00) Fixed costs (5,000.00) Fixed costs (5,000.00) Depreciation 0.00 Tax (38,737.50) EBT 129,125.00 OCF 90,387.50 less: tax (38,737.50) EAT 90,387.50 Output = 725 NPV 20X2 = 307,639.74 (35,000.00) + 90,387.50 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.13: EMS KAYAK GmbH’s profit and cash flow calculation (6) The DOL for an increase of 200 kayaks from 525-kayaks is: DOL (5)-(6) = ((129,125/ 92,125) - 1) / ((725/ 525) - 1) = 11.05. For an increase of 1 % of the kayaks the profit will increase by 1.05 %. For the next increase by 100 kayaks, from 725 to 825, we study Figure 9.14, which shows the profit and cash flows for 825 kayaks with regard to the outsourcing situation. We indicate this scenario by (7). <?page no="129"?> Berkau: Management Accounting 7e 9-129 / u [EUR] [EUR] Sales 400.00 330,000.00 Proceeds 330,000.00 Var. Costs 215.00 (177,375.00) Var. Costs (177,375.00) Fixed costs (5,000.00) Fixed costs (5,000.00) Depreciation 0.00 Tax (44,287.50) EBT 147,625.00 OCF 103,337.50 less: tax (44,287.50) EAT 103,337.50 Output = 825 NPV 20X2 = 356,730.43 (35,000.00) + 103,337.50 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.14: EMS KAYAK GmbH’s profit and cash flow calculation (7) The calculation of a DOL at higher outputs makes the DOL decrease slightly: DOL (6)-(7) = ((147,625/ 129,125) - 1) / ((825/ 725) - 1) = 11.04. Below, we show the situation in a costvolume-diagram not to scale. Figure 9.15: Graphical implication of the outsourcing effect The outsourcing of the hull production is shown in Figure 9.15. In the diagram, the sales are represented by a bold line. The initial cost line is a straight line starting-off at the fixed costs. The intersection of the cost line and the sales line <?page no="130"?> Berkau: Management Accounting 7e 9-130 marks the break-even point A. Arrow 1 indicates the reduction of fixed costs by disposal of the machinery when farming out production steps, as in the case of EMS KAYAK GmbH with the hull production. As a further outsourcing effect variable costs increase which leads to an increase of the slope of the cost function as indicated by the arrow 2. As a result of the changes, the break-even point moves from A to B which means towards lower volumes. The company breakseven at lower volume which improves its risk situation. The calculation of a ‘neutral’ increase of proportional costs can be downloaded through Link 9.B. Link 9.B: Neutral cost increase If EMS KAYAK GmbH farms out hull production, the break-even point moves down on the volume scale, which indicates lower risks because less kayaks are required for breaking-even. As in this example depreciation becomes zero, the profit and cash flow are the same for the break-even points. Furthermore, the investing cash flow becomes zero. This results for the EMS KAYAK GmbH case study in a situation where all break-even points are at the same volume. Observe the situation of EMS KAYAK GmbH ordering hulls from a supplier for additional 15.00 EUR/ ky in Figure 9.16. / u [EUR] [EUR] Sales 400.00 10,810.81 Proceeds 10,810.81 Var. Costs 215.00 (5,810.81) Var. Costs (5,810.81) Fixed costs (5,000.00) Fixed costs (5,000.00) Depreciation 0.00 Tax (0.00) EBT 0.00 OCF 0.00 less: tax (0.00) EAT 0.00 Output = 27.02702703 NPV 20X2 = 0.00 0.00 + 0.00 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.16: EMS KAYAK GmbH’s break-even point <?page no="131"?> Berkau: Management Accounting 7e 9-131 As result of the break-even point calculation, #ky BE = #ky C-BE = #ky F-BE = 227.03 kayaks. This is a significant risk reduction. 9.11. DOL for Cash Flows Next, we focus on cash flows and study what happens to cash flows if revenue changes. The DOL(CF) is the degree of operating cash flow leverage. It measures the sensitivity of a firm’s operating cash flows to the sales. The DOL(CF) is: Sales OCF CF DOL ) ( We determine EMS KAYAK GmbH’s DOL(CF) for an increase of 200 kayaks. The base case (1) applies. DOL(CF) (1)-(3) = ((100,100/ 72,100) - 1) / ((725/ 525) - 1) = 1 1.01. The result shows that an increase of 1 % sales will increase the operating cash flow by 1.01 %. 9.12. Summary The degree of operating leverage DOL measures the sensitivity of the profit (EBIT, or in some cases only NOI) to changes in volume or sales. The DOL depends on the cost structure. High DOLs are regarded as risky as a company’s profits and cash flows react to sales reductions sensitively. This increase the standard deviation of profits. At the same time, a high DOL requires dominant fixed costs which is a weakness if it comes to adjust capacities or liquidate the business. 9.13. Working Definitions Accounting Break-Even Point: The Accounting break-even point is based on the output which makes the company earn a profit of zero. Cash Break-even Point: The financial break-even point is based on the output that makes the operating cash flow become zero. Degree of Operating Cash Flow Leverage: The DOL(CF) is the degree of operating cash flow leverage. It measures the sensitivity of a firm’s operating cash flows to the sales. Degree of Operating Leverage: The factor between the changes in EBIT and in sales is called the degree of operating leverage DOL. The DOL is equal to changes in terms of EBIT over changes in terms of sales. Degree of Operating Leverage Concept: The Degree of Operating Leverage (DOL) is a concept that tells managers how profit will change based on variations in revenues. Financial Break-even Point: The financial break-even point is at the output where the net present value is zero. Net Operating Income (NOI): The net operating income is the profit that remains after all operating costs are paid. 9.14. Question Bank: (1) What is a financial break-even point? 1. The output where the borrowing interest is covered by the revenue. <?page no="132"?> Berkau: Management Accounting 7e 9-132 2. The output where the present value of free cash flows over the periods of a project equals zero. 3. The output where the financial cash flows’ present value is zero. 4. The output where operating cash flows intercept with financing and investing cash flows. (2) A company calculates a DOL to be 5. Sales are 120,000.00 EUR (net amount). Actual profit is 75,000.00 EUR. How much is the profit at sales of 150,000.00 EUR? 1. 78,750.00 EUR . 2. 150,000.00 EUR . 3. 90,000.00 EUR . 4. 168,750.00 EUR . (3) What is a DOL-cash flow? 1. Δ CF / Δ EBIT. 2. Δ CF / Δ Sales. 3. Δ CF / Δ Proceeds. 4. Δ Sales / Δ CF. (4) What is a net operating income in rental business? 1. Profit after deduction of operational costs. 2. Proceeds less depreciation. 3. Fees paid by the tenant of the property agent. 4. Proceeds less maintenance. (5) What does a high DOL tell? 1. The variable costs are high in comparison of fixed costs. 2. The company is flexible. 3. The company has free capacity. 4. Profits increase more than sales due to high investments. 9.15. Solutions 1-2; 2-4; 3-2; 4-1; 5-4. <?page no="133"?> Berkau: Management Accounting 7e 10-133 10. Performance Measurement 10.1. What is in the Chapter? This chapter covers the measurement of performance based on the case study VANHUIZEN BV which is a car windows tinting service. We study return figures and the concept of the Economic Value Added EVA TM for two divisions of VANHUIZEN BV and compare their performance. 10.2. Learning Objectives In this chapter, you learn different concepts of performance valuation from the general management perspective. We teach you technical terms and key performance measures and you will learn when to apply which one. We analyse the impacts of different concepts for performance figures reported for companies of divisions thereof. It is required to monitor performance ratios regularly and to allocate resources to maximise performance business. After studying this chapter, you know different performance ratios and understand their meaning. 10.3. What is Performance? Performance measures the output of a company, e.g. the number of goods/ services. If performance is related to an internal organisational unit, e.g., to a cost centre or a division, we use the technical term volume. Volume is proportional to the output, e.g. as more goods are manufactured as 45 BV = Besloten vennootschap met beperkte aansprakelijkheit. more energy is provided in a supporting energy cost centre. We measure the volume of the energy cost centre in kWH and call it a reference unit. Its amount depends on the output of goods. We acknowledge, a reference unit depends proportional on the volume/ output as well as on the costs. Some cost centres allow us to allocate costs as well as revenues. Then we can calculate the profit of the organisational unit. Such units are known as profit centres. For them we can use profits to measure performance. Accordingly, the performance unit is, e.g. EUR, US-$, AUD etc. Performance of a division is measured as pre-tax profit or profit margins. This applies mostly for performance measurement in group companies, in joint ventures or divisions. In this chapter which is linked to general management we cover performance measurement for divisions (profit centres). We study the most appropriate performance measurement figures which are expressed in currency units or percentages. (The performance measurement for internal cost centres based on reference units is covered in chapter (15), in the cost Accounting section). Below, we study performance measurement for divisions of VANHUIZEN BV 45 . It runs its divisions as profit centres. <?page no="134"?> Berkau: Management Accounting 7e 10-134 10.4. C/ S VANHUIZEN BV VANHUIZEN BV is a Dutch automobile accessories company with branches in Geldern and Pieterburen. These 2 branches are divisions. The company is specialised in tinting car windows. Its headquarters is based in Kampen. Window tinting is a manual process. Foils are purchased in different colours and with different shade characteristics from the supplier OCTUPUS PLC. The foils are cut manually (with a scalpel) to fit the windows of the customers’ motor vehicle. The degree of automation for the window tinting process is low, as most of the work is craftsmanship. Regarding the cost structure, the cost categories below apply: - Materials, foils. - Miscellaneous: like gloves, knives, soap. - Labour. - Store rent. - Depreciation on the cutter-table. The business model of VANHUIZEN BV includes its deployment of workers for window tinting and marketing the service to customers. The foils are materials for the business operations. Most of the costs are direct materials and direct labour. The company’s return on investment is high as the assets’ value is low in comparison to other costs. A situation of high performance based on low asset values occurs for many service renderers, e.g. consultancies, doctors’ clinics or law firms. To provide an overview of VANHUIZEN BV, we show below its data sheet: Data Sheet for VANHUIZEN BV: CClassification: Manufacturing; Revenue per car: 400.00 EUR/ u; Sales quantity: 2,080 cars / 3,640 cars; Materials: 150.00 EUR/ car; Labour: 75.00 EUR/ car; Miscellaneous: 5,000.00 EUR / 8,000.00 EUR Order management: 40,000.00 EUR / 40,000.00 EUR; Depreciation: 100,000.00 EUR / 200,000.00 EUR; Other expenses: 40,000.00 EUR / 60,000.00 EUR; Headquarters costs: 400,000.00 EUR; Assets: 1,000,000.00 EUR / 2,000,000.00 EUR as costs of acquisition VAT ignored. At VANHUIZEN BV, the price for a car window tinting is 400.00 EUR/ car. During the last years, the below disclosed revenues and costs were recorded in its divisions. In the GELDERN store, 2,080 cars were ‘tinted’; in PIETERBUREN the output was 3,640 cars. Both divisions’ profitability reports are shown in Figure 10.1 and Figure 10.2. <?page no="135"?> Berkau: Management Accounting 7e 10-135 [EUR] Revenue 832,000 Other income 832,000 Materials (312,000) Miscellaneous (5,000) Labour, var (156,000) Labour, fixed (40,000) Depreciation (100,000) Other expenses (40,000) Earnings before int. & taxes (EBIT) 179,000 Vanhuizen BV - GELDERN PROFITABILITY ANALYSIS for the year ended 31.12.20X1 Figure 10.1: Profitability analysis for the GELDERN branch [EUR] Revenue 1,456,000 Other income 1,456,000 Materials (546,000) Miscellaneous (8,000) Labour, var (273,000) Labour, fixed (40,000) Depreciation (200,000) Other expenses (60,000) Earnings before int. & taxes (EBIT) 329,000 Vanhuizen BV - PIETERBUREN PROFITABILITY ANALYSIS for the year ended 31.12.20X1 Figure 10.2: Profitability analysis for the PIETERBUREN branch VANHUIZEN BV wants to know which division performs best. At first, we compare the profits before taxes. We acknowledge that profit in the PIETERBUREN division is higher than in GELDERN. However, figures for depreciation and other costs indicate that the branch is just bigger which means it has more capacity. There is more revenue, higher labour costs and more depreciation. Following Drury, we divide profit in controllable and non-controllable portions, and in portions necessary and unnecessary for business operations. We further consider costs allocated to divisions, like <?page no="136"?> Berkau: Management Accounting 7e 10-136 law service, HR department and Accounting. In the case of VANHUIZEN BV, these costs fall under headquarters costs and are independent form operations in the divisions. Division revenues are based on the net selling price of the tinting service which is 400.00 EUR/ car. In the GELDERN division, total sales are: 2,080 × 400 = 8832,000.00 EUR. In PIETERBUREN, we calculate: 3,640 × 400 = 1 1,456,000.00 EUR. For profit calculation, we deduct costs from revenues. As we analyse the performance of the divisions, costs are studied regarding their dependency on management decisions, their necessity for the division and where they originate from, e.g. some costs are allocated from the headquarters. We only can hold managers responsible for what they can decide. As a result, it would be misleading to include headquarters cost in proficiency (performance) reports for divisions. We use the performances also for the evaluation of managers. We calculate different profits by stepwise deducting cost from revenues. The calculations give us a sequence of performance measures: (a) Short-run (variable) contribution margin. (b) Controllable contribution margin. (c) Divisional contribution margin. (d) Divisional net profit. Compare the below calculations to Figure 10.3! 10.5. Short-run (Variable) Contribution Margin In both divisions, the variable costs contain materials (foils) and direct labour. At VANHUIZEN BV, workers are only paid for tinting car windows. Hence, labour is a direct cost. After deduction of variable costs from revenues, we arrive at the variable and short-run contribution margin in GELDERN and in PIETERBUREN. As the short-run contribution margin fully depends on the volume, we call it a variable contribution margin. The variable contribution margin in GELDERN is: 832,000 - 2,080 × (150 + 75) = 3 364,000.00 EUR. In PIETERBUREN, the variable contribution margin is equal to: 1,456,000 - 3,640 × (150 + 75) = 6 637,000.00 EUR. 10.6. Controllable Contribution Margin Next, we deduct all controllable fixed costs from the short-run contribution margin. Fixed and controllable costs are for miscellaneous materials, e.g. gloves, knives and soap, as well as for fixed labour. The latter one is for the order management inside of the stores. Controllable costs are needed for the operations in the divisions, but they are not variable because they are not related to the volume/ output. Therefore, they are classified as fixed costs and depend on local (in the divisions) management decisions. Deducting controllable fixed costs from the variable contribution margin gives us in the controllable contribution margins. In the GELDERN branch, the controllable contribution margin is equal to: 364,000 - 40,000 - 5,000 = 3 319,000.00 EUR. In PIETERBUREN the controllable contribution margin is: 637,000 - 40,000 - 8,000 = 5 589,000.00 EUR. <?page no="137"?> Berkau: Management Accounting 7e 10-137 10.7. Divisional Contribution Margin Next, further fixed costs are deducted from the controllable contribution margins. The deductions are for costs which will become obsolete once the division is closed-down. About these costs local managers (in the divisions) do not decide. They are necessary for maintaining a division but decisions about them are made by general management. At VANHUIZEN BV, these costs are depreciation on the cutter tables and rental costs for the shop. Headquarters makes all investment decisions and signs rental agreement with landladies/ landlords. After deduction of these costs for continued operations from the controllable contribution margin, we arrive at the divisional contribution margin. The divisional contribution margin in GELDERN is equal to: 319,000 - 100,000 - 40,000 = 1179,000.00 EUR. The divisional contribution margin in PIETERBUREN is: 589,000 - 200,000 - 60,000 = 329,000.00 EUR. 10.8. Divisional Net Profit With the divisional contribution margin, the profit (before taxes) per divisions has been calculated. Note, the divisions do not pay taxes but the company does. In the last step headquarters costs are allocated to the divisions. In the headquarters only cost for administration occur as no operations are carried out. The allocation of headquarters’ costs to divisions is not helpful for performance measurement. However, we calculate a total net profit (before tax) to analyse the profit per division. Headquarters costs are 400,000.00 EUR/ a and are allocated evenly, at a 50 : 50 ratio, to the 2 divisions. We derive the divisional profit before taxation by deduction of 200,000.00 EUR from the divisional contribution margins in GELDERN and PIETERBUREN. The branch in GELDERN made a loss of: 179,000 - 200,000 = - - 21,000.00 EUR. The divisional net profit in PIETERBUREN is: 329,000 - 200,000 = 129,000.00 EUR. Study the entire calculation of performance measures in Figure 10.3: Geldern Pieterburen Total sales 832,000 1,456,000 less variable costs (468,000) (819,000) Variable short-run Contribution Margin 364,000 637,000 less controllable fixed costs (45,000) (48,000) Controllable Contribution Margin 319,000 589,000 less non-avoidable costs (140,000) (260,000) Divisional Contribution Margin 179,000 329,000 less HQ contribution (200,000) (200,000) Divisional NP before taxes (21,000) 129,000 Vanhuizen BV PERFORMANCE REPORT for 20X1 Figure 10.3: Performance figures for VANHUIZEN BV <?page no="138"?> Berkau: Management Accounting 7e 10-138 The controllable contribution margin is the most appropriate measurement for departmental performance. The controllable contribution margin considers all costs in the power of division management. No depreciation on divisional assets nor costs for the shop rent are considered as local managers do not decide thereon. They only change once the branch is closed-down meaning if VANHUIZEN BV stops rental payments and liquidates a division’s assets. In preparation for ratio calculations, we analyse the whole company and determine the net operating profit after taxes. The profit earned by all divisions together is the taxable income for VANHUIZEN BV. We apply a total income tax rate of 30 %. Hence, the income taxes are: 108,000 × 30% = 3 32,400.00 EUR. The net profit after taxation amounts to: 108,000 - 32,400 = 75,600.00 EUR. Geldern Pieterburen Total sales 832,000 1,456,000 less variable costs (468,000) (819,000) Variable short-run Contribution Margin 364,000 637,000 less controllable fixed costs (45,000) (48,000) Controllable Contribution Margin 319,000 589,000 less non-avoidable costs (140,000) (260,000) Divisional Contribution Margin 179,000 329,000 less HQ contribution (200,000) (200,000) Divisional NP before taxes (21,000) 129,000 Entire NP before taxes less income taxes Net operating profit after taxes NOPAT 108,000 (32,400) 75,600 Vanhuizen BV PERFORMANCE REPORT for 20X1 Figure 10.4: Profit calculation VANHUIZEN BV We acknowledge that the divisions differ in size and volume. This requires a more sophisticated analysis as we discussed so far. Therefore, we introduce more meaningful performance ratios. We discuss below: - Return on investment. - Return on equity. - Residual income. - Economic value added EVA TM . 10.9. Return on Investment The return on investment shows the profit as percentage of the investments. It supports comparisons between investments of different sizes. If the return is calculated for an entire <?page no="139"?> Berkau: Management Accounting 7e 10-139 company, it is known as the return on assets ROA. In the case of VANHUIZEN BV we consider the investments at cost of acquisition in the stores to be 1,000,000.00 EUR for the GELDERN division and 2,000,000.00 EUR in PIETERBUREN. For performance measurement any of (a) the controllable contribution margin, (b) the divisional contribution margin or (c) the divisional profit, can serve as ROInominator. As we measure the performance of managers, we calculate the return on investment based on the controllable contribution margin and get the following return figures: ROI GELDERN = 319,000 / 1,000,000 = 3 31.90 %/ a and: ROI PIETERBUREN = 589,000 / 2,000,000 = 29.45 %/ a. If we compare investments to other investment opportunities, we should consider the divisional contribution margin for the nominator of the return on investment ratio, which gives: ROI div,GELDERN = 179,000 / 1,000,000 = 17.9 %/ a and: ROI Div,PIETERBUREN = 329,000 / 2,000,000 = 1 16.45 %/ a. The return on investment comes with a systematic weakness for decision making: Consider that division managers are only keen to invest if the return on investment for her/ his division will increase. In case the return on similar investments is 17.0 %/ a and the manager in GELDERN is offered an investment opportunity (store extension) that comes with an estimated return of 17.5 %/ a, she/ he would forfeit the good (better than alternatives) opportunity because it will dilute the average return of her/ his division. Remember, the return rate is 17.9 %/ a in GELDERN. In the other division, the manager in PIETERBUREN would be happy to invest in an extension of her/ his shop which gives her/ him a 16.8 %/ a return because it helps him/ her to increase her/ his average return on investment which was before 16.45%. However, both investment decisions are wrong. Because a return on investment of 17 %/ a is available for investments, the manager in GELDERN should take the opportunity to extend her/ his business at 17.5 %/ a of return and the manager in PIETERBUREN should deny the offer of a 16.8 %/ a investment as there are better alternatives available. This example shows that managers who are guided only by the return on investment are prone to make wrong decisions. Another weakness results from the denominator of the return on investment. The denominator either is the initial investment (cost of acquisition) or its carrying value (after depreciation). In case the initial investment value applies, managers are motivated to reinvest continuously, as new investments do not change their performance. If the carrying amount applies for the denominator of the return of investment figure, managers are adamant to not invest because depreciation diminishes the denominator of the return continuously. This is a very comfortable way to increase performance with hands down. We study the ROI disadvantages for VANHUIZEN BV: We apply a return of investment calculation based on the controllable contribution margin in the nominator and the <?page no="140"?> Berkau: Management Accounting 7e 10-140 carrying value of the cutter tables in the denominator. The carrying value of the investments is the fair value for asset valuation. Hence, it gives us the correct input for a return ratio. We consider the cutter tables are depreciated over a period of 10 years and the ones in GELDERN are more than 5 years old and the ones in PIETERBUREN are more than 2 years old. Hence, the carrying value of the tables in GELDERN is: CA cutter = 1,000,000 - 5 × 100,000 = 5 500,000.00 EUR. The return on investment for the division in GELDERN is then: 179,000 / 500,000 = 3 35.8 %/ a. In PIETERBUREN the return on investment for the division is lower: 329,000 / (2,000,000 - 2 × 200,000) = 2 20.56 %/ a. In both cases, the return on investment increases only due to depreciation. In the next year, the return in PIETERBUREN will ceteris paribus become: 329,000 / (2,000,000 - 3 × 200,000) = 2 23.5 %/ a. As we see, the return increases progressively. However, aging of machinery is not supposed to drive performance ratios. As a result, we suggest avoiding the return on investments for performance comparisons if assets of different ages are in use. 10.10. Return on Equity The problems regarding the denominator of the return on investment figure can be remedied by a comparison of returns on equity. However, it is in general difficult to allocate portions of equity to divisions. The return on equity shows the profit after taxation as percentage of the book value of the company. The return on equity provides the owners of a company with a performance ratio which is based on their investment. The owners hold equity which includes reserves and retained earnings as well as the share capital. Hence, their input (denominator) is the book value of the company. The profit of the company (nominator) is the profit after taxes. We consider the whole company VANHUIZEN BV and calculate its performance ‘available’ for distribution to the owners. The net operating profit after taxes is 75,600.00 EUR. The profit is divided by the book value of the company which we pretend to be 900,000.00 EUR. The return on equity is: 75,600 / 900,000 = 88.4 %/ a. Note, we still did not solve the problem, how to allocate equity to divisions and therefore calculate performance on company basis. A further weakness of the return on equity is that is misleading due to the leverage effect. The leverage effect makes the return on equity increase based on the debt-to-equity ratio. This has been discussed in chapter (7). In cases, when the return on investment exceeds capital costs, high debts make the return on equity increase. This means we report performance caused by borrowing. The Link 4.A demonstrates how the leverage effect changes the return on equity calculation by an alteration of VANHUIZEN BV’s capital structure. <?page no="141"?> Berkau: Management Accounting 7e 10-141 Link 10.A: Alternative capital structure 10.11. Residual Income The residual income is the profit or profit contribution after deduction of allocated capital costs. The residual income is calculated here as the controllable contribution margin less capital costs. It gives an absolute figure expressed in currency units. At VANHUIZEN BV, the residual income is calculated for the two divisions based on capital costs of 17 %/ a. In GELDERN the residual income is: 319,000 - 17% × 1,000,000 = 1149,000.00 EUR. For the PIETERBUREN branch, the residual income is: 589,000 - 17% × 2,000,000 = 2 249,000.00 EUR. The residual income indicates that both branches achieve an excess over their capital costs. 10.12. Economic Value Added (EVA™) The economic value added EVA TM tells us how much the company increases in value after deduction of employed capital costs (WACC) from the net operating profit after taxes. For 46 Read for its calculation out textbook Financial Statements. EVA TM calculations in a division, we ignore income taxes. The economic value added is a modified residual income calculation and got registered by the Stern Steward consulting organisation as their trademark. The EVA TM is the divisional profit +/ - Accounting adjustments, less cost of capital (WACC). Adjustments are required to distribute once-off costs, e.g. for Marketing campaigns or product development. The costs of capital are the weighted average costs of capital. Weighted average costs of capital (WACC) are capital costs when different interest rates and opportunity costs for equity are considered proportionally to their portions of financing the business. 46 Below, we pretend that VANHUIZEN BV is financed by 30 % equity, 40 % bank loan, with an annual rate of interest of 5.5 %/ a, and 30 % bonds, with a coupon rate of 4.5 %/ a. The costs of equity are 17 %/ a (opportunity costs). According to the given figures, the weighted average costs of capital are: 30% × 17% + 40% × 5.5% + 30% × 4.5% = 8 8.65 %/ a. The company owes the bank 1,200,000.00 EUR and pays: 5.5% × 1,200,000 = 6 66,000.00 EUR/ a interest. The coupon per annum is equal to another capital cost of: 900,000 × 4.5% = 40,500.00 EUR. We further assume, interest is already included in the headquarters cost of 400,000.00 EUR for both divisions and requires adjustments. We reduce the headquarters costs by: 66,000 + 40,500 = 1 106,500.00 EUR. As a result, the headquarters costs now are: <?page no="142"?> Berkau: Management Accounting 7e 10-142 400,000 - 106,500 = 2 293,500.00 EUR. Each division covers half thereof: 293,500/ 2 = 1 146,750.00 EUR. The adjustment is required as we compare for EVA TM the net operating profit after taxes to capital costs. Interest is no operational cost. Check Figure 10.5 for the profit calculation where the value for allocated costs from the headquarters has been changed: Geldern Pieterburen Total sales 832,000 1,456,000 less variable costs (468,000) (819,000) Variable short-run Contribution Margin 364,000 637,000 less controllable fixed costs (45,000) (48,000) Controllable Contribution Margin 319,000 589,000 less non-avoidable costs (140,000) (260,000) Divisional Contribution Margin 179,000 329,000 less HQ contribution (adjusted) (146,750) (146,750) Divisional NP before taxes 32,250 182,250 Entire NP before taxes less income taxes Net operating profit after taxes NOPAT 214,500 (64,350) 150,150 Vanhuizen BV PERFORMANCE REPORT for 20X1 Figure 10.5: VANHUIZEN BV’s performance clear of interest/ coupon Now, the divisional net profit for GELDERN is: -21,000 + 66,000/ 2 + 40,500/ 2 = 3 32,250.00 EUR/ a. The divisional net profit for PIETERBUREN is: 129,000 + 66,000/ 2 + 40,500/ 2 = 182,250.00 EUR. 47 For further adjustments we assume, VANHUIZEN BV spent during the last year 5,000.00 EUR on an advertising campaign which requires an adjustment. The amount is allocated to divisions at a 1 : 1 ratio. Advertising is an operational activity and must be deducted from the net operating profit after taxes. 47 We would not deduct interest/ coupon twice however, we make the adjustments to change the allocation to the asset structure of VANHUIZEN BV. We now calculate the EVA TM by the net operating profit before taxes adjusted for interest/ coupon and advertisements and deduct the cost of capital, based on the WACC calculation. The economic value added in GELDERN is: EVA TMGELDERN = 32,250 - 2,500 - 8.65% × 1,000,000 = - -56,750.00 EUR. The one in PIETERBUREN is equal to: EVA TMPIETERBUREN = 182,250 - 2,500 - 8.65% × 2,000,000 = 6 6,750.00 EUR. We could say, the company’s value decreases in GELDERN but increases in In order to keep the case simple, we apply the entire calculation, which gives us the adjusted earnings after taxes. <?page no="143"?> Berkau: Management Accounting 7e 10-143 PIETERBUREN. In total, the company decreased by: 6,750 - 56,750 = - -50,000.00 EUR. We check the result with the initial performance calculation of 108,000 EUR, as in Figure 10.3. We reduce this figure (net profit of both divisions) for the cost of equity: 900,000 × 17% = 1 153,000.00 EUR and for the advertising costs (adjustment of 5,000.00 EUR). The EVA TM is the same: 129,000 - 21,000 - 153,000 - 5,000 = - -50,000.00 EUR. Through Link 10.B you can download an EVA TM calculation prepared for an investor who buys the entire company and finances the acquisition by a loan. Link 10.B: EVA TM for an investor 10.13. Summary For performance measurement, we studied different steps of contribution margin calculation to determine an appropriate performance measure. Situations for performance measurement can assess managers' achievements or investment decisions. We introduced most common performance ratios: Return on investment, residual income and economic value added EVA TM and demonstrated their calculations for the case study VANHUIZEN BV. 10.14. Working Definitions Earnings per Share: EPS is based on IAS 33 and divides the earnings available for distribution to ordinary shareholders by the number of ordinary shares outstanding. Economic Value Added EVA TM : The economic value added EVA TM expresses how much the company increases in value by deducting the capital costs based on the WACC calculation from the net operating profit after taxes. Residual Income: The residual income is the profit or profit contribution after deduction of allocated capital costs Return on Equity: The return on equity shows the profit after taxation as percentage of the book value of the company. Return on Investment: The return on investment shows the profit as percentage of the investment. Weighted Average Costs of Capital: Weighted average costs of capital (WACC) are capital costs when different interest rates and opportunity costs for equity are considered proportionally to their portions of financing the business. 10.15. Question Bank (1) A profit centre in a production firm records 100,000.00 EUR revenue, 15,000.00 EUR materials, 20,000.00 EUR depreciation and 5,000.00 EUR for utilities. The amount of 85,000.00 EUR is called … <?page no="144"?> Berkau: Management Accounting 7e 10-144 1. Short-run contribution margin. 2. Controllable contribution margin. 3. Divisional contribution margin. 4. Net profit. (2) A company is financed by a bank loan of 100,000.00 EUR with an interest rate of 5 %, bonds to the extent of 500,000.00 EUR with a coupon rate of 4 % and 900,000.00 EUR equity. The expected return on investment is 11 %. How much are the weighted cost of capital? 1. 8.3 % . 2. 4.5 % . 3. 4.2 % . 4. 6.7 % . (3) A company earns a revenue of 120,000.00 EUR. The proportional costs are 34,000.00 EUR and depreciation is amounting to 12,000.00 EUR. The company is half financed (400,000.00 EUR) by a bank loan with an interest rate of 3.5 %. Equity is amounting to 400,000.00 EUR. The expected return on equity is 10 %. How much is the residual income? 1. 34,000.00 EUR . 2. 47,000.00 EUR . 3. 60,000.00 EUR . 4. 46,000.00 EUR . (4) The performance of a division manager should be measured by: 1. Divisional net profit. 2. Divisional contribution margin. 3. Controllable contribution margin. 4. Revenues applicable. (5) The economic value added is: 1. Net operating profit before tax less weighted average cost of capital × capital employed. 2. Net operating profit after tax less weighted average cost of capital × capital employed. 3. Net operating profit before tax less average cost of capital × capital employed. 4. Net operating profit after tax less average cost of capital × equity. 10.16. Solutions 1-1; 2-1; 3-1; 4-3; 5-2. <?page no="145"?> Berkau: Management Accounting 7e 11-145 11. Accounting for Mergers and Acquisitions 11.1. What is in the Chapter? In this chapter, we demonstrate the preparation of acquisitions and mergers and how to calculate the price for a company’s sale transaction. We further show how hostile take-overs work and what impact they have on the shareholders (targeted and buying company). The case study OHIO FRIED CHICKEN is about a South African chicken restaurant and is discussed for different scenarios: We show a private purchase, an acquisition by the Malaysian company AYAM GORENG Sdn. Bhd. as a cross border acquisition and a merger after an friendly take-over by LOS POLLOS ASADOS (Pty) Ltd. 11.2. Learning Objectives In this chapter, you learn which Accounting information supports a merger with, or an acquisition of another company. In particular, you learn about cross-border acquisitions. We show the basic differences between acquisitions of a subsidiary and merging of companies in terms of Accounting. 11.3. M&A - Overview Mergers and Acquisitions (M&As) can be made for strategic reasons, e.g. to increase economics of scale or economics of scope. We skip the screening of the right company-to-buy, but we show Accounting instruments used to prepare M&As. Here, the target company has been found already and its purchase price is known. We study the case of OHIO FRIED CHICKEN in Worchester in South Africa which is for sale. It is a privately-owned firm. Therefore, no audited financial statements are available for analysis. The evaluation of the business covers the steps below: (1) General description of OHIO FRIED CHICKEN. (2) Business valuation. (3) Investment appraisal. (4) Financial statement analysis. (5) Risk Management. For teaching purposes, we split item (5) for this case study and discuss 3 different scenarios: (5-1) an acquisition by a private investor, (5-2) an acquisition by the foreign company AYAM GORENG Sdn. Bhd. which requires the preparation of group statements and (5-3) a merger with another company LOS POLLOS ASADOS (Pty) Ltd. based on a friendly take-over and resulting in a new company. 11.4. General Description of OHIO FRIED CHICKEN OHIO FRIED CHICKEN is a privatelyowned restaurant. It is for sale through a local agency. The sale includes all company assets and inventory at the time of transaction. The purchase price for the company is 895,000.00 ZAR. The restaurant is based in a rented building in the centre of Worcester. In the nearby area of its location is a McDonald’s restaurant, a KFC restaurant, a Debonairs Pizza delivery service, an <?page no="146"?> Berkau: Management Accounting 7e 11-146 Ocean Fisheries restaurant and a Wimpy. The major dishes are deep-fried chicken parts and fries. Furthermore, cold drinks are served in the restaurant. The restaurant deploys no waiter. Customers order at the counter and take their food and drinks to their tables for sit-in or take it away. 2 employees work in the restaurant at a time. The case is derived from ‘financials” which the agent provides. To study how to develop a business concept from the given information download the below available documentation about the preparation work. Link 11.A: OFC Preparations OHIO FRIED CHICKEN is acquired for 895,000.00 ZAR. We pretend the company is sold 5 years later at the same price. The company earns a revenue of 1,797,000.00 ZAR/ a. This is calculated as 119,800 dishes at 15.00 ZAR/ u. The volume does not increase but there is an increases of prices every year at a rate of 9 %. The materials at OHIO FRIED CHICKEN are food and drinks which add 48 We refer to the expression from Financial Accounting and consider that a liquidation does not lead to revenues and profits. up to 1,086,000.00 ZAR. The material expenses increase at a rate of 7.5 %. Fixed costs are labour and depreciation. Labour is 88,000.00 ZAR and increases every year by 5 %. Depreciation on the equipment is 25,000.00 ZAR and does not change over the 5-years life. The equipment must be renewed every 4 years at capital expenditures of 100,000.00 ZAR. OHIO FRIED CHICKEN pays very month 15,000.00 ZAR/ m for rent which increases at a rate of 10 % every year. There are further miscellaneous costs for administration 65,000.00 ZAR. These costs remain constant over the time. 11.5. Business Valuation There is no right or correct value for a business. We discuss three methods for business valuation: (1) market value, (2) book value and (3) its shareholder valued based on the discounted cash flow method. MMarket value: The price for a business depends on the market, which means it depends on supply and demand. We can compare the company to others to determine whether the price of 895,000.00 ZAR is appropriate. Due to a lack of comparison, we cannot calculate a fair market price here. Book value: The book value is derived from Bookkeeping records. It represents the gains 48 on liquidation for all assets at fair values less the total of debts at settlement values. It is also the value of equity. As we do not have a balance sheet, <?page no="147"?> Berkau: Management Accounting 7e 11-147 we calculate the value based on the information gathered from the agent. The assets in the kitchen are deep fryers, a refrigerator and the interior (banks and tables). We estimate their cost of acquisition at 100,000.00 ZAR. We assume the assets have been depreciated to an extent of 75 % already. The equipment’s fair value is: 25% × 100,000 = 225,000.00 ZAR. The value of inventories is materials for 3 days: 1,086,000 × 3/ 365 = 8 8,926.03 ZAR. We acknowledge that from an investor’s point of view, the costs of acquisition for OHIO FRIED CHICKEN based on book values are highly over-priced. In general, a valuation at book values tells us, how much it costs to copy the company. No intangibles, e.g. reputation or customer base are considered in the books. Shareholder value at discounted cash flows: Although the company is no public company based on shares, we calculate its shareholder value based on the discounted cash flow method. The discounted cash flow method determines the value of a business as the total of the present value of all free cash flows. To determine the present values, cash flows are discounted at the rate of capital costs. The discounted cash flows method compares the total of free cash inflows at present values to the total of the discounted cash outflows. The free cash flow is the operating cash flow plus the investing cash flow. It is called ‘free’ because the payments are available for paying dividends to the shareholders or for retiring debts, such as resulting from bank loans or from bond redemption. In chapter (7) we introduced a capital budget table. It has been set-up to calculate OHIO FRIED CHICKEN’s free cash flows and discount them at a rate of 6.3 %. Although the company has no debts we pretend for the weighted average cost of capital WACC calculation the company’s assets to be financed at a 60 : 40 ratio. The major portion of the capital is financed by a bank loan with an annual rate of interest of 8.5 %/ a. The other portion is opportunity cost based on a 3 %/ a return from McDonald’s shares (after tax). Hence, the weighted average costs of capital are: (60% × 8.5 + 40% × 3)/ 100% = 6 6.3 %/ a. Find below the excel sheet for the shareholder value calculation. <?page no="148"?> Berkau: Management Accounting 7e 11-148 Figure 11.1: Capital budget table for OHIO FRIED CHICKEN The shareholder value is 1,101,406.84 ZAR. The excel sheet is available for download through the link below: Link 11.B: CBT 11.6. Investment Appraisal The assessment of OHIO FRIED CHICKEN’s profitability is calculated based on the techniques introduced in chapter (7). PPayback method: For the payback method we calculate the cumulative free cash flows. <?page no="149"?> Berkau: Management Accounting 7e 11-149 t=0 t=1 t=2 t=3 t=4 t=5 Cost of acquisition (895,000.00) Revenue 1,797,000.00 1,958,730.00 2,135,015.70 2,327,167.11 2,536,612.15 Materials (1,086,000.00) (1,167,450.00) (1,255,008.75) (1,349,134.41) (1,450,319.49) Labour (88,000.00) (92,400.00) (97,020.00) (101,871.00) (106,964.55) Total variable costs (1,174,000.00) (1,259,850.00) (1,352,028.75) (1,451,005.41) (1,557,284.04) Rent (180,000.00) (198,000.00) (217,800.00) (239,580.00) (263,538.00) Depreciation (25,000.00) (25,000.00) (25,000.00) (25,000.00) (25,000.00) Administration (65,000.00) (65,000.00) (65,000.00) (65,000.00) (65,000.00) Total fixed costs (270,000.00) (288,000.00) (307,800.00) (329,580.00) (353,538.00) EBIT 353,000.00 410,880.00 475,186.95 546,581.71 625,790.12 Income tax 105,900.00 123,264.00 142,556.09 163,974.51 187,737.03 EAT 247,100.00 287,616.00 332,630.87 382,607.19 438,053.08 Procees form liquid. 895,000.00 Capital expenditure (895,000.00) 0.00 (100,000.00) 0.00 0.00 0.00 Operating CFs 0.00 378,000.00 435,880.00 500,186.95 571,581.71 650,790.12 Free cash flow (895,000.00) 378,000.00 335,880.00 500,186.95 571,581.71 650,790.12 Cumulative FCFs (895,000.00) (517,000.00) (181,120.00) 319,066.95 890,648.66 1,541,438.77 Ohio Fried Chicken CAPITAL BUDGET TABLE for PAYBACK CALCULATION Figure 11.2: Payback calculation The restaurant pays back the initial cost of acquisition in the 3 rd year. Pretending the cash flows occur evenly distributed over the year, the payback period requires in the 3 rd year: 365 × 181,120 / (181,120 + 319,066.95) = 132.17 days which we must round-up to guarantee that the payback is complete. Therefore, the payback period ends on the 13.05.[t = 3] (no leap day). Average annual return ARR: The Accounting return requires to calculate the average free cash flows over the 5-years life of the investment project. Average free cash inflows are: (378,000 + 335,880 + 500,186.95 + 571,581.71 + 650,790.12) / 5 = 4 487,287.75 ZAR. Therefore, the average annual return is: 487,287.75 / 895,000 = 5 54.45%/ a. Present value NPV: The present value of the free cash flows has been calculated as the shareholder value in Figure 11.1. It is 1,101,406.84 ZAR. Yield calculation: For the yield calculation we pretend the interest rate i equals the weighted cost of capital of 6.3 % and there is no drawing in t = 0. The highest yield possible is for a future value of capital C T to be zero. The yield level is: 1,101,406.84 / ((1+6.3%) -1 + (1+6.3%) -2 + (1+6.3%) -3 + (1+6.3%) -4 + (1+6.3%) -5 ) = 263,607.53 ZAR. No basis vector applies for this calculation. Internal rate of return IRR: The internal rate of return is: 31.62 %. It has been calculated by the MS-Excel function IRR(). The analysis based on methods of investment appraisal gives us the certainty that OHIO FRIED CHICKEN is a profitable and economically-advantageous restaurant. However, we also acknowledge that the book value of the company is low. This implies that the investment is risky as it is easy to copy. We run a risk analysis at the end of the chapter after preparing financial statements. As Risk Management is based on financial statements, we next discuss 3 scenarios of buying OHIO FRIED CHICKEN and prepare the financial statement linked thereto. <?page no="150"?> Berkau: Management Accounting 7e 11-150 11.7. Financial Statements For our further considerations about of the acquisition, we describe 3 scenarios: (a) P Private purchase: The restaurant is bought by a private investor. (b) AAcquisition by another company: The restaurant is bought by another company which is a holding company. (c) MMerger: The restaurant is merged with another company. 11.8. Private Purchase (4-1) In case the company is privately bought the investor pays the owner the demanded price of 895,000.00 ZAR and receives all company assets in return. The balance sheet of the new established company after the purchase looks as in Figure 11.3: A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 25,000 Owner's equity 33,926 Intangibles Financial assets Current assets Liabilities Inventory 8,926 Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 0 Total assets 33,926 Total equity and liab. 33,926 Ohio Fried Chicken STATEMENT of FINANCIAL POSITION as at 1.01.2015 Figure 11.3: OHIO FRIED CHICKEN’s balance sheet The balance sheet only shows the restaurant’s assets. The purchase price is not relevant as it has been paid to the previous owner. The total of the assets is the carrying value of fixed assets and inventories. The purchase method applies. We prepare an income statement for OHIO FRIED CHICKEN based on the capital budget table in Figure 11.1. Observe the budgeted income statement for the first Accounting period in Figure 11.4. <?page no="151"?> Berkau: Management Accounting 7e 11-151 [ZAR] Revenue 1,797,000 Other income 1,797,000 Materials (1,086,000) Labour (88,000) Depreciation (25,000) Other expenses (245,000) Earnings before int. & taxes (EBIT) 353,000 Interest Earnings before taxes (EBT) 353,000 Ohio Fried Chicken STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.[t=1] Figure 11.4: Budgeted income statement for OHIO FRIED CHICKEN The profit is transferred to the equity section and increases the investor’s capital, called ‘owners’ equity’. As OHIO FRIED CHICKEN has been bought by a private investor, no company taxes apply. All income, materials, wages and other costs are paid on cash. The operating cash flow is: 1,797,000 - 1,086,000 - 88,000 - 245,000 = 3 378,000.00 ZAR. No further cash flows apply. Observe the balance sheet as at 31.12.[t=1] (one year after acquisition) in Figure 11.5: A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 0 Owner's equity 386,947 Intangibles Financial assets Current assets Liabilities Inventory 8,926 Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 378,000 Total assets 386,926 Total equity and liab. 386,947 Ohio Fried Chicken STATEMENT of FINANCIAL POSITION as at 31.12.[t=1] Figure 11.5: OHIO FRIED CHICKEN’s budgeted balance sheet [ZAR] <?page no="152"?> Berkau: Management Accounting 7e 11-152 11.9. Acquisition by another Company (4- 2) Next, we discuss that OHIO FRIED CHICKEN is transferred to a limited company by the name of OHIO FRIED CHICKEN (Pty) Ltd. and thereafter bought by the foreign investor AYAM GORENG Sdn. Bhd. Together, both companies form the AYAM GORENG Group. CCompany establishment: OHIO FRIED CHICKEN (Pty) Ltd. is founded by a share issue of 35,000.00 ZAR. The new limited company takes over OHIO FRIED CHICKEN based on its assets at fair values. The remaining value of: 35,000 - 25,000 - 8,926.03 = 1 1,073.97 ZAR is added to cash/ bank of the new company. The balance sheet of OHIO FRIED CHICKEN (Pty) Ltd. before the acquisition is shown in Figure 11.6: A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 25,000 Share capital 35,000 Intangibles Reserves Financial assets Retained earnings Current assets Liabilities Inventory 8,926 Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 1,074 Tax liabilities Total assets 35,000 Total equity and liab. 35,000 Ohio Fried Chicken (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.[t=0] Figure 11.6: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet Acquisition: The acquisition of OHIO FRIED CHICKEN (Pty) Ltd. follows: The buyer is AYAM GORENG Sdn. Bhd. 49 in Kuantan. AYAM GORENG Sdn. Bhd. is a holding company. A holding company is a company with the only purpose of holding other companies; it does not carry out business operations. AYAM GORENG Sdn. Bhd. is established by the proprietors with a total contribution of 400,000.00 MYR as share capital. Its reporting currency is Malaysian Ringgit MYR. 49 Sdn. Bhd. stands for sendirian berhad. <?page no="153"?> Berkau: Management Accounting 7e 11-153 A C, L Non-current assets [MYR] Equity [MYR] P, P, E Share capital 400,000 Intangibles Reserves Financial assets Retained earnings Current assets Liabilities Inventory Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 400,000 Tax liabilities Total assets 400,000 Total equity and liab. 400,000 Ayam Goreng Sdn. Bhd. STATEMENT of FINANCIAL POSITION as at 31.12.[t=0] Figure 11.7: AYAM GORENG Sdn. Bhd.’s opening balance sheet AYAM GORENG Sdn. Bhd. buys OHIO FRIED CHICKEN (Pty) Ltd. at 895,000.00 ZAR. The currency exchange rate at the time of acquisition is: 1.00 MYR = 3.00 ZAR. Hence, the Ringgit-purchase price of OHIO FRIED CHICKEN (Pty) Ltd. is equal to: 895,000 / 3 = 2 298,333.00 MYR. After the acquisition of OHIO FRIED CHICKEN (Pty) Ltd., AYAM GORENG Sdn. Bhd. discloses its balance sheet as in Figure 11.8. The balance sheet is now dated on the first day of [t=1]. A C, L Non-current assets [MYR] Equity [MYR] P, P, E Share capital 400,000 Intangibles Reserves Investments 298,333 Retained earnings Current assets Liabilities Inventory Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 101,667 Tax liabilities Total assets 400,000 Total equity and liab. 400,000 Ayam Goreng Sdn. Bhd. STATEMENT of FINANCIAL POSITION as at 1.01.[t=1] Figure 11.8: AYAM GORENG Sdn. Bhd.’s balance sheet after acquisition We look at AYAM GORENG Sdn. Bhd.’s balance sheet after the acquisition and notice the investment and: 400,000 - 298,333.33 = 1 101,666.67 MYR left in its bank account. The investment is calculated based on the Ringgit-valuation of OHIO FRIED CHICKEN (Pty) Ltd. <?page no="154"?> Berkau: Management Accounting 7e 11-154 CConsolidations: With the acquisition of OHIO FRIED CHICKEN (Pty) Ltd., AYAM GORENG Sdn. Bhd. gains control power over OHIO FRIED CHICKEN (Pty) Ltd. This defines a group and requires the preparation of group statements by the parent. A group (in terms of Accounting) is a set of companies where the parent gains control over its subsidiary. A parent is the company controlling other group member companies. A subsidiary is a company controlled by a parent. 50 In the case of AYAM GORENG Group, AYAM GORENG Sdn. Bhd. is the parent and OHIO FRIED CHICKEN (Pty) Ltd. is the subsidiary. They prepare group statements based on Malaysian Financial Reporting Standards and IFRSs. Group statements require consolidations. The first group statements are due at the time of acquisition. The reporting currency is the parent’s one: Malaysian Ringgit MYR. In preparation for the consolidation of financial statements, OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet must be transferred to the reporting currency. The currency transfer is required, because the assets, equity and liabilities of both companies are added for the aggregated statements. AYAM GORENG Sdn. Bhd.’s single-entity financial statements comply with the Group Accounting policies already. OHIO FRIED CHICKEN (Pty) Ltd.’s single-entity financial statements are transferred to the reporting currency MYR. No further adjustments are made. The adjusted financial statements for OHIO FRIED CHICKEN (Pty) Ltd. are displayed in Figure 11.9: A C, L Non-current assets [MYR] Equity [MYR] P, P, E 8,333 Share capital 11,667 Intangibles Reserves Financial assets Retained earnings Current assets Liabilities Inventory 2,975 Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 358 Tax liabilities Total assets 11,667 Total equity and liab. 11,667 Ohio Fried Chicken (Pty) Ltd. ADJUSTED STATEMENT of FINANCIAL POSITION as at 1.01.[t=1] Figure 11.9: OHIO FRIED CHICKEN (Pty) Ltd.’s adjusted balance sheet To prepare group statements as at 1.01.[t=1] (acquisition day) AYAM 50 Read our textbook Financial Statements, chapter (8). GORENG Sdn. Bhd. carries out a capital consolidation. With the acquisition of <?page no="155"?> Berkau: Management Accounting 7e 11-155 OHIO FRIED CHICKEN (Pty) Ltd., all assets, equity and liabilities of the business have been assigned to the group. Technically, all items of the single-entity balance sheets are added in preparation for calculating the items on the aggregated balance sheet. E.g., cash/ bank of the group is equal to: 101,666.67 + 357.99 = 1102,024.66 MYR. An aggregated balance sheet is an interim balance sheet in preparation for consolidated financial statements. Thereafter, the consolidations can be calculated. A consolidation is a correction of figures on the balance sheet and/ or income statement that otherwise will be counted twice. Double recognition occurs in the case of AYAM GORENG Group on the aggregated balance sheet. It contains the investment resulting from the parent’s asset side and the equity of the subsidiary, disclosed as the book value of OHIO FRIED CHICKEN (Pty) Ltd., both to the extent of 11,666.67 MYR. The fair value of the investment in OHIO FRIED CHICKEN (Pty) Ltd. and the equity of OHIO FRIED CHICKEN (Pty) Ltd. must be cancelled out. The investment value is 298,333.33 MYR and the equity is 11,666.67 MYR. The capital consolidation results in a high difference on consolidation: 298,333.33 - 11,666.67 = 2 286,666.66 MYR. This value is disclosed as goodwill in the consolidated financial statements. It represents the confidence of the buyer closing a good deal by the acquisition of the company above its book value. The buyer is convinced the subsidiary was underrated. Observe the capital consolidation in the consolidation worksheet and in the consolidated financial statements thereafter in Figure 11.10 and Figure 11.11. <?page no="156"?> Berkau: Management Accounting 7e 11-156 AYAM GORENG Sdn. Bhd. OHIO FRIED CHICKEN (Pty) Ltd. AGGR. CAP. CONS CONS. F/ S N-cur Assets P,P,E 8,333 8,333 8,333 Int. assets 0 0 Investments 298,333 298,333 (298,333) 0 Goodwill 0 286,667 286,667 cur Assets Inventory 2,975 2,975 2,975 Receivables 0 0 Prepaid exp. 0 0 Cash 101,667 358 102,025 102,024.66 400,000 11,667 411,667 (11,667) 400,000 SH's capital Issued capital (400,000) (11,667) (411,667) 11,667 (400,000) Reserves 0 0 Reval. Reserves 0 0 Retained ear. 0 0 M.I. 0 0 Liabilities Int. bear. liab. 0 0 Payables 0 0 Provisions 0 0 Def. income 0 0 Tax liabilities 0 0 (400,000) (11,667) (411,667) 11,667 (400,000) Figure 11.10: Consolidation worksheet [MYR] The group statements consider goodwill to an extent of: 895,000 - 35,000 = 860,000.00 ZAR or 286,666.66 MYR. The goodwill is very high. This marks the investment as risky. Its price was mostly driven by the reputation and customer base. <?page no="157"?> Berkau: Management Accounting 7e 11-157 A C, L Non-current assets [MYR] Equity [MYR] P, P, E 8,333 Share capital 400,000 Intangibles Reserves Goodwill 286,667 Retained earnings non-ctrl interest 0 Current assets Liabilities Inventory 2,975 Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 102,025 Tax liabilities Total assets 400,000 Total equity and liab. 400,000 Ayam Goreng Sdn. Bhd. CONSOLIDATED STATEMENT of FINANCIAL POSITION as at 1.01.2015 Figure 11.11: AYAM GORENG Sdn. Bhd. consolidated balance sheet Profit calculation: We move to the end of the year [t=1]: The profit calculations are the same as for a private purchase. In contrast to the privately-owned restaurant, the OHIO FRIED CHICKEN (Pty) Ltd. as a limited company pays now income taxes in South Africa. Hence, the income statement for OHIO FRIED CHICKEN (Pty) Ltd. contains tax liabilities at an income tax rate of 30 %/ a. [ZAR] Revenue 1,797,000 Other income 1,797,000 Materials (1,086,000) Labour (88,000) Depreciation (25,000) Other expenses (245,000) Earnings before int. & taxes (EBIT) 353,000 Interest Earnings before taxes (EBT) 353,000 Income tax expenses (105,900) Deferred taxes Earnings after taxes (EAT) 247,100 Ohio Fried Chicken (Pty) Ltd. STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.2015 Figure 11.12: OHIO FRIED CHICKEN (Pty) Ltd.’s budgeted income statement <?page no="158"?> Berkau: Management Accounting 7e 11-158 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 0 Share capital 35,000 Intangibles Reserves Financial assets Retained earnings 247,100 Current assets Liabilities Inventory 8,926 Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 379,074 Tax liabilities 105,900 Total assets 388,000 Total equity and liab. 388,000 Ohio Fried Chicken (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.2015 Figure 11.13: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet Financial statements: At the end of the Accounting period [t=1], AYAM GORENG Group must prepare group statements again. In preparation, we check the currency exchange rate between South African Rand and Malaysian Ringgit. The rate still is: 1.00 MYR = 3.00 ZAR. OHIO FRIED CHICKEN (Pty) Ltd.’s adjusted balance sheet looks as in Figure 11.14. As AYAM GPORENG Sdn. Bhd. is a company, no dividend tax applies. A C, L Non-current assets [MYR] Equity [MYR] P, P, E 0 Share capital 11,667 Intangibles Reserves Financial assets Retained earnings 82,367 Current assets Liabilities Inventory 2,975 Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 126,358 Tax liabilities 35,300 Total assets 129,333 Total equity and liab. 129,333 Ohio Fried Chicken (Pty) Ltd. ADJUSTED STATEMENT of FINANCIAL POSITION as at 31.12.2015 Figure 11.14: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet <?page no="159"?> Berkau: Management Accounting 7e 11-159 The consolidation worksheet is prepared again. No changes for the capital consolidation are recorded. AYAM GORENG Sdn. Bhd. OHIO FRIED CHICKEN (Pty) Ltd. AGGR. CAP. CONS CONS. F/ S N-cur Assets P,P,E 0 0 0 Int. assets 0 0 Investments 298,333 298,333 (298,333) 0 Goodwill 0 286,667 286,667 cur Assets Inventory 2,975 2,975 2,975 Receivables 0 0 Prepaid exp. 0 0 Cash 101,667 126,358 228,025 228,025 400,000 129,333 529,333 (11,666) 517,667 SH's capital Issued capital (400,000) (11,667) (411,667) 11,667 (400,000) Reserves 0 0 Reval. Reserves 0 0 Retained ear. (82,367) (82,367) (82,367) M.I. 0 0 Liabilities Int. bear. liab. 0 0 Payables 0 0 Provisions 0 0 Def. income 0 0 Tax liabilities (35,300) (35,300) (35,300) (400,000) (129,333) (529,333) 11,667 (517,667) Figure 11.15: Consolidation worksheet in MYR A C, L Non-current assets [MYR] Equity [MYR] P, P, E 0 Share capital 400,000 Intangibles Reserves Goodwill 286,667 Retained earnings 82,367 non-ctrl interest 0 Current assets Liabilities Inventory 2,975 Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 228,025 Tax liabilities 35,300 Total assets 517,667 Total equity and liab. 517,667 Ayam Goreng Sdn. Bhd. CONSOLIDATED STATEMENT of FINANCIAL POSITION as at 31.12.[t=1] Figure 11.16: AYAM GORENG holding’s balance sheet as at 31.12.[t=1] <?page no="160"?> Berkau: Management Accounting 7e 11-160 11.10. Merger (4-3) If two (or more) companies merge, the companies cease to exist as separate entities and form one new legal entity. The new company prepares single-entity financial statements. Very often, equity is shared among the owners of the previous companies by the owners of both companies becoming shareholders of the new company. A merger requires some sort of capital consolidation as at the beginning of the new company’s life. The purchase method applies. All items are recognised at fair values. A goodwill can exist. We look at our case of the company OHIO FRIED CHICKEN (Pty) Ltd. which is established before the takeover. We assume, the company is taken-over by LOS POLLOS ASADOS (Pty) Ltd. which is a fastfood restaurant chain, based in Johannesburg. On 1.01.[t=1], LOS POLLOS ASADOS (Pty) Ltd. buys the company OHIO FRIED CHICKEN (Pty) Ltd. with the intention of merging. Before the transaction, LOS POLLOS ASADOS (Pty) Ltd. prepares the balance sheet as below in Figure 11.17: A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 4,000,000 Share capital 1,000,000 Intangibles Reserves 6,500,000 Financial assets Retained earnings 0 Current assets Liabilities Inventory 2,000,000 Interest bear liab 1,000,000 Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 2,500,000 Tax liabilities 0 Total assets 8,500,000 Total equity and liab. 8,500,000 Los Pollos Asados (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.[t=0] Figure 11.17: LOS POLLOS ASADOS (Pty) Ltd.’s balance sheet LOS POLLOS ASADOS (Pty) Ltd. buys OHIO FRIED CHICKEN (Pty) Ltd. at 895,000.00 ZAR which is the purchase price. The price exceeds the fair book value of OHIO FRIED CHICKEN (Pty) Ltd. The difference between the sales transaction price and the fair value is: 895,000 - 35,000 = 8 860,000.00 ZAR. A goodwill indicates that the acquisition of OHIO FRIED CHICKEN (Pty) Ltd. is overpriced. As this purchase leads to a merger, no goodwill is recognised. Therefore, the goodwill is transferred straight to profit or loss. <?page no="161"?> Berkau: Management Accounting 7e 11-161 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 4,025,000 Share capital 1,000,000 Intangibles Reserves 6,500,000 Financial assets Retained earnings (860,000) Current assets Liabilities Inventory 2,008,926 Interest bear liab 1,000,000 Accounts receivables Accounts payables Prepaid expenses Badwill Cash/ Bank 1,606,074 Tax liabilities 0 Total assets 7,640,000 Total equity and liab. 7,640,000 Los Pollos Asados (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 1.01.[t=1] Figure 11.18: LOS POLLOS ASADOS (Pty) Ltd.’s balance sheet after taking-over For public companies, mergers can be made with or without consent of the targeted company and are carried out on a tender offer basis. A tender offer is an offer to the shareholders to take-over their company either in exchange of a paid price per share or in exchange of shares of the acquirer. We discuss that LOS POLLOS ASADOS (Pty) Ltd. makes a tender offer to the owners of OHIO FRIED CHICKEN Ltd. (note the change of legal form to a company based on shares) to buy the company in exchange of an appropriate price or the shares of LOS POLLOS ASADOS (Pty) Ltd. We refer to Figure 11.17. To find an appropriate price, we prepare the calculations below: The book value of one ordinary 5-ZARshare of LOS POLLOS ASADOS (Pty) Ltd. before the merger is: (8,500,000 - 1,000,000) / 200,000 = 3 37.50 ZAR/ LOS POLLOS ASADOS share. The equivalent of a 5-ZAR-share of OHIO FRIED CHICKEN Ltd. is a book value of 5.00 ZAR/ OHIO FRIED CHICKEN Ltd. share. The owner of OHIO FRIED CHICKEN Ltd. will receive shares of LOS POLLOS ASADOS (Pty) Ltd. in exchange for her/ his shares in the company. No payment is made, which is known as takeover without consideration. We are interested in the calculation of a fair number of shares to be exchanged between LOS POLLOS ASADOS (Pty) Ltd. and the owners of OHIO FRIED CHICKEN Ltd. which is not yet the amount in the tender offer but for calculations a fair (goodwill ignored) one. Later we adjust the amount to make the deal attractive for OHIO FRIED CHICKEN Ltd.’s owners. For our next steps, we assume the share market price is equal to the book value. Hence, the book value of OHIO FRIED CHICKEN Ltd. is 35,000.00 ZAR. We refer to the book values because in our case study, both companies are not publicly traded and thus we do not know their share prices. <?page no="162"?> Berkau: Management Accounting 7e 11-162 A fair deal would be an exchange of: 35,000 / 37.50 = 9 933.33 LOS POLLOS ASADOS shares received by all owners of OHIO FRIED CHICKEN Ltd. in exchange for the company. This makes them become shareholders of the merged company. To make the deal more favourable for OHIO FRIED CHICKEN Ltd.’s shareholders, LOS POLLOS ASADOS (Pty) Ltd. increases the offer to 950 shares. This is called a premium. A fair price calculation also requires that no fresh shares are issued. Hence, LOS POLLOS ASADOS (Pty) Ltd. buys back 950 of its own shares at a fair price (here: book value) of 37.50 ZAR/ LOS POLLOS ASADOS shares. The value for the treasury stock is: 950 × 37.50 = 3 35,625.00 ZAR. As the merger transaction price, LOS POLLOS ASADOS (Pty) Ltd. transfers 950 ordinary shares of LOS POLLOS ASADOS (Pty) Ltd. to the shareholders of OHIO FRIED CHICKEN Ltd. This way, the shareholders of OHIO FRIED CHICKEN Ltd. exchange assets at a fair value of 35,000.00 ZAR to: 950 × 37.50 = 35,625.00 ZAR book value in shares. The proprietors of OHIO FRIED CHICKEN Ltd. accept the tender offer and sell their company to LOS POLLOS ASADOS (Pty) Ltd. for 950 LOS POLLOS ASADOS (Pty) Ltd. ordinary shares. After the deal, the balance sheet of LOS POLLOS ASADOS (Pty) Ltd. discloses the assets of the former OHIO FRIED CHICKEN Ltd. on its debit side. The item of cash/ bank is reduced by 35,625.00 ZAR due to the share buy-back. After the take-over, LOS POLLOS ASADOS records a loss on acquisition to the extent of: 35,000 - 35,625 = - -625.00 ZAR. A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 4,025,000 Share capital 1,000,000 Intangibles Reserves 6,500,000 Financial assets Retained earnings (625) Current assets Liabilities Inventory 2,008,926 Interest bear liab 1,000,000 Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 2,465,449 Tax liabilities 0 Total assets 8,499,375 Total equity and liab. 8,499,375 Los Pollos Asados (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 1.01.[t=1] Figure 11.19: LOS POLLOS ASADOS (Pty) Ltd.’s balance sheet after take-over If a public tender offer (PTO) is made without consent of the target company, the merger is classified as a hostile takeover. The difficulty about hostile takeovers is that for assessment of the target company the bidder lacks information because the target company will not cooperate and publishes confidential data for a business analysis. A common disadvantage of mergers is that companies cannot easily be separated later. <?page no="163"?> Berkau: Management Accounting 7e 11-163 11.11. Financial Statement Analysis The financial statements for OHIO FRIED CHICKEN do not exist, as the company is privately-owned before the sales transaction. We consider OHIO FRIED CHICKEN restaurant as a (Pty) Ltd. company in the way we introduced above. The balance sheet as at 1.01.[t=1] is displayed below: A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 25,000 Share capital 35,000 Intangibles Reserves Financial assets Retained earnings Current assets Liabilities Inventory 8,926 Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 1,074 Tax liabilities Total assets 35,000 Total equity and liab. 35,000 Ohio Fried Chicken (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.[t=0] Figure 11.20: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet The income statement is given by the next exhibit, see Figure 11.21. The income statement is based on the data recorded in t=1. <?page no="164"?> Berkau: Management Accounting 7e 11-164 [ZAR] Revenue 1,797,000 Other income 1,797,000 Materials (1,086,000) Labour (88,000) Depreciation (25,000) Other expenses (245,000) Earnings before int. & taxes (EBIT) 353,000 Interest Earnings before taxes (EBT) 353,000 Income tax expenses (105,900) Deferred taxes Earnings after taxes (EAT) 247,100 Ohio Fried Chicken (Pty) Ltd. STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.[t=1] Figure 11.21: OHIO FRIED CHICKEN (Pty) Ltd.’s income statement The balance sheet one Accounting period later is shown in Figure 11.22. A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 0 Share capital 35,000 Intangibles Reserves Financial assets Retained earnings 247,100 Current assets Liabilities Inventory 8,926 Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 379,074 Tax liabilities 105,900 Total assets 388,000 Total equity and liab. 388,000 Ohio Fried Chicken (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.[t=1] Figure 11.22: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet In preparation of calculating ratios we set-up an ‘average’ balance sheet with the average values derived from the beginning and the end of the Accounting period. E.g., the average value of P, P, E therein is equal to: (25,000 + 0) / 2 = 12,500.00 ZAR. <?page no="165"?> Berkau: Management Accounting 7e 11-165 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 12,500 Share capital 35,000 Intangibles Reserves Financial assets Retained earnings 123,550 Current assets Liabilities Inventory 8,926 Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 190,074 Tax liabilities 52,950 Total assets 211,500 Total equity and liab. 211,500 Ohio Fried Chicken (Pty) Ltd. average STATEMENT of FINANCIAL POSITION as at 31.12.2015 Figure 11.23: Average balance sheet for OHIO FRIED CHICKEN (Pty) Ltd. OHIO FRIED CHICKEN (Pty) Ltd. earns a profit of 353,000.00 ZAR before taxes. In order to calculate the return on assets, we divide the value by the total of assets. Accordingly, the return on assets is: 353,000 / 211,500 = 1 167 %/ a. The return on equity is equal to the profit after taxes divided by equity: 247,100 / (35,000 + 123,550) = 1 156 %/ a. The net earnings as percentage of sales are equal to: 247,100 / 1,797,321.12 = 14 %/ a. The budgeted sales volume is equal to: 12 × 149,776.76 = 1,797,321.12 ZAR. Regarding the return figures, OHIO FRIED CHICKEN (Pty) Ltd. is an excellent investment opportunity. To measure the impact on the investment on the sales we calculate the fixed asset turnover. It is equal to: 1,797,321.12 / 35,000 = 5 51. Capital structure and market price analysis do not apply for OHIO FRIED CHICKEN (Pty) Ltd. 11.12. Risk Analysis In this chapter, we only identify the risks for OHIO FRIED CHICKEN (Pty) Ltd. Therefore, we discuss the restaurant as a limited company. You find risk valuation in the next chapter (12) where simulation models are discussed in detail. The risks OHIO FRIED CHICKEN (Pty) Ltd. faces are: (A) Reputation risk. (B) Food price increase risk. (C) Staff fluctuation risk. (D) Competitor risk. (E) Asset structure risk. (F) Risk resulting from government restrictions. (G) Currency exchange risk. Ad 6(A): Reputation Risk The sales value of OHIO FRIED CHICKEN (Pty) Ltd. highly depends on its reputation. However, OHIO FRIED CHICKEN (Pty) Ltd.’s customers are not bound to the company. Companies cannot control the loyalty of their customers. Many try by loyalty programmes, e.g. airlines, but <?page no="166"?> Berkau: Management Accounting 7e 11-166 in the end the customer is free to decide about her/ his purchases or which service to buy. Although food is a daily necessity, there is a risk that customers decide to eat less chicken or that a trend develops to visit restaurants less often (e.g., a pandemic). Customer decisions can be based on internal reasons, such as bad food, or on irrational reasons, like rumours. For the buyer of OHIO FRIED CHICKEN (Pty) Ltd. the reputation risk is high. A problem for OHIO FRIED CHICKEN (Pty) Ltd. lies in its sales structure. The company is focussed only on chicken products which makes it vulnerable to changes in customer demands. Ad 6(B): Food Price Increase Risk OHIO FRIED CHICKEN (Pty) Ltd.’s cost structure is dominated by materials, in particular by chicken parts. Food prices are volatile. There can be many reasons why food prices increase. E.g., difficulties with a particular supplier can develop which can force the company to change its suppliers on short notice. Ad 6(C): Staff Fluctuation Risk OHIO FRIED CHICKEN (Pty) Ltd. depends on the staff working in the restaurant. They are the ‘face to the customer’. They also cover most of the operational management work, like forecast planning and material orders, to prevent the restaurant from understocking. On the other hand, overstocking leads to spoilage and waste as the chicken parts are perishable. Unsatisfied staff can have a noticeable bad impact on the customers and sales volume. On the other hand, friendly staff that builds a good personal customer relationship is very favourable for the business. In the restaurant, staff is the only visible contact person for the customers. OHIO FRIED CHICKEN (Pty) Ltd. pays its staff a low salary. The low salary taken into consideration, there is a risk that staff quits and accepts better paid job offers somewhere else. Ad 6(D): Competitor Risk There are popular fast-food restaurants in South Africa in the neighbourhood of OHIO FRIED CHICKEN (Pty) Ltd. Many of the restaurants are linked to fast-food chains, e.g. McDonald’s, to benefit from synergies and better purchase terms and conditions. OHIO FRIED CHICKEN (Pty) Ltd. competes with those restaurant chains. At the same time, the market volume around Worcester is limited. There are few customers coming from outside to have lunch/ dinner at OHIO FRIED CHICKEN (Pty) Ltd. However, Worcester is a drive-through city on the way from the Eastern Cape to Cape Town with access to the N1 autobahn. Ad 6(E): Asset Structure Risk The structure of the assets is based on a situation where OHIO FRIED CHICKEN (Pty) Ltd. earns high profits on a low investment base. This makes the company vulnerable. The company can be copied easily. All what is needed to open a similar restaurant is a location and some kitchen appliances. No special qualification is required for the deep-frying of chicken parts. Another risk results from the asset structure. If the company is acquired for <?page no="167"?> Berkau: Management Accounting 7e 11-167 895,000.00 ZAR, the new owner only gets assets at a fair value of less than 35,000.00 ZAR. The rest is paid for the reputation of the business and the knowledge/ experience of buying and frying chicken. In case the company is closed down the liquidation proceeds are low. To explain the situation of low asset values, we compare OHIO FRIED CHICKEN (Pty) Ltd. to a property investment in South Africa. Assume, an investor buys an apartment for 900,000.00 ZAR with the intention to rent it out. If the tenant falls behind with rent payments, the landlord can evict the property and is still left with the apartment worth 900,000.00 ZAR. Hence, the investment in property is less risky than the purchase of a fast-food restaurant with low asset values. Ad 6(F): Risks Resulting from Government Restrictions There is a risk that the South African government will change, e.g. the regulations for restaurants. This can be linked to the hygiene requirements. Also, a lockdown as under the Covid-19 pandemic is an example for government regulations. In case new requirements are implemented the owner of the restaurant must face further costs for certificates and examinations or a decrease in revenues. Ad 6(G): Currency Exchange Risk In case the ZAR depreciates to the target currency, the EUR value of the profit decreases. Changes of the currency exchange rate have a direct impact on the profit value of a South African investment as it is paid in ZAR. To demonstrate, how the currency risk works, we assume a European investor bought property in 2014 for 1,000,000.00 ZAR at an exchange rate of 14.00 ZAR = 1.00 EUR. He bought the property with the intention to rent it out for 9,000.00 ZAR/ m. He calculates a rental profit of: 11 × 9,000 = 99,000.00 ZAR. A portion of 9,000.00 ZAR is deducted as costs for property management, maintenance and repairs. The EUR-value of the rental profit is: 99,000 / 14 = 7,071.43 EUR/ a. The return on investment in ZAR equals: 99,000 / 1,000,000 = 9.9%. Now we move to January 2023. The profit is still 99,000.00 ZAR but it is now to be converted to a EUR value of: 99,000 / 20 = 4,950.00 EUR. The investment payment is still to be considered at the 2014 currency exchange rate of 14.00 ZAR = 1.00 EUR - as paid. Hence, the investment payment is: 1,000,000 / 14 = 71,428.57 EUR. The investor calculates his return on investments based on the current EUR-values. It gives a return to the extent of: 4,950 / 71,428.57 = 6.9%. The return declined by: 3% / 9.9% = 30.3%. 11.13. Summary Mergers and Acquisitions require strategic and Accounting valuations of the target firm. Regarding Accounting due diligence, methods of investment appraisal and budgeting apply. As a result, budgeted financial statements are prepared. In contrast to a merger <?page no="168"?> Berkau: Management Accounting 7e 11-168 where the companies are combined to one legal entity, group Accounting applies for an acquisition of a subsidiary because the purchased company stays legally independent and prepares its own single-entity financial statements. An important role plays the risk analysis for the purchase decision which includes the identification and evaluation of the company risks. 11.14. Working Definitions Aggregated Balance Sheet: An aggregated balance sheet is an interim balance sheet in preparation for consolidated financial statements the items of which contain the sums of all group member’s balance sheet items. Consolidation: A consolidation is a correction of figures on the balance sheet and/ or income statement that otherwise will be counted twice. Discounted Cash Flow Method: The discounted cash flow method determines the value of a business as the sum of the present values of all free cash flows. Free Cash Flow: The free cash flow is the operating cash flow plus the investing cash flow. Goodwill: Goodwill is the difference between the paid price for a company and its book value. Group: A group is a set of companies where the parent gains control over its subsidiary. Group Statements: Group statements are a set of financial statement prepared in addition to single-entity financial statements of each group member and report about the entire group a statement of financial position, a statement of comprehensive income, a statement of cash flows and a statement of changes in equity. Holding: A holding company is a company with the only purpose of holding other companies; it does carry out other business operations. Internal Rate of Return IRR: The internal rate of return is the rate of interest at which the present value is zero. Parent: A parent is the company controlling other group member companies. Profitability Index: The profitability index is the present value of payments divided by the initial investment cash outflow. Subsidiary: A subsidiary is a company controlled by a parent. Tender Offer: A tender offer is an offer to the shareholders to take-over their company either in exchange of a price per share or in exchange of shares of the acquirer. 11.15. Question Bank (1) Which statement is correct? 1. A hostile take-over only works with acquisitions. 2. A merger can be national as well as cross border. 3. An acquisition by a company requires considering the company bought as a subsidiary. 4. For buying a target company a public tender offer is required by law. (2) Company A is traded at 100.00 EUR/ s and company B at 60 EUR/ s. Company A’s issued shares are 100,000 s and company B 1,000 s. A makes a PTO to buy B. <?page no="169"?> Berkau: Management Accounting 7e 11-169 What is the fair number of shares to be exchanged without compensation? 1. 601 s . 2. 60 s . 3. 600 s . 4. 594 s . (3) Company A buys company B at 300,000.00 EUR when B’s 35,000 shares (nominal value 5.00 EUR/ s) are traded at 8.00 EUR/ s. The retained earnings are 50,000.00 EUR. How much is the goodwill? 1. 0.00 EUR . 2. 50,000.00 EUR . 3. 20,000.00 EUR . 4. 75,000.00 EUR . (4) A company discloses P, P, E at 60,000.00 EUR and cash/ bank at 55,000.00 EUR. The share capital is based on 100,000 shares, currently traded at 2.00 EUR/ s. The company discloses liabilities at 35,000.00 EUR. How much is the book value of the company? 1. 115.000.00 EUR . 2. 80,000.00 EUR . 3. 200,000.00 EUR . 4. 100,000.00 EUR . (5) What is the internal rate of return? 1. The profitability rate of inter-group investments. 2. The effective rate of interest. 3. The discount rate to apply to calculate a zero-present value. 4. Calculated and artificial dividend costs. 11.16. Solutions 1-3; 2-3; 3-4; 4-2; 5-3. <?page no="170"?> Berkau: Management Accounting 7e 12-170 12. Risk Valuation 12.1. What is in the Chapter? In this chapter we discuss the identification and measurement of company risks. A risk is an uncertain outcome of an event that affects profit and/ or cash flow. For risk valuation we calculate probability and determine the probability density function. To evaluate risk combinations, risks are simulated with a MonteCarloSimulation. In this chapter we study at first the case study ROCKS PLC., to learn about financial situations that can result in bankruptcy. This helps us to appraise risks. For understanding the basics of risk simulation, we explain the case WEATHERMAN who is a seller for sunglasses and umbrellas depending on the weather. This is a single risk. The next case of the consultancy NAMGURO Ltd. covers multiplerisks. We prepare a risk model for risk valuation to calculate the value at risk. We demonstrate how to determine the probability for NAMGURO Ltd. to go out of business (bankruptcy). 12.2. Leaning Objectives Risk valuation and risk management are the task of Management Accountants. They measure how risky a business is or becomes for its investors. The highest damage for the owners of a limited company is a complete loss of their investments. In this chapter, we teach risk identification, which brings the major risks of the business to light. Managerial Accounting strives to minimise, avoid or compensate risks. You learn about a method of risk evaluation for multi-risk situations. After studying this chapter, you understand the technical term risk and can run a MonteCarloSimulation on a spreadsheet to determine profit and cash flow risks for companies. The knowledge helps you to understand how risk management software works. You can determine bankruptcy probabilities linked to Accounting insolvency and/ or illiquidity. You also understand the risk management ratio value at risk (VaR). 12.3. Bankruptcy due to Over-Indebtedness A business must close-down once its debts exceed assets. This is referred to as over-indebtedness or Accounting insolvency. In limited companies the owners are not held reliable for such a loss as their responsibility is limited to the equity. Therefore, creditors can lose their funds. For their protection a company files for bankruptcy once it is too deep in debts (over-indebtedness) or if payment obligations cannot be fulfilled (illiquidity) anymore. 12.4. C/ S ROCKS PLC To study bankruptcy situations, we look at ROCKS PLC. It shows the balance sheet as below in Figure 12.1 at the beginning of the Accounting period 20X1. <?page no="171"?> Berkau: Management Accounting 7e 12-171 A C, L Non-current assets [GBP] Equity [GBP] P, P, E 2,500 Share capital 10,000 Intangibles Reserves 2,000 Financial assets Retained earnings Current assets Liabilities Inventory Interest bear liab 3,000 Accounts receivables 8,000 Accounts payables Prepaid expenses Provisions Cash/ Bank 4,500 Tax liabilities Total assets 15,000 Total equity and liab. 15,000 Rocks PLC STATEMENT of FINANCIAL POSITION as at 1.01.20X1 Figure 12.1: ROCKS PLC’s balance sheet If ROCKS PLC earns a loss that exceeds 12,000.00 GBP its debts will exceed the assets and it must file for bankruptcy. To keep the case study simple, we assume the company’s loss is 13,000.00 GBP and the contra entry is in the short-term liabilities; we make following Bookkeeping entry to record ROCKS PLC’s loss of 13,000.00 GBP: 51 DR P&L-Account.................. 13,000.00 GBP CR Accounts Payables............ 13,000.00 GBP The loss leaves ROCKS PLC’s over-indebted, its equity is negative. Study the balance sheet below in Figure 12.2. 51 To keep Bookkeeping simple, we debit a loss directly in the Profit and Loss account. <?page no="172"?> Berkau: Management Accounting 7e 12-172 A C, L Non-current assets [GBP] Equity [GBP] P, P, E 2,500 Share capital 10,000 Intangibles Reserves 2,000 Financial assets Retained earnings (13,000) Current assets Liabilities Inventory Interest bear liab 3,000 Accounts receivables 8,000 Accounts payables 13,000 Prepaid expenses Provisions Cash/ Bank 4,500 Tax liabilities Total assets 15,000 Total equity and liab. 15,000 Rocks PLC STATEMENT of FINANCIAL POSITION as at 31.12.20X1 Figure 12.2: ROCKS PLC.’s balance sheet What is so bad about the situation depicted in Figure 12.2? The answer lies in an assumed liquidation. We check what happens if the company is liquidated at fair values: ROCKS PLC sells all assets at their carrying values which adds up to 15,000.00 GBP. Next, ROCKS PLC retires all debts. We ignore transaction costs and penalties for premature loan repayments. ROCKS PLC must pay: 3,000 + 13,000 = 1 16,000.00 GBP. As the liquidation proceeds only cover 15,000.00 GBP ROCKS PLC cannot settle its debts completely. We assume, ROCKS PLC paid its creditors 15,000.00 GBP but then it is still left with debts to the extent of: 16,000 - 15,000 = 1 1,000.00 GBP. In this situation, the owners of ROCKS PLC file for bankruptcy. The owners lose all their interest in the company, but they also get away for free leaving the creditors with a claim of 1,000.00 GBP against a bankrupt company. The creditors lose 1,000.00 GBP. The amount is uncollectable as the company does not exist anymore. To protect creditors from those situations, a company cannot continue its operations once its equity becomes negative. In Accounting, we describe ROCKS PLC’s situation as Accounting insolvency. The company must cease operations and start insolvency procedures. A court representative (advisor) takes over the business to assure all creditors are equally refunded. As the liquidation proceeds are not enough to refund all creditors, they only expect a portion of their claims to be paid back. Bankruptcy procedures protect the creditors from the company worsen the situation by continuing operations. 12.5. Bankruptcy due to Illiquidity Another reason for bankruptcy is illiquidity which means the company cannot fulfil its payment obligations. This is caused by debts and negative cash flows. An insolvency occurs once the company has no or a negative cash/ bank balance and cannot obtain <?page no="173"?> Berkau: Management Accounting 7e 12-173 positive cash flows, not from operations nor from borrowing from creditors. 12.6. Risks We study how to avoid bankruptcy. Negative and dangerous developments of a company are often foreseeable. We call a threat for a company’s bankruptcy a risk. A risk is the outcome of an event by which something happens in a different way as foreseen or expected. Risks in business can drive a company into bankruptcy. E.g., a new competitor is a risk for a company because its market share is prone to diminish and as part of the competition, it might offer price discounts to customers. Risks are plan/ forecast deviations. In business, we do not classify risks in good or bad. Any deviation counts as risk. E.g., a student who expects a 60 % pass grade for an exam takes the risk that the exam is 40 % or 80 %. We express both deviations, positive as well as negative ones by the technical term risk. Even as a deviation towards a better exam result is called chance in common language, we call it a risk in business. We refer to this concept as symmetrical risk definition which is relevant for risk simulations. 12.7. Risk Management Valuation of risks and Risk Management aims to control risks of a company. As key measure, it tells us the probability for a company’s bankruptcy. Risk taking is normal in business. For risk management, a company must answer the two questions below: (1) ‘Should we take a risk linked to the business model? ’ (2) ‘How many risks can we take? ’ - The ability of risk taking depends on the financial position of the business. A company with high equity can withstand more risks than a poor one. The equity level is regarded as a risk shield. Similar considerations apply for cash flows. A company with high cash/ bank balance is safer because negative cash flows do not jeopardize its liquidity. In Risk Management, a risk is understood as the random deviation and is valued by the probability (%) of the deviation from the estimate. In terms of Mathematics, we call the estimate the expected value. In case a risk cannot be calculated by a probability (unknown probability) it will be referred to as an uncertainty. To manage risks, a company must value them. A risk valuation determines the monetary value of risks measured in currency units, because risks in business are deviations from profit or cash flow. The value of a risk is determined by the damage caused and its probability (%). The product of probability and damage gives the expected value of a risk. V(risk) = D × P (with: V = value, D = damage, P = probability [%].) E.g., a risk that inventory is stolen is the caused damage, e.g., 1,000.00 <?page no="174"?> Berkau: Management Accounting 7e 12-174 EUR, multiplied with the probability of theft which is 2 %. Hence, the risk’s value is: 1,000 × 2% = 20.00 EUR. This risk valuation is based on best estimates but does not consider deviations. Risk management is about the identification, calculation and controlling of risks taken by shareholders and creditors. The risk for these parties losing their funds depends on the volatility of the business's profits and cash flows. By risk management companies avoids or mitigates their risks. 12.8. Multiple Risk Taking In general, companies take more than one risk at a time. To calculate the resulting risk combination for shareholders and creditors, companies combine their risks for valuation. As risks depend mutually on each other, they can aggravate or compensate each other. One technique of risk combination is pairing risks and examine their mutual impacts. A company taking 10 single risks that depend on each other then would consider (10 - 1)! = 362,880 risk combinations. For that reason, an examination of risk dependencies in detail is not applicable in business. The effort exceeds the outcome. As an alternative, risk combinations based on a MonteCarloSimulation apply. A MonteCarloSimulation is a simulation of risks by which every single risk calculation is based on independent random figures in order to study the effect all single (independent) risks have together on a particular item, such as profit or cash flow. The name MonteCarloSimulation refers to gambling (Monaco). The comparison to gambling is often made in Mathematics as it is assumed that a dice has 6 equal sides - each number got the same probability of appearance. Diced numbers 1 to 6 are evenly distributed. An equal distribution is a distribution where every number has the same probability to appear. Every risk depends on one or multiple events. We analyse the occurrence of events measured by probabilities and disclosed as a percentage. 12.9. C/ S WEATHERMAN We discuss below the case study WEATHERMAN. See below its data sheet. Data Sheet for WEATHERMAN CClassification: Trading; Probabilities for rain/ sun/ overcast: 40 % / 30 % / 30 %; Profit on umbrella sale: 5.00 EUR/ u; Profit on sunglasses sale: 7.00 EUR/ u. Sales numbers: rain - 100 umbrellas, sun - 60 sunglasses, overcast - 20 umbrellas + 20 sun glasses; VAT ignored. WEATHERMAN is a seller for sunglasses and umbrellas. His profit is exposed to the weather. We discuss his profit risk. The weather is one event with different outcomes. There is a 40 % chance of rain, a 30 % probability for sunshine, and with a probability of 30 % no rain and no sun shine occurs, which we call overcast. For this example, no further weather <?page no="175"?> Berkau: Management Accounting 7e 12-175 conditions are discussed. The abovementioned events exclude each other. We measure the risk for WEATHERMAN’s profit. The profit depends on the sales of umbrellas and sunglasses. WEATHERMAN sells 100 umbrellas when it rains, 60 sunglasses when the sun is shining, and with overcast skies, he sells 20 umbrellas and 20 sunglasses. The profit per umbrella is 5.00 EUR/ u and per sunglasses 7.00 EUR/ u. We estimate WEATHERMAN’s profit: 40% × 100 x 5 + 30% × 60 x 7 + 30% × (20 × 5 + 20 × 7) = 3 398.00 EUR. For budgeting, the expected value is enough. However, we are aware of weather changes. The estimate does not show profit deviations. We use a random figure generator for profit simulation. Random figures are equally distributed, it means any percentage between 0 and 100 comes with the same probability. We use the random figure generator ‘RAN#’ on our calculator as well as the MS-Excel function RAND(). Figure 12.3: Random figure generator on a calculator (Casio) The generator provides figures between 0 and 1, such as 0.84. We multiply random figures with 100 to get figures between 0 and 99. As a result, each figure's probability to be drawn is 1%. 52 For the weather simulation, we must assign the drawn random figures to states 52 Due to rounding, the 0 and the 100 come with a probability of 0.5 % whereas all other 99 figures have a probability of 1 %. Technically, we multiply like below. ‘Like” means it does not matter which particular number is assigned to an event. It is only important to assign 40 figures to rain, 30 figures to sunshine and 30 figures to cloudy weather. 0 ... 39 rain. 40 ... 69 sunshine. 70 ... 99 cloudy weather. the results of the random figure generator with 100 and deduct 0.5 from the result. <?page no="176"?> Berkau: Management Accounting 7e 12-176 Now, the RAN# generator can simulate the weather. 40 % of the results indicate rain, 30 % indicate sunshine and another 30 % stand for cloudy weather. We simulate the weather and calculate WEATHERMAN’s profit as a result. We assume, for our first 5 simulation runs the random figures drawn: 53, 94, 68, 12, and 30. Observe the profits earned based on the weather simulations in Figure 12.4: Random umbrellas sold sun glasses sold Profit 53 0 60 420.00 94 20 20 240.00 68 0 60 420.00 12 100 0 500.00 30 100 0 500.00 Average: 416.00 Figure 12.4 WEATHERMAN’s profit simulation As it can be read from the table, the average profit differs from the estimate of 398.00 EUR. We run more simulations and notice that the average profit approximates the estimate. Observe below a 10,000 runs profit simulation based on a MS- Excel spreadsheet. Figure 12.5: WEATHERMAN’s profit MS-Excel simulation In the WEATHERMAN case study, we simulated one risk only (profit risk) and do not need to consider risk combinations. 12.10. Simulation of Multiple Risks In business, there are multiple risks with impacts on profit and/ or cash flows. For Risk Management, we must <?page no="177"?> Berkau: Management Accounting 7e 12-177 identify the risks and study what they depend on. Separate risks are simulated separately. In case a company takes 3 risks, it is required to set up 3 risk simulations which are based on mutually independent events and separate random figures. Hence, for a 3 risk case we draw 3 random figures for each simulation run. 12.11. C/ S NAMGURO Ltd. NAMGURO Ltd. is a consultancy. Watch below its data sheet. Data Sheet for NAMGURO Ltd. CClassification: Consulting; Revenue: 1,000,000.00 EUR/ a; Materials: 50,000.00 EUR/ a; Depreciation: 150,000.00 EUR/ a; Labour: 450,000.00 EUR/ a; Other expenses: 50,000.00 EUR/ a; Fluctuation risk: 20% -> -10 % in revenue and + 15 % in labour; 5 % -> -20 % in revenue and + 25 % in labour; Competitor risk: 30 % -> revenue towards 80 %; Failure risk: 2 % -> 400,000.00 EUR fine; VAT ignored. The company earns an annual revenue of 1,000,000.00 EUR/ a and its estimated profit is 210,000.00 EUR/ a. See the detailed profit calculation for NAMGURO Ltd. in Figure 12.6: Item [EUR] Revenue 1,000,000 Materials (50,000) Depreciation (150,000) Labour (450,000) Other expenses (50,000) Net profit (EBT) 300,000 Income tax (30%) (90,000) Profit for the period (EAT) 210,000 Namguro Ltd. STATEMENT of COMPREHENSIVE INCOME for year ended 31.12.20X5 Figure 12.6: NAMGURO Ltd.’s statement of comprehensive income NAMGURO Ltd. faces the 3 risks below which all have an impact on its profit. (1) Fluctuation risk: Fluctuation affects revenue and labour together: There is a 20 % probability that revenue decreases by 10 % and labour increases by 15 %. Furthermore, there is a 5 % probability that revenue decreases by 20 % and labour increases by 25 %. (2) Competition risk: There is a 30 % probability for a competitor penetrating NAMGURO Ltd.'s market. In that event, revenue will decrease to a level that is equal to 80 % of the previous one. No cost adaption is possible on short notice. <?page no="178"?> Berkau: Management Accounting 7e 12-178 ((3) Failure risk (making mistakes regarding consulting): There is a 2 % risk of a consulting error made by NAMGURO Ltd.'s consultants. In the event of a faulty consultation, NAMGURO Ltd. must pay a fine of 400,000.00 EUR. We record the fine as other expenses (OE). For 3 risks three random figures apply. This keeps the risks mutually independent. Observe the risk simulation with 10 runs as below where the random figures RAN# are equally distributed: RISK 1 RISK 2 RISK 3 Annual Surplus RAN# Effect RAN# Effect RAN# Effect 15 R90; L115 73 27 92,750 3 R90; L115 58 16 92,750 12 R90; L115 16 R80 98 -47,500 27 60 76 210,000 73 49 13 210,000 72 50 30 210,000 6 R90; L115 92 0 OE 450 -267,500 45 34 81 210,000 96 1 R80 78 70,000 33 8 R80 65 70,000 Figure 12.7: Results of NAMGURO Ltd.‘s profit simulation The profit calculations are based on 10 simulation runs, see Figure 12.7: The first simulation run gives a random figure indicating the fluctuation risk. It makes the revenue decline to the 90 % mark and labour costs increase due to new staff employment to 115 % of the previous value. The random figure for the competitor risk is 73. This indicates no change. The random figure for the failure risk is 27 which is with no impact on the income statement either. Line 1 gives the first simulation run’s profit: (90% × 1,000,000 − 50,000 − 150,000 − 115% × 450.000 − 50.000) × (1 − 30%) = 992,750.00 EUR. In line 3, NAMGURO Ltd. makes a loss: 90% × 80% × 1,000,000 − 50,000 − 150,000 − 115% × 450,000 − 50,000 = -- 47,500.00 EUR (no income taxes). Although the fluctuation and competitor risks are independent, they both reduce revenue. Hence, due to the competitor risk the revenue drops to 80 % of the already reduced revenue due to fluctuation. The average profit is calculated by the mean of NAMGURO Ltd.'s 10 profit simulation runs to: (92,750 + 92,750 - 47,500 + 3 × 210,000 - 267,500 + 210,000 + 2 × 70,000) / 10 = 8 85,050.00 EUR. So far, we only simulated the mean for the profit. Next, we determine the profit deviation. We calculate the standard deviation for NAMGURO Ltd.'s profit: [0.1 × ((92,750 - 85,050) 2 + (92,750 - 85,050) 2 + (- 47,500 - 85,050) 2 + 4 × (210,000 - 85,050) 2 + (-267,500 - 85,050) 2 + 2 × (70,000 - 85,050) 2 )] 0.5 = 1143,137.21 EUR. <?page no="179"?> Berkau: Management Accounting 7e 12-179 In business we assume the distribution of profits is normally distributed - without providing a mathematical proof. A normal distribution for profit then is indicated by a bell-shaped curve as probability-over-profit-function. The peak of the curve is where the mean of profit is. The mean value for NAMGURO Ltd.’s profit of 85,050.00 EUR is the most likely value for the distribution. 12.12. Normal Distributions The equation for a normal distribution is: (with: μ = mean, σ = standard deviation, f = probability, x = (here profit), e = Euler’s number) The probability (here: f) depends on constants, e.g. π, and on the mean μ and the standard deviation σ. In other words: once we know the mean and the standard deviation for a distribution, we can calculate it. From a normal distribution we can derive the value at risk. The value at risk is the lowest profit that is exceeded by 95 % of all cases. This is the profit value at the right border (max) under the distribution curve for the 1 st 5%area at the left of the distribution. To calculate probabilities with a normal distribution, we transfer it to a standard normal distribution. A standard normal distribution is a special normal distribution where the mean is 0 and the standard deviation is 1. The probabilities of a standard normal distribution are given by tables you can download from the internet or find in textbooks for Mathematics and Statistics. See the table for the right half of the standard normal distribution in Figure 8.10 (we used it in chapter (8) already for deriving profitability probabilities for DEERFIELD TOURS (Pty) Ltd.). Its figures represent probabilities. As the normal distribution is symmetrical, the maximum value becomes 50 %. We must transfer NAMGURO Ltd.’s normal distribution of profits (derived from simulated μ and σ) into a standard normal distribution. This means to transfer the xvalues (profit) to the z-amounts as listed in the table. The transformation equation from a normal distribution towards a standard normal distribution is: x x z ) ( (with: z = z-amount, μ = mean, σ = standard deviation, x = x-amount) We apply the standard normal distribution for NAMGURO Ltd. to calculate the value at risk for the profit: We put the mean of 85,050.00 EUR as xvalue into the transformation equation for the z-value: (μ - x*) / σ = (85,050 - <?page no="180"?> Berkau: Management Accounting 7e 12-180 85,050) / 143,137.21 = 0 0. Next, we check the z-value for the standard deviation to the right. Its z-value is: (μ - x**) / σ = (85,050 - (85,050 + 143,137.21)) / 143,137.21 = 1 1. These are the values we expected. The table of the standard normal distribution provides the probability for all zvalues that are between 0 and the figures listed. For example, the z-value of 3 gives a probability of 49.87 %, meaning this is the probability of all z-values between 0 and 3. We want to read the probability for NAMGURO Ltd.’s profit that is exceeded by 95 % of all cases. We find this value to the left of the distribution. As the curve for the standard normal distribution is symmetrical, we read the z-value for a 45 % probability on the right-hand side. The z-value is calculated by linear interpolation. It amounts to 1.645. The probability for a z-value of 1.645 is 45 %. The value at risk based on a 5% quartile is the profit that is exceeded with a probability of 95 %. The calculation is as follows: we read the z-value for a probability of 45 % from the table for a normal distribution and ‘retransform’ (dissolving the equation towards x) it to the x-value (profit). For NAMGURO Ltd. the VaR 5% for the profit is at z = -1.645. Accordingly: x = - 1.645 × σ + μ = -1.645 × 143.137.21 + 85,050 = - -150,410.71 EUR. NAMGURO Ltd.'s total profit risk is a 5 % probability that the loss is below negative 150,410.71 EUR (loss). This means there is a 95 % chance for NAMGURO Ltd. to exceed that profit mark. The value at risk is a common risk measure. 12.13. Bankruptcy Probability We can calculate the probability for NAMGURO Ltd.’s over-indebtedness as percentage. To determine the probability for an overindebtedness, we must know the equity. For our calculations, we pretend its equity is 100,000.00 EUR. Hence, we have to determine the probability for NAMGURO Ltd.’s loss to exceed -100,000.00 EUR. We put the value of -100,000.00 EUR into the transformation equation and receive a z-value of: z(-100,000) = (- 100,000 - 85,050) / 143,137.21 = - -1.29. We read the probability from the table to be 40.15 %. There is a probability of 40.15 % that the z-value is between 0 and 1.29. We want to know the probability that stands for values below -1.29. It is: 1 - 50% - 40.15% = 9 9.85%. Therefore, there is a 9.85 % chance of bankruptcy caused by over-indebtedness for NAMGURO Ltd. from the three risks above. 12.14. C/ S OHIO FRIED CHICKEN (Pty) Ltd. Next, we evaluate the risks for OHIO FRIED CHICKEN (Pty) Ltd., as discussed in chapter (11). Based on the past data, we already prepared a budgeted income statement as below in Figure 12.8. <?page no="181"?> Berkau: Management Accounting 7e 12-181 [ZAR] Revenue 1,797,000 Other income 1,797,000 Materials (1,086,000) Labour (88,000) Depreciation (25,000) Other expenses (245,000) Earnings before int. & taxes (EBIT) 353,000 Interest Earnings before taxes (EBT) 353,000 Income tax expenses (105,900) Deferred taxes Earnings after taxes (EAT) 247,100 Ohio Fried Chicken (Pty) Ltd. STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20Y5 Figure 12.8: Budgeted income statement for 20Y5 We start-off with the consideration of the sales risk: We assume the revenue is normally distributed. In contrast, material are not at risk as they can be adjusted to the demand. Labour and depreciation stay constant. The standard deviation of the revenue is 20 %. We calculate the probability for over-indebtedness under consideration of an equity of 35,000.00 ZAR taken from the balance sheet. In case the revenue and the materials increase by 20 %, the profit after taxes is: (120% × (1,797,000 - 1,086,000) - 88,000 - 25,000 - 245,000) × (1 - 30%) = 3346,640.00 ZAR. In case the revenue decreased by 20 % the profit after taxes equals: (80% × (1,797,000 - 1,086,000) - 88,000 - 25,000 - 245,000) × (1 - 30%) = 1147,560.00 ZAR. In the case of OHIO FRIED CHICKEN (Pty) Ltd., a normal distributed revenue with adjustments for the materials leads to a normal distributed profit after taxes with the mean 247,100.00 ZAR and the standard deviation of: 346,640.00 - 247,100 = 9 99,540.00 ZAR = 247,100 - 147,560. We transfer the normal distribution to a standard normal distribution. Here, μ = 247,100.00 ZAR and σ = 99,540.00 ZAR. We are interested in the critical profit for over-indebtedness. It is x = -35,000.00 ZAR, where the loss exceeds equity. We calculate the compatible z-value: z(- 35,000) = (-35,000 - 247,100) / 99,540 = -22.83. The table for a standard normal distribution shows for: z = 2.83 a probability of 49.77%. The value on the probability density function is left to the mean. Hence, the probability for the company OHIO FRIED CHICKEN (Pty) Ltd.’s Accounting bankruptcy is: 100% - 50% - 49.77% = 0 0.23%. <?page no="182"?> Berkau: Management Accounting 7e 12-182 In the next step, we check what happens if OHIO FRIED CHICKEN (Pty) Ltd. takes more risks. Expect the probability for bankruptcy to increase by taking more risks. We assume besides of the (1) sales risk, there is a (2) competitor risk and (3) a staff risk. For the competitor risk, we consider a 30 % probability that a competitor starts a restaurant business in Worcester next to OHIO FRIED CHICKEN (Pty) Ltd. The new restaurant causes OHIO FRIED CHICKEN (Pty) Ltd.’s revenue to decrease by 40 %. Staff will adjust the material orders to the lower demand. Another risk OHIO FRIED CHICKEN (Pty) Ltd. faces is the (3) staff risk. We assume a probability of 20 % that employees quit. We expect an increase of 30 % in labour costs for training costs. As there are now 3 risks, we prepare a MonteCarloSimulation to combine the risks. The simulation is based on 3 random figures. In MS-Excel, an equally distributed random figure is created by the RAND() function. This is used for risk 2 and 3. For risk (1), we need a generator for normal distributed random figures. In our case where the mean is 711,000.00 ZAR and the standard deviation is 142,200.00 ZAR, the MS-Excel function is: NORMINV(RAND(),711000,142200). Risk 1 Revenue - Materials new Rev - Materials Run NORMINV(RAND(),7110 00,142200) Rand() IF(RAND()<0.39,0.6*B17,B17) Rand() IF(RAND()<0.21,1.3*88000,8 8000) 1 876,212.68 0.63 876,212.68 0.00 114,400.00 2 651,029.90 0.91 651,029.90 0.53 88,000.00 3 696,900.57 0.39 418,140.34 0.19 114,400.00 4 897,554.14 0.66 897,554.14 0.99 88,000.00 5 766,368.41 0.29 459,821.05 0.78 88,000.00 6 684,339.36 0.92 684,339.36 0.59 88,000.00 7 668,555.95 0.78 668,555.95 0.18 114,400.00 8 707,504.00 0.89 707,504.00 0.15 114,400.00 9 518,167.23 0.59 518,167.23 0.75 88,000.00 10 795,291.06 0.76 795,291.06 0.83 88,000.00 Risk 2 labour Risk 3 Figure 12.9: Risk simulation (MonteCarloSimulation) <?page no="183"?> Berkau: Management Accounting 7e 12-183 Rev-Mat Labour Depr Other EBT EAT 876,212.68 -114,000.00 -25,000.00 -245,000.00 492,212.68 344,548.88 651,029.90 -88,000.00 -25,000.00 -245,000.00 293,029.90 205,120.93 418,140.34 -114,000.00 -25,000.00 -245,000.00 34,140.34 23,898.24 897,554.14 -88,000.00 -25,000.00 -245,000.00 539,554.14 377,687.90 459,821.05 -88,000.00 -25,000.00 -245,000.00 101,821.05 71,274.74 684,339.36 -88,000.00 -25,000.00 -245,000.00 326,339.36 228,437.55 668,555.95 -114,000.00 -25,000.00 -245,000.00 284,555.95 199,189.17 707,504.00 -114,000.00 -25,000.00 -245,000.00 323,504.00 226,452.80 518,167.23 -88,000.00 -25,000.00 -245,000.00 160,167.23 112,117.06 795,291.06 -88,000.00 -25,000.00 -245,000.00 437,291.06 306,103.74 Ohio Fried Chicken (Pty) Ltd. PROFIT and LOSS SIMULATION RESULTS Figure 12.10: Profit and loss simulation Check the profits of 10 simulation runs in Figure 12.10. The first risk gives us normally distributed revenues - material expenses. The second risk deducts these revenues based on the competitor risk and risk 3 considers the staff risk. Based on the design of our simulation, the figures are normally distributed with regard to the revenue and materials contribution, and they are further affected by the two other risks. For the sake of presentation in this textbook we limit the simulation to 10 runs. In order to manage the distribution, we calculate its mean and standard deviation. The profit mean is: (344,453.21 + 205,120.93 + 23,898.24 + 377,687.90 + 71,274.74 + 228,437.55 + 199,189.17 + 226,452.80 + 112,117.06 + 306,103.74)/ 10 = 2 209,483.10 ZAR. The profit standard deviation is: ((344,453.21 - 209,483.10) 2 + (205,120.93 - 209,483.10) 2 + (23,898.24 - 209,483.10) 2 + (377,687.90 - 209,483.10) 2 + (71,274.74 - 209,483.10) 2 + (228,437.55 - 209,483.10) 2 + (199,189.17 - 209,483.10) 2 + (226,452.80 - 209,483.10) 2 + (112,117.06 - 209,483.10) 2 + (306,103.74 - 209,483.10) 2 )/ 10) 0.5 = 109,392.34 ZAR. We calculate the probability for bankruptcy caused by over-indebtedness for OHIO FRIED CHICKEN (Pty) Ltd. Now, we consider 3 risks instead of one as we did before. The z-value for the loss of 35,000.00 ZAR amounts to: z(-35,000) = (-35,000 - 209,483.10)/ 109,392.34 = - -2.23. The table gives a probability for z = 2.23 to be 48.71 %. The probability for a bankruptcy due to over-indebtedness is: 1 - 50% - 48.71% = 1 1.29%. As we expected, the probability for bankruptcy increased by adding 2 further risks to the simulation model. The number of 10 simulation runs is not sufficient to prove the accuracy of the simulation. A simulation is considered accurate if its mean approximates the estimated value. <?page no="184"?> Berkau: Management Accounting 7e 12-184 12.15. Summary For the management of a company, we must identify and measure its risks. We demonstrated the calculation of the value at risk and a probability for bankruptcy based on a MonteCarloSimulation. A bankruptcy applies in case of an over-indebtedness or illiquidity. The case study ROCKS PLC shows the bankruptcy situation from the Accounting point of view. The case study WEATHERMAN explained the basics of risk simulation. The case study NAMGURO Ltd. demonstrated the combination of multiple risks with a MonteCarloSimulation approach. We applied the MonteCarloSimulation on the case study OHIO FRIED CHICKEN (Pty) Ltd. as well and applied one risk that gives us a normal distribution whereas the other risks are equally distributed. We demonstrated the calculation of the probability for bankruptcy based on the profit risk. 12.16. Working Definitions Equal Distribution: An equal distribution is a distribution where every number has the same probability to appear. MonteCarloSimulation: A MonteCarloSimulation is a simulation of risks by which every single risk calculation is based on independent random figures in order to study the effect all single risks have together on a particular item, such as profit or cash flow. Risk: A risk is the outcome an event by which something happens in a different way as foreseen or expected. Risk Management: Risk Management is about the identification, calculation and controlling of risks taken by shareholders and creditors. Uncertainty: In case a risk cannot be calculated by a probability (unknown probability) it will be referred to as an uncertainty. Value at Risk: The value at risk is the lowest profit that is exceeded by 95 % of all cases. Standard Normal Distribution: A standard normal distribution is a special normal distribution where the mean is 0 and the standard deviation is 1. 12.17. Question Bank (1) A standard normal distribution is a distribution where: 1. The estimate is 0 and the standard deviation is 1. 2. The estimate is 1 and the standard deviation is 0. 3. The mean is 0 and the standard deviation is 1. 4. The mean is 1 and the standard deviation is 0. (2) In Risk Management you get 5 observations: {3; 6; 4; 8; 2}. How much is the standard deviation? 1. 4.60 . 2. 2.15 . 3. 4.64 . 4. 0.96 . (3) A company identified 2 risks: (a) a normal distributed sales risk with a mean of 100,000.00 EUR and a standard deviation of 10,000.00 EUR and (b) a cost risk with a <?page no="185"?> Berkau: Management Accounting 7e 12-185 probability of 10 % that cost increase by 20%. The risk-free profit is 100,000 - 50,000 = 50,000.00 EUR. What is the best estimate? 1. 50,000.00 EUR . 2. 39,000.00 EUR . 3. 60,000.00 EUR . 4. 49,000.00 EUR . (4) A standard normal distribution for the profit has a mean of 40,000.00 EUR and a standard deviation of 15,000.00 EUR. How much is the probability of a loss? 1. 49.62% . 2. 0.38% . 3. 50.38% . 4. 1.00% . (5) A value at risk VAR 5% is… 1. … the value that is reached by 5 % of all cases. 2. … the value that is exceeded by a probability of 5%. 3. … the value that is exceeded by a probability of 95%. 4. … the value that is reached by 95 % of all cases. 12.18. Solutions 1-3; 2-2; 3-4; 4-2; 5-3. <?page no="186"?> Berkau: Management Accounting 7e 12-186 Section (3): Cost Accounting <?page no="187"?> Berkau: Management Accounting 7e 13-187 13. Full Cost Accounting Systems 13.1. What is in the Chapter? In the first chapter of the Cost Accounting section, we define costs and explain major cost terms, e.g. direct and indirect cost, manufacturing vs. non-manufacturing costs, product and period costs and differential costs, sunk costs and opportunity costs. The cost separation follows in chapter (14) together with the introduction of flexible budgeting. We further explain the structure of cost Accounting systems as shown in Figure 13.5 and the features of its components. The structure follows the cost flow through the system. The explanations in this and in the next following chapter (14) are supported by the case study GIULIO’s PIZZA&PASTA RISTORANTE. 13.2. Learning Objectives After studying this chapter you have a profound knowledge of the cost concept and know particular cost terms applicable in Management Accounting. You also understand how a Management Accounting system works. You are familiar with its structure and understand the cost flow through cost Accounting. You learn how cost Accounting systems support managers with product calculations, monitoring and calculating business profitability. 53 Find the case SCHLUCHMAN/ MOBILE TARTE FLAMBEE GmbH in the online materials you can download though the QR code in Link 6.B. 13.3. Cost Concepts Costs are the consumption of resources and are related to business model. E.g., materials become a cost, when consumed in production. Check the previous chapter (6) where on SCHLUCHMAN’s cost plan material costs for dough in 20X3 were planned to be: 180 × 100 × 0.1 × 1.20 = 2,160.00 EUR. In contrast, its purchases (liquidity plan) are cash flows: 2,160 + 30 = 2,190.00 EUR. The difference results from building a safety stock also shown on the balance sheet. 53 Next, we introduce major cost concepts in Management Accounting and illustrate them by small case studies. The cost concepts we cover are: (1) Direct vs. indirect costs. (2) Manufacturing vs. non-manufacturing costs. (3) Product cost vs. period costs. ( ) Variable vs. fixed costs. 54 (4) Differential/ sunk/ opportunity costs. 13.4. Direct vs. Indirect Costs For cost allocations, we distinguish direct and indirect costs. The latter ones are known as overheads. Direct costs are direct materials and direct labour. The term direct indicates that these costs can be traced to products. E.g., materials are assigned ‘directly’ to job orders. In Industrial Management a 54 Find cost separation in chapter (14). <?page no="188"?> Berkau: Management Accounting 7e 13-188 job order is an internal order to manufacturing a number (lot size) of specific products. The information which materials belong to a product is taken from the bill of materials BOM. The bill of materials is prepared in product design by engineers. In contrast to direct materials, overheads cannot be traced to job orders without allocations. They are at first assigned to a cost centre (recorded as cost centre specific manufacturing overheads) and thereafter allocated to good/ services (overhead application). For the distribution to cost objects (overhead application), Management Accountants prepare predetermined overhead allocation rates POR. They are planned in advance (budgeting). The rates divide the overheads by the planned volume (measured in reference units). We discuss the distinction between direct costs and overheads for labour costs: direct labour can be assigned straight to the product. We also use the expression ‘touch labour’. In contrast, indirect labour serves more or all products in a cost centre, e.g. supervisor’s salary, janitor costs, security service fees etc. The distribution of those costs requires applying predetermined overhead allocation rates POR, which are based on, e.g. the time workers spend on a particular product (direct labour hours). The POR’s unit is then, e.g. EUR/ hour. By multiplying the direct work hours with the POR, overheads are allocated to job orders and thus to the products. 55 Read for Management Accounting our textbook Financial Statements, chapter (9) and Schwellnuss, A.-G.: Produktionscontrolling. 13.5. Manufacturing vs. non-Manufacturing Costs Although the term manufacturing-related comes from Industrial Management, the cost concept applies in other industries, too. Frequently, they contain direct costs, e.g. direct materials, direct labour, and manufacturing overheads. In contrast, non-manufacturing costs are not linked to production or service rendering. They are, e.g. for selling and administration (SG&A), Accounting or Human Resources etc. Non-manufacturing costs are not considered for product calculations. Nonmanufacturing costs are recorded in separate accounts, e.g. Marketing account, HR account or Administration account etc. These accounts are closed-off to profit or loss. In Management Accounting, two further technical cost terms are frequently in use: (1) prime costs and (2) costs of conversion. (1) Prime costs are direct materials and direct labour. (2) The costs of conversion contain direct labour and manufacturing overheads. The latter ones represent the costs necessary to convert the materials to finished products, but they do not include material costs. The total of prime costs and manufacturing overheads are the cost of manufacturing. 55 13.6. Product vs. Period Costs Product costs are the costs of manufacturing assigned to finished goods inventory. They are the cost of <?page no="189"?> Berkau: Management Accounting 7e 13-189 manufacturing for those goods added to stock (finished goods inventory). When goods are added to stock, their costs (period costs), which include, e.g. labour, materials, depreciation, supervisor’s salary etc., become product costs and thus get deferred to later Accounting periods (when they are sold). This means, their cost consideration for profit and loss calculation is postponed to periods of their sale. Non-manufacturing costs are never product costs. Period costs are linked to the Accounting period they occur in. Period costs are not assigned to goods. All period costs are transferred to profit or loss at the end of the Accounting period. Period costs are nonmanufacturing costs, e.g. for administration, sales, Accounting etc. Also goods released from stock become period costs when they are sold during the period. This way, costs of goods sold are considered for the profit calculation. 13.7. C/ S STAFFORD (Pty) Ltd. We explain the distinction between product and period costs with a small case study: STAFFORD (Pty) Ltd. We also prepare financial statements for the company. STAFFORD (Pty) Ltd. is in the fashion industry and manufactures polo shirts in Cape Town. We ignore VAT. Find below the data sheet for STAFFORD (Pty) Ltd.: Data Sheet for STAFFORD (Pty) Ltd. CClassification: Production; Issued capital as per 1.01.20X1: 1,000,000.00 ZAR; P, P, E: sewing machinery: 4,000,000.00 ZAR; Materials: 800,000.00 ZAR/ a; consumed: 640,000.00 ZAR Labour: 1,900,000.00 ZAR/ a; direct labour: 1,600,000.00 ZAR; indirect labour: 300,000.00 ZAR (SG&A: 80,000.00 ZAR thereof); Depreciation on sewing machines: 500,000.00 ZAR/ a; Output: 320,000 u/ a; Sales: 250,000 u/ a at 34.00 ZAR/ u; VAT ignored. On 1.01.20X1, STAFFORD (Pty) Ltd. is established by a share issue of 100,000 ordinary shares at 10.00 ZAR/ s. STAFFORD (Pty) Ltd. buys sewing machines at 4,000,000.00 ZAR and pays by bank transfer. The company purchases fabric and yarn from its supplier at 800,000.00 ZAR (together). The purchases are recorded in the Raw Materials Inventory account. STAFFORD (Pty) Ltd. employs sewers and supervisors in the production department and pays 1,900,000.00 ZAR/ a for labour. Depreciation on machinery is 500,000.00 ZAR/ a. We study the accounts for the production of 320,000 polo shirts. All activities are recorded in 20X1. During the first Accounting period, STAFFORD (Pty) Ltd. sells 250,000 polo-shirts at 34.00 ZAR/ u. The revenue is: 250,000 × 34 = 8,500,000.00 ZAR. We study the Bookkeeping entries below: (1) Establishment of STAFFORD (Pty) Ltd.: DR Cash/ Bank.................... 1,000,000.00 ZAR CR Issued Capital............... 1,000,000.00 ZAR <?page no="190"?> Berkau: Management Accounting 7e 13-190 (2) Purchase of materials: DR Raw Materials Inventory...... 800,000.00 ZAR CR Cash/ Bank.................... 800,000.00 ZAR (3) Recording labour: DR Labour....................... 1,900,000.00 ZAR CR Cash/ Bank.................... 1,900,000.00 ZAR (4) Acquisition of machinery: DR P, P, E Account.............. 4,000,000.00 ZAR CR Cash/ Bank.................... 4,000,000.00 ZAR (5) Depreciation: DR Depreciation................. 500,000.00 ZAR CR Acc. Depr.................... 500,000.00 ZAR (6) Revenue recognition: DR Cash/ Bank.................... 8,500,000.00 ZAR CR Revenue...................... 8,500,000.00 ZAR Find the recording for the polo shirt production in Figure 13.1: D C D C (1) 1,000,000.00 (2) 800,000.00 (1) 1,000,000.00 (6) 8,500,000.00 (3) 1,900,000.00 (4) 4,000,000.00 Cash/ Bank C/ B Issued capital ISS D C D C (2) 800,000.00 (3) 1,900,000.00 Raw Materials Inventory RMI Labour-20X1 LAB D C D C (4) 4,000,000.00 (6) 8,500,000.00 Property, plant, equipment PPE Revenue-20X1 REV Figure 13.1: STAFFORD (Pty) Ltd.’s accounts <?page no="191"?> Berkau: Management Accounting 7e 13-191 D C D C (5) 500,000.00 (5) 500,000.00 Depreciation-20X1 DPR Acc depr ACC Figure 13.1: STAFFORD (Pty) Ltd.’s accounts (continued) The materials consumed in production are 640,000.00 ZAR (period costs). The labour is to an extent of 1,600,000.00 ZAR direct labour and for 300,000.00 ZAR indirect labour. Consider 80,000.00 ZAR of the indirect labour for selling and administrative costs (SG&A). The remainder is manufacturing overheads: 300,000 - 80,000 = 2 220,000.00 ZAR. The application of manufacturing overheads is at full meaning all overheads are applied. So far, all labour costs are period costs. We record the production as below in Figure 13.2. 56 D C D C (1) 1,000,000.00 (2) 800,000.00 c/ d 1,000,000.00 (1) 1,000,000.00 (6) 8,500,000.00 (3) 1,900,000.00 b/ d 1,000,000.00 (4) 4,000,000.00 c/ d 2,800,000.00 9,500,000.00 9,500,000.00 b/ d 2,800,000.00 Cash/ Bank C/ B Issued capital ISS D C D C (2) 800,000.00 WIP 640,000.00 (3) 1,900,000.00 WIP 1,600,000.00 c/ d 160,000.00 MOH 220,000.00 800,000.00 800,000.00 M/ A 80,000.00 b/ d 160,000.00 1,900,000.00 1,900,000.00 Raw Materials Inventory RMI Labour-20X1 LAB D C D C (4) 4,000,000.00 c/ d 4,000,000.00 P&L 8,500,000.00 (6) 8,500,000.00 b/ d 4,000,000.00 D C D C (5) 500,000.00 MOH 500,000.00 c/ d 500,000.00 (6) 500,000.00 b/ d 500,000.00 Depreciation-20X1 DPR Acc depr ACC Property, plant, equipment PPE Revenue-20X1 REV Figure 13.2: STAFFORD (Pty) Ltd.’s accounts 56 Study our textbook Basics of Accounting, chapter (25). <?page no="192"?> Berkau: Management Accounting 7e 13-192 D C D C RMI 640,000.00 IFG 2,960,000.00 LAB 220,000.00 WIP 720,000.00 LAB 1,600,000.00 DPR 500,000.00 MOH 720,000.00 720,000.00 720,000.00 2,960,000.00 2,960,000.00 D C D C WIP 2,960,000.00 COS 2,312,500.00 FGI 2,312,500.00 P&L 2,312,500.00 c/ d 647,500.00 2,960,000.00 2,960,000.00 b/ d 647,500.00 D C D C COS 2,312,500.00 Rev 8,500,000.00 LAB 80,000.00 P&L 80,000.00 M/ A 80,000.00 EBT 6,107,500.00 8,500,000.00 8,500,000.00 ITL 1,832,250.00 b/ d 6,107,500.00 R/ E 4,275,250.00 6,107,500.00 6,107,500.00 Profit and Loss P&L Marketing and administration M/ A Work in Process WIP Manufacturing overheads MOH Finished goods inventory FGI Cost of goods sold COS D C D C c/ d 1,832,250.00 P&L 1,832,250.00 c/ d 4,275,250.00 P&L 4,275,250.00 b/ d 1,832,250.00 b/ d 4,275,250.00 Income tax liabilities ITL Retained earnings R/ E Figure 13.2: STAFFORD (Pty) Ltd.’s accounts (continued) For the goods, correct values are shown in the Inventory accounts. During the Accounting period 20X1, the polo shirts are under production and considered workin-process (period costs). After production is completed, the polo shirts are added to finished goods and now become product costs. These costs are deferred to another Accounting period, such as the 70,000 polo shirts at unit costs of manufacturing of: 2,960,000 / 320,000 = 9 9.25 ZAR/ u. Therefore, finished goods of: 70,000 × 9.25 = 647,500.00 ZAR are transferred to the next Accounting period 20X2. Their costs of manufacturing occurred in 20X1. As we defer them, they are excluded from profit or loss in 20X1. They become period costs once sold. Even if we write-off the polo shirts for disposal because no sale is possible, e.g. because they are out of fashion they become expenses, recorded then as disposal or waste costs (period costs). All costs that are expensed during the Accounting period when they occur are <?page no="193"?> Berkau: Management Accounting 7e 13-193 period costs. This applies here for all non-manufacturing costs (80,000.00 ZAR Marketing costs) and the cost for all polo shirts sold (cost of sales COS). Releasing goods produced in prior periods from stock results in period costs, too, but does not apply for this case study. All period costs are considered for profit or loss (on the income statement). Observe the financial statements for STAFFORD (Pty) Ltd. in Figure 13.3 and Figure 13.4. [ZAR] Revenue 8,500,000 Other income 8,500,000 COS (2,312,500) Other expenses (80,000) Earnings before int and taxes (EBIT) 6,107,500 Interest 0 Earnings before taxes (EBT) 6,107,500 Income tax expenses (1,832,250) Deferred taxes Earnings after taxes (EAT) 4,275,250 Stafford (Pty) Ltd.'s STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X1 Figure 13.3: STAFFORD (Pty) Ltd.’s income statement <?page no="194"?> Berkau: Management Accounting 7e 13-194 A C, L Non-current assets [ZAR] Owners' capital [ZAR] P, P, E 3,500,000 Share capital 1,000,000 Intangibles Reserves Financial assets R/ E 4,275,250 Current assets Liabilities Inventory 807,500 Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 2,800,000 Tax liabilities 1,832,250 7,107,500 7,107,500 Stafford (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X1 Figure 13.4: STAFFORD (Pty) Ltd.’s balance sheet 13.8. Differential/ Sunk/ Opportunity Costs Most of Management Accounting data support decision making. Therefore, costs should be calculated in a way that the costs of alternatives become transparent. Decisions about the volume require to calculate costs for additional units manufactured. Differential costs are the costs for one additional unit of product produced, service rendered or they reflect a further reference unit consumed by resources deployed. Differential costs are based on already deployed resources. Therefore, additional investments are not considered for volume increase. If the capacity is not enough, production is not possible. A burger restaurant increase its costs for meat patties by every single additional burger. If production declines, the consumption of meat patties will follow the decrease. The costs for one meat patty are incremental costs caused by one additional burger. We call differential costs incremental if they are not indefinitely small. As differential costs change with the volume, the knowledge about incremental costs is required to decide about increases/ decreases in volume. Changes in volume apply for product mix decisions and budgeting. The low budget airline CHEAPY Ltd. exploits the concept of low differential costs. They cut them as much as possible, e.g. by not serving food on flights, not printing boarding passes, offering internet sales only and by not transporting luggage free of charge. The latter one is to spare luggage handler costs. If seats are not sold, CHEAPY Ltd. advertise them on short-term basis and at an extremely low price, just to exceed differential costs for a flight by the proceeds thereof. Besides of the Marketing effect, the cheap ticket still contributes to profit the only incremental costs left for CHEAPY Ltd. are airport landing fees which are accounted for on passenger count. (The landing fees depend on the <?page no="195"?> Berkau: Management Accounting 7e 13-195 airport, this is why CHEAPY Ltd. only flies into regional airports.) In contrast to differential costs, sunk costs are not linked to operations. They depend on decisions already made. Frequently, they are called committed costs, as companies are bound thereto by contractual agreements. Sunk costs are costs that cannot be changed anymore. They do not depend on decisions within the nearby future. The video rental WOTSCH GmbH takes out a bank loan of 100,000.00 EUR and agrees on interest payments of 4 %/ a by signing the loan contract. The interest falls under sunk costs. No matter, how many DVDs WOTSCH GmbH rents-out, the costs for interest remain the same. Opportunity costs are costs for an alternative given up in order to perform an activity. They seldom appear in Managerial Accounting records, but they are important for decision making. Check the case of the attorney Dr MEPPEN. Dr. Meppen decides to attend a seminar in family law on 4 Fridays in June. During this time, he gives up the opportunity to advice or to represent his clients in court and to charge in total 8,000.00 EUR. This would be the profit he could make during the time he now spends in the seminar. Hence, the opportunity costs for the seminar attendance are equal to 8,000.00 EUR (opportunity costs). For making his decision he must add them to the seminar fees and travel expenses. 13.9. Components of Cost Accounting Systems Cost Accounting enables us to calculate cost objects and determine the profitability of organisational units, mostly cost centres, and of the entire company. Cost Accounting is based either on budgeted (future) costs or on actual costs. In the latter case, costs can be derived from Financial Accounting records. A cost Accounting system is either based on all costs (full cost Accounting system as in this chapter (13)) or on partial costs (partial costing as in chapter (14)). It contains four major components we focus on in the next following paragraphs: (1) Cost category Accounting. (2) Cost centre Accounting. (3) Calculation. (4) Profitability analysis. See Figure 13.5 to study the cost Accounting components and the links between them. We follow this structure along the cost flow through it. <?page no="196"?> Berkau: Management Accounting 7e 13-196 Figure 13.5: Management Accounting system We explain cost Accounting based on the data flow indicated by the thick arrows in Figure 13.5. The thin ones are subjected to chapter (16). The cost Accounting system follows absorption costing, so we work without cost separation in this chapter and always consider full (variable and fixed) costs. 57 Actual cost Accounting is connected to Bookkeeping records. You can see the data link between Financial Accounting and Management Accounting at the top of Figure 13.5. Through this link, expenses/ costs and revenues are transferred to the Management Accounting system. Technically, these are two Accounting systems with access to the same data base. Once the Accountant records a Bookkeeping entry, e.g., rent, the debit entry is available for cost Accounting too. If the Bookkeeping entry is … DR Rent......................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR … its debit entry (rent) is available for cost Accounting. 58 So far, the cash/ bank entry is of minor interest. Real accounts do not determine cost rates or calculations. Revenues are transferred to Management Accounting too. In the box Financial Accounting system, a reference 57 In the next chapter (14) we apply partial costing. to the general ledger is made. This follows the idea that subordinated accounts, e.g. the purchase ledger, do not matter for cost Accounting. Below, we discuss the components as disclosed in Figure 13.5. 58 In this textbook congruence of cost and expenses applies by default. <?page no="197"?> Berkau: Management Accounting 7e 13-197 13.10. Cost Category Accounting The first box in the Management Accounting system stands for cost category Accounting. A cost category is a particular group of costs, e.g. rent Jan, rent Feb., with the same purpose (rent). The input for the cost category Accounting are expenses from Financial Accounting. In this textbook we pretend that all costs equal expenses. The output of cost category Accounting are cost assigned to categories which are either direct costs or overheads. Their classification depends on their relation to goods/ services. In a partial cost Accounting system, the cost separation belongs to cost category Accounting too. We discuss cost separation in the next chapter (14). As we focus on absorption costing, we skip the cost separation for now. The cost flow of overheads points in the direction of cost centre Accounting. Direct costs move to calculation ‘directly’. 13.11. Cost Centre Accounting For purposes of efficient control a company is divided into organisational units. Management Accounting uses cost centres. A cost centre is an organisational unit within a company, with a manager who takes responsibility for its costs. Costs depend on reference units. Preferably, only one reference unit per cost centre applies. In a Management Accounting system we assign costs to cost centres. It can be done directly without allocations, e.g., room costs are traced to the building where the only cost centre is located in. If the building hosts more than one cost centre the building costs must be split, e.g., based on the cost centres’ square metres. This is known as a cost allocation. Cost centre Accounting covers all functions within a cost centre. Between the cost centres, internal cost allocations are carried out if the cost centres support each other. After internal cost allocations the resulting costs (final costs) are divided by the cost centre performance measured in reference units. This gives a cost rate used for overhead allocations to products. A cost rate tells us how much costs are spent for one reference unit’s volume, e.g. EUR/ machine hour. If actual and standard cost data are available, costs can be monitored by variances between standard and actual costs. An analysis of cost deviation follows. Both is referred to as monitoring and covered in chapter (15). Cost monitoring also issues cost variance reports known as proficiency reporting. See chapter (17) for reporting. Reporting negative cost deviations makes managers anticipate lower profits than budgeted for. Cost deviations are caused by inefficient operations, e.g. rework, using alternative but more costly machines etc. From cost centre Accounting the cost flow continues to calculation or to profitability analysis. The arrow towards calculation follows an overhead allocation per predetermined overhead rates POR. They can be based on full costs or variable costs. The arrow to profitability analysis means the remaining costs move on to profit or loss. The transfer of cost centre cost to profit or loss applies for all non-manufacturing costs and for cost devia- <?page no="198"?> Berkau: Management Accounting 7e 13-198 tions. The latter case is known as underor over-application of overheads. It results from the cost allocations made by predetermined overhead allocation rates, meaning on planned costs basis. 13.12. Calculation A calculation determines the unit costs per product. Unit costs contain direct costs, e.g. direct labour or materials coming from cost category Accounting. Their amounts are taken from the bill of materials and the routings. Unit costs also contain applied manufacturing overheads. The overhead application is calculated by multiplying the predetermined overhead allocation rates POR with the performance the product received inside of the cost centre (utilisation factor). E.g., POR for a Volkswagen Golf dashboard assembly is 150.00 EUR/ h and the assembling time for one dashboard is 10 min., then the overheads allocated to the product are: 10 × 150/ 60 = 25.00 EUR/ VW-Golf. The sum of direct costs and overhead allocations gives the product costs. If the costs for a job order are divided by the lot size, the costs are referred to as unit costs. Companies do not manufacture one product at a time but define job orders linked to more products of the same kind. The number of goods produced by one job order is called lot size. In Figure 13.2, a job order for 320,000 polo shirts is recorded in the WIP-account. 59 Read for the formats of the profit and loss calculation our textbook Financial Statements, chapter (12). 13.13. Profitability Analysis The last step in cost Accounting is the profitability analysis, which is very close to the profit and loss calculation in Financial Accounting. We calculate the profit by deducting costs from revenues. The outcome is profit/ loss. The profitability analysis can be structured based on the nature of expense method or the cost of sales format. 59 In contrast to Financial Accounting, costs for taxation and Finance are frequently omitted in Management Accounting. We only calculate the profitability analysis ‘down to’ the earnings before taxes EBT or earnings before interest and taxes EBIT. If the cost of sales format applies, the profits can be calculated per product (or other cost objects, e.g. for customers or sales regions). A profitability analysis is carried out monthly. This gives managers on-time information about the profit situation and the chance to take corrective actions during the year. Next, we study cost Accounting with a case study about an Italian Restaurant, GIULIO’s PIZZA&PASTA RISTORANTE in Milano. As taxes do not matter, its legal form and tax calculations are omitted. For the sake of simplification, we pretend the restaurant is in private ownership. <?page no="199"?> Berkau: Management Accounting 7e 13-199 13.14. C/ S GIULIO’s PIZZA&PASTA RISTORANTE We discuss a cost Accounting system in detail following the 4 boxes in Figure 13.5. Parallel to our Accounting steps we show the calculated costs in the boxes. For this chapter, the restaurant applies an absorption costing. In the next chapter (14) we repeat the case study for partial cost Accounting. Data Sheet for GIULIO’s PIZZA&PASTA RISTORANTE CClassification: Hospitality Management; 3 dishes: pizza, lasagne, cannelloni, wine; Quantities: 50,000 pizza / 20,000 lasagnes / 10,000 cannelloni / 12,000 wines served by the glass; Net selling prices: 9.00 EUR / 8.00 EUR / 8.00 EUR / 5.00 EUR; Unit costs: 5.52 EUR/ pizza / 4.86 EUR/ lasagne / 4.53 EUR/ cannelloni / 2.69 EUR/ wine; 3 cost centres: Kitchen, Restaurant, Delivery; Cost centre costs: 64,960.00 EUR / 63,600.00 EUR / 29,000.00 EUR; VAT ignored. GIULIO’s PIZZA&PASTA RISTORANTE (GP&PR) bakes pizza and various (only 2) pasta dishes, which is lasagne and cannelloni. All dishes can be consumed in the restaurant or are delivered by GIULIO’s PIZZA&PASTA RISTORANTE’s take-away-service. GIULIO’s PIZZA&PASTA RISTORANTE’s bakes tuna pizza, lasagne and cannelloni. The restaurant buys pizza dough from a supplier. The same applies for lasagne and cannelloni noodles. The ingredients for the dishes are given by Figure 13.6, which we refer to as the ‘bill of materials’. It represents the material requirements per product (dish). Bill of materials BOM is a technical term from Industrial Management. We also could say recipe. As Managerial Accounting originates from production theory many expressions are factory language. <?page no="200"?> Berkau: Management Accounting 7e 13-200 Item Amount Purchase price/ u dough 150 g 0.80 tomato sauce 40 g 0.25/ 10g tuner 75 g 2.00/ 100g cheese 3 slices 0.20/ slice Item Amount Purchase price/ u lasagne noodles 100 g 0.50/ 100g tomato sauce 50 g 0.25/ 10g minced meat 80 g 1.00/ 100g cheese 5 slices 0.20/ slice Item Amount Purchase price/ u cannelloni noodles 100 g 0.50/ 100g cream sauce 50 g 0.20/ 10g cooked ham 60 g 1.20/ 100g cheese 5 slices 0.20/ slice Tuna Pizza BILL OF MATERIALS Lasagne BILL OF MATERIALS Cannelloni BILL OF MATERIALS Figure 13.6: GP&PR’s BOM Besides dishes, GIULIO’s PIZZA&PASTA RISTORANTE offers an Italian Chianti wine which is served by the glass. The purchase cost per 750 ml bottle is 6.00 EUR/ u. Next to direct materials, GIULIO’s PIZZA&PASTA RISTORANTE records its overheads. They are not linked to dishes or wines. Overheads are indirect costs which cannot be traced to a particular product or service. At GIULIO’s PIZZA&PASTA RISTORANTE, overheads are the salary for the chef at 4,000.00 EUR/ m, the salary for the order manager/ waiter at 2,800.00 EUR/ m, the salary for the delivery driver at 9.00 EUR/ h and depreciation on the restaurant interior, which contains the kitchen appliances (oven), and on the delivery car. The investment in the oven (for pizza and pasta dishes) is 24,000.00 EUR and the entire restaurant interior costs 18,000.00 EUR. Both assets are depreciated following straight-line method over 6 years. The delivery vehicle is a preowned Fiat bought at 8,000.00 EUR. It is depreciated over the next four years based on straight-line method, too. The Fiat’s operational costs are 1,000.00 EUR/ m. These costs cover petrol, maintenance and tear & wear parts. Rental costs for the restaurant building including water/ electricity supply are 3,000.00 EUR/ m. In cost Accounting, the budgeting procedures starts with performance planning. This is also known as reverse budgeting. <?page no="201"?> Berkau: Management Accounting 7e 13-201 Consider the profitability analysis box in Figure 13.5 as starting point. We start to plan costs from the number of pizza, pasta dishes and wines. The performance planning determines the volume for pizza, lasagne, cannelloni and wines sold during the upcoming year. GIULIO’S PIZZA&PASTA RISTORANTE plans 50,000 pizza/ a, 20,000 lasagne/ a and 10,000 cannelloni/ a. Furthermore, GIULIO’S PIZZA&PASTA RISTORANTE estimates to sell 4,000 bottles/ a of Chianti wine in the restaurant (served by the glass). The delivery service is planned to transport 20,000 dishes per annum. A food delivery takes on average 5 min. Next, we plan costs, beginning with direct costs. Direct costs are the materials/ ingredients. No direct labour applies because the chef at GIULIO’s PIZZA&PASTA RISTORANTE prepares all dishes; therefore, his salary is overheads. The calculation of materials is based on the bill of materials and the planned volume. 50,000 Tuna Pizza BILL OF MATERIALS Item Purchase price/ u Total costs dough 150 g 0.80/ 150g 40,000.00 tomato sauce 40 g 0.25/ 10g 50,000.00 tuner 75 g 2.00/ 100g 75,000.00 cheese 3 slices 0.20/ slice 30,000.00 195,000.00 20,000 Lasagne BILL OF MATERIALS Item Purchase price/ u Total costs lasagne noodles 100 g 0.50/ 100g 10,000.00 tomato sauce 50 g 0.25/ 10g 25,000.00 minced meat 80 g 1.00/ 100g 16,000.00 cheese 5 slices 0.20/ slice 20,000.00 71,000.00 10,000 Cannelloni Bill OF MATERIALS Item Purchase price/ u Total costs cannelloni noodles 100 g 0.50/ 100g 5,000.00 cream sauce 50 g 0.20/ 10g 10,000.00 cooked ham 60 g 1.20/ 100g 7,200.00 cheese 5 slices 0.20/ slice 10,000.00 32,200.00 Amount Amount Amount Figure 13.7: GP&PR’s direct costs based on products <?page no="202"?> Berkau: Management Accounting 7e 13-202 13.15. Cost Category Accounting - C/ S In total, direct materials per annum are amounting to: (1) Dough: 40,000.00 EUR/ a. (2) Tomato sauce: 50,000 + 25,000 = 7 75,000.00 EUR/ a. (3) Tuner fish: 75,000.00 EUR/ a. (4) Cheese: 30,000 + 20,000 + 10,000 = 60,000.00 EUR/ a. (5) Lasagne noodles: 10,000.00 EUR/ a. (6) Minced: 16,000.00 EUR/ a. (7) Cannelloni noodles: 5,000.00 EUR/ a. (8) Cream sauce: 10,000.00 EUR/ a. (9) Cooked ham: 7,200.00 EUR/ a. Next to the dishes, Italian Chianti wine is a direct cost, too. (10) Chianti wine: 6 × 4,000 = 2 24,000.00 EUR/ a. The total direct materials amount to: 40,000 + 75,000 + 75,000 + 60,000 + 10,000 + 16,000 + 5,000 + 10,000 + 7,200 + 24,000 = 3 322,200.00 EUR/ a. Next, we plan overheads for GIULIO’s PIZZA&PASTA RISTORANTE. There are indirect materials which we allocate based on percentages, like olive oil and dishwasher liquid. These are unreal overheads as they could be traced to the products. This would result for Giulio in more Accounting work not rectified by its outcome. Therefore, they are planned as overheads and amounting to: 1,440 l olive oil at 2.50 EUR/ l which gives: 1,440 × 2.50 = 3 3,600.00 EUR/ a and 720 l dishwasher liquid at 0.50 EUR/ l, which results in: 720 × 0.50 = 3 360.00 EUR/ a. All further costs at GIULIO’S PIZZA&PASTA RISTORANTE are classified as overheads. They are for salaries, rent, car operation and depreciation. In total, GIULIO’s PIZZA&PASTA RISTORANTE’s overheads are as below: (a) Olive oil: 3,600.00 EUR/ a. (b) Dishwasher liquid: 360.00 EUR/ a. (c) Chef’s salary: 4,000 × 12 = 4 48,000.00 EUR/ a. (d) Order manager’s/ waiter’s salary: 2,800 × 12 = 3 33,600.00 EUR/ a. (e) Driver’s salary: 20,000 × (5/ 60) x 9 = 15,000.00 EUR/ a. (f) Depreciation on the stove: 24,000/ 6 = 4 4,000.00 EUR/ a. (g) Depreciation on the restaurant interior: 18,000/ 6 = 3 3,000.00 EUR/ a. (h) Depreciation on the delivery-car: 8,000/ 4 = 2 2,000.00 EUR/ a. (i) Operating costs for the delivery-car: 1,000 × 12 = 1 12,000.00 EUR/ a. (j) Rent for the whole restaurant: 3,000 × 12 = 336,000.00 EUR/ a. The overheads add up to: 3,600 + 360 + 48,000 + 33,600 + 15,000 + 4,000 + 3,000 + 2,000 + 12,000 + 36,000 = 157,560.00 EUR/ a. After cost category Accounting, the cost Accounting system shows costs as in Figure 13.8. Check the cost category Accounting box. <?page no="203"?> Berkau: Management Accounting 7e 13-203 Figure 13.8: GP&PR’s Management Accounting system (1) 13.16. Calculation - C/ S The calculation procedures follow two steps: direct cost assignments and manufacturing overhead allocation. Materials are assigned directly to the products, which are pizza, lasagne, cannelloni and the Chianti wines. This is shown by Figure 13.7. Next we calculate the unit costs for materials. Unit costs are costs based on one unit of the product. In addition, there are direct costs for the Chianti wine. Observe the direct costs in Figure 13.9. <?page no="204"?> Berkau: Management Accounting 7e 13-204 1 Tuna Pizza DIRECT COSTS Item Purchase price/ u Unit costs dough 150 g 0.80/ 150g 0.80 tomato sauce 40 g 0.25/ 10g 1.00 tuner 75 g 2.00/ 100g 1.50 cheese 3 slices 0.20/ slice 0.60 3.90 1 Lasagne DIRECT COSTS Item Purchase price/ u Unit costs lasagne noodles 100 g 0.50/ 100g 0.50 tomato sauce 50 g 0.25/ 10g 1.25 minced meat 80 g 1.00/ 100g 0.80 cheese 5 slices 0.20/ slice 1.00 3.55 1 Cannelloni DIRECT COSTS Item Purchase price/ u Unit costs cannelloni noodles 100 g 0.50/ 100g 0.50 cream sauce 50 g 0.20/ 10g 1.00 cooked ham 60 g 1.20/ 100g 0.72 cheese 5 slices 0.20/ slice 1.00 3.22 1 Wine by the Glass DIRECT COSTS Item Purchase price/ u Unit costs wine 0.25 ml 6/ 0.75ml 2.00 2.00 Amount Amount Amount Amount Figure 13.9: GP&PR’s direct costs 13.17. Cost Centre Accounting - C/ S For budgeting and cost centre costing, we divide GIULIO’S PIZZA&PASTA RISTORANTE in 3 cost centres. They are the Kitchen, Restaurant/ Order Management and Delivery. GIULIO’S PIZZA&PASTA RISTORANTE calculates overheads per cost centre and thereafter determines the cost rates. The cost rate is calculated by dividing annual costs by the annual performance measured in reference units. Below, we analyse the three cost centres: Kitchen In the Kitchen, the overheads are: (a) Olive oil: 3,600.00 EUR/ a. (b) Dishwasher liquid: 360.00 EUR/ a. (c) Chef’s salary: 4,000 × 12 = 4 48,000.00 EUR/ a. (f) Depreciation on the stove: 24000/ 6 = 4,000.00 EUR/ a. (j) Rent for the entire restaurant: 3,000 × 12 = 3 36,000.00 EUR/ a. The rent is split to cost centres following the size of the floor area. The Kitchen area is 20 m 2 and the Restaurant/ Order Management area is 60 m 2 . Accordingly, 25% of the rent is allocated to <?page no="205"?> Berkau: Management Accounting 7e 13-205 the Kitchen, which is: 0.25 × 36,000 = 99,000.00 EUR/ a. The total Kitchen-overheads are: 3,600 + 360 + 48,000 + 4,000 + 9,000 = 64,960.00 EUR/ a. Restaurant/ Order Management In the Restaurant/ Order Management department, the overheads are: (d)Order manager/ waiter’s salary: 2,800 × 12 = 3 33,600.00 EUR/ a. (g)Depreciation on the restaurant interior: 18,000/ 6 = 3 3,000.00 EUR/ a. (j) Rent for the entire restaurant: 3,000 × 12 = 336,000.00 EUR/ a. The rent is split based on the restaurant area. The Restaurant/ Order Management covers 75 % of the rent: 75% × 36,000 = 2 27,000.00 EUR/ a. The total of overheads in the Restaurant/ Order Management are equal to: 33,600 + 3,000 + 27,000 = 63,600.00 EUR/ a. Delivery In the Delivery department, the overheads are: (e)Driver’s salary, based on 20,000 tours taking 5 minutes each and an hourly salary of 9.00 EUR/ h: 20,000 × (5/ 60) × 9 = 1 15,000.00 EUR/ a. (h)Depreciation on the delivery-car: 8,000 / 4 = 2 2,000.00 EUR/ a. (i) Operational costs for the deliverycar: 1,000 × 12 = 1 12,000.00 EUR/ a. The total Delivery overheads add up to: 15,000 + 2,000 + 12,000 = 2 29,000.00 EUR/ a. The costs are allocated to cost objects in Figure 13.10: Check the cost centre Accounting and calculation box. Figure 13.10: GP&PR’s Management Accounting system (2) <?page no="206"?> Berkau: Management Accounting 7e 13-206 Next, we calculate cost rates. The cost rate is costs of a cost centre divided by its volume related reference unit. The reference unit in the Kitchen is preparation time, measured in minutes. We assume, it takes 3 min to prepare a pizza, and it takes 2 min to make lasagne or cannelloni. In GIULIO’S PIZZA&PASTA RISTORANTE, the total preparation time is: 3 × 50,000 + 2 × (20,000 + 10,000) = 2 210,000 min (= 3,500 h). The cost rate in the Kitchen is: 64,960 / 3,500 = 1 18.56 EUR/ h = 0.31 EUR/ min. The rates are rounded. We stick to the cost rates measured in EUR/ h for further calculations as the rounding difference is less. The reference unit in the Restaurant/ Order Management is the volume of dishes served. This includes wines served at the tables, too. The total is: 50,000 + 20,000 + 10,000 + 3 × 4,000 = 9 92,000 dishes+wines. The cost rate is: 63,600 / 92,000 = 0 0.69 EUR/ dishes+wines. Costs in the Delivery department do not depend on the output. Therefore, they are considered as fixed costs. The costs are stand-by costs and are not allocated to products. After the cost rate calculations and determination of fixed costs, GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system shows the values for costs and cost rates as in Figure 13.11. Check the cost centre Accounting and calculation box. Figure 13.11: GP&PR’s Management Accounting system (3) <?page no="207"?> Berkau: Management Accounting 7e 13-207 13.18. Calculation - C/ S The next step completes the calculation. 60 Although materials are direct costs, some materials, e.g. cheese, are ingredients for more than one dish. Those material costs must be assigned to products. To debit the direct costs for (2) tomato sauce and for (4) cheese, the Accountant makes the Bookkeeping entries below: DR WIP Pizza.................... 50,000.00 EUR DR WIP Lasagne .................. 25,000.00 EUR CR Purchase (2) ................ 75,000.00 EUR DR WIP Pizza.................... 30,000.00 EUR DR WIP Lasagne .................. 20,000.00 EUR DR WIP Cannelloni............... 10,000.00 EUR CR Purchase (4)................. 60,000.00 EUR These Bookkeeping entries are no allocations, as we follow the BOM for assignments. The technical term is ‘tracing costs to objects”. Cost tracing is the assignment to Work-in-Process accounts without calculation. Cost tracing applies for direct costs only. D C D C (1) 40,000.00 (5) 10,000.00 (2) 50,000.00 (2) 25,000.00 (3) 75,000.00 (6) 16,000.00 (4) 30,000.00 c/ d 195,000.00 (4) 20,000.00 c/ d 71,000.00 195,000.00 195,000.00 71,000.00 71,000.00 b/ d 195,000.00 b/ d 71,000.00 D C D C (7) 5,000.00 (10) 24,000.00 c/ d 24,000.00 (8) 10,000.00 b/ d 24,000.00 (9) 7,200.00 (4) 10,000.00 c/ d 32,200.00 32,200.00 32,200.00 b/ d 32,300.00 WIP cannelloni WIP chianti WIP pizza WIP lasagne Figure 13.12: GP&PR’s manufacturing accounts (1) For overhead allocations we define cost centre accounts. Every MOH-account represents one cost centre. 60 In the accounts numbers (1) … (10) refer to items in the text. In GIULIO’S PIZZA&PASTA RISTORANTE, there are three cost centres. We make debit entries for the overheads (a) … (i). <?page no="208"?> Berkau: Management Accounting 7e 13-208 The last one, (j) rent, requires allocations (based on square metres) and is recorded later. D C D C (a) 3,600.00 (d) 33,600.00 (b) 360.00 (g) 3,000.00 (c) 48,000.00 (f) 4,000.00 D C (e) 15,000.00 (h) 2,000.00 (i) 12,000.00 MOH kitchen MOH restaurant/ order management MOH delivery Figure 13.13: GP&PR’s manufacturing accounts (2) (j) Rent requires a cost-split to allocate overheads to the cost centres Kitchen and Restaurant/ Order Management. The ratio is given by the cost centre floor areas in square metres. The cost allocation for (j) rent leads to the Bookkeeping entry below: DR WIP Kitchen.................. 9,000.00 EUR DR WIP Restaurant/ OM............ 27,000.00 EUR CR Rent......................... 36,000.00 EUR D C D C (a) 3,600.00 (d) 33,600.00 (b) 360.00 (g) 3,000.00 (c) 48,000.00 (j) 27,000.00 c/ d 63,600.00 (f) 4,000.00 63,600.00 63,600.00 (j) 9,000.00 c/ d 64,960.00 b/ d 63,600.00 64,960.00 64,960.00 b/ d 64,960.00 D C D C (e) 15,000.00 (j) 36,000.00 (j) 9,000.00 (h) 2,000.00 (j) 27,000.00 (i) 12,000.00 c/ d 29,000.00 36,000.00 36,000.00 29,000.00 29,000.00 b/ d 29,000.00 MOH delivery Rent MOH kitchen MOH restaurant/ order management Figure 13.14: GP&PR’s manufacturing accounts (3) <?page no="209"?> Berkau: Management Accounting 7e 13-209 The balancing figures in the accounts disclosed in Figure 13.14 equal to the costs shown in the calculation box and cost centre Accounting box in Figure 13.11. Next, we discuss the overhead application to products pizza, lasagne, cannelloni and wine. Pizza The overhead application is based on the cost rates calculated above. The Pizza (all pizza) bears: 3 × 50,000 × 18.56 × (1/ 60) = 4 46,400.00 EUR from the Kitchen. Furthermore, Pizza receives: 50,000 × 0.69 = 3 34,500.00 EUR from the Restaurant/ Order Management. The Bookkeeping entries are: DR WIP Pizza.................... 46,400.00 EUR CR MOH Kitchen .................. 46,400.00 EUR DR WIP Pizza.................... 34,500.00 EUR CR MOH Restaurant/ OM ............ 34,500.00 EUR The unit costs per pizza are: (195,000 + 46,400 + 34,500) / 50,000 = 5 5.51 800 EUR/ pizza. To keep rounding differences low, we calculate in 5 digits after the decimal point. Lasagne The Lasagne (all lasagnes) receives: 2 × 20,000 × 18.56 × (1/ 60) = 1 12,373.33 EUR from the Kitchen. Furthermore, Lasagne receives: 20,000 × 0.69 = 1 13,800.00 EUR from the Restaurant/ Order Management. The Bookkeeping entries are: DR WIP Lasagne .................. 12,373.33 EUR CR MOH Kitchen .................. 12,373.33 EUR DR WIP Lasagne .................. 13,800.00 EUR CR MOH Restaurant/ OM ............ 13,800.00 EUR The unit costs per lasagne are: (71,000 + 12,373.33 + 13,800) / 20,000 = 4 4.85 867 EUR/ lasagne. Cannelloni The Cannelloni receive: 2 × 10,000 × 18.56 × (1/ 60) = 6 6,186.67 EUR from the Kitchen. Furthermore, they bear: 10,000 × 0.69 = 6 6,900.00 EUR from the Restaurant/ Order Management. The Bookkeeping entries are: DR WIP Cannelloni............... 6,186.67 EUR CR MOH Kitchen .................. 6,186.67 EUR <?page no="210"?> Berkau: Management Accounting 7e 13-210 DR WIP Cannelloni............... 6,900.00 EUR CR MOH Restaurant/ OM............ 6,900.00 EUR The unit costs per one cannelloni are: (32,200 + 6,186.67 + 6,900) / 10,000 = 44.52 867 EUR/ cannelloni. Chianti The Chianti bears: 3 × 4,000 × 0.69 = 8,280.00 EUR from the Restaurant/ Order Management. The Bookkeeping entry is: DR WIP Chianti.................. 8,280.00 EUR CR MOH Restaurant/ OM............ 8,280.00 EUR The unit costs per Chianti are: (24,000 + 8,280) / 12,000 = 2 2.69 EUR/ Chianti. Check GIULIO’S PIZZA&PASTA RISTORANTE’s accounts in Figure 13.15: D C D C (1) 40,000.00 (5) 10,000.00 (2) 50,000.00 (2) 25,000.00 (3) 75,000.00 (6) 16,000.00 (4) 30,000.00 c/ d 195,000.00 (4) 20,000.00 c/ d 71,000.00 195,000.00 195,000.00 71,000.00 71,000.00 b/ d 195,000.00 b/ d 71,000.00 Kit 46,400.00 Kit 12,373.33 R/ O 34,500.00 c/ d 275,900.00 R/ O 13,800.00 c/ d 97,173.33 275,900.00 275,900.00 97,173.33 97,173.33 b/ d 275,900.00 b/ d 97,173.33 D C D C (7) 5,000.00 (10) 24,000.00 c/ d 24,000.00 (8) 10,000.00 b/ d 24,000.00 (9) 7,200.00 R/ O 8,280.00 c/ d 32,280.00 (4) 10,000.00 c/ d 32,200.00 32,280.00 32,280.00 32,200.00 32,200.00 b/ d 32,280.00 b/ d 32,200.00 Kit 6,186.67 R/ O 6,900.00 c/ d 45,286.67 45,286.67 45,286.67 b/ d 45,286.67 WIP cannelloni WIP chianti WIP pizza WIP lasagne Figure 13.15: GP&PR’s manufacturing accounts (4) <?page no="211"?> Berkau: Management Accounting 7e 13-211 D C D C (a) 3,600.00 (d) 33,600.00 (b) 360.00 (g) 3,000.00 (c) 48,000.00 (j) 27,000.00 c/ d 63,600.00 (f) 4,000.00 63,600.00 63,600.00 (j) 9,000.00 c/ d 64,960.00 b/ d 63,600.00 Pzz 34,500.00 64,960.00 64,960.00 Lsg 13,800.00 b/ d 64,960.00 Pzz 46,400.00 Cnl 6,900.00 Lsg 12,373.33 Chi 8,280.00 Cnl 6,186.67 c/ d 120.00 64,960.00 64,960.00 63,600.00 63,600.00 b/ d 120.00 D C D C (e) 15,000.00 (j) 36,000.00 (j) 9,000.00 (h) 2,000.00 (j) 27,000.00 (i) 12,000.00 c/ d 29,000.00 36,000.00 36,000.00 29,000.00 29,000.00 b/ d 29,000.00 MOH kitchen MOH restaurant/ order management MOH delivery Rent Figure 13.15: GP&PR’s manufacturing accounts (4) (continued) After the calculation of dishes and wine, the Management Accounting system discloses the values as depicted in Figure 13.16. Check the cost centre Accounting and calculation box. Figure 13.16: GP&PR’s Management Accounting system (4) <?page no="212"?> Berkau: Management Accounting 7e 13-212 13.19. Profitability Analysis - C/ S The last step in cost Accounting is the profit calculation. GIULIO’S PIZZA&PASTA RISTORANTE sells a pizza at 9.00 EUR/ u and lasagne and cannelloni at 8.00 EUR/ u each. A glass of wine costs 5.00 EUR/ u. The revenue for GIULIO’S PIZZA&PASTA RISTORANTE is: 50,000 × 9 + 20,000 × 8 + 10,000 × 8 + 12,000 × 5 = 7 750,000.00 EUR/ a. The profit calculation follows the cost of sales format. 61 A cost of sales format considers the cost of manufacturing allocated to the sold goods/ services. The costs of sales are deducted from revenues to calculate the margin (this is no contribution margin). Further down on the profit and loss statement, non-manufacturing costs are deducted. GIULIO’S PIZZA&PASTA RISTORANTE calculates its profit as the difference between 750,000.00 EUR and its costs. The first costs to be deducted are the cost of sales. These contain materials and allocated overheads and give for pizza, lasagne, cannelloni and wine together: 275,900 + 97,173.33 + 45,286.67 + 32,280 = 4 450,640.00 EUR/ a. The values are copied from the WIPaccounts to avoid rounding differences. The margin is equal to: 750,000 - 450,640 = 2 299,360.00 EUR. 62 Check the calculation and profitability analysis box in GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system in Figure 13.17: 61 Read our textbook Basics of Accounting, chapter (28). 62 In case we calculate based on unit costs, rounding differences will become a serious problem: Rates are multiplied by high quantities of dishes/ wines. For the unit cost calculation, rounding differences in the Kitchen and Restaurant/ Order Management are not considered, and remain in the cost centres. 750,000 - 5.51 800 × 50,000 - 4.85 867 × 20,000 - 4.52 867 × 10,000 - 2.69 000 × 12,000 - 29,000 = 750,000 - 450,640.10 - 29,000 = 270,359.90 EUR. In order to compare the result, deduct the remaining costs of the cost centre: 270,359.90 - 120 = 270,239.90 EUR. However, 0.10 EUR rounding difference stays due to our calculations. <?page no="213"?> Berkau: Management Accounting 7e 13-213 Figure 13.17: GP&PR’s Management Accounting system (5) The rounding difference from the Restaurant/ Order Management cost centre is added to non-manufacturing costs. This means the total of non-manufacturing costs are: 29,000 + 120 = 2 29,120.00 EUR/ a. 63 How it is Done (Cost Accounting) (1) Copy expenses from the Financial Accounting system to the Management Accounting system. (2) Check expenses for cost characteristics. Check further whether costs apply that do not fall under expenses. In the latter case add them to costs as imputed costs. (3) Transfer the direct costs to products’/ job orders’ WIP-accounts (4) Add manufacturing-related overheads to the cost centre accounts. Divide costs in case they apply for more than one cost centre, based on the rule of three following the characteristics of cost centres, like square metres, machine values, head count etc. (5) Run a cost separation for a partial cost Accounting system. For absorption cost Accounting skip step (5) and proceed to step (6). 63 In order check the calculations, we add the costs at different states of calculation: 450,640 + 29,120 = 450,640 + 29,000 + 120 = 64,960 + 63,600 + 29,000 + 195,000 + 71,000 + 32,200 + 24,000 = 322,200 + 157,560 = 479,760.00 EUR. The cost sum does not change. <?page no="214"?> Berkau: Management Accounting 7e 13-214 (6) In case of non-manufacturing overheads, such as Marketing and Distribution costs, add them to common (non-production-linked) cost centre accounts that are closed-off to the profitability analysis later. (7) In case of (mutually) cost centre support run a cost allocation as in chapter (16) of this textbook. (8) Calculate cost rates by dividing (final) costs of cost centres by their output. (9) Apply overheads based on predetermined overhead allocation rates POR and utilisation factors. Add them to the WIP-accounts. (10) Divide the total costs for job orders/ goods/ services by the lot size for the unit costs of manufacturing. (11) Transfer revenues from Financial Accounting to Management Accounting. Close-off the Revenue account to the Profit&Loss account. (12) Deduct the cost of goods sold from revenues. (13) Deduct non-manufacturing costs. (14) In case cost information is required for single products run step (11), (12) for single products or product groups thereof. 13.20. Summary A Management Accounting system receives costs from the Financial Accounting system and divides them in direct costs and overheads. The direct costs are assigned to goods/ services whereas overheads are allocated to cost centres. In the cost centres, cost rates are calculated for calculation. The unit costs per product contain direct costs plus allocated manufacturing overheads. The latter ones are allocated based on the predetermined overhead allocation rate POR. The profitability analysis calculates the net operating profit for the business. A Management Accounting system considers either planned (budgeted) costs or actual costs. 13.21. Working Definitions Cost of Conversion: The costs of conversion contain direct labour and manufacturing overheads. Cost Rate: The cost rate is costs of a cost centre divided by its volume related reference unit. Cost Tracing: Cost tracing is the assignment to Manufacturing Accounts without calculation. Differential/ Incremental Costs: Differential costs are the costs for one additional unit of product produced, service rendered or they reflect a further reference unit consumed by resources deployed. Overheads: Overheads (= overhead costs) are indirect costs which cannot be traced to a certain product or service. <?page no="215"?> Berkau: Management Accounting 7e 13-215 Period Costs: Period costs are linked to the Accounting period they occur in. Prime Costs: Prime costs are direct materials and direct labour. Product costs: Product costs are the costs of manufacturing assigned to finished goods inventory. Sunk Costs: Sunk costs are costs that cannot be changed anymore. Unit Costs: Unit costs are costs based on one unit of the good/ service. 13.22. Question Bank (1) In an absorption cost Accounting system, the arrow from cost centre Accounting to calculation represents… 1. … proportional cost rates. 2. … full cost rates. 3. … applied overheads based on proportional costs. 4. … applied overheads based on full costs. (2) In an absorption cost Accounting system, a cost centre plans 5,000.00 EUR/ m labour costs. Depreciation is 1,000.00 EUR/ m. The cost centres output is planned to be 100 units. The cost centre records an output of 110 units. How much are applied overheads? 1. 6,500.00 EUR . 2. 6,600.00 EUR . 3. 6,000.00 EUR . 4. 5,000.00 EUR . (3) In Managerial Accounting … 1. … proportional overheads are assigned to the profitability analysis and fixed overheads are assigned to products. 2. … direct costs and overheads are allocated to the profitability analysis. 3. … direct costs are assigned to cost centres and overheads are allocated to products 4. … direct costs are assigned to products and overheads are allocated to cost centres. (4) A company records 26,000.00 EUR labour costs in cost centres, 10,000.00 EUR depreciation and 45,000.00 EUR materials. The planned output is 1,000 units and the actual output is 900 units. The revenue per unit is amounting to 150.00 EUR/ u. How much is the profit per unit if an absorption costing applies? 1. 60.00 EUR/ u . 2. 65.00 EUR/ u . 3. 69.00 EUR/ u . 4. 64.00 EUR/ u . (5) In a production firm, the predetermined overhead allocation rate is 5,500 EUR/ 100 h and based on an absorption costing. The actual overheads are amounting to 5,800.00 EUR and the output is 95 h. Which statement is correct? 1. There are over-applied overheads of 575.00 EUR. 2. There are under-applied overheads of 575.00 EUR. 3. There are over-applied overheads of 275.00 EUR. 4. There are under-applied overheads of 275.00 EUR. <?page no="216"?> Berkau: Management Accounting 7e 13-216 13.23. Solutions 1-4; 2-2; 3-4; 4-1; 5-2. <?page no="217"?> Berkau: Management Accounting 7e 14-217 14. Flexible Budgeting / Standard Costing 14.1. What is in the Chapter? From this chapter onwards, we consider cost behaviour which is about the changes of costs caused by changes in volume. To make cost planning most realistic we must understand whether costs change with the volume or stay constant. We determine what drives costs to plan costs and profit under different output scenarios. The output of a company is the quantity of goods or services it renders. The volume of cost centres is output-driven. We introduce the key techniques for cost separation: the high-low method, the scatter graph and the simple regression method. All methods apply for the same case study DANNING (Pty) Ltd. which is a law firm in Australia. Thereafter, we return to the case study of GIULIO’s PIZZA&PASTA RISTORANTE. Now a partial cost accounting which distinguishes proportional and fixed costs applies. We only use proportional overheads for the calculation of cost rates. All fixed costs are closed-off to profit or loss. By comparison between the calculation and the profitability analysis in chapter (14) and the previous chapter (13) you can study the differences between absorption costing and partial cost Accounting. With a 3 rd case study LOGA (Pty) Ltd. in this chapter, we discuss the effect that goods added to stock and releases therefrom in later periods have on the profitability analysis. 14.2. Learning Objectives In this chapter, you learn the basic concepts of how to plan costs under consideration of volume. After studying this chapter, you can distinguish proportional and fixed costs. You also become aware of the reasons why for Management Accounting partial cost Accounting systems are better than costs calculated under an absorption costing system. You learn the key methods for cost separation and how to apply them. You know their strong and weak points. You can describe problems of full cost Accounting systems arising from adding products to stock and released from inventories in in later periods. 14.3. Variable vs. Fixed Costs In Management Accounting, costs are classified following their volume sensitivity. For the entire company, the volume is called the output. The output of a company is the quantity of goods produced or services rendered. The volume is the performance of a cost centre. Variable cost change with the output of the company. If changes are proportional to the cost centre volume, the costs are called proportional (linear) costs. We acknowledge: Proportional costs depend directly on the output. We study an example: A car manufacturer records assembling costs for dash boards. The factor, costs of conversion depend on, is the assembling time <?page no="218"?> Berkau: Management Accounting 7e 14-218 measured in hours. The assembling time for two dash board installations is double of the time for one. The time for three dash boards triples the assembling time, and so on. The assembling time varies proportionally with to the number of dash boards. The dash board directly depends on the output which is the amount of cars. Obviously, both: the costs and the output depend on the volume measured in assembling time. The assembling time is the volume (performance). The time unit (here: assembling-hours) is the reference unit. We divide costs in costs that depend on a reference unit and those that do not. That results in proportional costs and fixed costs. An example for fixed costs is depreciation: No matter how many products are manufactured on a machine, its depreciation is the same. Even if the machine is not deployed at all, depreciation 64 is still recognised for profit or loss. Another cost behavioural pattern is linked to step-fixed costs. Those are costs that increase once threshold values are exceeded. Think about a university, that runs an examination service desk. One administration officer assists 100 students per semester. In case the university enrols 200 students, it must deploy 2 officers. In case of 284 students, 3 admin officers are needed etc. Drawing a cost-over-student line comes out as a pattern that reminds us 64 An exception is if depreciation follows the number of production method. This method applies seldom, but regularly for aircrafts. Read our textbook Basics of Accounting, chapter (17) of a flair of stairs. Management Accountants call this cost behaviour stepfixed costs. In most situations in business, proportional and fixed costs are mixed. Mixed costs contain a portion that is proportionally depending on the output and another portion that is fixed. For budgeting, you must analyse how mixed costs change in response to various outputs. Therefore, we split fixed and proportional costs. This is known as cost separation. 14.4. Cost Accounting Systems A cost Accounting system that only considers variable (proportional) costs is called a partial cost Accounting system. In contrast, absorption costing systems are full cost Accounting systems (variable and fixed costs together). 14.5. Standard Costing Standard costing follows a partial Accounting system. As planned costs only apply for a particular volume costs comparisons would be distorted if the actual costs’ volume differs from the budget. Therefore, standard costs are planned costs adjustable to changes in volume. The name results from the standardisation of the unit costs. Standard costs are a planned cost function dependent on the volume. As also fixed costs apply in mixed costs, the calculation of standard costs <?page no="219"?> Berkau: Management Accounting 7e 14-219 requires knowledge about the entire cost function. Its parameters are fixed costs and proportional costs. The proportional costs represent the slope of the standard cost function. Fixed costs are the costs for a zero-volume. Once we know the standard costs we can calculate cost variances for the actual volume as recorded. See monitoring in chapter (15) for the details. 14.6. Cost Separation One possible approach for cost separation that is the technical term to determine the proportional cost portion and fixed costs within mixed costs is to analyse each cost category separately. We’ll exercise this option for the case study GUILIO’s PIZZA&PASTA RISTORANTE as the number of cost categories is quite low. However, in real companies frequently hundreds of different cost categories apply. Hence, the effort undertaken for such a cost separation would become quite intense. There are more efficient techniques for a cost separation: (a) High-low method. (b) Scatter graph. (c) Regression method. All methods result in a linear cost function in the format: C = PC × V[RU] + FC, with C = total costs, PC = proportional costs, V = volume, RU = reference unit and FC = fixed costs. The term V[RU] indicates that the volume is measured in reference units. The cost function can be shown by a cost-volume-diagram, which discloses the volume on its x-axis and the costs on the y-axis. 14.7. C/ S DANNING (Pty) Ltd. To compare the three mentioned methods, we study DANNING (Pty) Ltd., a tax law firm. DANNING (Pty) Ltd.’s tax attorneys prepare financial statements for their clients. For budgeting, the firm wants to know how costs depend on the output. DANNING (Pty) Ltd. measures its output in tax statements. DANNING (Pty) Ltd. recorded during the last four months the volume of tax statements and their costs. The total costs include the salary of administration staff as well as the tax attorneys’ remunerations. We classify the total costs in cost categories. The administration costs are fixed costs and the costs for the attorneys are proportional costs. DANNING (Pty) Ltd. does not know its proportional costs as the recorded costs are the total costs only. For flexible budgeting (based on the volume of tax statements) DANNING (Pty) Ltd. wants to understand its cost behaviour. It must determine its cost function C(TS) which depends on tax statements (TS). We separate costs based on a 4-months data observation. Observe the recorded total costs from the last four months in Figure 14.1: <?page no="220"?> Berkau: Management Accounting 7e 14-220 Month Costs [AUD] Tax statements January 27,500 30 February 32,500 40 March 37,500 50 April 30,000 35 Figure 14.1: DANNING (Pty) Ltd.’s cost volume records 14.8. High-low Method - DANNING (Pty) Ltd. The high-low method considers the highest and lowest observations with their cost and volume figures and determines a straight line that goes through these two points of the cost function. With the high-low method, DANNING (Pty) Ltd. only considers observations from January and March, where the records show the highest and lowest values (TS quantity). The level of 30 TS is the lowest observation, the number of 50 TS in March marks the highest performance recorded. The observations made in February and in April are ignored. DANNING (Pty) Ltd. knows the costs for the lowest performance: C(V=30TS) = 27,500.00 AUD and the peak costs are: C(V=50TS) = 37,500.00 AUD. You can take the costs straight from the observation records. The slope of the cost line represents the proportional costs PC and is equal to: (37,500 - 27,500) / (50 - 30) = 10,000 / 20 = 5 500.00 AUD/ TS. The fixed costs FC can be calculated based on the information provided for one observation, e.g. January. In January, the cost function applies: C (V=30TS) = 27,500 = 500 × 30 + FC. We solve the equation for the fixed costs: FC = 27,500 - 15,000 = 12,500.00 AUD. Based on the calculation of the proportional and fixed costs, DANNING (Pty) Ltd.’s cost function is: C (V[TS]) = 500 × V[TS] + 12,500. The application of the high-low method is very simple. Its weak point is the dependency on only 2 observations. Choosing exceptional high or low cost occurrences makes the high-low method fail easily. Therefore, we consider the high-lowmethod as not reliable for budgeting. 14.9. Scatter Graph - DANNING (Pty) Ltd. The scatter graph method is based on a graphic diagram for the costvolume observations and requires to manually draw a line on the diagram that meets most observations or is close to them. The scatter graph method requires drawing the monthly observations to scale which at DANNING (Pty) Ltd.’s results in 4 marks in the cost-volume diagram. In the next step, we draw a line through the marks. Check the handdrawn Figure 14.2. for DANNING (Pty) Ltd.’s costs. <?page no="221"?> Berkau: Management Accounting 7e 14-221 Figure 14.2: DANNING (Pty) Ltd.’s cost separation by scatter graph method Obviously, the scatter graph method is no exercisable option for professional Accounting work due to its lack in precision. On the other hand, the scatter graph technique might be appropriate to explain cost separation in academia or for a manager audience. 14.10. Regression Method - DANNING (Pty) Ltd. The regression method is the most common approach for cost separation in Management Accounting. The regression method calculates the function’s parameters based on all observations mathematically. It determines a function by minimising the difference between the square deviations and the function line for all observations to be on the calculated cost function or closest thereto. At DANNING (Pty) Ltd., we intend to determine a cost function by simple regression method. 65 The simple regression method is based on 2 independent equations linked to the cost-volume diagram. 2 equations can determine the 2 variables needed: PC (proportional costs) and FC (fixed costs). The equations consider all observations, numbered by the index i at DANNING (Pty) Ltd.: i = 1 … 4 as we made 4 observations. The cost formula to be determined comes with the common structure as: 65 The method is called ‘simple’ as only one parameter drives costs. If you use a regression method to determine property prices which depend on the square metres of the house, the plot size, the distance to the next bus stop etc, the regression method is no more ‘simple’ as is works with multiple parameters. <?page no="222"?> Berkau: Management Accounting 7e 14-222 C (V[TS]) = PC × V[TS] + FC (with: C = total costs, V = volume, TS = tax statements, PC = proportional costs, FC = fixed costs) The first equation for cost separation is based on i rectangles, which have an area of: TS i × C i , with i = 1 … 4 for 4 monthly observations. 4 1 2 4 1 4 1 i i i i i i i TS PC TS FC TS C The second equation is based on the costs only. There are 4 cost values C i . Its total is calculated as in the formula below: 4 1 4 1 4 i i i i TS PC FC C For a smooth calculation, we prepare some figures in advance to be inserted in the equations. Consider the calculations in Figure 14.3 as workings in preparation for the simple regression method. i C TS C x TS TS 2 1 27 500.00 30 825 000.00 900 2 32 500.00 40 1 300 000.00 1600 3 37 500.00 50 1 875 000.00 2500 4 30 000.00 35 1 050 000.00 1225 sum 127 500.00 155 5 050 000.00 6225 Figure 14.3: Workings for regression analysis We prepare the cost function for DANNING (Pty) Ltd.’s costs depending on the reference units, which is here the number of tax statement: From the 1 st equation, we derive: 5,050,000 = FC × 155 + PC × 6,225. From the 2 nd equation, we derive: 127,500 = FC × 4 + PC × 155. => FC = (127,500 - PC × 155) / 4 We insert the 2 nd equation into the 1 st one and solve the equation for PC: <?page no="223"?> Berkau: Management Accounting 7e 14-223 => 5,050,000 = 155 × (127,500 - PC × 155) / 4 + PC × 6,225 = 4,940,625 - PC × 6,006.25 + PC × 6,225 => PC = (5,050,000 - 4,940,625) / (6,225 - 6,006.25) = 5 500.00 AUD/ TS Next, we insert PC into the 2 nd equation and calculate the fixed costs FC: => FC = (127,500 - 500 × 155) / 4 = 12,500.00 AUD. Following the simple regression method, the cost function for DANNING (Pty) Ltd. also is: C(V[TS]) = 5 500 × V[TS] + 12,500 (same as calculated before). In case DANNING (Pty) Ltd. expects 48 tax statements in May, its planned total costs must be: C (V=48TS) = 500 × 48 + 12,500 = 3 36,500.00 AUD. Download some further consideration with regard to the simple regression method through Link 14.A below. Link 14.A: Common format for simple regression method 14.11. Partial Cost Accounting Systems For flexible budgeting we only consider proportional costs. Decision about fixed costs are related to investments and should rather be made based on methods of investment appraisal (see chapter (7)). Therefore, a partial cost Accounting system must include a cost separation. Only proportional costs are in use for the calculation of cost rates, e.g. PORs, and the product calculation. A partial cost Accounting system supports standard costing for effective cost monitoring. If a budget is prepared for different volumes it is called a flexible budget. To explain partial cost Accounting systems we refer to the same restaurant example as in chapter (13). Now, we split costs and prepare a flexible budget. For the product calculations we only use proportional costs. Fixed costs do not depend on the volume (prep time) and therefore are now transferred to the profitability analysis. In the case study, the output is measured by the number of pizza, lasagnes, cannelloni and Chiantis. 14.12. Allocation Principles To assess the cost allocations, we study cost allocation principles. There are 3 common principles: (1) Cost-by-cause principle. (2) Average principle. (3) Cost bearing capability principle. (1) The preferable rule for allocations is the cost-by-cause principle, meaning a cost object that causes costs must bear them. This results in a fair cost al- <?page no="224"?> Berkau: Management Accounting 7e 14-224 location, as proportional costs only apply when goods are manufactured or services are rendered. With no output no proportional costs exists and the total costs are equal to the fixed costs (zero volume). To follow the cost-bycause principle we must exclude fixed costs from cost allocations. In private life, you follow the cost-bycause principle too and call it fair: Who orders a beer in the pub must pay for it. (2) Following the average principle all costs are divided evenly and thereafter assigned to cost objects. You apply this principle if you have dinner with your friends and decide to share the bill evenly. If you are on diet you lose. Therefore, the average principle is not fair. It comes with another disadvantage. If the costs are fixed and the volume is volatile, the unit costs increase with low volumes. To stick to the dinner example, if all your friends leave before the bill comes, the portion you must pay becomes very high. (3) The cost bearing capability principle only charges the strongest cost object. For instance, you assign all overheads to the product, which sells best or has the highest profit margin. When you go out with your family and your father pays the full bill, the cost allocation principle follows the bearing capability principle for your family dinner. In a Management Accounting system, the cost-by-cause principle is the preferred one. This is not for reasons of justice but about how to plan costs precisely. Under the cost-by-cause principle changes in output/ volume are answered by the cost calculations best as proportional costs adjust to the output/ volume directly. In contrast, allocations of fixed costs to cost objects following the average principle lead to misleading cost information. If we plan fixed costs and allocate them to cost objects the unit costs will increase if volume diminishes. Costs per product swing with the changes of capacity. With idle plants products will be overcharged in contrast to situations when a company uses its full capacity. A company that calculates selling prices based on full costs will go out of business as in low demand situations it reacts totally wrong: it increases prices, because it considers costs to be high. Therefore, the allocation of fixed costs is avoided under flexible budgeting. Below, we discuss the case study GIULIO’s PIZZA&PASTA RISTORANTE. As with a partial cost Accounting system unit costs are constant. Thus, a budget can be prepared for different volume scenarios. We will calculate profit for various outputs of pizza, lasagne, cannelloni and Chianti. 14.13. C/ S GIULIO’s PIZZA&PASTA RISTORANTE At first we separate overheads. There is no need to check direct costs for cost behaviour as they are always proportional. After cost separation, we do cost centre Accounting, calculation and profitability analysis. For our case study, all direct costs are the same as in the previous chapter (13). Below, we only repeat the figures: <?page no="225"?> Berkau: Management Accounting 7e 14-225 (1) Dough: 40,000.00 EUR/ a. (2) Tomato sauce: 50,000 + 25,000 = 7 75,000.00 EUR/ a. (3) Tuner: 75,000.00 EUR/ a. (4) Cheese: 30,000 + 20,000 + 10,000 = 60,000.00 EUR/ a. (5) Lasagne noodles: 10,000.00 EUR/ a. (6) Minced: 16,000.00 EUR/ a. (7) Cannelloni noodles: 5,000.00 EUR/ a. (8) Cream sauce: 10,000.00 EUR/ a. (9) Cooked ham: 7,200.00 EUR/ a. (10) Chianti wine: 6 × 4,000 = 2 24,000.00 EUR/ a. With regard to overheads, we change the case study: (a)Olive oil: 3,600.00 EUR/ a. The consumption of olive oil depends proportionally on the output of dishes. However, there is no intention by GIULIO’s PIZZA&PASTA RISTORANTE’s Accountant to plan costs based on millilitres of olive oil consumption. We classify those material costs as unreal overheads. This means they are treated as fixed costs. Unreal overheads can be allocated to products by the cost-by-cause principle. However, they are not, because the effort for correct calculations is not justified by its outcome, which is the accurate cost information. Therefore, we transfer these costs to profit or loss as overheads. (b Dishwasher liquid: 360.00 EUR/ a. The dishwasher liquid consumption is regarded as unreal overheads, too. (c) Chef’s salary was in chapter (13) completely based on fixed costs: 4,000 × 12 = 448,000.00 EUR/ a. The chef’s salary now is replaced by mixed costs. The salary contains a fixed portion of 2,250.00 EUR/ m. This is the base salary. In addition, the chef earns 6.00 EUR/ h of preparation time, no matter for which dish. The reference unit for the Kitchen cost centre is preparation hours, in short: prep-h. Note, the output of the restaurant are pizza, lasagnes, cannelloni and Chiantis. In the Kitchen department, the volume is measured in prep-h. For the planned volume, the chef’s salary is the same as before in chapter (13): 27,000 + ((3 × 50,000) + 2 × (20,000 + 10,000)) × 6 × (1/ 60) = 48,000.00 EUR/ a. In case the dish amounts change, his salary will follow the changes. Therefore, we adjust the chefs pay to the volume directly. (d)Order manager’s/ waiter’s salary: 2,800 × 12 = 3 33,600.00 EUR/ a. The order manager/ waiter is considered as stand-by costs and does not depend on the number of dishes+wines ordered and served. Stand-by costs are costs, which occur if a company provides resources, without consideration of their use. (e, h, i) Driver’s salary: 20,000 × (5/ 60) x 9 = 1 15,000.00 EUR/ a, depreciation on the delivery-car: 8,000 / 4 = 2 2,000.00 EUR/ a and operating costs for the delivery-car: 1,000 × 12 = 1 12,000.00 EUR/ a, are replaced now by an outsourced delivery service and thus become completely proportional costs. The costs per delivery tour are 5.00 EUR/ tour. GIULIO’s PIZZA&PASTA RISTORANTE estimates the number of tours to be 5,800 in the next Accounting period. This means, that 36.25 % of the planned dishes are delivered and one tour transports 5 dishes on average. Per business policy, the restaurant refrains from wine deliveries. <?page no="226"?> Berkau: Management Accounting 7e 14-226 (f) Depreciation on the stove: 24,000/ 6 = 4 4,000.00 EUR/ a. (g)Depreciation on the Restaurant/ Order Management interior: 18,000/ 6 = 3,000.00 EUR/ a. (j) Rent for the restaurant: 3,000 × 12 = 36,000.00 EUR/ a. The cost planning is based on mixed costs. For every cost centre i, we determine its cost function in the format: C i (X) = PC i × X + FC i . In the case study, the cost centres come with different cost behaviours. In the Kitchen there are mixed costs. Restaurant/ Order Management only got fixed costs. Delivery is outsourced and has only proportional costs. We start with the cost function for the Kitchen: C kitchen (X) = PC kitchen × X + FC kitchen . Kitchen In the Kitchen, mixed costs apply. The cost function of the Kitchen depends on the preparation time. The volume is measured in prep-h. The slope of the cost line is: PC K = 6.00 EUR/ prep-h, because of the chef’s salary. No other proportional costs apply in the Kitchen. The fixed costs contain the unreal overheads for olive oil at 3,600.00 EUR/ a and dish washer liquid at 360.00 EUR/ a, the chef’s base salary of: 12 × 2,250 = 27,000.00 EUR/ a, and depreciation on the stove: 24,000 / 6 = 4 4,000.00 EUR/ a. In addition, 25 % of the rent, which is equal to: 0.25 × 36,000 = 9 9,000.00 EUR/ a is allocated to the Kitchen. The total of fixed costs in the Kitchen is: FC K = 3,600 + 360 + 27,000 + 4,000 + 9,000 = 43,960.00 EUR/ a. The cost-volume function in the Kitchen follows the equation: C Kitchen (X) = 6.00 EUR/ prep-h × X + 43,960.00 EUR/ a. The budgeted costs in the Kitchen are based on the workload of: (3 × 50,000 + 2 × (20,000 + 10,000)) / 60 = 33,500 prep-h and are equal to: C Kitchen (3,500) = 6 × 3,500 + 43,960 = 64,960.00 EUR/ a. Restaurant/ Order Management In the cost centre Restaurant/ Order Management, all costs are fixed. (d) Order manager’s/ waiter’s salary is: 2,800 × 12 = 3 33,600.00 EUR/ a. (g) Depreciation on the Restaurant/ Order Management interior is: 18,000/ 6 = 3 3,000.00 EUR/ a. (j) Rent for the Restaurant’s/ Order Management’s area of 60 m 2 is: 75% × 36,000 = 2 27,000.00 EUR/ a. The total of overheads in the Restaurant/ Order Management are equal to: FC Rest/ OM = 33,600 + 3,000 + 27,000 = 63,600.00 EUR/ a. The cost function is: C Rest/ OM = 63,600.00 EUR/ a. Delivery Due to the outsourcing, Delivery costs are now completely variable. The costs do not depend on the number of pizza, lasagnes and cannelloni but on X which is the number of deliveries. However, the deliveries are a percentage of the number of dishes. The cost function is: C Delivery (X) = 5.00 EUR/ tour × X. The budgeted costs for 5,800 tours are: C Delivery (5,800) = 5 × 5,800 = 2 29,000.00 EUR. The number of tours depends on the volume X as we consider a constant percentage of dishes to be delivered. 80,000 dishes × <?page no="227"?> Berkau: Management Accounting 7e 14-227 36.25% / 5 = 5 5,800 tours. As in chapter (13), we further pretend that deliveries are offered without further charges (free delivery). The cost Accounting system design for GIULIO’s PIZZA&PASTA RISTORANTE looks as in Figure 14.4. Figure 14.4: GP&PR’s Management Accounting system (calculation) We study the profitability analysis. In contrast to the unit cost calculation in Figure 13.16 and Figure 13.17, the unit costs now are only based on proportional costs. Expect lower unit costs. All fixed costs of the cost centres have been transferred to the fixed cost section (down) of the profitability analysis. We run a calculation - based on flexible budgeting - as below: Pizza The costs for the pizza include the direct materials and proportional costs for the chef’s salary and the delivery service. The calculation is based on the planned output of 50,000 pizza. The hours spent on pizza preparation are: 3 × 50,000 / 60 = 2 2,500 prep-h. The proportional costs for the chef based on a volume of 2,500 prep-h are equal to: 6 × 2,500 = 1 15,000.00 EUR. We must consider the portion of pizza that is delivered by the outsourced service, as well. The delivery service’s costs depend on the pizza, lasagne and cannelloni volume. Therefore, we consider the delivery costs as proportional product costs. The number of delivered pizza equals: 36.25% × 50,000 = 1 18,125 (delivered) pizza. The tour quantity is: 18,125 / 5 = 3,625 tours. The delivery costs for 50,000 pizza are equal to: 5 × 3,625 = 18,125.00 EUR. The total unit costs per pizza are calculated as proportional costs for all pizza divided by 50,000. The unit costs are: (195,000 + 15,000 + 18,125) / 50,000 = 4 4.56 EUR/ pizza. The <?page no="228"?> Berkau: Management Accounting 7e 14-228 value is rounded-off from 4.56 25 EUR/ pizza. Note, cost allocations in the Delivery department are based on the average principle because per tour 5 dishes are delivered. Lasagne The proportional costs per lasagne are direct materials, the chef’s proportional salary and delivery costs. The chef’s costs are based on the prep-h. The preph for lasagne amounts to: 2 × 20,000 / 60 = 6 666.67 prep-h. The chef’s proportional costs for the preparation of 20,000 lasagne is equal to: 6 × 666.67 = 4,000.00 EUR. The costs for delivery tours is: 5 × (20,000 × 36.25%) / 5 = 7,250.00 EUR. 66 The unit costs per lasagne are: (71,000 + 4,000 + 7,250) / 20,000 = 4 4.11 EUR/ lasagne - rounded-off from 4.11 25 EUR/ lasagne. Cannelloni The proportional cannelloni costs include direct materials, the chef’s proportional costs and delivery costs. The chef’s costs depend on the volume. The quantity of prep-h is: (2 × 10,000) / 60 = 333.33 EUR/ prep-h. The chef’s proportional costs amount to: 6 × 333.33 = 2,000.00 EUR. The costs for deliveries are half of the delivery costs for lasagne: 7,250 / 2 = 3 3,625.00 EUR. Hence, the proportional costs add up to: 32,200 + 2,000 + 3,625 = 3 37,825.00 EUR. The unit costs per cannelloni are: 37,825 / 10,000 66 We multiply by 5 as one tour costs 5.00 EUR and we divide by 5 as one tour transports 5 dishes. 67 For avoiding rounding differences, the calculation is based on original values. The 3 rd and 4 th digit after the decimal point are displayed in lower figures. If you want to compare the figures to Figure 13.8, where an amount of 322,200.00 EUR for direct = 33.78 EUR/ cannelloni. The value is rounded-off from 3.78 25 EUR/ cannelloni. Chianti The Chianti wine does not require preparation (chef) nor do wines get delivered. The unit costs result from direct materials. They are equal to: 24,000 / 12,000 = 2 2.00 EUR/ Chianti. The profitability analysis is based on the planned volume of 50,000 pizza, 20,000 lasagne, 10,000 cannelloni and 12,000 glasses of Chianti wine per year. The costs of sales are proportional costs only. A difference between revenue and proportional costs is called the contribution margin. The budgeted contribution margin can be displayed as per unit, too. Read for contribution margin Accounting chapter (20). GIULIO’s PIZZA&PASTA RISTORANTE’s total contribution margin equals: 50,000 × 9 + 20,000 × 8 + 10,000 × 8 + 12,000 × 5 - 4.56 25 × 50,000 - 4.11 25 × 20,000 - 3.78 25 × 10,000 - 2 × 12,000 = 750,000 - 372,200 = 3 377,800.00 EUR/ a. 67 All fixed costs must be covered by the contribution margin for the restaurant to earn a profit. The fixed costs include fixed Kitchen overheads and overheads in the Restaurant/ Order Management cost centre. No fixed costs apply in the Delivery cost centre (outsourcing). The costs is calculated, you have to add proportional overheads of 21,000.00 EUR (chef) and 29,000.00 EUR (Delivery) to get the total amount for proportional costs of: 322,200 + 21,000 + 29,000 = 372,200.00 EUR. <?page no="229"?> Berkau: Management Accounting 7e 14-229 fixed costs add up to: 43,960 + 63,600 = 1107,560.00 EUR/ a. GIULIO’s PIZZA&PASTA RISTORANTE’s profit is: 377,800 - 107,560 = 270,240.00 EUR/ a. Observe GIULIO’s PIZZA&PASTA RISTORANTE’s Management Accounting system as displayed in Figure 14.5 and compare the profit to Figure 13.17 in the previous chapter. Figure 14.5: GP&PR’s Management Accounting system (PA) The advantage of flexible budgeting is a precise cost planning which works on different volume levels. The profit can be calculated as below: m j n i i j j j FC X CM X P 1 1 ) ( ) ( (with: j = index for the product, j = 1 … m, i = index for the cost centre, i = 1 … m, P = profit, CM = contribution margin, X j = number of products, FC i = fixed costs) At GIULIO’s PIZZA&PASTA RISTORANTE, the contribution margins per product are: CM pizza = 9 - 4.56 25 = 44.43 75 EUR/ u. CM lasagne = 8 - 4.11 25 = 33.88 75 EUR/ u. CM cannelloni = 8 - 3.78 25 = 44.21 75 EUR/ u. CM Chianti = 5 - 2 = 33.00 EUR/ u. <?page no="230"?> Berkau: Management Accounting 7e 14-230 We call X 1 the number of pizza, X 2 the number of lasagnes, X 3 = the number of cannelloni and X 4 the number of Chiantis. The profit function of GIULIO’s PIZZA&PASTA RISTORANTE is given as: P(X 1 , X 2 , X 3 , X 4 ) = 4.43 75 × X 1 + 3.88 75 × X 2 + 4.21 75 × X 3 + 3 × X 4 - 43,960 - 63,600. We check the profit equation for the budgeted volumes for each dish+drink X j : X 1 = 50,000 pizza, X 2 = 20,000 lasagne, X 3 = 10,000 cannelloni and X 4 = 12,000 Chianti: P (50,000; 20,000; 10,000; 12,000) = 4.43 75 × 50,000 + 3.88 75 × 20,000 + 4.21 75 × 10,000 + 3 × 12,000 - 43,960 - 63,600 = 2 270,240.00 EUR. This corresponds with the value shown in Figure 14.5. With a flexible budgeting, GIULIO’s PIZZA&PASTA RISTORANTE now can plan profits for various output scenarios. Observe a few thereof in Figure 14.6: X 1 X 2 X 3 X 4 CM pizza CM lasagne CM canneloni CM Chiant FC kitchen FC rest/ OM NOP 1 1 1 1 4.44 3.89 4.22 3.00 (43,960.00) (63,600.00) (107,544.46) 50,000 20,000 10,000 12,000 221,875.00 77,750.00 42,175.00 36,000.00 (43,960.00) (63,600.00) 270,240.00 55,000 15,000 15,000 10,000 244,062.50 58,312.50 63,262.50 30,000.00 (43,960.00) (63,600.00) 288,077.50 60,000 10,000 10,000 14,000 266,250.00 38,875.00 42,175.00 42,000.00 (43,960.00) (63,600.00) 281,740.00 0 40,000 40,000 12,000 0.00 155,500.00 168,700.00 36,000.00 (43,960.00) (63,600.00) 252,640.00 45,000 25,000 15,000 10,000 199,687.50 97,187.50 63,262.50 30,000.00 (43,960.00) (63,600.00) 282,577.50 30,000 30,000 30,000 0 133,125.00 116,625.00 126,525.00 0.00 (43,960.00) (63,600.00) 268,715.00 Figure 14.6: GP&PR’s profit planning 14.14. Storing Goods that Include Fixed Costs The difference between full and partial cost Accounting affects the profit calculation even more when a company adds finished goods to stock or releases finished goods from inventory for sale. By adding goods to stock, their product costs are transferred from the production period to the period of sales. Under a partial cost Accounting, only proportional costs are considered as product costs. Cost only are recognised on the income statement (as costs) when finished goods are sold. Therefore, it makes a difference, whether product costs include fixed costs. Under a full cost Accounting system fixed costs are deferred by adding them to stock and distort the profit calculation. We should consider fixed costs in the periods they occur. We study the effect by the case study LOGA (Pty) Ltd. below. <?page no="231"?> Berkau: Management Accounting 7e 14-231 14.15. C/ S LOGA (Pty) Ltd. LOGA (Pty) Ltd. is a record label. Data Sheet for LOGA (Pty) Ltd. CClassification: Manufacturing; Production quantities: 1,000,000 CDs / 1,000,000 CDs / 1,000,000 CDs; Sales numbers: 800,000 CDs / 1,100,000 CDs / 1,100,000 CDs; Materials: 0.10 EUR/ CD; Direct labour: 0.30 EUR/ CD; Depreciation: 40,000.00 EUR; supervisor’s salary: 50,000.00 EUR; Distribution costs: 1.00 EUR/ CD; Marketing costs: 150,000.00 EUR; Net selling price: 2.50 EUR/ CD; VAT ignored. As we will demonstrate with the case LOGA (Pty) Ltd., a production firm applying a full cost Accounting system, makes mistakes regarding the profit calculation, just by adding finished goods to stock. Under absorption costing, finished goods put on stock include fixed costs. The fixed costs included in finished goods’ valuations then count for profit when goods are released from stock. As a consequence, profit disclosed in production periods is too high. In sales periods, it becomes too low. A better cost planning is achieved if no fixed costs are considered for product costs under a partial cost Accounting system. A company that applies a partial cost Accounting system, does not distort profits when it adds finished goods to stock or releases finished goods from stock. LOGA (Pty) Ltd. records music CDs from local artists, burns them, and distributes them online to wholesalers. In the fiscal year 20X7, LOGA (Pty) Ltd. produces 1,000,000 CDs and sells 800,000 thereof. In 20X8 the business produces 1,000,000 CDs and sells 1,100,000 units. The same production and sales figures as for 20X8 apply in 20X9. The direct costs are materials and labour. Material costs per CD are 0.10 EUR/ CD. The value for direct labour is 0.30 EUR/ CD. The overheads are partly manufacturing overheads. Depreciation on production facilities is 40,000.00 EUR/ a. Furthermore, the supervisor’s salary amounts to 50,000.00 EUR/ a. The distribution costs (non-manufacturing costs) are 1.00 EUR/ CD. The distribution costs are linked to the products and count as direct costs. We do not add them to the costs of manufacturing, as distribution is production-related. Fixed Marketing overheads are 150,000.00 EUR/ a. The revenue per CD is 2.50 EUR/ CD. We prepare a profitability analysis for the periods 20X7, 20X8 and 20X9. Firstly, we apply (1) a full cost Accounting system (absorption costing), and thereafter a (2) partial cost Accounting system. Ad (1): Absorption Costing For the profitability analysis, LOGA (Pty) Ltd. applies a profit and loss calculation following the cost of sales format. The company applies the first-in-first-out formula for all its inventory movements. As the unit costs are constant, the sequence of movements (additions to stock/ stock releases) does not matter. The calculation of cost of sales requires an inventory valuation at the end of the Accounting period. For CDs added to stock, their unit costs are recognised as finished goods. When CDs are released from stock, they are expensed, which <?page no="232"?> Berkau: Management Accounting 7e 14-232 means the CDs becomes costs of sale (period costs). In 20X7, LOGA (Pty) Ltd. produced 1,000,000 CDs, 800,000 CDs are sold, and the remaining 200,000 CDs are transferred to stock. For inventory valuation, a calculation of CDs is necessary: Direct materials and direct labour are: 0.10 + 0.30 = 0 0.40 EUR/ CD. The manufacturing overheads are completely fixed costs. The fixed overheads per CD include depreciation and the supervisor’s salary. They are equal to: (40,000 + 50,000) / 1,000,000 = 0 0.09 EUR/ CD 20X7 . The unit costs for 20X7 are: 0.40 + 0.09 = 0 0.49 EUR/ CD 20X7 . This gives a closing stock of: 200,000 × 0.49 = 9 98,000.00 EUR. In 20X7, the value of the produced CDs is equal to: 0.49 × 1,000,000 = 490,000.00 EUR. For the cost of sales calculation, LOGA (Pty) Ltd. adds the opening value (stock releases) to the manufacturing costs and deducts the value for the CDs added to stock. Observe Figure 14.7. In 20X7, the costs of sales are equal to: 490,000 - 98,000 = 392,000.00 EUR. The revenue is: 800,000 × 2.50 = 2 2,000,000.00 EUR. The non-manufacturing costs are distribution costs plus fixed Marketing costs, which add up to: 1 × 800,000 + 150,000 = 9 950,000.00 EUR. The profit is: 2,000,000 - 392,000 - 950,000 = 658,000.00 EUR. Observe the profitability analysis in Figure 14.7. 20X7 20X8 20X9 Sales 2,000,000 2,750,000 2,750,000 less: COS + OV 0 (98,000) (49,000) + Manufactured (490,000) (490,000) (490,000) - Closing stock 98,000 49,000 Gross margin 1,608,000 2,211,000 2,211,000 less: distribution expenses (prop) (800,000) (1,100,000) (1,100,000) less: marketing (fixed) (150,000) (150,000) (150,000) Net operating profit 658,000 961,000 961,000 Figure 14.7: LOGA (Pty) Ltd.’s profitability analysis (absorption costing) In 20X8, the unit costs are: 0.10 + 0.30 + (40,000 + 50,000) / 1,000,000 = 0 0.49 EUR/ CD 20X8 . The revenue is: 1,100,000 × 2.50 = 2 2,750,000.00 EUR. The costs of sales result from 200,000 CDs 20X7 , which are released from stock, 1,000,000 CDs 20X8 , which are produced in 20X8, and from which 10 % are added to stock. In the Accounting period 20X9, the 100,000 CDs 20X8 are released from stock and are sold together with 1,000,000 CDs 20X9 . Ad (2): Partial Costing Under a partial cost Accounting system, only proportional costs are considered for inventory valuation. No fixed costs are allocated. The proportional unit costs are the sum of direct materials and direct labour. The unit costs are: 0.10 + 0.30 = 0 0.40 EUR/ CD. As the fixed costs for manufacturing are not allocated to <?page no="233"?> Berkau: Management Accounting 7e 14-233 products, we deduct them from the contribution margin. 20X7 20X8 20X9 Sales 2,000,000 2,750,000 2,750,000 less: COS + OV 0 (80,000) (40,000) + Manufactured (400,000) (400,000) (400,000) - Closing stock 80,000 40,000 Contribution margin 1,680,000 2,310,000 2,310,000 less: depreciation on factory (40,000) (40,000) (40,000) less: supervisor's salary (50,000) (50,000) (50,000) less: distribution expenses (prop) (800,000) (1,100,000) (1,100,000) less: marketing (fixed) (150,000) (150,000) (150,000) Net operating profit 640,000 970,000 970,000 Figure 14.8: LOGA (Pty) Ltd.’s profitability analysis (partial costing) Under a partial cost Accounting system, we calculate different profits than in Figure 14.7. However, after we calculate the total profit for all three Accounting periods, we arrive at the same totals, which are: 658,000 + 961,000 + 961,000 = 640,000 + 970,000 + 970,000 = 2 2,580,000.00 EUR. The reason is, that the CDs put on stock have been completely released after three periods. The key question is ‘Which profits are correct? ’ The correct figures are the ones, calculated under the partial cost Accounting system. The fixed costs for the supervisor and for depreciation must count for the Accounting period they occur in. The profit in the Accounting period 20X7 in Figure 14.7 is too high to the extent of: 658,000 - 640,000 = 18,000.00 EUR. This difference reflects the value of fixed costs included in 200,000 CDs 20X7 . The fixed costs therein are: 200,000 × (40,000 + 50,000) / 1,000,000 = 1 18,000.00 EUR. In Accounting language, we say the fixed costs are deferred. The profit in the statement of 20X7 is higher by 18,000.00 EUR, because the fixed costs included in the CD stock do not reduce profit. In the next year, the profit is 961,000.00 EUR for the full cost calculation and 970,000.00 EUR under partial costing. The partial cost Accounting information is correct. Now the full cost Accounting system indicates a lower profit, as by releasing 100,000 CDs from stock: 100,000 × (40,000 + 50,000) / 1,000,000 = 9 9,000.00 EUR fixed costs are expensed, and reduce the actual profit of: 970,000.00 EUR to 961,000.00 EUR. The same effect applies in 20X9. Absorption costing distorts profit, as fixed costs allocated to finished goods are excluded from the profit calculation, if goods are added to stock. The fixed costs are considered later once the <?page no="234"?> Berkau: Management Accounting 7e 14-234 goods are released from stock. Therefore, the differences in profit are temporary. 14.16. Summary A flexible budgeting is based on production volumes. For unit cost calculations and for profitability analysis it is strongly recommended to only consider proportional costs. Then, the cost allocation is based on the cost-bycause principle and provides managers with fair and unbiased information. For supporting budgeting and decision making, costs can be planned correctly under a partial costing systems. A partial cost Accounting system provides correct profit calculation, as no fixed costs are deferred. Adding goods to stock does not distort the profit calculation, as only proportional costs are considered. 14.17. Working Definitions Contribution Margin: The difference between revenue and proportional costs is called the contribution margin. Cost Separation: Cost separation is the determination the proportional cost portions and fixed costs within mixed costs. Fixed Costs: Fixed costs do not change with the output. Flexible Budgeting: A cost planning based on partial costs, is referred to as flexible budgeting. High-Low Method: The high-low method considers the highest and lowest observations with their cost and volume figures and determines a straight line that goes through these two points of the cost function. Mixed Costs: Mixed costs contain a portion that is proportionally depending on the output and another portion that is fixed. Output: The output of a company is the quantity of goods produced or services rendered. Partial Costing: A Management Accounting system, based on separated proportional and fixed costs elements is called a partial costing system. Proportional Costs: Proportional costs depend directly on the output. Stand-by Costs: Stand-by costs are costs, which occur, when a company provides resources, without consideration of their use. Regression Method: The regression method calculates the function’s parameters based on all observations mathematically. It determines a function by minimising the difference between the square deviations and the function line for all observations to be on the calculated cost function or closest thereto. Scatter Graph: The scatter graph method is based on a graphic diagram for the cost-volume observations and requires to manually draw a line on the diagram that meets most observations or is close to them. Unreal Overheads: Artificial overheads can be allocated to products by the cost-by-cause principle. However, they are not, because the effort to calculate correctly is not justified by its outcome. 14.18. Question Bank (1) Under flexible budgeting, the cost rates for the application of overheads … 1. … contain direct costs only. <?page no="235"?> Berkau: Management Accounting 7e 14-235 2. … contain mixed costs only. 3. … contain proportional overheads only. 4. … contain fixed overheads only. (2) Under a partial cost Accounting system the contribution margin for product A is 65.00 EUR/ u and for product B 80.00 EUR/ u. The planned volume is 200 units/ a of product A and 400 units/ a of product B. Depreciation is amounting to 10,000.00 EUR/ a. How much is the profit if the product amounts are 400 units/ a of product A and 200 units/ a of product B? 1. 45,000.00 EUR/ a . 2. 42,000.00 EUR/ a . 3. 35,000.00 EUR/ a . 4. 32,000.00 EUR/ a . (3) Under a partial cost Accounting system the contribution margin is defined as: 1. Gross selling price less proportional costs. 2. Revenue less total product costs. 3. Revenue less variable costs. 4. Net selling price less total costs. (4) Under a partial cost Accounting system, the predetermined overhead allocation rate is calculated as 46,000 EUR/ 1,000 units. Depreciation is recognised at 20,000.00 EUR. In the actual Accounting period, the total overheads are amounting to 60,000.00 EUR and the output is 1,050 units. Which statement is correct? 1. There are 8,300 EUR under-applied overheads. 2. There are 8,300 EUR over-applied overheads. 3. There are 11,700 EUR under-applied overheads. 4. There are 11,700 EUR over-applied overheads. (5) Under a flexible budgeting, the cost rates for the application of overheads contain: 1. Proportional overheads. 2. Direct costs and proportional overheads. 3. Direct costs and fixed overheads. 4. Proportional and fixed overheads. 14.19. Solutions 1-3; 2-4; 3-3; 4-2; 5-1. <?page no="236"?> Berkau: Management Accounting 7e 15-236 15. Cost Monitoring 15.1. What is in the Chapter? With the lessons learned in chapter (14), we follow a partial cost Accounting system for monitoring. The case study CROXTON Ltd. is a laptop display manufacturer; we study its cost deviations at planned volume level in April 20X6, at a low level in May 20X6 and at a high level in June 20X6. Cost deviations, like consumption and volume variances, are calculated for the case and we discuss their meanings. We also introduce proficiency reports which show cost deviations for cost centres. 15.2. Learning Objectives After studying this chapter, you understand how monitoring checks the efficiency of cost centres, processes and/ or products. You got familiarised with the approach of standard costing. You made experiences with variance analysis. You understand the need for regular monitoring in all cost centres and can read and prepare a proficiency report. You further get to know who is held responsible for which type of cost variance. 15.3. Cost Deviations For the following considerations, we apply a partial cost Accounting system. It does not mean that we ignore fixed costs but we do not include them in cost rates and for product calculations. For monitoring we must apply standard costing. This enables us to plan costs flexible and compare costs to budget. For standard costing, we plan costs at minimum levels because goods and services are sold on competitive markets where other manufacturers or service providers offer the same or similar products. At the first glance, cost comparisons in a cost centre are straight forward. The actual costs should match the budget. A difference in costs is a deviation and needs to be analysed as it lowers the business profitability below its planned level. Positive deviations mean no success but indicate a faulty budgeting (costs are planned too generous). After the detection of deviations monitoring supports variance analysis. It determine whether cost deviations are significant and if so, it investigates what causes them and whether and how corrective actions can be taken. Cost comparisons are more challenging if actual costs are recorded at different volumes than budgeted. We should not compare actual costs for 100 units to a budget for 90 units. For meaningful cost deviation analysis we must compare actual to standard costs. The method is demonstrated by the case CROXTON Ltd. which is a production firm. 15.4. C/ S CROXTON Ltd. Find CROXTON Ltd.’s data sheet below: <?page no="237"?> Berkau: Management Accounting 7e 15-237 Data Sheet for CROXTON Ltd. CClassification: Manufacturing; Periods: April 20X6 / May 20X6 / June 20X6; Fixed costs: 100,000.00 EUR; Proportional costs: 5.00 EUR/ min; Planned output: 3,000 u; Planned costs: 160,000.00 EUR; Output: 3,000 u / 2,500 u / 4,000 u; Actual assembling time: 12,000 min / 10,000 min / 16,000 min; Actual labour: 42,000.00 EUR / 38,000.00 EUR / 50,000.00 EUR; Actual energy costs: 20,350.00 EUR / 13,000.00 EUR / 20,000.00 EUR; VAT ignored. CROXTON Ltd. produces laptop displays. The business applies a partial cost Accounting system. Although all actual cost are accounted for in categories, CROXTON Ltd.’s budget only is based on total costs (easy to plan). CROXTON Ltd. separates its costs on an analysis of past data. It knows that fixed costs are 100,000.00 EUR. The proportional costs in the cost centre Assembling depend on the volume X which is measured in assembling-min. The slope of the cost function is 5.00 EUR/ asbl-min. CROXTON Ltd. plans to assemble 3,000 displays during the Accounting periods April, May and June 20X6. Every display consumes an assembling time of 4 asblmin. Hence, 3,000 displays require: 4 × 3,000 = 1 12,000 asbl-min. The cost function is: C asbl (X) = 5.00 × X asbl + 100,000. The budgeted costs for 12,000 assembling-min are: C asbl (X=12,000asbl-min) = 5.00 × 12,000 + 100,000 = 1 160,000.00 EUR. In contrast to the budget, all actual costs are recorded for the 3 cost categories: labour, energy costs and depreciation. Labour and energy costs depend proportionally on the assembling time. Depreciation is fixed and equal to 100,000.00 EUR. 15.5. Actual Volume Equals Budgeted Volume: April 20X6 In April 20X6, the assembling time at CROXTON is 12,000 asbl-min. This is the volume of the cost centre. The actual (a) labour costs L a/ 4-20X6 are equal to 42,000.00 EUR and energy costs E a/ 4-20X6 are 20,350.00 EUR. Actual total costs for assembling in April are: C asbl/ a/ 4-20X6 = 42,000 + 20,350 + 100,000 = 1 162,350.00 EUR. A cost comparison gives a total cost variance for April 20X6 of: 162,350 - 160,000 = 2 2,350.00 EUR. As the variance is caused by a deviation of resource consumption, we call it ∆c. Figure 15.1 illustrates the cost situation by a costvolume diagram. After detection of the cost variance, it is the responsibility of the cost centre manager/ Accountant to identify reasons, e.g. rework caused by poor workmanship, idle time due to workers waiting for instructions, machine break downs, deployment of alternative machinery due to maintenance of the planned ones, giving the job to workers who charge more when the scheduled worker is on training etc. A variance analysis requires detailed knowledge about the operations. Therefore, the cost centre manager analyses deviations her-/ himself. <?page no="238"?> Berkau: Management Accounting 7e 15-238 Figure 15.1: CROXTON Ltd.’s cost variance in April 20X6 15.6. Actual Volume is below Budgeted Volume: May 20X6 Next, we study variances of costs as well as of volume. In May 20X6, CROXTON Ltd. assembles less displays than scheduled. The output only is 2,500 displays. The recorded labour costs are: L a/ 5-20X6 = 38,000 EUR and the energy costs are: E a/ 5-20X6 = 13,000.00 EUR. Depreciation remains D a/ 5-20X6 = 100,000.00 EUR. The actual total costs are equal to: C asbl/ a/ 5- 20X6 = 38,000 + 13,000 + 100,000 = 1 151,000.00 EUR. In contrast to the previous month, the actual volume in assembling hours differs from the budget. The mark for the actual costs has been moved to the left (in direction of lower volume) on the cost-volume-diagram in Figure 15.2. The actual volume X a/ 5-20X6 only is: 2,500 × 4 = 110,000 asbl-min. Figure 15.2: CROXTON Ltd.’s variance in May 20X6 <?page no="239"?> Berkau: Management Accounting 7e 15-239 The simple comparison of actual costs to budgeted costs, such as: 151,000 - 160,000 = - -9,000.00 EUR, does not make sense due to the difference in volume. In these cases, Management Accountants determine a consumption variance and a volume variance, both based on actual performance which here is 10,000 asbl-min. Check Figure 15.2. For the consumption variance, the standard costs at actual volume must be calculated. We adjust the budget to the actual volume. The standard costs at 10,000 asbl-min are: C asbl (X=10,000asblmin) = 5.00 × 10,000 + 100,000 = 150,000.00 EUR. In Figure 15.2, the consumption variance ∆c is: 150,000 - 151,000 = - -1,000.00 EUR. It is common Accounting practice, to express the variance as a percentage based on standard costs: -1,000 / 150,000 = - - 00.67%. The consumption variance is the difference between actual costs and standard costs (at actual volume). A negative consumption variance means that the cost centre performed at costs over budget. The cost centre manager is held responsible for consumption variances. A second variance is the volume variance Δv. The volume variance is a cost deviation resulting from changes in volume. The volume variance is the difference between applied overheads and standard costs (at actual volume). Overhead application is to connect cost centre overheads with products. We apportion overheads by multiplying the actual volume with the predetermined overhead allocation rate POR. The latter one is planned costs divided by planned volume measured in reference units, here in assembling-minutes. The volume variance is: ∆v 5/ 20X6 = 10,000 × 160,000/ 12,000 - 150,000 = - - 16,666.67 EUR. The relative volume variance in May 2016 is: -16,666.67 / 133,333.33 = - -12.5%. The total of consumption and volume variance is considered for profit or loss. In Management Accounting under-applied overheads show in the Manufacturing Overheads account and get closed-off to the Profit&Loss account. Therefore, deviations do not change the inventory valuation and count for profit or loss in the period of production. For the cost centre manager, changes in volume are beyond her/ his responsibility as the cost centre's volume depends on external factors, e.g. sales performance. CROXTON Ltd. prepares a cost centre proficiency report which is of a poor standard as it is not accurate to cost categories. The budgeting on all cost categories together prevents from a detailed variance analysis. The proficiency report is depicted in Figure 15.3: <?page no="240"?> Berkau: Management Accounting 7e 15-240 Budget Actual consumption variance ∆c volume variance ∆v Labour [EUR] n/ a 38,000.00 n/ a n/ a Energy [EUR] n/ a 13,000.00 n/ a n/ a Depreciation [EUR] n/ a 100,000.00 n/ a n/ a Total costs [EUR] 160,000.00 151,000.00 -1,000.00 -16,666.67 (non favourable) (non favourable) Rel variance [%] -0.67% -12.50% Performance [asbl-min] 12,000 10,000 Standard costs [EUR] 160,000.00 150,000.00 Overheads applied [EUR] 133,333.33 Over-/ under applied OHs [EUR] -17,666.67 Croxton Ltd. PROFICIENCY REPORT May 20X6 Figure 15.3: CROXTON Ltd.’s proficiency report May 20X6 15.7. Actual Volume Exceeding Budgeted Volume: June 20X6 Next, we study a situation where the volume exceeds the budgeted performance. In June 20X6, CROXTON Ltd. produces more displays than scheduled. The output is 4,000 units assembled in 16,000 minutes. The actual costs are labour: L a/ 6-20X6 = 50,000.00 EUR, energy costs: E a/ 6-20X6 = 20,000 EUR and depreciation: D a/ 6-20X6 = 100,000.00 EUR. The total costs are equal to: 50,000 + 20,000 + 100,000 = 1 170,000.00 EUR. The standard costs for 4,000 displays are: C asbl (X=16,000asbl-min) = 5.00 × 16,000 + 100,000 = 1 180,000.00 EUR. The consumption variance is: ∆c 6/ 20X6 = 180,000 - 170,000 = + + 110,000.00 EUR. The relative consumption variance is: 10,000 / 180,000 = 5 5.56%. The volume variance is: ∆v 6/ 20X6 = 16,000 × 160,000/ 12,000 - 180,000 = 3 33,333.33 EUR. The relative volume variance gives: 33,333 / 213,333.33 = 1 15.63%. This favourable consumption variance indicates a low planning standard at CROXTON Ltd. <?page no="241"?> Berkau: Management Accounting 7e 15-241 Figure 15.4: CROXTON Ltd.’s variance in June 20X6 The cost proficiency report for the month June 20X6 is displayed in Figure 15.5. Budget Actual consumption variance ∆c volume variance ∆v Labour [EUR] n/ a 50,000.00 n/ a n/ a Energy [EUR] n/ a 20,000.00 n/ a n/ a Depreciation [EUR] n/ a 100,000.00 n/ a n/ a Total costs [EUR] 160,000.00 170,000.00 10,000.00 33,333.33 (favourable) (favourable) Rel variance [%] 5.56% 15.63% Performance [asbl-min] 12,000 16,000 Standard costs [EUR] 160,000.00 180,000.00 Overheads applied [EUR] 213,333.33 Over-/ under applied OHs [EUR] (+/ -) 43,333.33 Croxton Ltd. PROFICIENCY REPORT June 20X6 Figure 15.5: CROXTON Ltd.’s proficiency report June 20X6 15.8. Summary A cost centre proficiency report provides information about the performance in a cost centre. The cost centre works well if its consumption variance is low. In contrast, the volume variance is caused by other volumes than <?page no="242"?> Berkau: Management Accounting 7e 15-242 scheduled and are beyond the responsibility of cost centre managers. Companies prepare monthly proficiency reports showing cost variances. For proficiency reports, a company must apply a partial cost Accounting system. 15.9. Working Definitions Consumption Variance: The consumption variance is the difference between actual costs and standard costs (at actual volume). Volume Variance: The volume variance is the difference between applied overheads and standard costs (at actual volume). 15.10. Question Bank (1) A company plans an output of 800 units. The planned costs are 12,400.00 EUR. There are 4,000.00 EUR fixed costs. The actual costs are 12,000.00 EUR for 750 products. How much is the volume variance? 1. 375 EUR . 2. 125 EUR . 3. 250 EUR . 4. 325 EUR . (2) In a partial cost Accounting system, the budgeted cost function over the performance is called: 1. Budgeted costs. 2. Plan costs. 3. Applied overheads. 4. Standard costs. (3) Which statement is wrong? 1. The cost centre manager is responsible for the consumption variance. 2. The volume difference is the difference between standard costs at actual performance less applied overheads. 3. The sum of consumption variance and volume difference is the difference of standard costs at actual performance and actual overheads. 4. The cost centre manager is responsible for the volume difference. (4) If actual costs are below standard costs, the difference is: 1. Favourable. 2. Non-favourable. 3. Not possible. 4. Normal. (5) A company detects a difference between planned costs and actual costs at the budgeted output level. The difference is called: 1. Budget variance. 2. Consumption variance. 3. Standard variance. 4. Volume variance. 15.11. Solutions 1-3; 2-4; 3-4; 4-1; 5-2. <?page no="243"?> Berkau: Management Accounting 7e 16-243 16. Cost Allocations 16.1. What is in the Chapter? The cost flow through a Management Accounting system is not always straight down from cost categories to cost centres and then to the products. It is very common, that cost centres support and charge each other. This results in a loop of the cost flow. We study the transportation business CLYDBANK Ltd. for cost allocations between its 4 cost centres. We discuss cost allocations following one-directional support at CLYDBANK Ltd. For the case TUSCAN (Pty) Ltd. we introduce mutual cost centre support based on 2 cost centres. Later in the chapter, we discuss a more complex case study HEISFELD Ltd. and cover mutual exchanges calculated for by the equation method and (for the same case) by iterations. 16.2. Learning Objectives In this chapter, we teach cost assignments and allocations. You learn how to allocate costs for different situations. After studying this chapter, you understand how cost allocations work and can distinguish particular steps of the allocation procedure. You can apply cost allocations and assess which method works best for your case. 16.3. Cost Allocations Cost allocation is the process of assigning costs from one cost object to another one by applying mathematic operations, mostly based on the rule of three. We now focus on mutual cost centre supports and study their costs exchanges. Following the cost flow in a Management Accounting system as illustrated in chapter (13/ 14) cost allocations apply at the 3 levels below: 16.4. The 1 st Allocation Overheads are derived from expense accounts in Financial Accounting, such as labour, materials etc., and assigned to cost centres. If more than one cost centre is charged with the costs, allocations apply in order to apportion costs. E.g., room costs are split between cost centres based on their square metre number. This has been shown for GUILIO’s PIZZA&PASTA RISTORANTE in chapter (13). 16.5. The 2 nd Allocation When performance is exchanged between cost centres, costs are transferred from one cost centre (sender) to another one (receiver) to refund the provider for its support. 16.6. The 3 rd Allocation Eventually, costs are transferred from cost centres to products based on cost rates. This is called overhead application. It works on basis of predetermined overhead allocation rates PORs. Cost allocations apply in absorption costing as well as under partial cost Accounting systems. For a partial cost Accounting, only proportional costs are considered for cost allocations <?page no="244"?> Berkau: Management Accounting 7e 16-244 whereas fixed costs are directed to profit or loss. 16.7. C/ S CLYDBANK Ltd. We study simple (one-directional) cost allocations for the case study CLYDBANK Ltd. CLYDBANK Ltd. is a transportation firm. The company is divided in 4 cost centres. - CC 01: City delivery transportation. - CC 02: Long distance transportation. - CC 03: Support. - CC 04: Storage. The ‘characteristics’ of the cost centres (see: Figure 16.1) are used for cost distributions. They serve as allocation base. E.g., square metres are used for a fair allocation of room costs to cost centres. At CLYDBANK Ltd., not all characteristics are of physical nature, e.g., insurance costs are allocated based on the assets’ costs of acquisition. It is assumed that the insurance covers damages at that cost base. If the insurance only refunds the actual value in case of a damage, we rather use carrying values for the assignments. Other characteristics at CLYDBANK Ltd. are the number of employees, square metres of the cost centre floor and working hours. The working hours per cost centre serve as 3 rd level cost allocation base, meaning the calculation of the transportation services. Cost centre characteristics are disclosed in Figure 16.1. Characteristics CC 01 (city) CC 02 (long distance) CC 03 (support) CC 04 (storage) # of employees 23 50 7 20 Square metres 450 1,100 100 200 Value of machinery 800,000.00 1,500,000.00 20,000.00 500,000.00 Output in hours 10,580 23,000 - 9,200 Clydbank Ltd. COST CENTRE CHARACTERISTICS Figure 16.1: CLYDBANK Ltd.’s cost centre characteristics CLYDBANK Ltd.’s costs are overheads. At CLYDBANK Ltd., 4 cost categories apply: labour, room, insurance and Human Resources HR costs. All actual overheads are derived from Financial Accounting records. The labour costs are 4,120,000.00 EUR, the room costs are 555,000.00 EUR, the insurance costs are 282,000.00 EUR and the Human Resource HR costs are 120,000.00 EUR. Check Figure 16.2 for the Labour, Room, Insurance and Human Resources HR cost accounts and their balances: <?page no="245"?> Berkau: Management Accounting 7e 16-245 D C D C 4,120,000.00 555,000.00 D C D C 282,000.00 120,000.00 Labour LAB Room ROO Insurance INS Human resources HR Figure 16.2: CLYDBANK Ltd.’s accounts Some overheads are easily traceable to the 4 cost centres (CC), as they got planned/ caused therein. This applies for direct labour. The values are derived directly from payroll Accounting: in CC 01: 920,000.00 EUR, in CC 02: 2,250,000.00 EUR, in CC 03: 350,000.00 EUR and in CC 04: 600,000.00 EUR. Next, we discuss the overheads. In contrast, room costs for the building (depreciation) to the extent of 555,000.00 EUR, insurance costs of 282,000.00 EUR and costs for Human Resource HR of 120,000.00 EUR require allocations to cost centres. We call them 1 st level allocations. 16.8. The 1 st Allocation - C/ S The first cost allocation connects costs from cost category accounts and cost centres. The accounts for accumulating overheads in cost centres are known as Manufacturing Overhead MOH accounts. At CLYDBANK Ltd., the room costs of 555,000.00 EUR are allocated based on square metres. This cost allocation follows a: 450 : 1,100 : 100 : 200 ratio. We cancel the ratio by dividing all figures by 50. This gives a: 9 : 22 : 2 : 4 ratio. E.g., the room costs allocated to CC 01 are: 555,000 × 9 / (9 + 22 + 2 + 4) = 1135,000.00 EUR. For the other cost centres, we calculate: 330,000.00 EUR, 30,000.00 EUR and 60,000.00 EUR. How it is Done (Cost Allocation) (1) Determine the value of the base figures for cost objects to which the costs are to be assigned. (2) Write the figures as an a : b : c ratio. If possible, divide the a-, band c-number by a constant figure (cancellation). (3) Calculate the percentages of the cost objects by dividing the base figure of one cost object by the total of all base figures: a / (a + b + c) (4) Multiply the total costs with the percentages. The insurance costs allocation to cost centres follows the costs of acquisition for insured machinery in a cost centre. The total of insurance costs is equal to <?page no="246"?> Berkau: Management Accounting 7e 16-246 282,000.00 EUR. We distribute them at a: 800,000 : 1,500,000 : 20,000 : 500,000 ratio. We cancel to 40 : 75 : 1 : 25. The portion of insurance costs for cost centre CC 01 is: 282,000 × 40 / (40 + 75 + 1 + 25) = 8 80,000.00 EUR. The other cost centres CC 02 … CC 04 are charged with 150,000.00 EUR, 2,000.00 EUR and 50,000.00 EUR respectively. The same approach applies for the Human Resource HR costs. They are allocated based on head counts as: 27,600.00 EUR, 60,000.00 EUR, 8,400.00 EUR and 24,000.00 EUR. We show cost allocations in the accounts. E.g., a cost allocation of insurance costs to cost centre CC 03 is recorded in the books as: DR MOH CC 03.................... 2,000.00 EUR CR Insurance ................... 2,000.00 EUR Check the cost allocations in Figure 16.3. . D C D C 4,120,000.00 (1) 920,000.00 555,000.00 (5) 135,000.00 (2) 2,250,000.00 (6) 330,000.00 (3) 350,000.00 (7) 30,000.00 (4) 600,000.00 (8) 60,000.00 4,120,000.00 4,120,000.00 555,000.00 555,000.00 Labour LAB Room ROO D C D C 282,000.00 (9) 80,000.00 120,000.00 (13) 27,600.00 (10) 150,000.00 (14) 60,000.00 (11) 2,000.00 (15) 8,400.00 (12) 50,000.00 (16) 24,000.00 282,000.00 282,000.00 120,000.00 120,000.00 Insurance INS Human resources HR D C D C (1) 920,000.00 (2) 2,250,000.00 (5) 135,000.00 (6) 330,000.00 (9) 80,000.00 (10) 150,000.00 (13) 27,600.00 c/ d 1,162,600.00 (14) 60,000.00 c/ d 2,790,000.00 1,162,600.00 1,162,600.00 2,790,000.00 2,790,000.00 b/ d 1,162,600.00 b/ d 2,790,000.00 MOH CC 01 MOH CC 02 Figure 16.3: CLYDBANK Ltd.’s accounts <?page no="247"?> Berkau: Management Accounting 7e 16-247 D C D C (3) 350,000.00 (4) 600,000.00 (7) 30,000.00 (8) 60,000.00 (11) 2,000.00 (12) 50,000.00 (15) 8,400.00 c/ d 390,400.00 (16) 24,000.00 c/ d 734,000.00 390,400.00 390,400.00 734,000.00 734,000.00 b/ d 390,400.00 b/ d 734,000.00 MOH CC 03 MOH CC 04 Figure 16.3: CLYDBANK Ltd.’s accounts (continued) In addition, we disclose the cost allocations in a table, study Figure 16.4. for the details. By the next step, we add all cost centre costs. We refer to the result as total costs. For cost centre CC 01 they are: 920,000 + 135,000 + 80,000 + 27,600 = 1,162,600.00 EUR. The total of assigned costs (traced and allocated) is equal to the balancing figure of the cost centre accounts in Figure 1 16.3. Check the spreadsheet for the cost allocations in Figure 16.4. Characteristics CC 01 (city) CC 02 (long distance) CC 03 (support) CC 04 (storage) # of employees 23 50 7 20 Square metres 450 1100 100 200 Value of machinery 800,000 1,500,000 20,000 500,000 Output in hours 10,580 23,000 - 9,200 Assigned labour costs 920,000 2,250,000 350,000 600,000 Allocations Room costs 135,000 330,000 30,000 60,000 Insurance costs 80,000 150,000 2,000 50,000 HR costs 27,600 60,000 8,400 24,000 total costs 1,162,600 2,790,000 390,400 734,000 Figure 16.4: CLYDBANK Ltd.’s cost allocations to cost centres The 2 nd Allocation - C/ S The second level of cost allocations reflects the support between cost centres. In case one cost centre supports another one, the receiving cost centre reimburses the rendering cost centre. We record exchanges as Bookkeeping entries. The sender cost centre is reimbursed by a credit entry and the receivers/ consumers are charged for the costs by debit entries made in their Manufacturing Overhead accounts. A cost centre that performs only for the support of other cost centres is called an auxiliary cost centre. <?page no="248"?> Berkau: Management Accounting 7e 16-248 At CLYDBANK Ltd., cost centre CC 03 falls under auxiliary cost centres. It only supports the other cost centres’ work based on the following percentages: 20 % of its performance supports cost centre CC 01, 70 % is for CC 02 and 10 % for CC 04. Once we add the percentages, we recognize the total performance is: 20% + 70% + 10% = 1 100%. The percentages are multiplied with the total costs of the cost centre CC 03 after 1 st level allocations are complete. The total costs of cost centre CC 03 at that stage are: 350,000 + 30,000 + 2,000 + 8,400 = 3 390,400.00 EUR. Below, we cover the 2 nd level allocations which is between CLYDBANK Ltd.’s cost centres: from cost centre CC 03 to cost centres CC 01, CC 02 and CC 04. As cost centre CC 03 performs to an extent of 20 % for cost centre CC 01, we charge CC 01 with costs of: 20% × 390,400 = 78,080.00 EUR. We make the Bookkeeping entry (17) as below: DR MOH CC 01.................... 78,080.00 EUR CR MOH CC 03.................... 78,080.00 EUR Cost centre CC 02 covers: 70% × 390,400 = 2273,280.00 EUR and cost centre CC 04 is charged: 10% × 390,400 = 3 39,040.00 EUR. Observe Bookkeeping entries (18) and (19). DR MOH CC 02.................... 273,280.00 EUR CR MOH CC 03.................... 273,280.00 EUR DR MOH CC 04.................... 39,040.00 EUR CR MOH CC 03.................... 39,040.00 EUR In Figure 16.5, all internal cost allocations are shown as Bookkeeping entries (17) … (19). <?page no="249"?> Berkau: Management Accounting 7e 16-249 D C D C (1) 920,000.00 (2) 2,250,000.00 (5) 135,000.00 (6) 330,000.00 (9) 80,000.00 (10) 150,000.00 (13) 27,600.00 c/ d 1,162,600.00 (14) 60,000.00 c/ d 2,790,000.00 1,162,600.00 1,162,600.00 2,790,000.00 2,790,000.00 b/ d 1,162,600.00 b/ d 2,790,000.00 (17) 78,080.00 c/ d 1,240,680.00 (18) 273,280.00 c/ d 3,063,280.00 1,240,680.00 1,240,680.00 3,063,280.00 3,063,280.00 b/ d 1,240,680.00 b/ d 3,063,280.00 D C D C (3) 350,000.00 (4) 600,000.00 (7) 30,000.00 (8) 60,000.00 (11) 2,000.00 (12) 50,000.00 (15) 8,400.00 c/ d 390,400.00 (16) 24,000.00 c/ d 734,000.00 390,400.00 390,400.00 734,000.00 734,000.00 b/ d 390,400.00 (17) 78,080.00 b/ d 734,000.00 (18) 273,280.00 (19) 39,040.00 c/ d 773,040.00 (19) 39,040.00 773,040.00 773,040.00 390,400.00 390,400.00 b/ d 773,040.00 MOH CC 01 MOH CC 02 MOH CC 03 MOH CC 04 Figure 16.5: CLYDBANK Ltd.’s accounts after internal cost allocations In the spreadsheet, the internal cost allocations are disclosed in one line indicated ‘CC 03’ under the header ‘Internal Cost Allocations’. For the reimbursed cost centre CC 03 a negative entry to the extent of 390,400.00 EUR has been entered. This shows that all costs of cost centre CC 03 are covered by the supported cost centres. <?page no="250"?> Berkau: Management Accounting 7e 16-250 Characteristics CC 01 (city) CC 02 (long distance) CC 03 (support) CC 04 (storage) # of employees 23 50 7 20 Square metres 450 1100 100 200 Value of machinery 800,000 1,500,000 20,000 500,000 Output in hours 10,580 23,000 - 9,200 Assigned labour costs 920,000 2,250,000 350,000 600,000 Allocations Room costs 135,000 330,000 30,000 60,000 Insurance costs 80,000 150,000 2,000 50,000 HR costs 27,600 60,000 8,400 24,000 1,162,600 2,790,000 390,400 734,000 Internal cost allocations CC 03 78,080 273,280 (390,400) 39,040 1,240,680 3,063,280 0 773,040 Figure 16.6: CLYDBANK Ltd.’s spreadsheet with internal cost allocations 16.9. The 3 rd Allocation - C/ S The last cost allocation serves the product calculation. We call it 3 rd level overhead allocation. In Manufacturing Accounting this is referred to as overhead application. At CLYDBANK Ltd., the cost centres’ outputs are given by the spreadsheet in Figure 16.1. E.g., the output of cost centre CC 01 is 10,580 hours. All cost rates for the 3 rd level allocation are measured in EUR per reference unit. At CLYDBANK Ltd. the reference unit is the same as for the output: hours. In contrast to output cost centres, auxiliary cost centres do not contribute directly to the goods production or to service rendering. Therefore, no output related reference unit for auxiliary cost centres applies. The table indicates this by ‘n/ a’ (not applicable) in the cell for the cost rates in the CC 03 column. At CLYDBANK Ltd., cost centres CC 01, CC 02 and CC 04 fall under output cost centres. An output cost centre is a cost centre that works directly for the product. The cost rate for the cost allocation is determined by dividing the final costs by the volume measured in reference units. Final costs are the costs after the 2 nd level cost allocations are complete. The cost rate of cost centre CC 01 is 1,240,680 / 10,580 = 1 117.27 EUR/ h. As a result, a city delivery (CC 01) that takes 20 min, is charged with: 20 × 117.27 / 60 = 339.09 EUR. The cost rates for the other cost centres are: CC 02: 3,063,280 / 23,000 = 1 133.19 EUR/ h and: CC 04: 773,040 / 9,200 = 8 84.03 EUR/ h. Figure 16.7 discloses the cost rates for the cost centres. <?page no="251"?> Berkau: Management Accounting 7e 16-251 Characteristics CC 01 (city) CC 02 (long distance) CC 03 (support) CC 04 (storage) # of employees 23 50 7 20 Square metres 450 1100 100 200 Value of machinery 800,000 1,500,000 20,000 500,000 Output in hours 10,580 23,000 - 9,200 Assigned labour costs 920,000 2,250,000 350,000 600,000 Allocations Room costs 135,000 330,000 30,000 60,000 Insurance costs 80,000 150,000 2,000 50,000 HR costs 27,600 60,000 8,400 24,000 1,162,600 2,790,000 390,400 734,000 Internal cost allocations CC 03 78,080 273,280 (390,400) 39,040 1,240,680 3,063,280 0 773,040 Cost rates[MYR/ h] 117.27 133.19 n/ a 84.03 Figure 16.7: CLYDBANK Ltd.’s cost centre rates Cost allocations apply for actual as well as for planned costs. The 2 nd level cost allocations at CLYDBANK Ltd. are one directional. Cost centre CC 03 renders service but does not receive any from others. Next, we define some technical terms for internal cost allocations before we study mutual cost exchanges. 16.10. Technical Terms for Cost Allocations Primary costs are costs of a cost centre that are assigned directly. This includes assignments by the 1 st level allocations. Primary costs cannot include portions received from other cost centres. E.g., primary costs of cost centre CC 03 are 390,400.00 EUR. Once further costs are assigned by 2 nd level allocations, the sum of costs in the cost centre is called its total costs. Total costs are the sum of primary costs and allocated costs (2 nd level allocations). The total costs of cost centre CC 01 are: 1,162,600 + 78,080 = 1 1,240,680.00 EUR. The total costs include primary costs of 1,162,600.00 EUR and secondary costs of 78,080.00 EUR. Secondary costs are costs a cost centre is charged with as a result from internal cost allocations (2 nd level allocations). After a cost centre is reimbursed by other cost centres for internal support we record a credit entry (discharging) for the costs covered. All remaining costs are its final costs. Final costs are primary costs plus secondary costs less discharged <?page no="252"?> Berkau: Management Accounting 7e 16-252 (refunded) costs from internal cost allocations (2 nd level allocations). The calculation of internal cost allocations (2 nd level allocations) becomes more complex if performance is exchanged mutually. This means one cost centre supports another one and receives support from the same cost centre in return. In those cases, 2 cost allocation methods apply. (1) Equation method. (2) Iteration method. 16.11. Equation Method (1) The equation method charges and discharges costs simultaneously. It uses 2 equations per cost centre, one for total costs TC i and another one for final costs FC j . The index for the cost centres is i and j. i stands for the receiving cost centres and j for providers. The total number of cost centres is n. (i = 1 … n; j = 1 … n). PC i stands for the primary costs of a cost centre. The factor α ij is the portion of the providing cost centre’s (j) performance, received by cost centre i. If cost centre A supports cost centre B to an extent of 35 % of its performance, α BA = 35%. n j j ij i i TC PC TC 0 ) 1 ( 0 n i ij j j TC FC (with: TC = total costs, PC = primary costs, α = percentage of allocation, FC = final costs, i, j = index for cost centres) To explain internal cost allocations with the equation method, we discuss the case study TUSCAN (Pty) Ltd. 16.12. C/ S TUSCAN (Pty) Ltd. TUSCAN (Pty) Ltd. is an Accounting firm in Papenburg and runs 2 cost centres which mutually support each other, Management and Accounting. The Management department works for the Accounting department to an extent of 50 %. The Accounting department provides service for Management to an extent of 10 %. The primary costs are given: for the Management department: 100,000.00 EUR and for the Accounting department: 400,000.00 EUR. The total costs TC for the departments are: TC A = PC A + α AM × TC M TC M = PC M + α MA × TC A At this stage, we do not know the total costs TC i . The 2 equations enable simultaneous (total) cost calculations: TC A = 400,000 + 50% × TC M TC M = 100,000 + 10% × TC A We insert the total cost for Management department into the first equation and solve it for TC A : <?page no="253"?> Berkau: Management Accounting 7e 16-253 TC A = 400,000 + 50% × (100,000 + 10% × TC A ) TC A = 450,000 / (1 - 5%) = 4 473,684.21 EUR. The total costs of the Management department are: TC M = 100,000 + 10% × 473,684.21 = 1 147,368.42 EUR. The second step is for the calculation of final costs of the cost centres: FC A = TC A × (1 - α MA ) FC M = TC M × (1 - α AM ) The calculation gives: FC A = 473,684.21 × (1 - 10%) = 4 426,315.79 EUR FC M = 147,368.42 × (1 - 50%) = 773,684.21 EUR To check the correctness of internal cost allocations, we add the final cost of the two departments Accounting and Management: 426,315.79 + 73,684.21 = 500,000.00 EUR. The sum proves correct calculations, if it is equal to the total of the primary costs: 400,000 + 100,000 = 500,000.00 EUR. 16.13. C/ S HEISFELD Ltd. We focus on another case study HEISFELD Ltd., which has more cost centres than TUSCAN (Pty) Ltd. HEISFELD Ltd. is a consultancy. HEISFELD Ltd. is divided in four cost centres: (1) Concept Development (C). (2) Webdesign (W). (3) Java Programming (J). (4) Administration (A). For all cost centers, the performances (= volumes) and outputs are measured in hours (C-h, W-h, J-h, A-h). The outputs are 300 W-h, 500 C-h and 100 J-h. Administration is an auxiliary cost centre because it does not deliver service to customers. The internal cost allocations require at first a performance planning to determine α ij as actual data about the performance are not available. We plan the performance by equations. For performance planning the internal support relationships are analysed: HEISFELD Ltd. knows that 6 W-h in the Webdesign cost centre need support from Concepts-Development to the extent of 1 C-h. <?page no="254"?> Berkau: Management Accounting 7e 16-254 1 J-h in the Java Programming cost centre requires support from the Concept Development to the extent of 2 C-h. For 3 W-h in the Webdesign cost centre 1 J-h from the Java Programming cost centre is necessary. Administration is needed to the extent of 1 A-h per 20 J-h, 1 A-h per 3 W-h and 1 A-h per 25 C-h. The performance planning results in 1 performance equation per cost centre. Therein the output marks the initial performance. E.g., in Concept Development it is 500 C-h. Additions are made for other cost centres’ support which depends on their performance. This way, the performance planning is interlinked between participating cost centres. We name P i the performance of the cost centre i and set up 4 performance equations for 4 cost centres. i = C, W, J or A. The performance equations are: P C = 500 + 2 × P J + (1/ 6) × P W P W = 300 P J = 100 + (1/ 3) × P W P A = (1/ 20) × P J + (1/ 3) × P W + (1/ 25) × P C It is helpful in an exam to check the units to verify the equations. E.g., in the first equation, the factor to be multiplied with P J is 2 C-h / J-h. Once multiplied with P J which is measured in J-h the resulting unit is C-h which is the correct unit to measure P C . The performance equation for the cost centre C is: P c = 500 C-h + (2 C-h/ J-h) × P j [J-h] + (1 C-h/ 6 W-h) × P W [W-h]. The performance in the Concept Development department P C serves its output as well as the support of Java Programming and Webdesign. Next, we solve the equations for performances P. As P W is known, we can calculate P J : P J = 100 J-h + (1 J-h / 3 W-h) × 300 W-h = 100 J-h + 100 J-h = 2 200 J-h. P C depends on only known parameters at this stage. Hence, P C = 500 + 2 × 200 + (1/ 6) × 300 = 9 950 C-h. The last value is for the performance in the Administration cost centre: P A = (1/ 20) × 200 + (1/ 3) × 300 + (1/ 25) × 950 = 1 148 A-h. In the Figure 16.8 each arrow represents a term in the performance equations. <?page no="255"?> Berkau: Management Accounting 7e 16-255 Figure 16.8: HEISFELD Ltd.’s performance structure We write every exchange by α and as percentage. The calculation of α-values is the major purpose of the performance planning here. The α-values are required for the calculation of total and final costs. α JA = 10/ 148 = 6 6.76% α WJ = 100/ 200 = 5 50% α WA = 100/ 148 = 6 67.57% α WC = 50/ 950 = 5 5.26% α CA = 38/ 148 = 225.68% α JC = 400/ 950 = 4 42.11%. Once α is known, we calculate the total and the final costs. We read the primary costs from the table in Figure 16.9. As we run a full cost Accounting system both, the proportional and the fixed costs, matter. Hence, the costs for Webdesign are: 10,100 + 20,000 = 3 30,100.00 EUR, for Concepts: 53,200.00 EUR, for Java Programming 24,000.00 EUR and for Administration 47,360.00 EUR. Webdesign Concepts Java Progr Admin Prim Costs, prop [EUR] 10,100 33,000 4,000 7,360 Prim Costs, fixed [EUR] 20,000 20,200 20,000 40,000 sum 30,100 53,200 24,000 47,360 Figure 16.9: HEISFELD Ltd.’s primary costs The equations for the total costs of the cost centres include primary costs and secondary costs from supporting cost centres. The equation of the total cost TC j are: TC C = 53,200 + (38/ 148) × TC A <?page no="256"?> Berkau: Management Accounting 7e 16-256 TC W = 30,100 + (100/ 200) x TC J + (100/ 148) × TC A + (50/ 950) × TC C TC J = 24,000 + (10/ 148) × TC A + (400/ 950) × TC C TC A = 47,360.00 EUR We prefer fractions over percentages to determine the total and final costs in this textbook as it avoids rounding adjustments. At first, we calculate the total costs for the Concept Development: TC C = 53,200 + (38/ 148) × 47,360 = 6 65,360.00 EUR. By the next step, we calculate the total costs in the Java Programming cost centre: TC J = 24,000 + (10/ 148) × 47,360 + (400/ 950) × 65,360 = 5 54,720.00 EUR. The total costs in the Website Design cost centre are: TC W = 30,100 + (100/ 200) × 54,720 + (100/ 148) × 47,360 + (50/ 950) × 65,360 = 92,900.00 EUR. With the total costs known, we can determine the final costs per cost centre. We take the equation for the final costs and determine FC j for all cost centres. Already at this stage, we know the finial costs for Administration FC A . As Administration is an auxiliary cost centre its final costs must be zero. FC C = TC C × (1 - (400/ 950) - (50/ 950)) = 3 34,400.00 EUR FC W = TC W × (1 - 0) = 992,900.00 EUR FC J = TC J × (1 - (100/ 200)) = 2 27,360.00 EUR FC A = 0.00 EUR To double-check the calculations, we compare the total of the primary costs to the total of final costs. Here, 30,100 + 53,200 + 24,000 + 47,360 = 34,400 + 92,900 + 27,360 = 154,660.00 EUR. As the totals match, we can be confident that our allocations are correct. However, this only is a check - no guarantee. After calculating the final costs per cost centre, we determine the cost rates for overhead application (3 rd level allocations). The formula for calculating the (predetermined) rates is POR i = FC i / output i . HEISFELD Ltd.’s POR-rates are: <?page no="257"?> Berkau: Management Accounting 7e 16-257 POR C = FC C / Output C = 34,400 / 500 = 68.80 EUR/ C-h POR W = FC W / Output W = 92,900 / 300 = 309.67 EUR/ W-h POR J = FC J / Output J = 27,360 / 100 = 273.60 EUR/ J-h POR A : n/ a 16.14. Iteration Method (2) The case HEISFELD Ltd. is simple as only 6 exchanges between 4 cost centres exist. If you consider that in a normal company a few hundred cost centres exists, you’ll understand the need for an alternative method of cost rate calculations which can be supported by software solutions. We discuss the iteration method in the online materials which you can download through Link 16.A. Link 16.A: Iteration Method How it is Done (Performance Planning) 68 (1) Determine the output of the cost centres, such as goods/ services by reverse budgeting. (2) Find an appropriate reference unit which is proportionally depending on the output and on the costs. (3) Plan or observe rules for mutual performance exchanges between cost centres, e.g. for one output unit cost centre A needs support from cost centre B to the extent of x reference units linked to its performance. (4) Prepare equations per cost centre for the total performance. The performance is the sum of the output plus support for other receiving cost centres. Express the support of other cost centres as factor × performance of the receiving cost centre. (5) In easy cases find a sequence to easily calculate the total performances. In more complex cases calculate the performance by equation method or iteration. (6) Divide the exchanged support by the total performance of a cost centre to calculate the percentage of performance exchange α AB . How it is Done (Cost Allocations) (1) Calculate the total costs as the sum of primary costs and costs for receiving support from other cost 68 Performance planning refers to the planning of the volume of a cost centre. <?page no="258"?> Berkau: Management Accounting 7e 16-258 centres. In a partial cost Accounting system, only proportional costs apply. (2) Record the receiving support from other cost centres as percentage × total costs, such as for the costs cost centre A is charged by cost centre B: α AB × TC B . (3) Prepare equations for the total costs of each cost centre that contains all primary costs PC and the sum of percentages of costs from supporting cost centres for received performance. (4) Solve the equations for the total costs of the cost centres TC i . In case mutual cost allocations exist solve the equation system by equation method or in more complex cases by iteration method. (5) Determine the final costs FC j . Prepare equations for every cost centre that is based on its total costs and deduct the percentages α of total costs that are for support of other cost centres to determine the final costs FC j . (6) Divide final costs FC by the output of the cost centres to calculate the cost rates. No cost rates for auxiliary cost centres apply. 16.15. Summary Management Accounting systems use 3 cost allocations to determine costs for cost objects. A 1 st level allocation is required to assign/ allocate overheads to cost centres. Direct costs can be traced whereas overheads most likely require (one-directional) allocations. The 2 nd level cost allocations reflect the performance exchange between cost centres. Mutual support relationships require an equation method or can be calculated by iteration method. The 3 rd level cost allocations use the final cost centre cost rates. The charges of products are based on budgeted (=predetermined) allocation rates. The latter allocation is known as manufacturing overhead application. Cost allocations do not change the total of costs. This can be used to doublecheck cost allocation results (in an Accounting exam). The total of primary costs must be equal to the total of final costs. 16.16. Working Definitions Auxiliary Cost Centre: A cost centre that performs only for the support of other cost centres is called an auxiliary cost centre. Cost Allocation: Cost allocation is the process of assigning costs from one cost object to another one by applying mathematic operations, mostly based on the rule of three. Final costs: Final costs are primary costs plus secondary costs less discharged (refunded) costs from internal cost allocations. Output Cost Centre: An output cost centre is a cost centre that works directly for the product. <?page no="259"?> Berkau: Management Accounting 7e 16-259 Primary Costs: Primary costs are costs of a cost centre that are assigned directly. Secondary Costs: Secondary costs are costs a cost centre is charged with as a result from internal cost allocations. Total Costs: Total costs are the sum of primary costs and allocated costs. 16.17. Question Bank (1) An auxiliary cost centre C records 12,000.00 EUR prime costs and gets 4,000.00 EUR allocated costs from a room cost centre. It supports 2 cost centres A and B with 40 % and 60 %. How much are allocated costs? 1. 4,800 / 7,200 / (12,000) . 2. 6,400 / 9,600 / 0 . 3. 6,400 / 9,600 / (16,000) . 4. 6,400 / 9,600 / 16,000 . (2) Cost centre X got total costs of 25,000.00 EUR. 5,000.00 EUR are allocated to cost centre Y and 20,000.00 EUR are output. Which exchange ratio is correct? 1. α XY = 20 % . 2. α YX = 20 % . 3. α XY = 25 % . 4. α YX = 25 % . (3) A company divides 34,000.00 EUR by head count. The cost centres A, B, C, D got 23 / 45 / 62 / 40 employees. How much costs are allocated to cost centre C? 1. 6,200.00 EUR . 2. 21,080.00 EUR . 3. 12,400.00 EUR . 4. 8,000.00 EUR . (4) A cost centre in a production firm receives insurance costs from an insurance cost centre. The insurance covers damages at replacement values. Which would be an appropriate allocation base? 1. Cost of acquisition. 2. Carrying amounts. 3. Gross purchase price. 4. Liquidation values. (5) Two cost centres exchange performance mutually. Cost centre A receives 30 % of cost centre B. Cost centre B receives 50 % of cost centre A. In both cost centres the primary costs are 10,000.00 EUR. How much are total costs in cost centre A? 1. 15.294.12 EUR . 2. 11,304.35 EUR . 3. 17,647.06 EUR . 4. 13,043.48 EUR . 16.18. Solutions 1-3; 2-2; 3-3; 4-2; 5-1. <?page no="260"?> Berkau: Management Accounting 7e 17-260 17. Reporting 17.1. What is in the Chapter? As cost information is needed to control the business, prepare budgets, make calculations, monitor deviations in cost centres, run business profitability checks etc., it must be brought to the managers’ attention. This is studied in this chapter. We show what contents needs to be reported and how to design reports. We discuss the case study LEBUHRAYA Ltd. a production firm for wine bottles. You’ll see its calculation and the Bookkeeping records made and we show how to develop a report, e.g. the statement of cost of goods sold and a profitability analysis. We further show examples for business graphics linked to LEBUHRAYA Ltd.’s report. 17.2. Learning Objectives After studying this chapter, you understand how to prepare reports and got experience with manufacturing reporting in a production firm. You can prepare reports in Management Accounting and you know how to read them. You further develop an idea for the design of reports which include business graphics. Besides reporting this chapter prepares you for the next following ones about manufacturing Accounting. 17.3. Providing Information as an Accounting Task Within a company, a lot of information about resource consumption and costs is available. It can be derived from budgeting and the Bookkeeping records. As a lot of information is available, monitoring must filter data for significance and to provide managers with useful controlling information tailored to their special information needs. This includes the analysis of information needs and disclosure preferences of the receiving managers. Management Accountants prepare reports which include cost allocations towards the cost objects of interest. Reports frequently include comparisons to prior periods and ratios, e.g. for performance and liquidity. In addition to standard reporting, Management Accountants provide support for special situations. This is known as exceptional reporting. E.g., an exceptional report is triggered when a cost deviation exceeds a threshold value, and the manager in charge must assess the importance and the reasons for the cost variance occurrence. The analysis should help to find a cure to keep costs at bay and/ or suggest corrective actions. Next, we demonstrate two examples for a manufacturing report. We prepare these two reports for the case study LEBUHRAYA Ltd.: - Cost of goods sold (COS) report. - Profitability statement. 17.4. C/ S LEBUHRAYA Ltd. We study the case of LEBUHRAYA Ltd. See below its data sheet. We derive the reporting information from its books and thereafter design the reports. <?page no="261"?> Berkau: Management Accounting 7e 17-261 Data Sheet for LEBUHRAYA Ltd. CClassification: Manufacturing; Opening values: 20,000.00 EUR in RMinventory; 5,000.00 EUR in WIP; Purchase: 100,000.00 EUR; direct materials: 55,000.00 EUR; indirect materials 50,000.00 EUR; Direct labour 180,000.00 EUR; indirect labour: 20,000.00 EUR; Depreciation: 80,000.00 EUR; Administration: 50,000.00 EUR; Marketing: 10,000.00 EUR; Addition to finished goods: 300,000.00 EUR; Cost of sales: 150,000.00 EUR; 225,000.00 EUR in revenue; VAT ignored. On its balance sheet, LEBUHRAYA Ltd. discloses the opening values for inventory in its Raw Material Inventory account: 20,000.00 EUR and Work-in-Process account: 5,000.00 EUR. During the Accounting period 20X6, LEBUHRAYA Ltd. records purchases for 100,000.00 EUR. The materials used in production are 55,000.00 EUR direct materials and 50,000.00 EUR indirect materials. The indirect materials are assigned to the Manufacturing Overheads account. Furthermore, LEBUHRAYA Ltd. records labour to an extent of 200,000.00 EUR. 180,000.00 EUR thereof is direct labour and assigned to work-in-process. The remaining portion of 20,000.00 EUR is indirect labour. LEBUHRAYA Ltd. adds indirect labour to the Manufacturing Overheads account. Another manufacturing overhead is depreciation. LEBBUHRAYA (Pty) Ltd. depreciates its production facilities for 80,000.00 EUR/ a. Non-manufacturing overheads apply for administration to the extent of 50,000.00 EUR and Marketing 10,000.00 EUR. At first, we record the costs received from Financial Accounting. Figure 17.1 shows the opening values. D C D C OV 20,000.00 OV 5,000.00 Raw materials inventory RMI Work in process-20X6 WIP Figure 17.1: LEBUHRAYA Ltd.’s opening values The opening value in the WIP-account indicates job orders in production that have been started in prior Accounting periods but are not finished yet. The value of 5,000.00 EUR in LEBUHRAYA Ltd.’s WIP-account includes labour, materials and applied overheads from 20X5. (1 … 3) On 2.01.20X6, LEBUHRAYA Ltd. records labour and purchases. As we do not intend to prepare financial statements in this chapter, only Managerial Accounting information is relevant. Hence, we only make Bookkeeping entries excluding VAT and ignore most of the real accounts, e.g., Accounts Payables and the Cash/ Bank account. By the Bookkeeping entry (2), the Purchase account is closed-off to the Inventory account. <?page no="262"?> Berkau: Management Accounting 7e 17-262 DR Purchase..................... 100,000.00 EUR CR Cash/ Bank.................... 100,000.00 EUR DR Inventory.................... 100,000.00 EUR CR Purchase..................... 100,000.00 EUR DR Labour....................... 200,000.00 EUR CR Cash/ Bank.................... 200,000.00 EUR (4) LEBUHRAYA Ltd. records depreciation on 31.12.20X6. DR Depreciation................. 80,000.00 EUR CR Acc. Depr.................... 80,000.00 EUR (5 … 9) For Management Accounting, LEBUHRAYA Ltd. prepares a WIPaccount and a Manufacturing Overheads account. Direct materials and labour are assigned to the WIP-account. Indirect materials, indirect labour and depreciation are added to manufacturing overheads. On 1.03.20X6, the Management Accountant allocates materials, labour and depreciation to the WIP-account and MOH-account. DR WIP-account.................. 55,000.00 EUR CR Inventory Account............ 55,000.00 EUR DR MOH Account.................. 50,000.00 EUR CR Inventory Account............ 50,000.00 EUR DR WIP-account.................. 180,000.00 EUR CR Labour....................... 180,000.00 EUR DR MOH Account.................. 20,000.00 EUR CR Labour....................... 20,000.00 EUR DR MOH Account.................. 80,000.00 EUR CR Depreciation................. 80,000.00 EUR (10) LEBUHRAYA Ltd. applies overheads completely. No predetermined overhead allocation rates POR apply (simplification). Accordingly, all manufacturing overheads are transferred to work-inprocess: Here, the cost centre is discharged by 150,000.00 EUR to be added to the WIP-account. The Bookkeeping entries are recorded on 15.03.20X6. DR WIP-account.................. 150,000.00 EUR CR MOH Account.................. 150,000.00 EUR <?page no="263"?> Berkau: Management Accounting 7e 17-263 (11) With the job orders recorded, LEBUHRAYA Ltd. produces 405,000 wine bottles. 300,000 wine bottles thereof are completed on 31.03.20X6. LEBUHRAYA Ltd. closes one job order and puts 300,000 wine bottles on stock. The cost of manufacturing per wine bottle are 1.00 EUR/ u (given for this case study). The value of the finished goods inventory is equal to: 1 × 300,000 = 3 300,000.00 EUR. DR Finished Goods Inventory..... 300,000.00 EUR CR WIP-account.................. 300,000.00 EUR (12) On 4.04.20X6, 150,000 wine bottles are sold at a net selling price of 1.50 EUR/ u. The total revenue is: 1.50 × 150,000 = 2 225,000.00 EUR. The revenue is recorded on 5.04.20X6. DR Cash/ Bank.................... 225,000.00 EUR CR Revenue...................... 225,000.00 EUR (13) For the sale 150,000 wine bottles are released from stock. They become period costs and require a debit entry in the Cost of Sales account. The movement of goods is recorded on 4.04.20X6. DR COS Account.................. 150,000.00 EUR CR FG Inventory................. 150,000.00 EUR (14; 15) No further business activities take place. We record Administration and Marketing costs, both on 30.06.20X6. They represent non-manufacturing overheads. DR Administration............... 50,000.00 EUR CR Cash/ Bank.................... 50,000.00 EUR DR Marketing.................... 10,000.00 EUR CR Cash/ Bank.................... 10,000.00 EUR Check LEBUHRAYA Ltd.’s accounts to familiarise yourself with its profit calculation in Figure 17.2. <?page no="264"?> Berkau: Management Accounting 7e 17-264 D C D C OV 20,000.00 (5) 55,000.00 OV 5,000.00 (11) 300,000.00 (2) 100,000.00 (6) 50,000.00 (5) 55,000.00 c/ d 15,000.00 (7) 180,000.00 120,000.00 120,000.00 (10) 150,000.00 c/ d 90,000.00 b/ d 15,000.00 390,000.00 390,000.00 b/ d 90,000.00 Raw materials inventory INV Work in process-20X6 WIP D C D C (1) 100,000.00 (2) 100,000.00 ... (1) 100,000.00 (12) 225,000.00 (3) 200,000.00 (14) 50,000.00 (15) 10,000.00 Purchase-20X6 PUR Cash/ Bank C/ B D C D C (3) 200,000.00 (7) 180,000.00 (4) 80,000.00 (9) 80,000.00 (8) 20,000.00 200,000.00 200,000.00 Labour-20X6 LAB Depreciation-20X6 DPR D C D C (11) 300,000.00 (13) 150,000.00 P&L 225,000.00 (12) 225,000.00 c/ d 150,000.00 300,000.00 300,000.00 b/ d 150,000.00 D C D C (13) 150,000.00 P&L 150,000.00 (14) 50,000.00 P&L 50,000.00 FG inventory FGI Revenue-20X6 REV Cost of sales-20X6 COS Administration-20X6 ADM D C D C (15) 10,000.00 P&L 10,000.00 COS 150,000.00 REV 225,000.00 ADM 50,000.00 MKT 10,000.00 EBT 15,000.00 225,000.00 225,000.00 b/ d 15,000.00 Marketing-20X6 MKT Profit and Loss-20X6 P&L Figure 17.2: LEBUHRAYA Ltd.’s accounts <?page no="265"?> Berkau: Management Accounting 7e 17-265 On the statement of financial position, LEBUHRAYA Ltd. discloses: 15,000 + 90,000 + 150,000 = 2 255,000.00 EUR in inventories. The value contains raw materials, work-in-process and finished goods. The Profit&Loss account has not been closed-off to the Retained Earnings account yet. Furthermore, the Cash/ Bank account is not balanced-off either, as it does not matter for our purpose of reporting manufacturing costs. To inform managers at LEBUHRAYA Ltd. about the cost of sales structure and about the profit earned with 150,000 wine bottles, providing T-accounts won’t be appropriate. We cannot expect all managers to be Accounting experts. In a factory, the plant manager most likely is an engineer. Therefore, the Management Accountant prepares a report which states the information required. We design a report as a cost of sales statement for the Accounting period 20X6. We study this report in Figure 17.3. Item Amount OV Raw materials 20,000 Purchases 100,000 120,000 Closing stock raw materials (15,000) Indirect materials (50,000) Total direct materials 55,000 Direct labor 180,000 Prime cost 235,000 Applied overheads 150,000 385,000 OV Work in process WIP 5,000 390,000 Closing stock work in process WIP (90,000) COST of MANUFACTURING 300,000 OV FG inventory 0 Closing stock of FG inventory (150,000) COST of GOODS SOLD COS 150,000 Lebuhraya Ltd. STATEMENT of COST of GOODS SOLD as for the period ended 31.12.20X6 Figure 17.3: LEBUHRAYA Ltd.’s statement of COS The report shows data about the costs of manufacturing and costs of sales for the Accounting period 20X6. The costs of manufacturing are linked to 300,000 wine bottles completed in production. As half of them are sold during the Accounting period 20X6, the costs of sales are calculated by deducting the <?page no="266"?> Berkau: Management Accounting 7e 17-266 closing stock of finished goods from the costs of manufacturing: 300,000 - 150,000 = 1 150,000.00 EUR. 4 steps are necessary to calculate the cost of manufacturing. The report follows these 4 steps. It contains 4 sections linked to the calculation steps. We calculate the costs of manufacturing as a total of materials, labour and overheads. The last step is the adjustment of inventory. We discuss the steps below in detail: (1) Calculation of materials. (2) Calculation of labour. (3) Application of overheads. (4) Adjustments for opening and closing stock of finished goods. 17.5. Calculation of Materials (1) The calculation of the costs of manufacturing starts-off from the opening value of raw materials. The first calculation determines the direct cost of materials. The calculation is based on the opening value of raw materials plus purchases less closing stock. Furthermore, indirect materials are deducted because they are considered as a portion of the applied overheads further down in the report. The calculation of direct materials gives: 20,000 + 100,000 - 15,000 - 50,000 = 55,000.00 EUR. 17.6. Calculation of Labour (2) For the LEBUHRAYA Ltd. case study, labour is direct labour to the extent of 180,000.00 EUR. Indirect labour is not considered at this part of the report, as it is included in applied overheads. After adding direct labour, the costs of manufacturing are: 55,000 + 180,000 = 235,000.00 EUR. 17.7. Application of Overheads (3) Regarding overheads, we do not bother the managers with the details. The report adds 150,000.00 EUR applied overheads to the calculation. In case further information is required, the Accountant can offer to run a ‘data drill-down’ and provide more details about the cost centre costs. After adding overheads, the costs of manufacturing become: 235,000 + 150,000 = 3 385,000.00 EUR. 17.8. Adjustments (4) The calculated costs of manufacturing do not yet consider the closing balance of the WIP-account nor its opening value. The opening value matters, as it represents production costs from previous Accounting periods. At the same time, costs for goods not yet finished are not supposed to be included in the costs of manufacturing. For this reason, the opening value of the WIP-account is added, and the closing balance is deducted. The costs of manufacturing then become equal to: 385,000 + 5,000 - 90,000 = 3 300,000.00 EUR. 17.9. COS-Report Although the costs of manufacturing can be derived from the accounts, the statement of cost of sales in Figure 17.3 provides more user-friendly information. In case the recipient of the report has further information needs, she/ he will ask the Accountant for support. E.g., it could be required to see the unit costs of manufacturing which are: 300,000 / <?page no="267"?> Berkau: Management Accounting 7e 17-267 300,000 = 1 1.00 EUR/ u. Another information need could be about costs transferred to the next Accounting period. Here, the production manager spends 90,000.00 EUR on the production of 105,000 wine bottles that are not completed yet. These bottles are the opening value in the WIP-account for the next Accounting period. The department worked the wine bottles already, therefore the bottles under production are valued at unit costs of: 90,000 / 105,000 = 00.86 EUR/ u and remain in the cost centre. If work is not completed, goods are not transferred to stock. Therefore, the WIP-account is not discharged and the costs stay within the cost centre. On the other hand, in our case the cost centre benefitted from 5,000.00 EUR opening value in work-in-process. Cost centre managers must know direct labour and overheads. The value for purchases, the closing stock etc. are less important, as those cannot be changed in a production cost centre. However, labour costs and overheads can. Working overtimes, extra shifts, rework etc. affect the cost centre proficiency and thus, they are of high interest. The same applies for the overheads which depend on decisions made by the manager, such as indirect materials consumption, indirect labour, cost centre administration, contributions to other cost centres etc. To learn about its cost deviations, LEBUHRAYA Ltd. must prepare a proficiency report as discussed in chapter (15). Here, a report, which focusses on the profitability analysis is set up. See Figure 17.4. Item Amt. Sales 225,000 COST of GOODS SOLD (150,000) Gross margin 75,000 Extraordinary income 0 Gross income 75,000 Further expenses Administration (50,000) Marketing (10,000) Net operating profit 15,000 Lebuhraya Ltd. STATEMENT of PROFITABILITY for the period ended 31.12.20X6 Figure 17.4: LEBUHRAYA Ltd.’s profitability analysis 17.10. Business Graphics To gain an overview of the profit and cost information, many managers prefer the display in business graphics which can be added to reports. Check Figure 17.5 for some examples. In a real company, Management Accounting considers the detailed information needs and preferences of the recipients <?page no="268"?> Berkau: Management Accounting 7e 17-268 (managers) for the design of the report. actual profit Direct Materials 55,000.00 actual budget deviation Sales 225,000.00 Direct Labour 180,000.00 20X3 370,000.00 400,000.00 (30,000.00) COS 150,000.00 Applied Overheads 150,000.00 20X4 380,000.00 400,000.00 (20,000.00) Admin 50,000.00 20X5 390,000.00 400,000.00 (10,000.00) Marketing 10,000.00 20X6 385,000.00 400,000.00 (15,000.00) Net operating profit bT 15,000.00 Lebuhraya Ltd. PROFIT REPORT 20X6 Lebuhraya Ltd. COST REPORT 20X6 Lebuhraya Ltd. PROFIT TO BUDGET Sales 20X3 - 20X6 Direct Materials Direct Labour Applied Overheads COS Admin Marketing Net operating profit bT (100,000.00) (50,000.00) 0.00 50,000.00 100,000.00 150,000.00 200,000.00 250,000.00 300,000.00 350,000.00 400,000.00 450,000.00 20X3 20X4 20X5 20X6 actual budget deviation Figure 17.5: Business graphic report LEBUHRAYA Ltd. 17.11. Summary Management Accountants provide information in reports. The reports contain calculations, ratios and/ or comparisons, which are useful for managers to make good decisions. Reports are prepared on monthly and annual basis. Besides of standard reports, Management Accountants provide exceptional reports, too. Frequently business graphics, like charts and pie diagrams are included in the reports to make information more visible. 17.12. Question Bank (1) A report discloses purchases at 10,000.00 EUR, an opening value of raw materials at 2,500.00 EUR, a closing stock of raw materials of 1,000.00 EUR and indirect materials of 4,000.00 EUR to be allocated by the application of overheads. How much is the total of direct materials? 1. 10,000.00 EUR . 2. 12,500.00 EUR . 3. 11,500.00 EUR . 4. 7,500.00 EUR . (2) Which items do you find on the cost of goods sold report? 1. Primary costs, closing stock of WIP, applied overheads. 2. Prime costs, closing stock of WIP, applied overheads. 3. Prime costs, opening value of finished goods, total of overheads. 4. Primary costs, closing stock of finished goods, total of overheads. (3) A report of profitability analysis discloses a gross margin of 33,000.00 EUR, rental income of 4,000.00 EUR, interest of 1,000.00 EUR and Marketing expenses of 2,000.00 EUR. Which statement is correct? 1. The net profit is amounting to 26,000.00 EUR. 2. The net profit after tax is amounting to 18,200.00 EUR. <?page no="269"?> Berkau: Management Accounting 7e 17-269 3. The net profit is amounting to 23,800.00 EUR. 4. The net profit after tax is amounting to 23,800.00 EUR. (4) Which are prime costs? 1. Direct labour and total of materials. 2. Direct labour and direct materials. 3. Originally assigned costs before internal cost allocations. 4. Labour and materials. (5) What is the difference between unit cost of manufacturing and unit costs of goods sold? 1. A difference results from production in different Accounting periods at different costs. 2. None. 3. The sales margin. 4. Inventory changes: add opening value and deduct closing stock. 17.13. Solutions 1-4; 2-2; 3-4; 4-2; 5-1. <?page no="270"?> Berkau: Management Accounting 7e 18-270 18. Job Order Costing (Manufacturing Accounting) 18.1. What is in the Chapter? The chapter (18) is about manufacturing Accounting. This is Accounting in a production department. In this chapter we cover job order costing and in the next following chapter (19) process costing. In manufacturing Accounting, we calculate the unit costs per product. A job order costing is based on singular job orders which bear the costs. In contrast, a process costing is suitable if production follows a continuous material flow through the factory, e.g. in a brewery. In chapter (18) we study MAHKOTA (Pty) Ltd., a production firm for cell phone pouches. The company produces 2 types of goods in separate job orders. We study the Bookkeeping entries and how job order costing supports the unit cost calculations for batches of pouch-A and pouch-B. We also show a detailed business profitability statement based on the cost of sales format which discloses the margin for both products. A second case study WEIXDORF (Pty) Ltd. shows a more complex job order costing system with inventory valuations considered. 18.2. Learning Objectives Manufacturing Accounting is relevant for Financial Accounting (inventory valuation) 69 as well as for Management Accounting (calculation). 69 Read our textbook Financial Statements, chapter (9). In this chapter (18) you learn how a job order costing based on internal job orders works. After studying this chapter, you understand calculation and accounts in manufacturing Accounting. 18.3. Calculations Calculations tell us the unit cost of manufacturing for goods/ services. In general, manufacturers control production costs based on internal job orders. When a job order starts, material is released from stock and added to the Job Order account (WIP-account). During production the job order increases in valuation as cost of manufacturing are recognised to its account. Every workstation and department involved adds its costs to the product’s value. This works either by assigning direct costs to job orders or by cost allocations from cost centres to job orders. When manufacturing is complete goods are added to stock and the costs of the batch are added to finished goods inventories. By dividing the cost of manufacturing for a batch through its lot size we calculate the unit costs of manufacturing. A job order is an internal order for the production of goods or parts thereof. A job order is recorded in a Job Order account or its reconciliation account: Work-in-Process account. In this textbook a WIP-4711 account represents the batch 4711. In contrast, the <?page no="271"?> Berkau: Management Accounting 7e 18-271 WIP-account is the reconciliation account for all job order accounts together. Manufacturing Accounting begins with adding direct costs to job orders (WIP-account). Compare the procedure to chapter (13) and (14). Overheads in cost centres are accumulated in MOH-accounts. In general, each cost centre has 1 Manufacturing Overheads account, e.g. the Assembling cost centre records its manufacturing overheads in the MOH-Assembling account. For every cost centre we plan an allocation rate, known as the predetermined overhead allocation rate POR. PORs are the planned overheads (not standard costs! ) per planned output of the cost centre. We also call the latter one planned performance or budgeted volume and measure it in reference units. The application of overheads requires to multiply the actual performance (measured in RU) with the POR. The applied overheads then are recognised on the WIP-account and credited to the MOH account. If cost deviations occurred the overhead application results in a closing balance of the MOH account. If the MOH account is debit balanced (b/ d on the debit side), the allocation of overheads is called underapplied. In the opposite case we refer to the situation as over-application of overheads. The closing balance of the MOH account is closed-off to profit or loss or to the Cost of Sales account. The application of overheads is shown as an arrow from cost centre Accounting to the calculation box in Figure 13.5. A company that applies a partial cost Accounting system, will only consider proportional costs for the POR. All fixed costs are transferred to profit or loss. In contrast, with an absorption costing, a manufacturer considers full costs for its PORs. This increases the unit costs in situations of over-capacity and should be avoided. 70 How it is Done (Job Order Costing) (1) Record Bookkeeping entries for basic accounts, e.g. labour, depreciation, administration etc. (2) Divide costs in manufacturing costs and non-manufacturing costs. (3) Prepare Job Order accounts for internal job orders, linked to products (goods/ services). (4) Prepare Manufacturing Overhead accounts for each cost centre. Plan cost rates for cost centres by dividing budgeted overheads by planned performance of the cost centre. (5) Assign direct costs, e.g. direct labour and direct materials, to job orders. Make debit entries in the Job Order accounts. 70 IAS 2.13 does not allow full-cost calculations for inventory valuations when the capacity does not approximate normal capacity. For Management Accounting we rather follow partial costing and avoid the problem. <?page no="272"?> Berkau: Management Accounting 7e 18-272 (6) Accumulate all manufacturing overheads to the Manufacturing Overhead account. (7) Apply overheads based on the predetermined overhead allocation rate to job orders. Calculate the value for the transferred manufacturing overheads by multiplying the actual job order performance with the predetermined overhead allocation rate. Make debit entries in the Job Order accounts and credit the Manufacturing Overhead account. (8) Once a job order is finished, goods are transferred to the Finished Goods Inventory account. Make a debit entry in the Finished Goods Inventory account and credit the value to the Job Order account. For unit cost calculation, divide the total costs of the finished goods by the lot size of the job order. (9) Balance-off the Job Order accounts. Use the Workin-Process account as summary account. Its balance is to be disclosed as inventory of work-in-process on the balance sheet. (10) Close-off the Manufacturing accounts to the Cost of Goods Sold COS account or directly to the Profit&Loss account for overor under-applied overheads. (11) Once goods are sold, debit them to the Cost of Goods Sold COS account and reduce the stock of finished goods by a credit entry in the Finished Goods Inventory account. (12) Record revenue. (13) Close-off all Cost of Goods Sold accounts (= Cost of Sales accounts) to the Profit&Loss account. (13) Recognise all non-manufacturing costs on the Profit&Loss account. (14) Calculate profit before taxation. 18.4. C/ S MAHKOTA (Pty) Ltd. We introduce the first case study for job order costing: MAHKOTA (Pty) Ltd. MAHKOTA (Pty) Ltd. is a company in Melbourne producing cell phone pouches. MAHKOTA (Pty) Ltd. applies an absorption costing system. Data Sheet for MAHKOTA (Pty) Ltd. CClassification: Manufacturing; Issued capital: 50,000.00 AUD; Bank loan: 300,000.00 AUD; interest 10,500.00 AUD/ a; P, P, E: 200,000.00 AUD; depreciation: 40,000.00 AUD; Products: A / B Purchase: 120,000.00 AUD; closing stock 17,000.00 AUD; Direct materials: 12,000.00 AUD/ a / 17,000.00 AUD/ a; Labour: 300,000.00 AUD/ a; labour for administration: 94,000.00 AUD/ a; <?page no="273"?> Berkau: Management Accounting 7e 18-273 PPOR: 16.00 AUD/ h; production time: 9,875 h / 9,875 h; Batch costs: 110,500.00 AUD / 78,750.00 AUD; Under-applied overheads: 4,000.00 AUD; Lot sizes: 13,000 u / 20,000 u; Sales rate: 80% / 30%; Net selling prices: 20.00 AUD/ u / 28.00 AUD/ u; GST ignored. On 2.01.20X2, MAHKOTA (Pty) Ltd. is established with 50,000.00 AUD. MAHKOTA (Pty) Ltd. takes out a bank loan for 300,000.00 AUD that requires an annual payment of interest to the extent of 10,500.00 AUD/ a. No pay-off of the loan is considered for this case study. (1) On 2.01.20X2, MAHKOTA (Pty) Ltd.’s Accountant records the business inception. DR Cash/ Bank.................... 50,000.00 AUD CR Issued Capital............... 50,000.00 AUD (2; 3) The bank loan is recorded one day later. However, the interest for the bank loan is recorded at the time of its payment, which is on 31.12.20X2. DR Cash/ Bank.................... 300,000.00 AUD CR Interest Bear. Liabilities... 300,000.00 AUD DR Interest..................... 10,500.00 AUD CR Cash/ Bank.................... 10,500.00 AUD We acknowledge that (here) interest is not linked to production. It is classified as non-manufacturing overheads. MAHKOTA (Pty) Ltd. does not capitalise its borrowing costs. (4, 5) MAHKOTA (Pty) Ltd. buys machinery for 200,000.00 AUD and accounts for depreciation on straight-line method over 5 years. Depreciation commences at the beginning of 20X2 (full year). Depreciation for 20X2 is equal to: 200,000 / 5 = 440,000.00 AUD/ a. We record the acquisition on 3.01.20X2 and depreciation thereon on 31.12.20X2. DR P, P, E Account.............. 200,000.00 AUD CR Cash/ Bank.................... 200,000.00 AUD DR Depreciation ................. 40,000.00 AUD CR Acc. Depr. .................. 40,000.00 AUD (6 … 10) MAHKOTA (Pty) Ltd. buys materials for 120,000.00 AUD and uses 103,000.00 AUD thereof in production. MAHKOTA (Pty) Ltd. manufactures 2 pouch types: pouch-A: a normal protection for the back of the cell phone and pouch-B: same as pouch-A but with a flap to cover the screen. Pouch-A receives 12,000.00 AUD/ a direct materials and pouch-B gets 17,000.00 AUD/ a. The remaining materials are charged to the Manufacturing Overheads account. <?page no="274"?> Berkau: Management Accounting 7e 18-274 On 15.01.20X2, MAHKOTA (Pty) Ltd. adds the purchases to raw material inventories (perpetual inventory movement system). DR Purchase..................... 120,000.00 AUD CR Cash/ Bank.................... 120,000.00 AUD DR Inventories.................. 120,000.00 AUD CR Purchase..................... 120,000.00 AUD For production, MAHKOTA (Pty) Ltd. defines two job orders. Job order Pouch-A and the other one for pouches-B. 71 All direct materials are added to the job orders. The following Bookkeeping entries apply on 15.01.20X2. DR WIP Pouch-A.................. 12,000.00 AUD CR Inventory.................... 12,000.00 AUD DR WIP Pouch-B.................. 17,000.00 AUD CR Inventory.................... 17,000.00 AUD The materials assigned to the Manufacturing Overheads account are equal to: 120,000 - 12,000 - 17,000 - (120,000 - 103,000) = 7 74,000.00 AUD. The closing balance is 17,000.00 AUD. DR MOH Account.................. 74,000.00 AUD CR Inventory.................... 74,000.00 AUD (11) We add depreciation to the MOH account. DR MOH Account.................. 40,000.00 AUD CR Depreciation................. 40,000.00 AUD (12 … 14) MAHKOTA (Pty) Ltd.’s labour costs amount to 300,000.00 AUD. All labour is overheads, but 94,000.00 AUD thereof is for administration. This means 94,000.00 AUD are non-manufacturing overheads. The remainder of: 300,000 - 94,000 = 2 206,000.00 AUD is added to the Manufacturing Overheads account. On 15.01.20X2, MAHKOTA (Pty) Ltd. records labour as below: 71 The WIP-account is the reconciliation account for all Job Order accounts. We call a Job Order account for Pouch A ‘WIP Pouch-A’. The name for the reconciliation account is WIP-account and does not carry a number or designator. <?page no="275"?> Berkau: Management Accounting 7e 18-275 DR Labour....................... 300,000.00 AUD CR Cash/ Bank.................... 300,000.00 AUD DR Administration............... 94,000.00 AUD CR Labour....................... 94,000.00 AUD DR MOH Account.................. 206,000.00 AUD CR Labour....................... 206,000.00 AUD (15; 17) The application of overheads is based on a predetermined overhead allocation rate of 16.00 AUD/ h (see below). The reference unit is production time in the manufacturing cost centre. The predetermined overhead allocation rate is based on planned overheads (320,000.00 AUD) and 20,000 h production time. This gives for the POR: 320,000 / 20,000 = 1 16.00 AUD/ h. The actual production time in the manufacturing cost centre is 19,750 h. Half of the production time is spent on pouches-A and the other half on pouches-B. The overheads allocated to each product are: 9,875 × 16 = 1 158,000.00 AUD. The application of overheads leads to two Bookkeeping entries, both recorded on 30.09.20X2. DR WIP Pouch-A .................. 158,000.00 AUD CR MOH Account.................. 158,000.00 AUD DR WIP Pouch-B .................. 158,000.00 AUD CR MOH Account.................. 158,000.00 AUD MAHKOTA (Pty) Ltd. applies less overheads than accumulated in its Manufacturing Overheads account. Overheads are under-applied: The difference is: 74,000 + 40,000 + 206,000 - 2 × 158,000 = 4 4,000.00 AUD. We close-off the Manufacturing Overheads account to the cost of sales. DR COS Account.................. 4,000.00 AUD CR MOH Account.................. 4,000.00 AUD MAHKOTHA (Pty) Ltd. finishes the production of 13,000 pouches-A and completes job order pouches-B (job order pouches-A has been split for short-time delivery). The batch costs are 110,500.00 AUD for pouches-A and 175,000.00 for pouches-B. (18; 19) The unit costs per pouch-A are equal to: 110,500 / 13,000 = 8 8.50 AUD/ u and for pouch-B to: 175,000 / 20,000 = 8.75 AUD/ u. The calculations follow the number of the goods transferred to stock. On 31.10.20X2, the finished goods are stored in inventories. The value of the finished pouches-A are equal to: 8.50 × 13,000 = 1 110,500.00 AUD. The value of the finished pouches-B are: 8.75 × 20,000 = 1 175,000.00 AUD. MAHKOTA (Pty) Ltd. records the additions to stock on 31.10.20X2. <?page no="276"?> Berkau: Management Accounting 7e 18-276 DR FG Inventory A............... 110,500.00 AUD CR WIP Pouch-A.................. 110,500.00 AUD DR FG Inventory B............... 175,000.00 AUD CR WIP Pouch-B.................. 175.000.00 AUD (20 … 23) On 24.11.20X2, MAHKOTA (Pty) Ltd. sells 80 % of the pouches-A and 30 % of pouches-B. The sale requires 4 Bookkeeping entries. The first two thereof are for the inventory movements. The costs of sales for the pouches are based on the unit costs of manufacturing and equal to (pouch-A): 80% × 13,000 × 8.50 = 8 88,400.00 AUD and (pouch-B): 30% × 20,000 × 8.75 = 52,500.00 AUD. We record the costs of goods sold. DR COS Account.................. 88,400.00 AUD CR FG Inv A..................... 88,400.00 AUD DR COS Account.................. 52,500.00 AUD CR FG Inv B..................... 52.500.00 AUD The net selling price per pouch-A at MAHKOTA (Pty) Ltd. is 20.00 AUD/ u, and for pouch B it is 28.00 AUD/ u. The revenue is equal to (pouch-A): 80% × 13,000 × 20 = 2 208,000.00 AUD and (pouch-B): 30% × 20,000 × 28 = 1 168,000.00 AUD. We record the revenue on 24.11.20X2. DR Cash/ Bank.................... 208,000.00 AUD CR Revenue...................... 208,000.00 AUD DR Cash/ Bank.................... 168,000.00 AUD CR Revenue...................... 168,000.00 AUD Observe the profit calculation and the accounts for MAHKOTA (Pty) Ltd.’s pouch production in Figure 18.1. <?page no="277"?> Berkau: Management Accounting 7e 18-277 D C D C (1) 50,000.00 (3) 10,500.00 c/ d 50,000.00 (1) 50,000.00 (2) 300,000.00 (4) 200,000.00 b/ d 50,000.00 (22) 208,000.00 (6) 120,000.00 (23) 168,000.00 (12) 300,000.00 c/ d 95,500.00 726,000.00 726,000.00 b/ d 95,500.00 Cash/ Bank C/ B Issued capital ISS D C D C c/ d 300,000.00 (2) 300,000.00 (3) 10,500.00 P&L 10,500.00 b/ d 300,000.00 Interest bearing liabilities IBL Interest-20X2 INT D C D C (4) 200,000.00 c/ d 200,000.00 (5) 40,000.00 (11) 40,000.00 b/ d 200,000.00 D C D C c/ d 40,000.00 (5) 40,000.00 (6) 120,000.00 (7) 120,000.00 b/ d 40,000.00 Property, plant, equipment PPE Depreciation-20X2 DPR Acc depr ACC Purchase-20X2 PUR D C D C (7) 120,000.00 (8) 12,000.00 (10) 74,000.00 (15) 158,000.00 (9) 17,000.00 (11) 40,000.00 (16) 158,000.00 (10) 74,000.00 (14) 206,000.00 c/ d 4,000.00 c/ d 17,000.00 320,000.00 320,000.00 120,000.00 120,000.00 b/ d 4,000.00 (17) 4,000.00 c/ d 17,000.00 Raw materials inventory RMI Manufacturing overheads MOH D C D C (8) 12,000.00 (18) 110,500.00 (9) 17,000.00 (19) 175,000.00 (15) 158,000.00 c/ d 59,500.00 (16) 158,000.00 170,000.00 170,000.00 175,000.00 175,000.00 b/ d 59,500.00 WIP pouch-A WIP pouch-B Figure 18.1: MAHKOTA (Pty) Ltd.’s accounts <?page no="278"?> Berkau: Management Accounting 7e 18-278 D C D C (12) 300,000.00 (13) 94,000.00 (13) 94,000.00 P&L 94,000.00 (14) 206,000.00 300,000.00 300,000.00 Labour-20X2 LAB Administration-20X2 ADM D C D C (17) 4,000.00 P&L 144,900.00 (18) 110,500.00 (20) 88,400.00 (20) 88,400.00 c/ d 22,100.00 (21) 52,500.00 110,500.00 110,500.00 144,900.00 144,900.00 b/ d 22,100.00 Cost of sales-20X2 COS FG inventory pouch-A FGA D C D C (19) 175,000.00 (21) 52,500.00 P&L 376,000.00 (22) 208,000.00 c/ d 122,500.00 (23) 168,000.00 175,000.00 175,000.00 376,000.00 376,000.00 b/ d 122,500.00 FG inventory pouch-B FGB Revenue-20X2 REV D C D C COS 144,900.00 REV 376,000.00 c/ d 126,600.00 P&L 126,600.00 ADM 94,000.00 b/ d 126,600.00 INT 10,500.00 EBT 126,600.00 376,000.00 376,000.00 R/ E 126,600.00 b/ d 126,600.00 Profit and Loss-20X2 P&L Retained earnings R/ E Figure 18.1: MAHKOTA (Pty) Ltd.’s accounts (continued) We prepare a profitability analysis for MAHKOTA (Pty) Ltd. that displays the earned profit per product. The adjustment of cost of sales for the under-applied overheads is assigned to other costs. We do not connect variances with single products. Therefore, the product related profitability analysis makes us consider the volume difference to the entire profit. Together with the cost for administration, the total of other costs are: 4,000 + 94,000 = 9 98,000.00 AUD. Interest is a non-manufacturing cost item and is not part of cost of goods sold. <?page no="279"?> Berkau: Management Accounting 7e 18-279 A B Revenue 208,000 168,000 Other income 208,000 168,000 COS, non-adjusted (88,400) (52,500) 119,600 115,500 Other costs Earnings before int and taxes (EBIT) Interest Earnings before taxes (EBT) Mahkota Pty Ltd. STATEMENT of PROFITABILITY for the year ended 31.12.20X2 235,100 (98,000) 137,100 (10,500) 126,600 Figure 18.2: MAHKOTA (Pty) Ltd.’s profitability analysis The business profitability analysis in Figure 18.2 follows the cost of sales format. To prove the consistency with the double entry system, we prepare a pro-forma balance sheet for MAHKOTA (Pty) Ltd. as at 31.12.20X2. As the case study is for management Accounting, no income taxes are considered. Observe the balance sheet in Figure 18.3. A C, L Non-current assets [AUD] Owners' capital [AUD] P, P, E 160,000 Share capital 50,000 Intangibles Reserves Financial assets R/ E 126,600 Current assets Liabilities Inventory 221,100 Interest bear liab 300,000 A/ R A/ P Prepaid expenses Provisions Cash/ Bank 95,500 Tax liabilities 476,600 476,600 Mahkota Pty Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X2 Figure 18.3: MAHKOTA (Pty) Ltd.’s pro-forma balance sheet So far, we studied the structure of a job order costing system with the case study MAHKOTA (Pty) Ltd. 18.5. C/ S WEIXDORF Ltd. We discuss next a more complex case but follow the same concept as for the <?page no="280"?> Berkau: Management Accounting 7e 18-280 previous case study. We discuss a company with more products and more cost centres. We also show the effect of goods being stored in inventory. The company WEIXDORF Ltd. produces 3 different types of ice cream (banana, lemon and strawberry) in 2 cost centres: Production and Filling. You can download the case study from the online study materials through Link 18.A. Link 18.A: WEIXDORF Ltd. job order costing 18.6. Summary A job order costing system is designed to calculate products in a manufacturing company. It applies Work-in-Process WIP-accounts and Manufacturing Overheads MOH-accounts. The allocation of overheads charges goods with their share of manufacturing overheads caused by their utilisation of production facilities. The application of overheads is based on predetermined overhead allocation rates POR. Any deviation between actual overheads and applied overheads is closedoff to the Cost of Sales account or directly to profit and loss and changes the operational profit for the period. The chapter covers 2 case studies. One for a pouch manufacturer and a more complex one for a company producing ice cream. 18.7. Working Definitions Job Order: A job order is an internal order for the production of goods or parts thereof. Predetermined Overhead Allocation Rate: A predetermined overhead allocation rate (POR) is a cost rate for charging products with cost centre overheads that is based on budgeted overheads and budgeted cost centre outputs. 18.8. Question Bank (1) A production firm plans 12,000.00 EUR overheads and a performance of 1,000 units. The actual overheads are 12,500.00 EUR for 950 units. Which statement is correct? 1. There is an under-application of overheads of 1,100.00 EUR. 2. There is an over-application of overheads of 1,100.00 EUR. 3. There is an under-application of overheads of 600.00 EUR. 4. There is an over-application of overheads of 600.00 EUR. (2) What is the correct Bookkeeping entry for an over-application of overheads? 1. DR MOH account; CR WIPaccount. 2. DR WIP-account; CR MOH account. 3. DR MOH account; CR COS account. <?page no="281"?> Berkau: Management Accounting 7e 18-281 4. DR COS account; CR MOH account. (3) Which item should not be recorded in a MOH account? 1. Rent for the factory building. 2. Insurance costs for production facilities. 3. Maintenance expenses. 4. Depreciation on delivery van. (4) A manufacturing company records direct labour of 2,000.00 EUR, direct materials of 5,000.00 EUR and applied overheads of 3,500.00 EUR. All 100 goods are finished and added to stock. 40 goods are sold. Which Bookkeeping entry is wrong? 1. DR WIP-account 3,500 EUR; CR MOH account 3,500 EUR. 2. DR COS account 2,100 EUR; CR MOH account 2,100 EUR. 3. DR FGI account 10,500 EUR; CR WIP-account 10,500 EUR. 4. DR COS account 4,200 EUR; CR FGI account 4,200 EUR. (5) What is the adjustment of cost of sales for? 1. For unsold goods. 2. For interest. 3. For over-applied overheads. 4. For other income. 18.9. Solutions 1-1; 2-3; 3-4; 4-2; 5-3. <?page no="282"?> Berkau: Management Accounting 7e 19-282 19. Process Costing (Manufacturing Accounting) 19.1. What is in the Chapter? In this chapter (19) we study process costing which applies for manufacturing with a continuous flow of materials through a production line. The purpose of process costing is the same as for job order costing. As the products follow an identical sequence of production steps, a process costing is a simplification of job order costing. The case study EDEWECHT (Pty) Ltd. is about a shoe manufacturer. We use the case for process costing introduction and discuss how to deal with inventory balancing figures for unfinished goods. 19.2. Learning Objectives In this chapter, you learn an alternative calculation suitable for line production. You will understand the account structure of and the cost flow through a process costing system. You will observe that the goods' unit costs steadily increase while flowing through the manufacturing facilities. After studying this chapter, you understand and can apply a process costing system. You also can calculate goods produced in production lines. You can distinguish a job order costing system from a process costing system. You also know how to calculate goods not yet finished based on equivalent units and can consider opening stock in production (WIP) for different cost categories and at various percentages of completion for calculation. 19.3. Principle of Process Costing Process costing follows a multiple-step calculation. With every step along the production line, the unit costs of manufacturing increase. Every department allocates its costs to the goods manufactured. As the material flow is continuous, we allocate the period costs to the performance per period, in general: we allocate monthly costs to the output of products per month. The unit costs per production step are accumulated in WIP-accounts. The application of WIP-accounts is similar to a job order costing system but the meaning is different. Under a job order costing, the WIP-accounts stand for the job order. Now, the WIP-account represents all costs of production during a month in a cost centre. A MOH account is in general not required but can apply to distinguish direct costs and overheads. Costs of prior production steps are transferred to the next WIP-account. The last production step completes the goods. Accordingly, we terminate the calculation of costs of manufacturing and close it off to inventories of finished goods. Although there is a continues flow of units, the best way to capture the idea of a process costing system is thinking about an assembling line, where a particular batch of units moves from one production step to the next one. We pretend that the batch leaves every step of production after completion and then is transferred to the next one. <?page no="283"?> Berkau: Management Accounting 7e 19-283 Note, as the previous costs centres are discharged, we make Bookkeeping entries like: DR WIP i - CR WIP i-1 (i represents the sequence of cost centres). We demonstrate the unit cost calculation under a process costing with the case study EDEWECHT (Pty) Ltd. How it is Done (Process Costing) (1) Record Bookkeeping entries in basic accounts, e.g. labour, depreciation, administration etc. (2) Divide costs in manufacturing costs and non-manufacturing costs. (3) Prepare Work-in-Process accounts for every production step. (4a) Prepare Manufacturing Overhead accounts for the cost centres, where the production steps take place in. Apply overheads. (4b) Alternatively debit manufacturing overheads to the WIP-accounts directly. (5.1) If the products are finished within a production step, divide the total costs of the Work-in-Process account by the number of products completed. (5.2) If the products are not finished completely within a production step, express the product volume by equivalent units. Calculate the equivalent unit as percentage of completion × number of unfinished goods. For finished goods, the completion rate is 1. Divide the costs of the current production step by the amount of equivalent units. The costs of previous production steps are allocated to the products by the product volume (not by the number of equivalent units, because only goods completed with regard to a production step are moved to the next one! ) Not completed goods are not transferred to the next production step and appear as balancing figure (debit balanced) in the Work-in-Process account. Completed products are transferred to the next Work-in-Process account. (6) Transfer completed goods of a production step to the Work-in-Process account for the next production step. Costs of manufacturing are numbers of goods × unit costs. (7) Once goods are finished, transfer them to stock. Make a debit entry in the Finished Goods Inventory account and credit the value to the (last) Work-in-Process account. For unit cost calculation, divide the total costs of finished goods by the volume of finished goods per period. <?page no="284"?> Berkau: Management Accounting 7e 19-284 (8) Once goods are sold, add them to the Cost of Goods Sold COS account and reduce the finished goods inventories by a credit entry in the Finished Goods Inventory account. (9) Record the revenue. (10) Add all non-manufacturing costs to the Profit&Loss account. (11) Debit the cost of sales to the Profit&Loss account. (12) Calculate the profit. 19.4. C/ S EDEWECHT (Pty) Ltd. We illustrate the concept by a case study about a shoe manufacturer. We discuss 3 production steps at EDEWECHT (Pty) Ltd. and calculate the shoes completed and those left in manufacturing. Data Sheet for EDEWECHT (Pty) Ltd. CClassification: Manufacturing; Period: 20X4; Three production steps: body manufacturing, sole fixing and leather treatment; Purchases: 160,000.00 EUR; Labour: 540,000.00 EUR; includes indirect labour of 450,000.00 EUR; Depreciation: 120,000.00 EUR; Splitting ratios: materials: 1 : 2 : 1 / labour: 1 : 1 : 1 / indirect labour: 3 : 1 : 1 / depreciation: 0 : 0 : 1; Production volume: 10,000 u; completed 9,500 u thereof; Percentage of completion for remainder: 20 %; Sales quantity: 8,000 u; net selling price: 175.00 EUR/ u; VAT ignored. EDEWECHT (Pty) Ltd. produces shoes in 3 production steps. They are: (1) Manufacturing of the shoe body. (2) Sole adhesion. (3) Leather treatment. The operations are organised in a line. All shoes go through all three production steps in the above-mentioned sequence. EDEWECHT (Pty) Ltd.’s cost centre structure reflects the production steps. In cost centre CC-001 the shoe body is manufactured. In cost centre CC-002 the sole is glued under the shoe body and in cost centre CC-003, EDEWECHT (Pty) Ltd. treats the leather surface. In a production line, all goods are manufactured in a first-in-first-out sequence. EDEWECHT (Pty) Ltd. does not distinguish shoes (we pretend they have all the same size). During the Accounting period 20X4, EDEWECHT (Pty) Ltd. records the following costs for purchases and total material costs (no closing stock; all purchases used in production): 160,000.00 EUR, for labour: 540,000.00 EUR (included therein: indirect labour in manufacturing: 450,000.00 EUR) and for depreciation on production facilities: 120,000.00 EUR. No non-manufacturing costs apply. Observe Figure 19.1. <?page no="285"?> Berkau: Management Accounting 7e 19-285 D C D C (1) 160,000.00 (2) 160,000.00 (2) 160,000.00 D C D C (3) 540,000.00 (4) 120,000.00 Purchases-20X4 PUR RM inventory RMI Labour-20X4 LAB Depreciation-20X4 DPR D C D C ... (1) 160,000.00 (4) 120,000.00 (3) 540,000.00 Cash/ Bank C/ B Acc depr ACC Figure 19.1: EDEWECHT (Pty) Ltd.’s accounts We allocate all manufacturing costs straight to the WIP-accounts which represent the 3 cost centres. MOH accounts are omitted. For the allocation of materials, a 1 : 2 : 1 ratio towards the cost centres CC-001, CC-002 and CC-003 applies. Accordingly, 40,000.00 EUR are assigned to cost centre CC-001, 80,000.00 EUR to cost centre CC-002 and another 40,000.00 EUR to cost centre CC-003. The allocation of other costs is similar: The allocation of direct labour follows a 1 : 1 : 1 ratio and the allocation of indirect labour is at a 3 : 1 : 1 ratio. Depreciation only applies in cost centre CC-003. (5 … 8) EDEWECHT (Pty) Ltd. records the costs for materials, labour and depreciation in its cost centres as below: DR WIP-account CC-001........... 40,000.00 EUR DR WIP-account CC-002........... 80,000.00 EUR DR WIP-account CC-003........... 40,000.00 EUR CR Raw Materials Inventory...... 160,000.00 EUR DR WIP-account CC-001........... 30,000.00 EUR DR WIP-account CC-002........... 30,000.00 EUR DR WIP-account CC-003........... 30,000.00 EUR CR Labour....................... 90,000.00 EUR DR WIP-account CC-001........... 270,000.00 EUR DR WIP-account CC-002........... 90,000.00 EUR DR WIP-account CC-003........... 90,000.00 EUR CR Labour....................... 450,000.00 EUR DR WIP-account CC-003........... 120,000.00 EUR CR Depreciation ................. 120,000.00 EUR <?page no="286"?> Berkau: Management Accounting 7e 19-286 Study Figure 19.2 for the accounts. D C D C (1) 160,000.00 (2) 160,000.00 (2) 160,000.00 (5) 160,000.00 D C D C (3) 540,000.00 (6) 90,000.00 (4) 120,000.00 (8) 120,000.00 (7) 450,000.00 540,000.00 540,000.00 Purchases-20X4 PUR RM inventory RMI Labour-20X4 LAB Depreciation-20X4 DPR D C D C ... (1) 160,000.00 (4) 120,000.00 (3) 540,000.00 D C D C (5) 40,000.00 (5) 80,000.00 (6) 30,000.00 (6) 30,000.00 (7) 270,000.00 (7) 90,000.00 340,000.00 200,000.00 Cash/ Bank C/ B Acc depr ACC WIP CC-001 (body) WIP CC-002 (sole) D C (5) 40,000.00 (6) 30,000.00 (7) 90,000.00 (8) 120,000.00 280,000.00 WIP CC-003 (leather) Figure 19.2: EDEWECHT (Pty) Ltd.’s accounts No opening values for work-in-process applies at EDEWECHT (Pty) Ltd. in 20X4. EDEWECHT (Pty) Ltd. starts the production of 10,000 shoes in the Accounting 72 A unit of shoes is a pair of shoes. period 20X4. 72 9,500 shoes are completed and transferred to stock. 500 shoes remain in the cost centre CC-003 for leather treatment and are shown as <?page no="287"?> Berkau: Management Accounting 7e 19-287 balancing figure in the WIP CC-003 account in Figure 19.4. These shoes are still under production. The leather treatment of the 500 unfinished shoes is completed to an extent of 20 %. Hence, we only can allocate 20 % of manufacturing costs in that cost centre to these shoes. In the cost centre CC-001, all costs for materials and labour are assigned to 10,000 shoes. This results in unit costs of: 340,000 / 10,000 = 3 34.00 EUR/ u after the first production step. Once the shoes are transferred to cost centre CC-002, their costs are added to the WIPaccount CC-002. We recognise them by Bookkeeping entry (9): DR WIP CC-002................... 340,000.00 EUR CR WIP CC-001................... 340,000.00 EUR The total costs in cost centre CC-002 include materials, labour and unit costs for 10,000 shoes from the previous production step. The costs in cost centre CC- 002 are equal to: 80,000 + 30,000 + 90,000 + 340,000 = 5 540,000.00 EUR. Again, the cost centre costs are allocated to 10,000 shoes. The unit costs for the shoes leaving cost centre CC-0002 are: 540,000 / 10,000 = 5 54.00 EUR/ u. After completion of production step (2), all 10,000 shoes are transferred to cost centre CC-003. This requires transferring shoe unit costs of 54.00 EUR/ u for all shoes to cost centre CC-003. The total value is: 10,000 × 54 = 5 540,000.00 EUR. We discharge the WIP CC-002 account and add its costs to the WIP CC-003 account. DR WIP CC-003................... 540,000.00 EUR CR WIP CC-002................... 540,000.00 EUR At this stage, the accounts for the cost centres are shown in Figure 19.3. D C D (5) 40,000.00 (9) 340,000.00 (5) 80,000.00 (10) 540,000.00 (6) 30,000.00 (6) 30,000.00 (7) 270,000.00 (7) 90,000.00 340,000.00 (9) 340,000.00 540,000.00 WIP CC-001 (body) WIP CC-002 (sole) Figure 19.3: EDEWECHT (Pty) Ltd.’s WIP-accounts <?page no="288"?> Berkau: Management Accounting 7e 19-288 D C (5) 40,000.00 (6) 30,000.00 (7) 90,000.00 (8) 120,000.00 (10) 540,000.00 820,000.00 WIP CC-003 (leather) Figure 19.3: EDEWECHT (Pty) Ltd.’s WIP-accounts (continued) So far, we covered the basics for process costing. Once all production steps are completed, the last WIP-account for cost centre CC-003 would be closed-off to stock. In that case shoes to the extent of 820,000.00 EUR would be added to stock. One pair of shoes would be valued at: 820,000 / 10,000 = 8 82.00 EUR/ u. 19.5. Uncompleted Production Steps For the case study EDEWECHT (Pty) Ltd., we analyse how to record manufacturing costs, if a production step is not completed. Here, some shoes in production step 3 are only finished to an extent of 20 % regarding the full workload. Only 9,500 shoes finish the leather treatment, the remainder is still under production at the yearend. The percentage of completion for those shoes is 20 %. We take the cost of manufacturing from the WIP CC-002 account and record cost centre CC-003. All 10,000 shoes arrived in cost centre CC-003 are completed with regard to the shoe body and the sole adhesion. The costs of previous production steps are 540,000.00 EUR. In the Leather Treatment cost centre CC 03, costs for materials, labour, and depreciation apply to the extent of: 40,000 + 30,000 + 90,000 + 120,000 = 2 280,000.00 EUR and are assigned to shoes. Only 9,500 units are completed and are charged with 100 % of costs. The other 500 shoes are completed to only a percentage of 20 %. Therefore, only 20 % of the costs can apply. For cost calculation in CC 03, we calculate with equivalent units. 19.6. Equivalent Units Calculation Under a process costing system uncompleted products are represented by equivalent units. An equivalent unit is the quantity of goods calculated as number × percentage of completion. Equivalent units apply to allocate costs fairly to not yet finished goods. If all products were completed, we could transfer the costs to all products at the same rate. If all products are completed to a same percentage, we can do the same. Only if some products are completed and others are not, we must allocate costs based on their equivalent units. Below, we apply the concept of cost allocation based on equivalent units for EDEWECHT (Pty) Ltd.: At EDEWECHT (Pty) Ltd.’s cost centre CC-003, 9,500 shoes are finished in the Leather Treatment - but for 500 shoes <?page no="289"?> Berkau: Management Accounting 7e 19-289 the leather treatment is only completed to a degree of 20 %. For the cost allocations, we replace 500 uncompleted shoes by: 500 × 20% = 1 100 equivalent units. Hence, the total costs of cost centre CC-003 are allocated to: 9,500 + 100 = 99,600 equivalent units. This gives: 280,000 / 9,600 = 2 29.17 EUR/ u cost of manufacturing in CC 03 added to every completed shoe (9,500). The calculation of the unit costs for completed shoes gives: 54 + 29.17 = 8 83.17 EUR/ u. (11) The total value of shoes transferred to stock is equal to: 9,500 × 83.17 = 790,115.00 EUR. DR FG Inventory................. 790,115.00 EUR CR WIP CC-003................... 790,115.00 EUR The value of the remaining 500 uncompleted shoes in cost centre CC-003 is equal to the balancing figure of the Work-in-Process CC-003 account. It is: 820,000 - 790,115 = 2 29,885.00 EUR. To double-check the value, we calculate the 500 uncompleted shoes by equivalent units. The unit costs per uncompleted shoe are: 54 + 20% × 29.17 = 59.84 EUR/ u. The calculation of the closing stock is based on 500 uncompleted shoes and gives: 500 × 59.84 = 29,920.00 EEUR. The comparison to the balancing figure reveals a rounding adjustment to be made for: 29,885 - 29,920 = 2 25.00 EUR. 19.7. Profit Calculation - C/ S We calculate EDEWECHT (Pty) Ltd.’s profit. (12; 13) EDEWECHT (Pty) Ltd. sells 8,000 shoes at a net selling price of 175.00 EUR/ u. The revenue is: 175 × 8,000 = 1,400,000.00 EUR. The cost of sales are: 83.17 × 8,000 = 6 665,360.00 EUR. DR Cash/ Bank.................... 1,400,000.00 EUR CR Revenue...................... 1,400,000.00 EUR DR Cost of Sales................ 665,360.00 EUR CR FG Inventory................. 665,360.00 EUR The gross profit (there are no non-manufacturing costs in this case study) is: 1,400,000 - 665,360 = 7 734,640.00 EUR. The calculation is shown in Figure 19.4. <?page no="290"?> Berkau: Management Accounting 7e 19-290 D C D C (1) 160,000.00 (2) 160,000.00 (2) 160,000.00 (5) 160,000.00 D C D C (3) 540,000.00 (6) 90,000.00 (4) 120,000.00 (8) 120,000.00 (7) 450,000.00 540,000.00 540,000.00 Purchases-20X4 PUR RM inventory RMI Labour-20X4 LAB Depreciation-20X4 DPR D C D C ... (1) 160,000.00 (4) 120,000.00 (12) 1,400,000.00 (3) 540,000.00 Cash/ Bank C/ B Acc depr ACC D C D C (5) 40,000.00 (9) 340,000.00 (5) 80,000.00 (10) 540,000.00 (6) 30,000.00 (6) 30,000.00 (7) 270,000.00 (7) 90,000.00 340,000.00 (9) 340,000.00 540,000.00 D C D C (5) 40,000.00 (11) 790,115.00 (11) 790,115.00 (13) 665,360.00 (6) 30,000.00 c/ d 124,755.00 (7) 90,000.00 790,115.00 790,115.00 (8) 120,000.00 b/ d 124,755.00 (10) 540,000.00 c/ d 29,885.00 820,000.00 820,000.00 b/ d 29,885.00 WIP CC-003 (leather) FG inventory FGI WIP CC-001 (body) WIP CC-002 (sole) D C D C P&L 1,400,000.00 (12) 1,400,000.00 (13) 665,360.00 P&L 665,360.00 Revenue-20X4 REV Cost of goods sold-20X4 COS Figure 19.4: EDEWECHT (Pty) Ltd.’s accounts <?page no="291"?> Berkau: Management Accounting 7e 19-291 D C COS 665,360.00 P&L 1,400,000.00 GP 734,640.00 1,400,000.00 1,400,000.00 b/ d 734,640.00 Profit and Loss-20X4 P&L Figure 19.4: EDEWECHT (Pty) Ltd.'s accounts (continued) 19.8. Summary In a process costing system, the calculation is based on the value added to units per step of production. The value is carried forward to the next following production step. Under a process costing system, Work-in-Process accounts represent cost centres. Direct costs and overheads are allocated to the Work-in-Process accounts. The value added to every unit of production are the manufacturing costs in a cost centre divided by the number of units completed therein. The last WIPaccount is closed-off to the Finished Goods Inventory account once all goods are completed. If goods are not completed, their calculation of the production step’s cost which has not been finished is based on equivalent units. Only goods that are completed in a production step are moved forward to the next one respectively to inventories. 19.9. Working Definition Equivalent Unit: An equivalent unit is the quantity of goods calculated as number × percentage of completion. 19.10. Question Bank (1) Which statement is wrong? 1. In a process costing system, costs are calculated on process cost rates. 2. In a process costing system, the closing amount the WIP-account is transferred to the next production step. 3. In a process costing system, the MOH account is not required. 4. In a process costing system, equivalent units are used of production is not completed. (2) A company produces 500 goods and completes 450 thereof. The remaining goods are completed to an extent of 20 %. How much are the equivalent units? 1. 500 . 2. 475 . 3. 450 . 4. 460 . (3) In a process costing system production of 400 units occur in 2 cost centres. In both cost centres labour is 5,000.00 EUR. Materials apply in the first cost centre to the extent of 800.00 EUR. Depreciation in the 2 nd cost centre is 1,000.00 EUR. How much are the unit costs of manufacturing if all goods are completed? 1. 31.50 EUR . <?page no="292"?> Berkau: Management Accounting 7e 19-292 2. 27.00 EUR . 3. 29.50 EUR . 4. 17.00 EUR . (4) In a process costing system, a manufacturer records in the last production step: 10,000.00 EUR from previous production steps and 8,550.00 EUR for labour. The output is 900 goods, and 100 goods are completed to a percentage of 50%. What is the value of stock (FG) additions? 1. 17,573.68 EUR . 2. 17,100.00 EUR . 3. 1,450.00 EUR . 4. 16,695.00 EUR . (5) In a process costing system with 4 production steps, how many Bookkeeping entries in the form DR WIP-account; CR WIPaccount are required at least? 1. 0 . 2. 3 . 3. 4 . 4. 5 . 19.11. Solutions 1-1; 2-4; 3-3; 4-2, 5-2. <?page no="293"?> Berkau: Management Accounting 7e 20-293 20. Contribution Margin Accounting 20.1. What is in the Chapter? A product calculation and profitability analysis which is based on partial cost Accounting requires the management for its fixed costs. We cover fixed cost management by two methods in the next following chapters. Chapter (20) deals with contribution margin Accounting. We discuss how a hotel chain allocates its fixed costs to different divisions (houses) for the case study FLINDERS Ltd. This chapter is followed by activity based costing in chapter (21). 20.2. Learning Objectives A management of fixed costs is important, because fixed costs dominate the cost mix in many companies. A partial cost Accounting system excludes fixed costs from cost rates as they do not matter for short-term decisions. Therefore, partial costing must be paired with the management of fixed costs mostly in an extra Accounting system. You learn in this chapter how fixed cost management works. After studying this chapter, you know how to structure fixed costs and how to allocate them to cost objects on different levels of aggregation. The cost objects can be divisions, customer, distribution channels etc. We show how to design and run a multiple-level contribution margin Accounting system. 20.3. The Structure of a Profitability Analysis System A contribution margin has been introduced in chapter (14) together with flexible budgeting. We defined the contribution margin as difference between revenue and proportional costs. The contribution margin must cover all fixed costs and a company’s profit. In a multiple-level contribution margin Accounting system, the profit is calculated following the cost of sales format. Therefore, it can be structured along cost objects, e.g. we calculate the contribution margin for each product. We calculate for all of them the revenue and deduct variable costs. For n products we determine n contribution margins-1 (CM1). To make decisions in fixed cost management, we need to know how contribution margin and fixed costs are linked together. In the first step, all contribution margins together must exceed fixed costs for the company. This is required for the company to earn a profit. The problem is frequently to connect fixed costs with single products. Therefore, we prepare contribution margins on a higher aggregation level, e.g. the contribution margin-2. It is calculated for a combination of products, e.g. for a product group. On the other side of the calculation, we identify fixed costs for that particular product group. Once we deduct from the total of contribution margins-1 the fixed costs for product groups we arrive at the contribution margin-2. <?page no="294"?> Berkau: Management Accounting 7e 20-294 In the case study below, we discuss a hotel with various houses. We calculate the contribution margins-1 (CM) for rooms in each house. We deduct room related proportional costs (cleaning) from revenues. The next step is to combine rooms to hotels by adding the room-related contribution margins-1 per hotel and deduct fixed hotel cost therefrom. This gives the contribution margin-2 (CM2). By the next step we combine hotels in the same city to calculate the contribution margin-3 (CM3). That one is the difference between the total of the contribution margins-2 less city related fixed costs. The last contribution margin in the case study FLINDERS Ltd. is for the entire company and is equal to its profit. Figure 20.2 shows the business profitability analysis with multiple contribution margins for the case study. The process of defining groups and calculating a next-level contribution margins by adding the contribution margins of single elements and deducting fixed costs for the group therefrom can be continued over multiple levels and following different criteria of aggregation. For the cost object structure the ability to connect fixed costs with aggregated objects is decisive. Only allocations of costs based on the cost-by-cause principle are accepted. A multiple-level contribution margin Accounting assigns fixed costs to different levels of aggregation and avoids any allocations accounted for on average basis. A multiple-level contribution margin Accounting provides managers with valuable information that supports decisions about fixed costs on group levels, e.g. for product groups, distribution channels, customer groups etc. 20.4. C/ S FLINDERS Ltd. We study multiple-level contribution margin Accounting for the case study FLINDERS Ltd. It is about a hotel chain that owns houses in Berlin and Amsterdam. Find below the data sheet for FLINDERS Ltd. Data Sheet for FLINDERS Ltd. CClassification: Hospitality Management; Period: 7/ 20X6 (actual); Hotels: B-Charlottenburg; B-Lichtenberg; B-Moabit; B-Zehlendorf; AMS- Duivendrecht; Room quantity: 36 / 25/ 18 / 29 / 120; Prices per stay (1 person): 130.00 EUR / 110.00 EUR / 105.00 EUR / 130.00 EUR / 90.00 EUR; Occupation [stays/ m]: 860 / 560 / 490 / 550 / 3,400; Proportional costs: 15.00 EUR/ stay; Labour (fixed): 42,000.00 EUR/ m / 39,000.00 EUR/ m / 36,000.00 EUR/ m / 39,000.00 EUR/ m / 57,000.00 EUR/ m; Depreciation: 25,000.00 EUR/ m / 9,000.00 EUR/ m / 6,000.00 EUR/ m / 27,000.00 EUR/ m / 60,000.00 EUR/ m; Gym costs: 4,500.00 EUR/ m / 4,500.00 EUR/ m / 4,500.00 EUR/ m / n/ a / n/ a; Purchases: B: 23,500.00 EUR/ m; AMS: 18,000.00 EUR/ m; HR and management costs: 56,000.00 EUR/ m; VAT ignored. FLINDERS Ltd. is a hotel chain. It runs 4 hotels in Berlin (Charlottenburg, Zehlendorf, Moabit and Lichtenberg). Another hotel is in Amsterdam Duivendrecht. Three of the German hotels <?page no="295"?> Berkau: Management Accounting 7e 20-295 (Charlottenburg, Moabit and Lichtenberg) have a gym and employ a PEinstructor. Each hotel runs a restaurant. The purchases (groceries, kitchen tools etc.) for all restaurants in Berlin are made in Charlottenburg together. The hotel in Amsterdam Duivendrecht runs its own procurement office. The Human Resource department and the management for all hotels is based in Berlin Lichtenberg. The Berlin hotels are small hotels with 18 to 36 rooms. The hotel in Amsterdam Duivendrecht is bigger (120 rooms). The net room rates per stay in Berlin are in a range from 105.00 EUR/ stay to 130.00 EUR/ stay depending on the district where the hotel is located. The hotel in Amsterdam charges 90.00 EUR/ stay. For the actual calculations below, the room numbers do not matter. Only the volume of stays counts for the profitability analysis. The reference unit is ‘stays’. A stay is one room for one night. Observe the basic data recorded for the Accounting period July 20X6 for the 5 hotels in Figure 20.1. Amsterdam Charlottenburg Lichtenberg Moabit Zehlendorf Duivendrecht #-rooms 36 25 18 29 120 net price / stay 130.00 110.00 105.00 130.00 90.00 Stays (nights rented out) 860 560 490 550 3,400 Berlin Figure 20.1: FLINDERS Ltd.’s sales information for 7/ 20X6 The revenue is calculated by multiplying the room rates with the stays. E.g., for the hotel in Berlin Charlottenburg the revenue is: 130 × 860 = 1 111,800.00 EUR. The proportional costs are given. Most of the costs in the hotels are fixed costs, only room cleaning depends on the number of stays. The proportional costs per stay in each hotel are equal to: 15.00 EUR/ stay, therefore in the hotel in Charlottenburg, the proportional costs are: 15 × 860 = 1 12,900.00 EUR/ m. The contribution margin-1 (CM1) is calculated by deducting proportional costs from revenues. The contribution margin- 1 (CM1) for the hotel in Charlottenburg gives: 111,800 - 12,900 = 9 98,900.00 EUR/ m. In order to earn profit, the contribution margins of all hotels together must cover the fixed costs of the company. The total of the five CM1s adds up to: 98,900 + 53,200 + 44,100 + 63,250 + 255,000 = 5 514,450.00 EUR. The total of fixed costs is 451,000.00 EUR/ m, see below. Hence, FLINDERS Ltd. earns a profit of: 514,450 - 451,000 = 6 63,450.00 EUR/ m. The overheads for the 5 hotels (in total 451,000.00 EUR/ m) include fixed labour, depreciation, fixed gym costs, purchase costs (not for materials but for the Procurement office) and the Human Resources/ Management department costs. The total of the fixed overheads is: 213,000 + 127,000 + 13,500 + 41,500 + 56,000 = 4 451,000.00 EUR. The next question for the managers is ‘Where does FLINDERS Ltd. earn its profit? ’. <?page no="296"?> Berkau: Management Accounting 7e 20-296 To answer this question, FLINDERS Ltd.’s prepares a multiple-level contribution accounting. The fixed costs which can be linked to the 5 hotels directly, are fixed labour costs, depreciation and in some hotels gym costs. The three cost categories are assigned directly to the hotels. No allocations of fixed costs between hotels are made. The difference between the CM1s and fixed overheads per hotel gives the contribution margins-2 (CM2s). A negative CM2 indicates, the hotel makes a loss. At FLINDERS Ltd., this applies for the hotels in Moabit and in Zehlendorf. Next, the fixed costs per hotel groups are calculated. FLINDERS Ltd. intends to deduct the cost for the purchase division from the total of all Berlin-based hotels’ contribution margins. The costs of the central purchase department are for all hotels in Berlin. We form the hotel groups ‘Berlin’ and ‘Amsterdam’. The hotel in Amsterdam Duivendrecht runs its own procurement. The intention is to not allocate costs for central procurement to single hotels. Instead we link those costs in full to the groups ‘Berlin’ and ‘Amsterdam’ respectively. We start in Berlin: For the next contribution margin’s calculation, we add all CM2s in Berlin. It gives: 27,400 + 700 - 2,400 - 2,750 = 2 22,950.00 EUR/ m. The total of the contribution margins in Berlin should cover the procurement costs of 23,500.00 EUR/ m. As the calculation reveals this is not the case. This means that the hotels in Berlin do not contribute to FLINDERS Ltd.’s profit, because the CM3 in Berlin is negative: 22,950 - 23,500 =- -550.00 EUR/ m. In contrast, the contribution margin-3 for the hotel in Amsterdam, is equal to: 138,000 - 18,000 = 1 120,000.00 EUR. Hence, FLINDERS Ltd. needs the hotel in Amsterdam to cover the loss in Berlin. On the next level we form a cost object group ‘all hotels’ which represents the entire company. We add the two CM3s: -550 + 120,000 = 1 119,450.00 EUR. Therefrom, all fixed costs for the central Human Resource/ Management department are deducted. This gives us the contribution margin-4, which is FLINDERS Ltd.'s net operating profit: 119,450 - 56,000 = 6 63,450.00 EUR. Observe the calculation in Figure 20.2. It summarizes the above discussed multiple-level contribution margin accounting and the final calculation of FLINDERS Ltd.’s profit for the 5 hotels. <?page no="297"?> Berkau: Management Accounting 7e 20-297 Amsterdam Charlottenburg Lichtenberg Moabit Zehlendorf Duivendrecht Revenue 111,800 61,600 51,450 71,500 306,000 Prop costs (cleaning) (12,900) (8,400) (7,350) (8,250) (51,000) CM 98,900 53,200 44,100 63,250 255,000 Labour (fixed) (42,000) (39,000) (36,000) (39,000) (57,000) Depreciation (fixed) (25,000) (9,000) (6,000) (27,000) (60,000) Gym expenses (4,500) (4,500) (4,500) CM 2 27,400 700 (2,400) (2,750) 138,000 138,000 Purchase (18,000) CM 3 120,000 HR, management Operating profit -56,000 63,450 Berlin Flinders Ltd. CONTRIBUTION MARGIN ACCOUNTING 22,950 (23,500) (550) 119,450 Figure 20.2: FLINDERS Ltd.’s multiple-level CMA 20.5. Summary Multiple-level contribution margin Accounting assigns fixed costs to cost objects on different levels of aggregation. No allocations based on the average principle towards cost objects apply. The managers can study what fixed costs are for, which gives them valuable information for fixed cost management and product mix decisions. In this chapter we demonstrated the application of a multiple-level contribution margin Accounting system. 20.6. Question Bank (1) In a multiple-level contribution margin Accounting, the last costs deducted are: 1. Product group related costs. 2. Product related fixed costs. 3. Contribution margin. 4. Costs for the entire company. (2) A company produces 2 products A and B. The contribution margin for A is 6.00 EUR and for B 8.00 EUR. Both product quantities are 1,000 units. The product related fixed costs are 2,500.00 EUR and 3,000.00 EUR respectively. The fixed costs linked to the entire company are 5,000.00 EUR. How much is profit? 1. 9,000.00 EUR . 2. 7,500.00 EUR . 3. 3,500.00 EUR . 4. 5,000.00 EUR . (3) What is a contribution margin? 1. Proceeds less cost of sales. 2. Revenue less product costs. 3. Proceeds less proportional costs. 4. Revenue less proportional costs. <?page no="298"?> Berkau: Management Accounting 7e 20-298 (4) What is the allocation principle under contribution margin Accounting? 1. Average principle. 2. Cost-by-cause principle. 3. Direct assignment by tracing. 4. Group allocations. (5) What cost Accounting system is a multiple-level margin Accounting linked to? 1. Partial cost Accounting. 2. Activity Based Costing. 3. Absorption costing. 4. Full cost Accounting system. 20.7. Solutions 1-4; 2-3; 3-4; 4-2; 5-1. <?page no="299"?> Berkau: Management Accounting 7e 21-299 21. Activity Based Costing and Target Costing 21.1. What is in the Chapter? In this chapter about activity based costing, a modern Controlling approach based on business processes. Activity based costing is an alternative to multiple-level contribution margin Accounting. We only recommend the application of activity based costing for calculations, if contribution margin Accounting CMA fails, meaning, if fixed costs cannot be connected to cost objects or groups thereof. In those cases, contribution margins remain small, and a huge block of fixed costs remains. Why do we prefer CMA? It is because of an activity based costing is based on the average principle for cost allocation. This is what we only accept if a cost allocation under the cost-by-cause principle does not work out. Another aspect of activity-based costing is that it helps to (re-)structure business processes and therefore supports Process Management. 73 Here, we introduce the concept of an activity based costing system (ABC) and discuss its application for the airline company TORQUAY Ltd. We focus on their fixed overheads for Ticketing, Re-Scheduling and Advertising departments. We compare the costs allocations made by ABC to those resulting from a traditional cost Accounting system. An Accounting system is called traditional if it follows the cost centre structures. Further, we discuss activity based management ABM which is about 73 Read the book Scheer: ARIS. making changes of the business operations and adjust budgeted costs for processes and business activities. This leads to monitoring which is similar but different to standard costing. We apply the same case TORQUAY Ltd. for activity based management (ABM). The part ABM has been placed to the online materials. In the second section of this chapter, we discuss the concept of target costing. We stick to be case study TORQUAY Ltd. and design the business class service based on a target costing model. 21.2. Learning Objectives Activity based costing (ABC) became a popular Management Accounting instrument during the last decades. It focusses on business activities and process chains. In this chapter, you learn how ABC assigns costs to business processes, which are sequences of business activities across departmental borders. You will understand that in an ABC system, costs are accounted for on the average principle and allocated by cost drivers. After studying this chapter, you know how ABC works and you can distinguish it from a partial costing paired with contribution margin Accounting. You can discuss and decide about the right cost Accounting system for the management of fixed costs. <?page no="300"?> Berkau: Management Accounting 7e 21-300 21.3. Background for ABC ABC apportions fixed costs to business activities. The allocation of overheads breaches with the cost-by-cause principle as it follows the average principle. The cost drivers in use do not allow a fair cost allocation. A cost driver is a unit which measures activity performances, and which influences the resource allocation thereto. Allocations based cost drivers only divide fixed costs. The main difference between a reference unit (traditional cost Accounting) and a cost driver (ABC) is that a cost driver is not proportional depending on the output. Cost allocations per average lead to volatile unit costs. If the cost driver is low, cost rates become very high. This is useful for decision making regarding business reengineering but must be avoided for product calculations. The reason for the introduction of ABC are today’s cost structures. Many overheads are nowadays fixed costs. This is caused by how companies work and what kind of resources they apply. With machinery replacing direct work, product costs include less proportional labour but contain more maintenance, depreciation and costs for supervision. The application of a traditional partial cost Accounting system for a percentage of variable costs between 2 …5 %, leads to high contribution margins and huge blocks of fixed costs. Caused by the lack of traditional cost Accounting systems to support fixed cost management, Accountants have looked for factors that drive costs, even if they do not cause them. Most costs are driven by activities. Therefore, it makes sense to analyse activities for cost management. ABC allocates all (total) costs to activities based on the average principle. E.g., in procurement, costs for order management are completely fixed costs. Proportional costs simply do not exist, because the department’s cost do not depend on the output. Whether a purchase is for 1 part or for 1,000 parts, the purchase costs are equal. Therefore, we define the order quantity or the number of order items as major cost driver. The overheads for purchasing can be planned and monitored by cost drivers. A cost driver (CD) is a factor activity costs depend on. Fixed costs are not changed by cost drivers, but management makes decisions about the allocation of resources to, e.g., the procurement department, based on cost drivers and costs per activity. 21.4. How does ABC Work? Under ABC we assign costs to cost centres like in a traditional cost Accounting system. Costs of cost centres are structured following their dependency on cost drivers and allocated to cost pools. A cost pool is a portion of costs which depends on the same cost driver. The allocations are unidirectional. No internal cost allocations are needed for ABC. All costs allocated to cost pools are divided by the activity volume (measured in CDs) to calculate the process cost rate. The unit for the process cost rate is, e.g., EUR/ CD. We apply the process cost rate for entire <?page no="301"?> Berkau: Management Accounting 7e 21-301 business processes as well as for activities. For the latter one we use the expression activity cost rate. 74 We discuss below an example from the university to explain the concept. A ‘How is it done’ section follows. 21.5. Activity Costs for a Professor We want to implement a cost management system in a faculty. Its 1 st level cost allocation assigns salary, office costs and computer costs to the cost centre (Teaching department). This cost allocation is followed by defining cost pools. To determine the values, an Accountant interviews the professors and identifies activities they work on and how much time they need. The answer could be that teaching classes and lesson preparation takes 60 % of their workload, 30 % is for research and writing books/ articles and 10 % is spent on administration duties. Therefore, the Accountant defines three cost pools, (1) for teaching, which depends on the cost driver teaching workload (number of weekly classes), (2) for research, which depends on the number of research/ publication projects, and (3) for administration, which depends on the number of meetings the professors must attend. Based on the interview results, e.g. the cost pool Teaching carries 60 % of the cost centre costs. The next step is the calculation of the activity cost rates, by dividing the allocated costs by the cost driver volume. A A process/ activity cost rate is the total of costs assigned to a process/ activity divided by the activity’s volume [CD]. A process cost rate represents the costs spent on average on a one-time-execution of an activity/ business process. We now calculate process costs for a class taught 4 lessons per week: Assume, the costs allocated to the cost centre are 500,000.00 EUR/ a. Teaching receives: 60% × 500,000 = 3 300,000.00 EUR/ a. All professors together teach 200 classes/ week during the year per workload agreement. This gives a process cost rate for Teaching of: 500,000 × 60% / 200 = 11,500 EUR/ weekly classes. Calculating a class requires to know the weekly hours. This is the 3 rd level cost allocation. A class taught 4 lessons per week for one year costs: 4 × 1,500 = 6,000.00 EUR/ a. 21.6. Business Process Calculation ABC assigns fixed costs that can be allocated by cost drivers, to cost pools. In the cost pools, process cost rates for activities are calculated. For business process calculation, all activities of a business process chain need to be calculated by multiplying the process cost rates PCR with their utility factor. A utility factor tells us how frequently (at how many CDs) an activity is performed within a business process. A business process is a sequence of activities to serve a product. Examples for business processes are treatment of complaints in a department store, checking your tax statement at the revenue service, exam enrolment at the university etc. Activities are the elements of business processes. 74 Read about the support of ABC with artificial intelligence my dissertation: Berkau: Vernetztes Prozeßkostenmanagement. <?page no="302"?> Berkau: Management Accounting 7e 21-302 How it is Done (Activity Based Costing) (1) Record/ Plan costs in cost centres. (1 st cost allocation) (2) Design business process models that contain activities in cost centres. (3) Identify cost drivers for activities. (4) Define cost pools which contain activities that depend on the same cost drivers. The cost pool can cross department borders. (5) Allocate resources to cost pools. The resource allocation is based on interviews with cost centre experts. In the interviews, the workload per cost pool is determined. Use percentages provided by the experts or time records to calculate a cost allocation ratio between cost pools. Allocate costs based on the ratios. (6) Measure/ plan the activity volume and express them in cost driver units. (7) Divide the costs in a cost pool by the cost driver numbers to calculate the process/ activity cost rate PCR. The unit of the process/ activity cost rate is, e.g. EUR/ CD-value. (8) Record/ plan the cost driver volume per product. This is the utility factor for an activity linked to the product. (9) Aggregate activities to business process. (10) Calculate goods/ services that apply the activities/ business process by multiplying the process cost rates with the utility factor(s). (11) Add the business process chain’s costs based on the activity costs therein. 21.7. Case Study TORQUAY Ltd. We study ABC for an airliner. TORQUAY Ltd. runs a traditional cost Accounting system. Operation department’s cost allocation is based on the reference unit seat-kilometers (number of seats available × distance flown in km). TORQUAY Ltd. applies a partial and traditional cost Accounting system. See below its data sheet: Data Sheet for TORQUAY Ltd. CClassification: Aviation; Routes: Europe / FarEast; Aircraft: 787 (250-seater) / 777 (400seater); Distance: 468 km / 5,349 km; Monthly ticket quantity: 6,000 / 11,500; Net ticket price per flight: 400.00 EUR/ passenger / 900.00 EUR/ passenger; Fuel costs per flight: 20,000.00 EUR / 70,000.00 EUR; Depreciation: 1,100,000.00 EUR/ m; Labour: 120,000.00 EUR/ m; Airport landing fees: 50,000.00 EUR/ flight; Ticket sales costs: 2,000,000.00 EUR/ m; Check-in costs: 120.00 EUR/ passenger; VAT ignored. <?page no="303"?> Berkau: Management Accounting 7e 21-303 TORQUAY Ltd. daily (30 days/ month) operates two routes: - Route Europe: 468 km, sells per month 6,000 tickets at 400.00 EUR/ flight. The aircraft is a Boeing 787 (250-seater). - Route FarEast: 5,349 km, sells per month 11,500 tickets at 900.00 EUR/ flight. The aircraft is a Boeing 777 (400-seater). Check the revenues in Figure 21.1. Europe FarEast Revenue 2,400,000 10,350,000 Figure 21.1: TORQUAY Ltd.’s revenue Monthly depreciation on both aircrafts (together) is 1,100,000.00 EUR/ month. Labour is equal to 40,000.00 EUR/ month for the pilots and 80,000.00 EUR/ month for the cabin crew. The airport fees (APF) are 50,000.00 EUR per landing and takeoff circle (= per flight). Fuel costs are 20,000.00 EUR/ flight for the Europe flight and 70,000.00 EUR/ flight for the FarEast route. The Ticket Sales Office charges 2,000,000.00 EUR per month (TKT). The airport company charges 120.00 EUR/ p per passenger check-in. (CKI) According to this cost information, we calculate the Europe and the FarEast route based on a traditional cost Accounting system. Later in this chapter, we calculate the cost for the Ticket Sales Office under ABC. 21.8. Traditional Cost-Accounting System - C/ S Observe direct costs and overheads in Figure 21.2. The route calculation contains airport costs for check-in-service and fuel costs as direct costs. The airport company costs (CKI) per Europe flight depend on the passenger count and are: 6,000 × 120 = 7 720,000.00 EUR/ m. For the FarEast flights, the airport company charges: 11,500 × 120 = 1 1,380,000.00 EUR/ m. The fuel costs (FUE) are disclosed per month: 30 × 20,000 = 600,000.00 EUR/ m for the Europe route and: 30 × 70,000 = 2 2,100,000.00 EUR/ m for the FarEast route. Overheads are recorded in the Manufacturing Overhead account. They include depreciation (DPR), take-off and landing fees (APF), Ticket Sales Office costs (TKT) and labour (LAB) for the pilots and the cabin crew. The total overheads are: 1,100,000 + 3,000,000 + 2,000,000 + 120,000 = 6 6,220,000.00 EUR/ m. Under traditional cost Accounting the overhead application is based on seatkm. The seat-km-amount on the Europe route is: 468 × 250 = 1 117,000 seat-km. The FarEast flight with a 400-seater aircraft gets: 5,349 × 400 = 2 2,139,600 seatkm. The overheads allocated to the Europe route are: (117,000 / (117,000 + 2,139,600)) × 6,220,000 = 3 322,494.02 EUR/ m. The Overhead allocation to the FarEast route gives: (2,139,600 / (117,000 + 2,139,600)) × 6,220,000 = 5,897,505.98 EUR/ m. <?page no="304"?> Berkau: Management Accounting 7e 21-304 D C D C DPR 1,100,000.00 Eur 322,494.02 CKI 720,000.00 APF 3,000,000.00 FE 5,897,505.98 FUE 600,000.00 TKT 2,000,000.00 MOH 322,494.02 c/ d 1,642,494.02 LAB 120,000.00 1,642,494.02 1,642,494.02 6,220,000.00 6,220,000.00 b/ d 1,642,494.02 Manufacturing Overheads MOH WIP Europe W_E D C CKI 1,380,000.00 FUE 2,100,000.00 MOH 5,897,505.98 c/ d 9,377,505.98 9,377,505.98 9,377,505.98 b/ d 9,377,505.98 WIP FarEast WFE Figure 21.2: TORQUAY Ltd.’s accounts The route calculation is shown in Figure 21.3. As the net operating profit proves, the two routes are similar in terms of profitability. Europe FarEast Revenue 2,400,000 10,350,000 direct costs: - Check-in expenses (720,000) (1,380,000) - Fuel expenses (600,000) (2,100,000) Overheads (322,494) (5,897,506) Net operating profit 757,506 972,494 Figure 21.3: TORQUAY Ltd.’s calculation (traditional cost Accounting) The product manager of the FarEast route feels uncomfortable with the overhead allocation based on seat-km. Due to the longer distance, the FarEast route covers an unreasonably high portion of the overheads. Many overheads, e.g. ticket sale costs, take-off and landing fees and check-in costs, do not depend on the distance. Therefore, they overcharge the FarEast route. 21.9. Activity Based Costing (partial) - C/ S TORQUAY Ltd. establishes a partial ABC system. The Ticket Sales Office division is turned into an ABC cost center. To implement ABC only in particular areas and to combine it a with traditional cost Accounting systems is quite common in Management Accounting. <?page no="305"?> Berkau: Management Accounting 7e 21-305 At TORQUAY Ltd., we calculate cost centre costs and define cost pools. Regarding the cost allocations, the process costs are allocated based on the time spent on activities. To determine the time spent on activities, TORQUAY Ltd. runs an activity analysis for the Ticket Sales Office. The activity analysis reveals that 60 % of the time in the Ticket Sales Office is for making bookings. The cost driver is the number of tickets sold. 20 % of the time in the Ticket Sales Office is spent on passengers’ re-schedulings. Every month, 500 re-schedulings for the Europe route and 1,100 for the FarEast route occur. 20 % of the time in the Ticket Sales Office is for making flight offers. The offer volume is 2,000 offers per month. The offer volume is evenly distributed over the 2 routes. TORQUAY Ltd. defines three cost pools for its Ticket Sales Office cost centre. The cost pool Ticketing depends on the CD ticket volume. The cost pool Re-scheduling depends on the cost driver re-scheduled trips. The cost pool Advertising depends on the number of offers made. The total costs in the Ticket Sales Office are still 2,000,000.00 EUR/ m. The allocation of the overheads to the cost pools gives: 60% × 2,000,000 = 1 1,200,000.00 EUR/ m for Ticketing, 20% × 2,000,000 = 400,000.00 EUR/ m for Re-scheduling and another 400,000.00 EUR/ m for Advertising. The cost driver volumes are the sold tickets, which are equal to: 6,000 + 11,500 = 1 17,500 sold tickets/ m. The quantity of rescheduled trips is equal to: 5 500 + 1,100 = 1,600 rescheduled trips/ m and 2,000 flight offers/ m are made every month. Observe the calculation of the process/ activity cost rates for the activities Ticketing, Rescheduling and Advertising in Figure 21.4. The process/ activity cost rate for Ticketing is: 1,200,000 / 17,500 = 6 68.57 EUR/ sold ticket. The process cost rate for Rescheduling is equal to: 400,000 / 1,600 = 2 250.00 EUR/ re-scheduled trip and the process cost rate for Advertising is: 400,000 / 2,000 = 2 200.00 EUR/ offer. Cost pool Costs CD PCR Ticketing 1,200,000 17,500 68.57 Rescheduling 400,000 1,600 250.00 Advertising 400,000 2,000 200.00 Figure 21.4: TORQUAY Ltd.’s ABC cost centre Sales Office The new Accounting system for the Ticket Sales Office affects the route calculation. At first, the traditionally allocated overheads do not contain the Ticket Sales Office’s overheads anymore. The reduction of 2,000,000.00 EUR causes seat-km-based allocated overheads to decrease. The overheads allocated under traditional cost Accounting to the Europe route now are: (6,220,000 - 2,000,000) × ((117,000 / (117,000 + 2,139,600)) = 2 218,798.19 EUR/ m. The FarEast route bears: (6,220,000 - 2,000,000) × ((2,139,600 / (117,000 + 2,139,600)) = 4 4,001,201.81 EUR/ m. <?page no="306"?> Berkau: Management Accounting 7e 21-306 Second, the costs for the Ticket Sales Office are spit following the cost driver volumes. The Europe route’s Ticketing costs are: 6,000 × 68.57 = 4 411,428.57 EUR/ m. The FarEast route’s Ticketing costs are: 11,500 × 68.57 = 7 788,571.43 EUR/ m. The calculation of the Rescheduling and Advertising costs follows the same procedure and is disclosed in Figure 21.5. Europe FarEast Revenue 2,400,000 10,350,000 Direct costs: - Check-in expenses (720,000) (1,380,000) - Fuel expenses (600,000) (2,100,000) ABC: - Ticketing (411,429) (788,571) - Rescheduling (125,000) (275,000) - Advertising (200,000) (200,000) Overheads (218,798) (4,001,202) Net profit 124,773 1,605,227 Figure 21.5: TORQUAY Ltd.’s route calculation on a partial ABC system As a result of ABC-costing, the net operational profits calculated for the 2 flights change significantly. However, the total profit over both routes remains the same. ABC only affects the allocation of costs to routes. The cost information provided by ABC is closer to the business process behavioral characteristics and the activity trigger mechanism. The new profits prove the FarEast route earns a higher net operational profit than the Europe flights. This should have an impact on management decisions about the product mix (offered flight destinations) and/ or price decisions. We must admit that the route calculation is not based on the cost-by-cause principle and allocates costs by applying the average principle. We must acknowledge that the previous cost allocation was not following the cost-bycause principle either as the seat-km is no appropriate reference unit in this case. 21.10. Activity-based Management An ABC has a weak point. It only distributes costs. This does not tell us how costs will react on volume changes. This requires a different cost analysis and management. ABC provides cost rates for activities, which make you think, more activities will lead to higher costs and less activity reduce costs. This is not the case. As ABC only allocates costs, the total of costs do not depend on the cost drivers. Therefore, changes of processes have no impact on costs. For cost management based on ABC, costs must be changed by decisions about resources, followed by a new ABCcalculation/ analysis. Activity based management (ABM) is a management procedure based on activitybased costing information. In ABM, <?page no="307"?> Berkau: Management Accounting 7e 21-307 cost decisions come first. Mostly, methods from investment appraisal apply because those decisions are longterm. After deciding about resources and costs thereof, cost pooling, calculation of process/ activity cost rates and business process calculation follow. With ABM, business process numbers and costs are not interrelated as the cost-by-cause principle does not apply. If the manager ceteris paribus halves the process volume but does not adjust resources, the cost rate per process simply doubles. In contrast, an increase of process volume reduces the process cost rate. Therefore, process cost rates merely reflect (inverted) capacity load rates for cost pools. This aspect of ABC is important for understanding ABM. For this reason, we discuss ABM for TORQUAY Ltd. We discuss 2 alternative scenarios for which we change the business model and make decisions about the adjustment of resources. Thereafter, we plan/ monitor ABC by process/ activity cost rate analysis. Companies applying ABC for ABM set standard activity cost rates and compare the actual ones to these standards, e.g. a bank where in many branches the same activities take place, e.g. opening a bank account. A low activity cost rate is favourable, however, to go below the standard activity cost rate means that the activity cannot be performed because it overwhelms the person that carries it out (work overload). Download the ABM case study TORQUAY Ltd. through Link 21.A. Link 21.A: ABM - TORQUAY Ltd. 21.11. Target Costing Target costing is a concept for product design. It is based on ABC if product features impact overheads. It determines a ranking or preferably a percentage of importance regarding the product’s features. The target costs result from revenues obtainable for the product and assigned to the features at the same ratio as the importance for the customers. For the explanation of target costing we analyse the design of TORQUAY Ltd.’s business class service. 21.12. Design of a Business Class Service - C/ S A business class seat on TORQUAY Ltd.’s FarEast route sells at 4,000.00 EUR. The company calculates a profit margin of 40 % which results in total target costs of: (1 - 40%) × 4,000 = 2 2,400.00 EUR. TORQUAY Ltd. splits the target costs and connects them with business class service features. In a working, we determine all necessary passenger costs. These are the costs per economy passenger on the FarEast route. We identify the costs allocated to <?page no="308"?> Berkau: Management Accounting 7e 21-308 passengers by head count: airport company costs at 120.00 EUR (check-in), fuel at: 70,000 / 400 = 1 175 EUR/ passenger, ticketing following the ABC calculation (see above): 68.57 EUR, overheads: 4,001,201.81 / (30 × 400) = 3 333.43 EUR/ passenger. The total costs are: 120 + 175 + 68.57 + 333.43 = 6 697.00 EUR/ passenger. TORQUAY Ltd. deducts from the target costs the costs per economy class passenger and calculates: 2,400 - 697 = 1,703.00 EUR per passenger extra target costs for business class features. Based on a marketing analysis the customers allocate percentages to the features which are important to them. They claim that for them the most important feature is space (50 %). It follows extra service (20 %), bigger screens for the flight entertainment (5 %), lounge access (10 %) and the possibility to reschedule flights without extra charge (15%). For the calculation of the business class service, we accept that costs below the target costs can be spent on other features and those above must be deduct from other features’ target costs. We first calculate the costs for all features except of extra space and later allocate all unused target costs to extra space. This follows the passengers’ vote of space being their first priority. For the extra service onboard TORQUAY Ltd. calculates target costs of: 20% × 1,703 = 3 340.60 EUR/ passenger. The airline calculates the labour costs per flight attendant to be 1,500.00 EUR per flight, which includes the extra stay-over costs. Therefore, the extra service of 1 additional flight attendant per 5 business class passengers leaves: 340.6 - 1,500 / 5 = 4 40.60 EUR/ passenger for more expensive meals served during 1 flight. According to this calculation, the airline spends its target costs on service as required. Furthermore, TORQUAY Ltd. can spend target costs of: 1,703 × 5% = 8 85.15 EUR/ passenger on bigger screens. The screens are part of the entertainment system which is replaced every year. For the aircraft on the FarEast route this is equal to a depreciation over: 12 × 30 = 360 flights. Therefore, the costs of acquisition for the screens cannot exceed: 360 × 85.15 = 3 30,654.00 EUR. TORQUAY installs screens for 2,000.00 EUR/ u in its business class seats. The remainder is allocated to extra space. We calculate the per flight depreciation on the screens to be: 2,000 / 360 = 5 5.56 EUR/ u. This leaves TORQUAY Ltd. with extra target costs of: 85.15 - 5.56 = 7 79.59 EUR/ passenger to be spent on extra space. A lounge access at the airport cost 30 EUR/ passenger. From the target costs of: 170.30 EUR there is: 170.30 - 30 = 140.30 EUR/ passenger left for extra space. If there was a more luxury lounge available at the airport, TORQUAY Ltd. would book that option, however there is no better lounge. The acquisition of an own lounge is no option. The rescheduling option costs based on the ABC calculation 250.00 EUR/ rescheduling. We assume every passenger makes use of this service. Its target costs are: 15% × 1,703 = 2 255.45 EUR. In this case, the target costs are not sufficient to cover the service. TORQUAY Ltd. deducts the extra costs of: 255.45 - <?page no="309"?> Berkau: Management Accounting 7e 21-309 250 = 5 5.45 EUR/ passenger from the target costs for extra space. Following the space requirements, TORQUAY Ltd. is prepared to spend 50% × 1,703 = 8 851.50 EUR/ passenger for extra space. The extra cabin space is calculated as an empty seat in the economy class. For its calculation, we deduct check-in and ticketing costs from the economy flight costs: 697 - 120 - 68.57 = 5 508.43 EUR/ passenger (we do not deduct seat depreciation). 75 Therefore, the floor area in the aircraft for a business seat is designed with: 1 + (851.50 + 79.59 + 140.30 - 5.45)/ 508.43 = 3 3.10 as much space as an economy seat. 76 Based on a planning following target costing, TORQUAY Ltd. designs its product business class seat with an area 3.10 times bigger than an economy seat, with extra service where one flight attendant looks after only 5 passengers and serves meals that are 40.60 EUR more expensive as in the economy class. Each business class passenger can enjoy a bigger screen worth 2,000.00 EUR, visit the lounge at the departure airport and has the right to reschedule her/ his flight free of charge. 21.13. Summary ABC and ABM are concepts based on the assignment of fixed costs to business processes activities. This gives the company transparency of its activities’ cost structure. The cost allocation under ABC is helpful for the management of fixed costs. Decisions about 75 If sure the economy class section is always booked out, TORQUAY Ltd. can use opportunity the business processes and resource allocations thereto, should be based on ABC if only few proportional costs exist. As ABC allocates fixed costs to products, it should not apply for product calculations. The chapter demonstrates the application of ABC for the Ticket Sales office of an airline. ABM focusses on changes of processes and making decisions about resources. By planning/ monitoring process/ activity cost rates Management Accountants support managers by making decisions about efficient resource allocations. A resource decision is well made if the resulting process/ activity cost rates are low but not below standard. Monitoring of activity based costs is linked to single activities and entire process chains. We demonstrated a target costing for the design of the business class service for TORQUAY Ltd. 21.14. Working Definitions Activity: Activities are the elements of business processes. Activity Based Management: Activity-based management is a management procedure based on activitybased costing information. Business Process: A business process is a sequence of activities to serve a product or service. Cost Driver: A cost driver is a factor activity costs depend on. Cost Pool: A cost pool is a portion of costs which depends on the same cost driver. costs of 900 - 120 - 68.57 = 711.43 EUR/ passenger. 76 With opportunity costs this gives a factor of 2.5. <?page no="310"?> Berkau: Management Accounting 7e 21-310 Process Cost Rate: A process/ activity cost rate is the total of costs assigned to a process/ activity divided by the activity’s volume [CD]. 21.15. Question Bank (1) What is the difference between a cost driver and a reference unit? 1. A reference unit depends proportional on the output. 2. None. 3. A cost driver is more accurate as it refers to activities. 4. A cost driver measures the cost of a cost pool in compliance with the cost-by-cause principle. (2) In a cost pool, labour costs are 5,000.00 EUR and Depreciation 3,000.00 EUR. Activity A takes 35 % of the time and activity B the rest. Activity A’s cost driver is 500 and activity B’s cost driver 300. What is the process/ activity cost rate of activity A? 1. 10.00 EUR/ CD . 2. 3.50 EUR/ CD . 3. 10.40 EUR/ CD . 4. 5.60 EUR/ CD . (3) Which statement is wrong? 1. An ABC system allocates costs based on the average principle. 2. An ABC system cost functions based on cost drivers are always linear cost functions. 3. In an ABC system fixed costs become proportional process costs. 4. In an ABC system, no mutual cost allocations between activities take place. (4) What is the best strategy in ABM? 1. Add workload to departments/ cost pools where process cost rates are low. 2. Add workload to departments/ cost pools where the process cost rates are high. 3. A high process cost rate indicates a high loading factor for an activity. 4. A process cost rate indicates the proportional costs per business process. (5) In a cost pool an activity shows a process cost rate of 50.00 EUR/ CD. The activity quantity is 2,000 CDs. When increasing the activity output by 500 CDs, further 25,000.00 EUR depreciation apply. How much cost 10 CDs? 1 500.00 EUR . 2. 625.00 EUR . 3. 1,000.00 EUR . 4. 400.00 EUR . 21.16. Solutions 1-1; 2-4; 3-3; 4-2; 5-1. <?page no="311"?> Berkau: Management Accounting 7e 22-311 22. Abbreviations ABC Activity Based Costing ABM Activity Based Management Acc Accounting Acc Accumulated Acc Depr Accumulated Depreciation, in accounts: AcD Acc IL Accumulated Impairment Loss Adj Adjustment alu Aluminium AMS Amsterdam AP Airport fees A/ P Accounts Payables APC Airport Company Costs (for check-in) A/ R Accounts Receivables ARR Annual Average Return (Rate) / a per annum, per year AUD Australian Dollar B Berlin Bal Balance BCE Business Car Expenses BE Break-even Bhd. Berhad BOM Bill of materials b/ d Balance brought down B/ S Balance Sheet BV Besloten Vennootschap met Beperkte Aansprakelijkheid C Costs (total) C Credit CaE Catering Costs, Business Entertainment Costs CapRes Capital Reserves C-BE Cash-Break-even C/ B Cash/ Bank CBT Capital Budget Table CC Cost Centre CD Cost Driver CEO Chief Executive Officer c/ d Balance carried down c/ f Carried Forward (Profit) CF Cash Flow CFO Chief Financial Officer, Accountant CFS Statement of Cash Flows CIS Contribution Income Statement CM Contribution Margin <?page no="312"?> Berkau: Management Accounting 7e 22-312 CMA Contribution Margin Accounting CMRatio Contribution Margin Ratio COS Cost of Sales, Cost of Goods Sold CR Credit Recorded, Credit Entry CVP Cost Volume Profit CVPA Cost Volume Profit Analysis, CVP-analysis D damage D Debit D Debts, Liabilities D2E Debt to Equity Ratio, Indebtedness Rate / d per day Δ PC Delta Proportional Costs Dep Department Depr Depreciation DIS Discount (Rate) DOL Degree of Operating Leverage DOL(CF) Degree of Operating Leverage - Cash Flow DR Debit Recorded, Debit Entry e Euler’s number E Equity EarnRes Earnings Reserves EAT Earnings after Taxes EBIT Earnings before Interest and Taxes EBT Earnings before Taxes eCBT Extended Capital Budget Table EPS Earnings per Share ESG Environment - Social - Corporate Governance EUR Euro EVA TM Economic Value Added FA Financial Accounting F-BE Financial Break-even FC Fixed Costs fCF Cash Flow from Financing Activities FE FarEast FG Finished Goods FGB Finished Goods, banana FGd Finished Goods, doors FGI Inventory of Finished Goods account FGL Finished Goods, lemon FGS Finished Goods, strawberry FGw Finished Goods, windows FIFO First-in-first-out Fin Finance fst 90°-Fastener FUE Fuel costs <?page no="313"?> Berkau: Management Accounting 7e 22-313 FV Future Value GBP British Pound Sterling GP Gross Profit GP&PR GUILIO’s PIZZA&PASTA RISTORANTE GR Garden Route GST Goods and Service Tax, same as Value Added Tax VAT HGB Handelsgesetzbuch hin Hinge HQ Headquarters IAS International Accounting Standards IBL Interest Bearing Liabilities iCF Cash Flow from Investing Activities ID Identifier, Identification Number IFRS International Financial Reporting Standards I/ L Impairment Loss Inc. Incorporation (USA) INS Insurance account INT Interest account Inv Inventory IRM Inventory of raw materials I/ S Income Statement ISS Issued Capital IT Income Taxes ITL Income Tax Liabilities JO Job Order KB KIRSTENBOSCH (Pty) Ltd. kg Kilogram KL Kuala Lumpur ky kayak, #ky = number of kayaks LAB Labour account Liab Liability, Liabilities Lst Loss on settlement Ltd. Limited company LoD Loss on Disposal m Metre MA Management Accounting M/ A Management and Administration M&A Mergers and Acquisitions Mat Materials, Material Costs McT McTOY GmbH MG Merchandise Goods MOF Manufacturing Overheads account for the Filling department MOI Memorandum of Incorporation MOH Manufacturing Overheads account / m per month <?page no="314"?> Berkau: Management Accounting 7e 22-314 MOP Manufacturing Overheads for the Production department MoS Margin of Safety, MoS unit is based on units, MoS % is based on sales portions MTF MOBILE TARTE FLAMBEE GmbH MTN Maintenance account MYR Malaysian Ringgit NoE Nature of Expense method NOP Net Operating Profit NOPAT Net Operating Profit After Taxes NP Net Profit NPV Net Present Value NSP Net Selling Price oCF Cash Flow from Operating Activities OE Owners Equity OEX Other Expenses OM Order Management OTH Other Costs out Outsourcing P Probability P Profit P out Profit for outsourcing scenario PA Profitability Analysis pan Pane P&L Profit and Loss, Profit&Loss account PC Proportional costs PC Primary Costs PCR Process Cost Rate P.I. Profitability Index PLC Public Limited Company (in the UK) PoD Profit on Disposal POR Predetermined Overhead Allocation Rate PPE Property, Plant and Equipment account P, P, E Property, Plant and Equipment PRE Prepaid Expenses PRT Payroll Tax PRT Pro Rata Temporis, per rate (Pty) Ltd. Proprietary limited company (in Australia, South Africa) PTO Public Tender Offer PUR Purchases PV Present Value R South African Rand R/ E Retained Earnings Res, RES Reserves Rev Revenue, Sales RI Residual Income <?page no="315"?> Berkau: Management Accounting 7e 22-315 RM Malaysian Ringgit (currency in Malaysia) RMF Raw Material Inventory - Fruit account RMI Raw Material Inventory account RMM Raw Material Inventory - Milk account RNT Rent account R.O. Returns Outwards RoA Register of non-current Assets ROA Return on Assets ROE Return on equity ROO Room Costs RU Reference Unit SCap Share Capital Sch SCHLUCHMAN SCE Statement of Changes in Equity SCF Statement of Cash Flows SCI Statement of Comprehensive Income scr Screw Sdn. Bhd. Sendirian Berhad SFP Statement of Financial Position ShD, S4D Shareholder for Dividend account sht Sheet SHV Shareholder Value SOH Service Overheads, Service Overheads account SPA Sales and Purchase Agreement str Strip T/ A Trading Account Tkt Ticketing TS Tax Statement (used in a case study as reference unit) / u per unit V Value VAT Value Added Tax, same as Goods and Service Tax GST / w per week WACC Weighted Average Cost of Capital W_E Work in Process - Europe account WFE Work in Process - FarEast account WIB Work in Process - Banana Ice Cream account WIL Work in Process - Lemon Ice Cream account WIP Work in Progress, Work-in-Process account, WIP-account WIS Work in Process - Strawberry Ice Cream account Wst Waste ZAR South African Rand σ Standard deviation μ Mean <?page no="316"?> Berkau: Management Accounting 7e 23-316 23. Table of Figures Figure 1.1: Accounts 1.22 Figure 3.1: PENOR PLC’s statement of financial position as at 1.01.20X1 3-32 Figure 3.2: Balance sheet 3-33 Figure 3.3: Income statement 3-34 Figure 4.1: PENOR PLC’s bank loan 4-39 Figure 4.2: Profitability analysis (1) 4-41 Figure 4.3: Unit costs of manufacturing per batch 4-41 Figure 4.4: Profitability analysis (2) 4-42 Figure 4.5: Cost of manufacturing COM report 4-43 Figure 4.6: Cost of goods sold report 4-44 Figure 4.7: Profitability analysis for Management Accounting 4-45 Figure 4.8: Pro-forma balance sheet 4-45 Figure 4.9: Revenue plan 4-47 Figure 4.10: Interest and pay-off schedule 4-47 Figure 4.11: Cost plan 4-48 Figure 4.12: Profitability plan 4-48 Figure 4.13: Budgeted balance sheet (annual) 4-49 Figure 4.14: Business plan for PENOR PLC 4-50 Figure 6.1: KIRSTENBOSCH (Pty) Ltd.’s revenue plan 6.67 Figure 6.2: KIRSTENBOSCH (Pty) Ltd.’s interest and pay-off schedule 6.68 Figure 6.3: KIRSTENBOSCH (Pty) Ltd.’s cost plan 6.68 Figure 6.4: KIRSTENBOSCH (Pty) Ltd.’s profitability plan 6-69 Figure 6.5: KIRSTENBOSCH (Pty) Ltd.’s liquidity plan 6-70 Figure 6.6: KIRSTENBOSCH (Pty) Ltd.’s pro-forma balance sheet 6-71 Figure 6.7: KIRSTENBOSCH (Pty) Ltd.’s statement of cash flows 6-73 Figure 6.8: BANTRY Ltd.’s balance sheet (20X2) 6-75 Figure 6.9: BANTRY Ltd.’s interest and pay-off plan 6-76 Figure 6.10: BANTRY’s revenue plan 6.77 Figure 6.11: BANTRY Ltd.’s material requirements’ plan 6.77 Figure 6.12: BANTRY Ltd.’s cost plan 6.78 Figure 6.13: BANTRY Ltd.’s closing stock valuation 6.79 Figure 6.14: BANTRY Ltd.’s profit plan 6.80 Figure 6.15: BANTRY Ltd.’s liquidity plan 6-81 Figure 6.16: BANTRY Ltd.’s budgeted balance sheet 6.82 Figure 7.1: Capital budget table WALLINGFORD Ltd. 7-91 Figure 7.2: eCBT for WALLINGFORD Ltd. (I) 7-92 Figure 7.3: eCBT WALLINGFORD Ltd. (II) 7-93 Figure 7.4: eCBT for WALLINGFORD Ltd. (III) 7-93 Figure 7.5: NPV calculation for the 1 st investment alternative 7-95 Figure 7.6: Calculating IRR by goal seek function 7-97 Figure 8.1: DEERFIELD TOURS (Pty) Ltd.’s CIS (1) 8-105 Figure 8.2: DEERFIELD TOURS (Pty) Ltd.’s CIS (2) 8-105 Figure 8.3: DEERFIELD TOURS (Pty) Ltd.’s CIS (3) 8-106 Figure 8.4: DEERFIELD TOURS (Pty) Ltd.’s CIS (base case) 8-107 <?page no="317"?> Berkau: Management Accounting 7e 23-317 Figure 8.5: DEERFIELD TOURS (Pty) Ltd.’s CIS (online-shop) 8-107 Figure 8.6: DEERFIELD TOURS (Pty) Ltd.’s CIS (bungee jumping) 8-108 Figure 8.7: DEERFIELD TOURS (Pty) Ltd.’s calculation of adj. NSP 8-109 Figure 8.8: Observations 8-110 Figure 8.9: DEERFIELD TOURS (Pty) Ltd.’s CIS (internet campaign) 8-111 Figure 8.10: Standard normal distribution table 8-112 Figure 8.11: DEERFIELD TOURS (Pty) Ltd. 2-product CIS 8-113 Figure 8.12: DEERFIELD TOURS (Pty) Ltd.’s 2-product CIS (2) 8-114 Figure 8.13: Goal seek function for break-even point 8-114 Figure 8.14: DEERFIELD TOURS 2-product CIS (3) 8-115 Figure 9.1: DEERFIELD TOURS (Pty) Ltd. break-even point 9-118 Figure 9.2: DEERFIELD TOURS (Pty) Ltd.’s/ profit calculation (1 additional traveller) 9-119 Figure 9.3: DEERFIELD TOURS (Pty) Ltd.’s CIS (11 travellers) 9-119 Figure 9.4: EMS KAYAK GmbH’s profit and cash flow calculation (1) 9-122 Figure 9.5: EMS KAYAK GmbH’s Accounting break-even point (2a) 9-123 Figure 9.6: EMS KAYAK GmbH’s profit and cash flow calculation (2b) 9-124 Figure 9.7: EMS KAYAK GmbH’s cash break-even point (2b) 9-124 Figure 9.8: EMS KAYAK GmbH’s financial break-even point (2c) 9-125 Figure 9.9: EMS KAYAK GmbH’s financial break-even point (2c) 9-125 Figure 9.10: EMS KAYAK GmbH’s profit and cash flow calculation (3) 9-126 Figure 9.11: EMS KAYAK GmbH’s profit and cash flow calculation (4) 9-127 Figure 9.12: EMS KAYAK GmbH’s profit and cash flow calculation (5) 9-128 Figure 9.13: EMS KAYAK GmbH’s profit and cash flow calculation (6) 9-128 Figure 9.14: EMS KAYAK GmbH’s profit and cash flow calculation (7) 9-129 Figure 9.15: Graphical implication of the outsourcing effect 9-129 Figure 9.16: EMS KAYAK GmbH’s break-even point 9-130 Figure 10.1: Profitability analysis for the GELDERN branch 10-135 Figure 10.2: Profitability analysis for the PIETERBUREN branch 10-135 Figure 10.3: Performance figures for VANHUIZEN BV 10-137 Figure 10.4: Profit calculation VANHUIZEN BV 10-138 Figure 10.5: VANHUIZEN BV’s performance clear of interest/ coupon 10-142 Figure 11.1: Capital budget table for OHIO FRIED CHICKEN 11-148 Figure 11.2: Payback calculation 11-149 Figure 11.3: OHIO FRIED CHICKEN’s balance sheet 11-150 Figure 11.4: Budgeted income statement for OHIO FRIED CHICKEN 11-151 Figure 11.5: OHIO FRIED CHICKEN’s budgeted balance sheet [ZAR] 11-151 Figure 11.6: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet 11-152 Figure 11.7: AYAM GORENG Sdn. Bhd.’s opening balance sheet 11-153 Figure 11.8: AYAM GORENG Sdn. Bhd.’s balance sheet after acquisition 11-153 Figure 11.9: OHIO FRIED CHICKEN (Pty) Ltd.’s adjusted balance sheet 11-154 Figure 11.10: Consolidation worksheet [MYR] 11-156 Figure 11.11: AYAM GORENG Sdn. Bhd. consolidated balance sheet 11-157 Figure 11.12: OHIO FRIED CHICKEN (Pty) Ltd.’s budgeted income statement 11-157 Figure 11.13: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet 11-158 Figure 11.14: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet 11-158 Figure 11.15: Consolidation worksheet in MYR 11-159 Figure 11.16: AYAM GORENG holding’s balance sheet as at 31.12.[t=1] 11-159 <?page no="318"?> Berkau: Management Accounting 7e 23-318 Figure 11.17: LOS POLLOS ASADOS (Pty) Ltd.’s balance sheet 11-160 Figure 11.18: LOS POLLOS ASADOS (Pty) Ltd.’s balance sheet after taking-over 11-161 Figure 11.19: LOS POLLOS ASADOS (Pty) Ltd.’s balance sheet after take-over 11-162 Figure 11.20: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet 11-163 Figure 11.21: OHIO FRIED CHICKEN (Pty) Ltd.’s income statement 11-164 Figure 11.22: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet 11-164 Figure 11.23: Average balance sheet for OHIO FRIED CHICKEN (Pty) Ltd. 11-165 Figure 12.1: ROCKS PLC’s balance sheet 12-171 Figure 12.2: ROCKS PLC.’s balance sheet 12-172 Figure 12.3: Random figure generator on a calculator (Casio) 12-175 Figure 12.4 WEATHERMAN’s profit simulation 12-176 Figure 12.5: WEATHERMAN’s profit MS-Excel simulation 12-176 Figure 12.6: NAMGURO Ltd.’s statement of comprehensive income 12-177 Figure 12.7: Results of NAMGURO Ltd.‘s profit simulation 12-178 Figure 12.9: Budgeted income statement for 20Y5 12-181 Figure 12.10: Risk simulation (MonteCarloSimulation) 12-182 Figure 12.11: Profit and loss simulation 12-183 Figure 13.1: STAFFORD (Pty) Ltd.’s accounts 13-190 Figure 13.2: STAFFORD (Pty) Ltd.’s accounts 13-191 Figure 13.3: STAFFORD (Pty) Ltd.’s income statement 13-193 Figure 13.4: STAFFORD (Pty) Ltd.’s balance sheet 13-194 Figure 13.5: Management Accounting system 13-196 Figure 13.6: GP&PR’s BOM 13-200 Figure 13.7: GP&PR’s direct costs based on products 13-201 Figure 13.8: GP&PR’s Management Accounting system (1) 13-203 Figure 13.9: GP&PR’s direct costs 13-204 Figure 13.10: GP&PR’s Management Accounting system (2) 13-205 Figure 13.11: GP&PR’s Management Accounting system (3) 13-206 Figure 13.12: GP&PR’s manufacturing accounts (1) 13-207 Figure 13.13: GP&PR’s manufacturing accounts (2) 13-208 Figure 13.14: GP&PR’s manufacturing accounts (3) 13-208 Figure 13.15: GP&PR’s manufacturing accounts (4) 13-210 Figure 13.16: GP&PR’s Management Accounting system (4) 13-211 Figure 13.17: GP&PR’s Management Accounting system (5) 13-213 Figure 14.1: DANNING (Pty) Ltd.’s cost volume records 14-220 Figure 14.2: DANNING (Pty) Ltd.’s cost separation by scatter graph method 14-221 Figure 14.3: Workings for regression analysis 14-222 Figure 14.4: GP&PR’s Management Accounting system (calculation) 14-227 Figure 14.5: GP&PR’s Management Accounting system (PA) 14-229 Figure 14.6: GP&PR’s profit planning 14-230 Figure 14.7: LOGA (Pty) Ltd.’s profitability analysis (absorption costing) 14-232 Figure 14.8: LOGA (Pty) Ltd.’s profitability analysis (partial costing) 14-233 Figure 15.1: CROXTON Ltd.’s cost variance in April 20X6 15-238 Figure 15.2: CROXTON Ltd.’s variance in May 20X6 15-238 Figure 15.3: CROXTON Ltd.’s proficiency report May 20X6 15-240 Figure 15.4: CROXTON Ltd.’s variance in June 20X6 15-241 Figure 15.5: CROXTON Ltd.’s proficiency report June 20X6 15-241 <?page no="319"?> Berkau: Management Accounting 7e 23-319 Figure 16.1: CLYDBANK Ltd.’s cost centre characteristics 16-244 Figure 16.2: CLYDBANK Ltd.’s accounts 16-245 Figure 16.3: CLYDBANK Ltd.’s accounts 16-246 Figure 16.4: CLYDBANK Ltd.’s cost allocations to cost centres 16-247 Figure 16.5: CLYDBANK Ltd.’s accounts after internal cost allocations 16-249 Figure 16.6: CLYDBANK Ltd.’s spreadsheet with internal cost allocations 16-250 Figure 16.7: CLYDBANK Ltd.’s cost centre rates 16-251 Figure 16.8: HEISFELD Ltd.’s performance structure 16-255 Figure 16.9: HEISFELD Ltd.’s primary costs 16-255 Figure 17.1: LEBUHRAYA Ltd.’s opening values 17-261 Figure 17.2: LEBUHRAYA Ltd.’s accounts 17-264 Figure 17.3: LEBUHRAYA Ltd.’s statement of COS 17-265 Figure 17.4: LEBUHRAYA Ltd.’s profitability analysis 17-267 Figure 17.5: Business graphic report LEBUHRAYA Ltd. 17-268 Figure 18.1: MAHKOTA (Pty) Ltd.’s accounts 18-277 Figure 18.2: MAHKOTA (Pty) Ltd.’s profitability analysis 18-279 Figure 18.3: MAHKOTA (Pty) Ltd.’s pro-forma balance sheet 18-279 Figure 19.1: EDEWECHT (Pty) Ltd.’s accounts 19-285 Figure 19.2: EDEWECHT (Pty) Ltd.’s accounts 19-286 Figure 19.3: EDEWECHT (Pty) Ltd.’s WIP-accounts 19-287 Figure 19.4: EDEWECHT (Pty) Ltd.’s accounts 19-290 Figure 20.1: FLINDERS Ltd.’s sales information for 7/ 20X6 20-295 Figure 20.2: FLINDERS Ltd.’s multiple-level CMA 20-297 Figure 21.1: TORQUAY Ltd.’s revenue 21-303 Figure 21.2: TORQUAY Ltd.’s accounts 21-304 Figure 21.3: TORQUAY Ltd.’s calculation (traditional cost Accounting) 21-304 Figure 21.4: TORQUAY Ltd.’s ABC cost centre Sales Office 21-305 Figure 21.5: TORQUAY Ltd.’s route calculation on a partial ABC system 21-306 <?page no="320"?> Berkau: Management Accounting 7e 24-320 24. List of Links Link 3.A: Financial statement preparation PENOR PLC ...................................... 3-35 Link 4.A: Bookkeeping entries................................................................................... 4-46 Link 6.A: C/ S McTOY GmbH ................................................................................. 6-84 Link 6.B: C/ S SCHLUCHMAN................................................................................ 6-84 Link 8.A: Spreadsheet for CIS ................................................................................. 8-105 Link 9.A: Excel sheet EMS KAYAK GmbH ........................................................ 9-122 Link 9.B: Neutral cost increase ................................................................................ 9-130 Link 10.A: Alternative capital structure ................................................................ 10-141 Link 10.B: EVA TM for an investor.........................................................................10-143 Link 11.A: OFC Preparations ................................................................................11-146 Link 11.B: CBT ........................................................................................................11-148 Link 14.A: Common format for simple regression method ..............................14-223 Link 16.A: Iteration Method .................................................................................. 16-257 Link 18.A: WEIXDORF Ltd. job order costing .................................................18-280 Link 21.A: ABM - TORQUAY Ltd. .....................................................................21-307 <?page no="321"?> Berkau: Management Accounting 7e 25-321 25. Literature Atkinson, A.A. et al. [2016]: Management Accounting. 6 th edition. London. Atrill, P.; McLaney, E. [2022]: Management Accounting for Decision Makers. 10 th edition. London. Berkau, C. [2021]: Basics of Accounting. 6th edition, Munich. Berkau, C. [2022]: Financial Statements, 7th edition, Munich. Berkau, C. [1994]: Vernetztes Prozeßkostenmanagement. Wiesbaden. Badenhorst, W.; Kotze, L.; Pretorius, D. [2022]: GAAP Handbook - Financial Accounting and Reporting Practice. Johannesburg. Britzelmaier, B. [2017]: Controlling - Grunlagen, Praxis, Handlungsfelder. 2. Aufl., Hallbergmoos. Correia, C. et al. [2019]: Financial Management. 9 th edition, Cape Town. Datar, S.M.; Rajan, M.V. [2023]: Horngren’s Financial & Managerial Accounting, 8 th Edition. New York, NJ. Drukarczyk, J.; Lobe, S [2014]: Finanzierung. 11. Auf., München Drury, C. [2021]: Management Accounting for Business. 8 th edition, Florence KY. Flynn, D.; Koornhof, C. [2016]: Fundamental Accounting. 7 th edition. 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München. <?page no="323"?> Layout ISBN 978-3-7398-3194-7 Prof. Dr. Carsten Berkau Prof. Dr. Carsten Berkau teaches Accounting and teaches Accounting and Management Accounting at the University of Applied Management Accounting at the University of Applied Sciences in Osnabrück, Germany. Sciences in Osnabrück, Germany. Other textbooks are Other textbooks are Basics of Accounting, Financial Basics of Accounting, Financial Statements Statements and and Bilanzen Bilanzen.. www.uvk.de Management Accounting is a textbook for business management study programmes. It covers the international syllabus of cost accounting and controlling on bachelor ’s and master ’s levels. Prof. Berkau has more than 25 years of teaching experience in Germany (UAS Osnabrück) and at international universities in South Africa, Malaysia, China, the Netherlands, and South Korea. The textbook follows a case study-based approach. All methods are discussed by easily understandable cases. The calculations demonstrate how to apply management accounting step by step. In the first chapters, the case study PENOR PLC about a British windows/ doors manufacturer explains the differences between financial accounting (IFRSs) and management accounting. In the next following sections, the textbook covers two points of view: (1) a controlling view, with budgeting, cost-volume-profit analysis, degree of operating leverage, investment appraisal, mergers and cross-border acquisitions and risk valuation (Monte- CarloSimulation); (2) a cost accounting view that covers management accounting systems, flexible budgeting, cost allocation methods, performance measurement, monitoring, reporting, product calculation, manufacturing accounting ( job order and process costing), activity-based costing, target costing and contribution margin accounting. On the UVK website, numerous exam tasks with complete solutions, further study materials, and links to video clips produced by Prof. Berkau are available for download.