Basics of Accounting
Part 2: Managerial Accounting
0219
2018
978-3-7398-0412-5
978-3-8676-4847-9
UVK Verlag
Carsten Berkau
Keabetswe Sylvia Berkau
Basics of Accounting targets students in international business study programs. It covers the widely applied syllabus of Accounting at universities on bachelor's and master's level. In this book, the application of the methods comes first. The Basics teach how to do Accounting by a case study based approach. All cases were taken from former exam papers at international universities and calculated completely and illustrated understandably.
Managerial Accounting is about Accounting for managers. It is linked to General Management where companies are seen as a whole as well as to Cost Accounting which comprises all methods/instruments applicable for calculations, budgeting and cost monitoring in business.
<?page no="1"?> Carsten Berkau Basics of Accounting Manag Accounting <?page no="3"?> Carsten Berkau Basics of Accounting Manag Accounting Edition UVK Verlagsgesellschaft mbH · Konstanz und München <?page no="4"?> Bibliografische Information der Deutschen Bibliothek Die Deutsche Bibliothek verzeichnet diese Publikation in der Deutschen Nationalbibliografie; detaillierte bibliografische Daten sind im Internet über <http: / / dnb.ddb.de> abrufbar. ISBN 978-3-86764- - 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. © UVK Verlagsgesellschaft mbH, Konstanz und München 201 Einbandgestaltung: Susanne Fuellhaas, Konstanz UVK Verlagsgesellschaft mbH Schützenstr. 24 · 78462 Konstanz Tel. 07531-9053-0 · Fax 07531-9053-98 www.uvk.de <?page no="5"?> 1 1. Conventions 1-7 2. Introduction to Management Accounting 2-13 3. Case Study PENOR Ltd. - Financial Accounting 3-18 4. Case Study PENOR Ltd. - Managerial Accounting 4-42 5. Characteristics of Management Accounting and Major Differences to Financial Accounting 5-72 6. Cost Planning / Business Plan 6-81 7. Cost Concepts, Cost Behaviour and Cost Separation 7-111 8. Cost Volume Profit Analysis (CVP-Analysis) 8-130 9. Degree of Operating Leverage (DOL) 9-144 10. Performance Measurement 10-161 11. Accounting for Mergers and Acquisitions 11-174 12. Risk Valuation 12-206 13. Structure of Cost Accounting Systems 13-224 14. Flexible Budgeting / Marginal Cost Accounting 14-244 15. Cost Monitoring 15-257 16. Cost Allocations 16-265 17. Reporting 17-287 18. Job Order Costing (Manufacturing Accounting) 18-295 19. Process Costing (Manufacturing Accounting) 19-316 20. Multi-Level Contribution Margin Accounting 20-326 21. Activity Based Costing 21-330 22. Abbreviations 22-343 23. Table of Figures 23-348 24. Literature 24-353 <?page no="7"?> This text book is based on the syllabus of Controlling / Managerial Accounting classes we teach in Germany, Malaysia, South Korea and South Africa. Basics of Accounting is a text book to support students studying Accounting. The approach is teaching case study based. We introduce to the methods of Accounting and explain them from the scratch on. The idea is to show our readers how to apply the Accounting instruments by easily understandable cases. As we address international students we teach along an international Accounting syllabus. From the 5 th edition of the text book “Berkau, C.: Basics of Accounting” onwards, we print it now in two parts: Part 1 is about Bookkeeping and an introduction to Financial Accounting and Part 2 is about Managerial Accounting. In general, the two parts are taught at universities as two separate subjects too. Although this is the second part of the text book Managerial Accounting is readable without studying Financial Accounting before. However, we recommend reading our Basics of Accounting in the sequence: Part 1 at first and then continue by Part 2. In contrast to the contents of the Basics of Accountings’ 4 th edition, part 2 is a 250 %-extended extract of the Management Accounting chapters (40) - (52) therein. It now contains a more detailed Managerial Accounting syllabus with further cases added and additional chapters with regard to Mergers and Acquisitions, Risk Valuation and performance measurement. Additionally, aspects of Hospitality Management are now covered. Basics of Accounting - Part 2: Managerial Accounting is a text book for the bachelor’s and for the master’s degree level. For its understanding, a moderate/ basic level of Accounting knowledge is required. The text book targets students who learn Management Accounting in a general or specialised Management study program. After studying this text book, you understand Management Accounting as an important discipline in Business and Management and know major developments, such as ABC-Costing, flexible Budgeting, Fixed Cost Management etc., and you achieved knowledge of how to perform the basic features of a Management Accounting system. You gain systemic competences which means you know what data input is required for Managerial Accounting’s application and where to retrieve it from, and you develop communication skills to discuss the subject in business based on its widely used technical terms. To put it simple: You know how to do Management Accounting and you understand Management Accountants and how they to their job. We primary do not target students who intend to start a career as tax lawyer and/ or auditor or Chartered Accountant and therefor major in Accounting. For those students, statements based on national tax law have <?page no="8"?> a higher importance and in general are taught before commercial financial statements. For those students our book falls into the category of entrance level books in international Accounting. For this reason, we named our book ‘Basics of Accounting. We are making the attempt to teach Accounting on a sufficient sophisticated Management level but with a moderate and appropriate workload for our students and readers. This text book (Part 1) starts on level zero and takes you to the Managerial Accounting requirements for industrial managers within less than 400 pages. In order to jump-start Management Accounting without studying part 1 of this text book we begin with a casebased description of Financial Accounting. We explain the basics of Bookkeeping and financial statement preparation by the fictional production firm PENOR Ltd. This helps you to review Financial Accounting if you studied already Accounting and familiarises you with the formats here in use. If you are new in Accounting, the chapter provides you with a quick tour through and an efficient introduction to Financial Accounting as required for the understanding of Managerial Accounting. In the next following chapter, the same case study PENOR Ltd. is used again, now in order to introduce the features of Management Accounting. We compare Financial Accounting to Managerial Accounting and show your in which regards Financial Accounting is more (too much) and where Management Accounting becomes wider and deeper than financial statements. The case study PENOR Ltd. gives you an overview of Managerial Accounting. As Managerial Accounting is supportive to two kind of managers we show 2 different angles of the subject in the following chapters of the text book: (1) Accounting for General Management and (2) Cost Accounting. Ad (1): Accounting for General Management If the general managers’ work is to be facilitated by Accounting information, we consider mainly data about the entire company. Aspects, such as the preparation of a business plan (Budgeting), break-even analysis or degree of operating leverage, are covered. This also applies for the Mergers and Acquisitions and Risk Management. Our chapters (6) to (12) are dedicated to General Management. Ad (2): Cost Accounting If Accounting supports management on the operational level, calculations and reports are required to be on a more detailed level. This includes defining cost centre structures, the design of Cost Accounting systems and cost centre based features, such as cost allocations and Cost Monitoring as well as Calculations, either based on Job Order Costing or Process Costing, ABC-Costing and Contribution Margin Accounting. The chapters (13) to (21) cover Cost Accounting. In this text book, every topic of Management Accounting is covered by a single chapter. You can either study out Basics of Accounting cover to <?page no="9"?> cover if you intend to get the full picture, or in case you are more experienced in Accounting already, you can read it being more picky. Choose the instruments you want to know about and read the related chapters of your subject of interest. In most cases, the chapters do not depend on each other. In case they do, you find references in the text for your orientation. All chapters explain Managerial Accounting by easy case studies. With regard to the complexity, the case studies are on examination task level. They are only as complex as required for capturing the methods. Our approach is to show how Accounting is done! For this reason, the text book cuts theoretical discussions short. We intend to teach what Management Accountants do and want you to achieve a good insight of how they work - no matter where your career takes you to: working as a Management Accountant or together with them. The case-based teaching method requires that you study the provided case studies with perseverance, best you take a calculator and recalculate the tables and accounts we provide you with. Take the time to understand the calculations properly! Once you applied Managerial Accounting yourself you understand the concepts. We do not want to put you in a position where you have to talk about Management Accounting but feel uncertain about on how it is applied. Hence, we strictly avoid buzz word hopping. We teach all methods that clearly that you can apply them. In order to make the subject as simple as possible, we apply consistent formats and standards over the whole text book. You will also notice that all exhibits appear to look very similar. As it is internationally common practice, we use accounts for explanations because they show you not only the additions and deductions but the cost flows too. In contrast, you will find in German text books seldom accounts which results from a stricter separation of Financial and Managerial Accounting. We are keen to explain every calculation in the text in detail and print results in bold figures in order to make you find results used in tables and exhibits easily. We find that every manager has to have a sound knowledge of Managerial Accounting as the fate of the company lays in their hands. Accounting does not provide you with business ideas which means ideas about what products or services in which quantities to produce but it tells you the financial impacts of your decisions and doings. It helps you to control business. Managerial Accounting is similar in all countries around the world. However, as no legal standards apply, there are slightly different methods and technical terms in use. This text book is for the use in international study programs and follows international terminology and conventions. For your help, we added paragraphs titled ‘How it is Done’ in order to give you guidance when you go through the steps of calculation. In case your professor gives you an open book exam, <?page no="10"?> these paragraphs can turn out to become pretty helpful as they treat Managerial Accounting as a recipe in a cooking book. We thank Dr. Jürgen Schechler from UVK-Lucius publisher in Munich, who is our lector. He endorses our book projects and provides a very nice and friendly atmosphere for our writing. He manages to make the text book affordable for our students by controlling the printing costs. Under www.uvk-lucius.de we put a high amount (more than 1,200 pages) of free study materials online for you - in particular a glossary, case studies and exam tasks with detailed solutions. Feel also free to follow us on twitter, under: ‘@CBerkau’. As you only can understand Accounting by doing we motivate you put hands on Accounting: Enjoy Accounting! Cape Town/ Osnabrück, in November 2017 <?page no="11"?> In this text book, the below listed conventions apply in order to simplify the cases. These conventions are about legal forms, tax rates, formats, etc. They also apply for examples and exercises you’ll find online on the UVK- Lucius.de-website. At this stage of reading, you won’t understand them all, we just put them at the beginning of the book for you to find them easily and upfront. Note, that they apply for the whole book. They come in alphabetic order below. Account Names: All names of accounts in the text book for Bookkeeping entries are written with capital letters in the text, such as ‘Cash/ Bank account’. We intent you to focus on the accounts for financial statement preparation. However, an account that is not subject to our recordings in the company is written with small letters. Assume there is a bank account with Deutsche Bank and we refer to that account. In that situation, the writing is with small letters: bank account. We do not make Bookkeeping entries therein, but Deutsche Bank AG does. Accounting Periods: Accounting periods always start on 1.01. and end on 31.12. Furthermore, to keep the examples transferable to later classes, we indicate the decade by an X, as in 20X4. X is followed by Y and Z. Alphabetic Order: For all lists, we apply an alphabetic order. Bookkeeping Entries: All Bookkeeping entries are printed in bold and cover the whole page’s width. This way we move them into the centre of the text to give them special attention. Bookkeeping Entries: We write the Bookkeeping entries as debit entries and credit entries. DR stands for debit recorded and CR for credit recorded. All Bookkeeping entries are printed in bold. See, i.e. the 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 When writing Bookkeeping entries in the text, account names always are written with capital letters, such as Motor Vehicle account. In contrast, writing ‘The item is added to motor vehicles’ indicates we do not refer to the account but to the assets ‘motor vehicles’. The identifier for a Bookkeeping entry always comes in brackets, such as Bookkeeping entry (1). <?page no="12"?> Calculations: In calculations, we only show the units with the results. I.e., 10 + 20.50 = 30.50 EUR. Furthermore, the figures in calculations come without any digits after the decimal point in case they equal to zero. The final result is printed in bold and comes always with two digits after the decimal point and the currency unit. Printing results bold helps you to find figures calculated in the text. All calculations are accurate to the EUR-cent or other currency 1/ 100amounts. Case Studies: The case studies provided by this text book are as easy as possible. Stories are kept simple in order to focus on Accounting. Sometimes you’ll get the impression the examples are too easy or unreal. However, our aim is not storytelling. Accounting cases can become pretty complex easily. Case Study Text Cash Flow Separation: An operating cash flow is a cash flow that does not result from investing nor financing activities. However, interest payments are always regarded as financing cash flow. Companies: For our text book, the legal form of companies does not count very much. Legal forms are country-wise different and are not subject to the Accounting syllabus. However, in contrast to IFRSs we do not refer to companies as “entities”. The IFRS-expression is due to standardisation purpose. Once you take a look at one of the standards and find the word “entity” just remember they are referring to a company. The standards avoid legal aspects of national law with regard to the company’s definition validity. However, we use the technical term “business”, “firm” and “company” interchangeably. Companies mostly are public companies, such as GmbH, AG, Pty Ltd., PLC, Inc. etc. Currency Unit: For all examples, the currency unit will be Euro (EUR). Be aware that all Bookkeeping entries and accounts are in EURs, too. The reporting currency in the statements is EUR. Data format in tables: In tables, negative figures are often disclosed in brackets. (7.50) equals to - 7.50 EUR. In all tables, the currency is EUR, as indicated. Deferred Payment of Income Taxes: In the case studies no deferred payments are made to the revenue service. Taxes are calculated at the year end and are added to short-term liabilities, mostly to Income Tax Liabilities account. <?page no="13"?> Financial Statements for Taxation: It is not intended to deepen your knowledge in tax statements. However, tax statements are relevant to ascertain income taxes liabilities and deferred taxes. To keep examples simple, the total income tax rate always equals to 30 %. Language: This text book is written in South African English. Learning Objectives and Summaries: Every chapter starts by the learning objectives and ends by a summary. Legal Forms of a Business: For this text book we normally use Ltd., (Pty) Ltd., Sdn. Bhd., Bhd., AG, GmbH, UG, PLC, Inc. etc. If nothing has been mentioned together with the company’s name assume the company is a privately-owned business, like SANDPIPER BOOKS for a privatelyowned bookstore. Length of a Month/ Year: 1 month = 21.5 days = 4.3 weeks. 1 year = 12 months = 365 days = 52 weeks. Level of Precision: The level of precision is 2 digits after the decimal point. Results from workings are rounded also. You can use rounded figures for further calculations, i.e. in examinations or case study workings. Sometimes we calculate in MS Excel; in that case the calculation in the background is more precise than the one displayed and visible to you. (Note, rounding is a minor problem for you.) Names: We always use names for companies and write them by capital letters. I.e. SCHULZE-BRAMMELKAMP Ltd. There are no links to actual existing persons or companies intended. In case there are similarities it will be coincidently. In case we refer to actually existing firms we make that clear by the text. You can search for the case studies by the names online in case we refer to it. We only use them once for a case study. Non-existing items: In case something has not been mentioned in a case study you should assume it won’t exist. Sometimes case studies have been cut short in order to get a point made more clearly. Notes: In the text book, we sometimes give you some notes in brackets. They always start by (Note, …) These are some additional hints to better understand our examples or some remarks why we are doing something the way we do. Payment Terms: Payments for all kind of taxes and for dividends are due in the next Accounting period. Furthermore, we ignore any consequence on tax income resulting from profits carried forward or backwards. <?page no="14"?> Presentation of Accounts: Accounts are displayed in the easiest format possible. See the accounts for the car acquisition’s Bookkeeping entry: 20,000.00 4,000.00 24,000.00 Figure 1.1: Accounts In figures, accounts are often displayed with abbreviations due to a better overview. Instead of ‘Property, Plant and Equipment’ we write ‘P, P, E’. Names of accounts only start by a capital letters and then the remaining name is written in small letters. I.e., Motor vehicle as the header of an account displayed. Abbreviations are listed at the end of this text book. Pro-Rata-Temporis Calculation of Depreciation and Interest: Although given as annual rates, depreciation and interest are calculated on a pro rata temporis (PRT) basis and accurate to the month. Pro rata temporis is Latin and means proportional to the time. Monthly depreciation is ascertained as annual depreciation divided by 12. In case the company is in possession of the asset for a shorter period than a full year, all months will count for depreciation if the asset is deployed for the major duration thereof. If the asset is bought on 6.01.20X1 the January will be relevant for depreciation. If the asset is sold on 28.12.20X1 the December counts for depreciation, too. If the asset is sold on 5.12.20X1, the December won’t be considered for depreciation. Interest rates are given on an annual basis with annual compounding only. For loans taken for shorter periods than a year, interest is also calculated on a pro rata temporis basis accurate to the month. The monthly rate of interest is the annual rate divided by 12. The interest is compounded annually and paid at the end of the Accounting period. If a bank loan of 100,000.00 EUR is taken on 4.06.20X4 and the annual rate of interest is 10 %/ a, the interest paid at the end of the year will equal to: 7 × 100,000 × 10%/ 12 = 5,833.33 EUR. In general, pay-off payments take place at the end of the Accounting period. If not, the calculation is to be made in intervals. If there is an extra pay-off payment at the end of each quarter the interest has to be calculated for 4 quarterly periods. Interest is only calculated for debts, such as bank loans, bonds etc. No overdraft of the bank account is considered. In particular, we do not check <?page no="15"?> a bank loan’s balance during the Accounting period for overdrafts and calculate interest thereon. However, an overdrawn bank account leads to a liability recognition. Interest and pay-off are always paid instantly which means the credit entry is in the Cash/ Bank account. Quotation of Law Texts: Law texts are quoted like ‘§ 266 II HGB’ or ‘IAS 1.68’. We use the original law names and no translations thereof. Hence, the HGB is the German Civic Code, called in German: Handelsgesetzbuch (HGB). In this text book, we quote paragraphs mostly without section references and standards mostly without paragraph reference. Note, that IFRS paragraphs are subject to changes frequently. Sequence of Bookkeeping Entries: The sequence of Bookkeeping entries comes along the logical procedure defined by the text reading. Sometimes this differs from the timeline of activities. If there is the acquisition of assets and later these assets are written-off by depreciation, we put these Bookkeeping entries next to each other in the text, although the acquisition might take place on 2.01.20XX and depreciation is recorded on 31.12.20XX. 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 return amount in this text book. Note, the tax on capital returns is not regarded as income tax for the company, although it is owed by the company on behalf of its shareholders. The tax on capital returns is a withholding tax. Total Income Tax: All tasks and exams are based on a total income tax rate of 30 %. Taxation is not part of our Management Accounting syllabus. Value Added Tax, Goods and Service Tax: VAT stands for value added tax and GST for Goods and Service Tax. Except of the United Arabic Emirates and some U.S. states such as Delaware, consumers pay VAT once they buy goods or services. We only apply one VAT account. This is different to German Bookkeeping, where input-VAT and output-VAT is recorded in separate accounts: Vorsteuerforderung and Umsatzsteuerschuld. For international Accounting make debit and credit entries in the VAT account. The VAT rate for all case studies and examples equals to 20 %. We ignore any lower/ reduced VAT rates as apply in some countries for food, books etc. Working Definitions: In this text book, we mark some definitions in bold letter writing in the text and copy them to the end of the chapter to make learning Accounting easier for you. We deliberately call them working definitions. The working definitions are to help you to understand the concepts. In contrast, proper academic definitions are more accurate but often more difficult to understand <?page no="16"?> as they must cover all cases and exceptions possible. 10-20-30 Rule: In this text book, the 10-20-30 rule applies. As long as 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="17"?> Managerial Accounting is Accounting for managers. The design of Management Accounting concepts depends on the information requirements. We divide this book in two sections, Management Accounting for General Management and Cost Accounting. The support of general management focusses on the entire company. I.e., a return figure calculated as a company’s annual profit as percentage of its total assets is regarded as a General Management aspect. In contrast, the calculation of a cost rate in a cost centre is assigned to Cost Accounting because it is not linked to the whole business. In contrast to Financial Accounting, which aims to inform the investors and creditors about the last Accounting period’s profit, Management Accounting is focussed on future activities and monitoring of actual data in order to keep the business processes on track. For Management Accounting, no legal requirements, such as IFRSs, apply. Management Accounting is based on production theory and cost theory. The information managers need in order to control the business are different to findings than can be derived from financial statements. Very few small businesses can be run based by Financial Accounting information but the majority of companies installs a formal Accounting system that meets the managers’ requirements for setting objectives, planning of future activities, monitoring actual activities and calculating profitability on a shortterm basis. Hence, information in Management Accounting is based on periods shorter than a year. Most managers plan and monitor their business based on a monthly basis. As a further difference to Financial Accounting, Management Accounting is operated on an organisational unit’s base. Therefore, companies are divided in units referred to as responsibility centres, i.e. cost centres, which are controlled separately. Often these cost centres are even turned into profit centres and plan their own income statement, called Profitability Analysis. Companies run hundreds of responsibility centres which are planned and monitored in distributed units. The way we understand the role of Management Accountants, is as a counsellor for managers. In an organisational chart, the chief financial officer CFO is the head of Accounting with responsibility for all Accounting and Finance issues which include Financial Accounting with regard to keep records and prepare financial statements and tax statements, and Management Accounting which includes the maintaining of Accounting records, the planning and monitoring of activities/ products and reporting. Under Finance falls taking custody of the company’s funds and liquidity planning. The aim of the Management Accounting system is to provide managers with solid and relevant data for planning, Monitoring and making the right economic decisions. <?page no="18"?> In particular, Basics of Accounting covers the below listed chapters, which are structured in three sections: Section (1): Introduction to Management Accounting Section (2): Management Accounting for General Management Section (3): Cost Accounting Section (1): Introduction to Management Accounting In the first section, the case study PENOR Ltd. is used in order to repeat the preparation of financial statements and to lay out differences between Management Accounting and Financial Accounting. After the Introduction and a convention chapter, the chapter (3) discusses how financial statements are prepared for PENOR Ltd. along IFRSs. In chapter (4), the same case study PENOR Ltd. which is a production firm for aluminium windows and doors applies in order to introduce to the basics of Management Accounting, such as cost planning, recording data in an integrated Accounting system, product Calculation based on Manufacturing Accounting (Job Order Costing) and preparing a business plan. The chapter (5) summarizes the characteristics of Management Accounting and discusses the major differences to Financial Accounting. Section (2): Management Accounting for General Management In chapter (6), the business plan which was introduced by the PENOR Ltd. case study is prepared for different case studies in Hospitality Management and Industrial Management. A business plan contains a revenue plan, a cost plan, a profit plan and a liquidity plan. After being approved, the business plan is referred to as the (master) budget. The chapter covers Budgeting along a Full Cost Accounting system and shows the complete planning procedure. Chapter (7) introduces all major cost terms and shows the difference between proportional and fixed costs as well as methods for Cost Separation. The study of cost behaviour is required for meaningful cost planning. The cost-volume-profit analysis is introduced in chapter (8). It ascertains the break-even-point which is the amount of output (volume) where the company earns a zero profit. As costs start at fixed costs and the revenue at the point (0/ 0) the cost curve lays above revenues at first. At the breakeven point the cost curve intersects the revenue curve. Once the production output exceeds the break-even amount the company starts earning profits because then the revenue curve is above the cost curve. The chapter shows how companies apply the what-if analysis in order to facilitate decisions about output volume and product mix. In chapter (9), we discuss the degree of operational leverage which tells managers how much profit or cash flow will increase as a result of an every incremental addition to output and to revenue. The chapter (10) describes methods of performance measurement. All major performance ratios are explained by the case study VANHUIZEN BV and are discussed with regard to their benefits as well as particular problems that can mislead managers’ decisions. <?page no="19"?> The next following chapters are linked to Mergers and Acquisitions. In chapter (11) we present Accounting due diligence work for company valuations when preparing company take-overs and/ or mergers. In chapter (12), we study a modern approach for Risk Valuation based on the MonteCarloSimulation. The technical term value at risk VaR is introduced as well as the calculation of the probability for companies to fail their objectives with regard to profit and cash flow. Also the probability of bankruptcy is determined. Section (3): Cost Accounting Cost Accounting covers methods of how costs are allocated within a company. The chapter is placed behind the Management Accounting for General Management section in order to refer to the Accounting principles already covered. 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. In particular, the cost flow through a Management Accounting system is subject to the discussion. The case study GUILIO’s PIZZA&PASTA RESTAURANTE is used for the explanation of every single step in a Management Accounting system. The chapter (14) is linked closely to the previous one and shows the difference between a Full Cost Accounting system and flexible Budgeting. In order to compare the systems, the same case study about the Italian restaurant applies. In chapter (15), Cost Monitoring is covered. We show how to calculate and read cost deviations in order to analyse reasons thereof. The chapter (16) is about cost allocations. We show methods for internal cost allocations, such as the equation method and the iteration method. In chapter (17), we introduce reporting in Industrial Management and present a report for the cost of sales in a production firm as an example. Manufacturing Accounting is important for Industrial Management. It was introduced by the PENOR Ltd. case study already and will be covered by the chapters (18) and (19) in 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 the management of fixed costs. The chapter (21) is about Activity Based Costing. The next upcoming chapters in this text book are as follows: <?page no="20"?> ( 0) Introduction ( 1) Conventions Section (1): Management Accounting and Financial Accounting ( 2) Introduction to Management Accounting ( 3) Case Study PENOR Ltd. - Financial Accounting ( 4) Case Study PENOR Ltd. - 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) Cost Concepts, Cost Behaviour and Cost Separation ( 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) Structure of Cost Accounting Systems (14) Flexible Budgeting / Marginal Cost Accounting (15) Cost Monitoring (16) Cost Allocations (17) Reporting on Manufacturing Accounting (18) Job Order Costing (Manufacturing Accounting) (19) Process Costing (Manufacturing Accounting) (20) Multi-Level Contribution Margin Accounting (21) Activity Based Costing <?page no="21"?> Section (1): Management Accounting and Financial Accounting Part (1) discusses the differences between Financial Accounting and Management Accounting. We give you an overview of the chapters for you to understand the flow of discussion in this part (1) better. In chapter (3) Case Study PENOR Ltd. - Financial Accounting, we introduce the case study PENOR Ltd. that is a production firm for aluminium windows and doors in Germany. The case study starts by the recording of activities as Bookkeeping entries. We refer to the financial statements as prepared along the IFRSs. We deliberately show aspects relevant for the preparation of financial statements, such as different purchase prices, payment terms and prepaid costs. We also cover the discounting of liabilities and their disclosure. We repeat the basics of Financial Accounting and set up a full set of financial statements that comprises a statement of financial position, a statement of comprehensive income, a statement of changes in equity and a statement of cash flows. As we only introduce Financial Accounting or refresh your knowledge thereof we do not cover the notes. In contrast to the previous chapter, we discuss the same case study PENOR Ltd. for Managerial Accounting. The chapter (4) Case Study PENOR Ltd. - Managerial Accounting shows what aspects of Financial Accounting become irrelevant for Management Accounting and can be ignored or simplified. On the other hand, we show that the company cannot be controlled by the financial statements only and explain Budgeting, cost deviations and the product and profit calculation by Manufacturing Accounting. We applying the Work-in- Process and the Manufacturing Overheads accounts. We also prepare a report as a statement of cost of goods manufactured and cost of goods sold and prepare a business plan for the next upcoming two years. The chapter (5) Characteristics of Management Accounting and Major Differences to Financial Accounting explains Management Accounting by referring to the previous chapters’ case study PENOR Ltd. and shows the differences between Financial Accounting and Management Accounting. <?page no="22"?> Leaning Objectives: This chapter repeats the basic knowledge about Financial Accounting. It shows how an European company prepares financial statements and what information can be derived therefrom by the case study PENOR Ltd. Why do we start a text book for Managerial Accounting by financial statements? We want to show that in real business the financial statements are available and that Managerial Accounting is derived from Accounting records. Furthermore, in order to understand Management Accounting, some knowledge about Accounting concepts is essential. For example, you should be able to understand the double entry system and the Accounting equation. The fundamentals of Financial Accounting are covered by the text book ‘Berkau: Basics of Accounting, Part (1): Bookkeeping and Financial Accounting’ from scratch on. Financial Accounting is legally required and makes a company report to their owners, legal entities and other parties interested on its financial position, its profit and its cash flows based on actual data. Companies that are publically owned, such as GmbHs, companies on shares, or Inc. and limited companies, such as a Ltd., (Pty) Ltd., PLCs, prepare a set of financial statements that comprises along IAS 1.10: - Statement of financial position as at the end of the period - Statement of profit and loss and other comprehensive income for the period - Statement of changes in equity for the period - Statement of cash flows for the period - Notes, comprising a summary of significant Accounting policies and other explanatory information - Comparative information in respect of the proceeding period […]. - A statement of financial position as at the beginning of the earliest comparative period when an entity applies an Accounting policy retrospectively or makes a retro perspective restatement of items in its financial statements, or when it reclassifies items in its financial statements […]. In order to repeat the preparation of financial statements or alternatively to give you a short briefing thereon, we use the case study PENOR Ltd. We discuss how the company is established and observe its activities during the first Accounting period. We show what kind of information is provided by the financial statements and what information is additionally required in order to control the business. This means, we start with Financial Accounting and continue with Management Accounting in the next chapter. We also mention which information is important for legal aspects, such as international Accounting standards IFRS, even if it does not matter for Management Accounting. (Note, in case you know how to prepare financial statements just skip the next pages <?page no="23"?> and go to the financial statements in Figure 3.10, Figure 3.13, Figure 3.14 and Figure 3.15! ) The approach to introduce Management Accounting this way got the following advantages: (1) Accounting is taught from the legal perspective at first. This is the experience every new established company is going to make. (2) It makes the reader repeat Financial Accounting and lifts him/ her on an advantaged level of Accounting knowledge. (3) It gives the chance to introduce formal standards which applies in this and in the Bookkeeping and Financial Accounting part text book. (4) It shows the differences between Financial Accounting and Management Accounting. Unfortunately, the approach also comes with disadvantages: (1) The next following case study is quite long and requires some perseverance in order to work through it. (2) Some aspects are shown and later discontinued in order to emphasise the differences. You might get the impression to read something irrelevant. However, this reflects the reality in business as you derive Managerial Accounting from financial statements. We decided the advantages outweigh the disadvantages and go through the case study PENOR Ltd. as announced. In case you feel as a Financial Accounting expert, move to the 2 nd part of the case study in chapter (4) after taking a look at its financial statements. The case study PENOR Ltd. is about a fictive production firm and covers 3 items in the next two chapters: (A) Inception (B) Financial Accounting (C) Management Accounting (Note, item C is discussed in the next chapter! ) We start with the incorporation of PENOR Ltd. Ad (A): Inception (Note, the case study is fictive. In Germany it is required to establish such a company in the legal form of a GmbH and to follow the regulations of the German Handelsgesetzbuch HGB. For this international text book we simplify the situation and assume, PENOR Ltd. follows IFRSs.) <?page no="24"?> DR Cash/ Bank.................... 400,000.00 EUR CR Issued Capital............... 400,000.00 EUR 400,000.00 400,000.00 400,000.00 400,000.00 Figure 3.1: PENOR Ltd.’s statement of financial position as at 1.01.20X1 Ad (B): Financial Accounting (Note, the latter one is fictional. Germany companies in the legal form of a public company prepare financial statements pursuant to §§ 242, 264 HGB the Handelsgesetzbuch in Germany.) <?page no="25"?> DR Cash/ Bank.................... 200,000.00 EUR CR Interest Bearing Liabilities. 200,000.00 EUR DR Interest..................... 6,000.00 EUR CR Cash/ Bank.................... 6,000.00 EUR DR Interest Bearing Liabilities. 20,000.00 EUR CR Cash/ Bank.................... 20,000.00 EUR IAS 1.69: An entity shall classify a liability as current when (a) it expects to settle the liability in its normal operating cycle, (b) it holds the liability primary for the purpose of trading, (c) the liability is due to be settled within twelve months after the reporting period, or (d) it does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period […]. (Note, you can register at www.IFRS.org and then download the IFRSs standards! ) Figure 3.2: IFRSs website for standards download <?page no="26"?> DR Interest Bearing Liabilities. 20,000.00 EUR CR Short-term Liabilities....... 20,000.00 EUR 400,000.00 6,000.00 400,000.00 200,000.00 20,000.00 20,000.00 200,000.00 6,000.00 20,000.00 20,000.00 Figure 3.3: PENOR Ltd.’s accounts DR P, P, E...................... 150,000.00 EUR DR VAT.......................... 30,000.00 EUR CR Cash/ Bank.................... 180,000.00 EUR <?page no="27"?> DR Depreciation ................. 30,000.00 EUR CR Acc. Depr. CNC-Saws.......... 30,000.00 EUR DR Rent......................... 97,500.00 EUR CR Cash/ Bank.................... 97,500.00 EUR DR Prepaid Expenses............. 7,500.00 EUR CR Rent......................... 7,500.00 EUR 400,000.00 6,000.00 400,000.00 200,000.00 20,000.00 180,000.00 97,500.00 20,000.00 200,000.00 6,000.00 20,000.00 Figure 3.4: PENOR Ltd.’s accounts <?page no="28"?> 20,000.00 150,000.00 30,000.00 30,000.00 30,000.00 97,500.00 7,500.00 7,500.00 Figure: 3.4: PENOR Ltd.’s accounts (continued) DR Purchase..................... 600,000.00 EUR DR VAT.......................... 120,000.00 EUR CR Cash/ Bank.................... 720,000.00 EUR <?page no="29"?> DR Purchase..................... 450,000.00 EUR DR VAT.......................... 90,000.00 EUR CR Accounts Payables............ 270,000.00 EUR CR Cash/ Bank.................... 270,000.00 EUR DR Purchase..................... 600,000.00 EUR DR VAT.......................... 120,000.00 EUR CR Accounts Payables............ 720,000.00 EUR DR Purchase..................... 40,000.00 EUR DR VAT.......................... 8,000.00 EUR CR Cash/ Bank.................... 48,000.00 EUR DR Purchase..................... 26,000.00 EUR DR VAT.......................... 5,200.00 EUR CR Cash/ Bank.................... 31,200.00 EUR DR Purchase..................... 270,000.00 EUR DR VAT.......................... 54,000.00 EUR CR Cash/ Bank.................... 324,000.00 EUR <?page no="30"?> DR Accounts Receivables......... 16,200.00 EUR CR Discount Received............ 16,200.00 EUR DR Discount Received............ 16,200.00 EUR CR VAT.......................... 2,700.00 EUR CR Purchase..................... 13,500.00 EUR DR Purchase..................... 1,250,000.00 EUR DR VAT.......................... 250,000.00 EUR CR Cash/ Bank.................... 1,500,000.00 EUR DR Cash/ Bank.................... 15,000.00 EUR CR VAT.......................... 2,500.00 EUR CR Return Outwards.............. 12,500.00 EUR DR Purchase..................... 20,000.00 EUR DR VAT.......................... 4,000.00 EUR CR Cash/ Bank.................... 24,000.00 EUR <?page no="31"?> Figure 3.5: PENOR Ltd.’s purchases in 20X1 400,000.00 6,000.00 400,000.00 200,000.00 20,000.00 15,000.00 180,000.00 6,062,280.00 97,500.00 720,000.00 270,000.00 720,000.00 48,000.00 31,200.00 324,000.00 1,500,000.00 24,000.00 20,000.00 200,000.00 6,000.00 20,000.00 20,000.00 150,000.00 Figure 3.6: PENOR Ltd.’s accounts <?page no="32"?> 30,000.00 2,700.00 30,000.00 120,000.00 2,500.00 90,000.00 1,010,380.00 120,000.00 8,000.00 5,200.00 54,000.00 250,000.00 4,000.00 30,000.00 97,500.00 7,500.00 7,500.00 270,000.00 600,000.00 13,500.00 12,500.00 450,000.00 600,000.00 40,000.00 26,000.00 270,000.00 1,250,000.00 20,000.00 16,200.00 16,200.00 16,200.00 1,750,000.00 500,000.00 250,000.00 250,000.00 250,000.00 400,000.00 400,000.00 5,051,900.00 Figure 3.6: PENOR Ltd.’s accounts (continued) <?page no="33"?> DR Labour....................... 1,750,000.00 EUR CR Social Security / p........... 250,000.00 EUR CR Payroll tax.................. 400,000.00 EUR CR Cash/ Bank.................... 1,100,000.00 EUR DR Labour....................... 250,000.00 EUR CR Social Security / p........... 250,000.00 EUR DR Social Security / p........... 500,000.00 EUR CR Cash/ Bank.................... 500,000.00 EUR DR Payroll tax.................. 400,000.00 EUR CR Cash/ Bank.................... 400,000.00 EUR DR Cash/ Bank.................... 6,062,280.00 EUR CR VAT.......................... 1,010,380.00 EUR CR Revenue...................... 5,051,900.00 EUR The valuation of finished goods is called Calculation. <?page no="34"?> Figure 3.7: Direct materials for windows Figure 3.8: Direct materials for doors <?page no="37"?> 400,000.00 6,000.00 400,000.00 400,000.00 200,000.00 20,000.00 400,000.00 15,000.00 180,000.00 6,062,280.00 97,500.00 720,000.00 270,000.00 48,000.00 31,200.00 324,000.00 1,500,000.00 24,000.00 1,100,000.00 500,000.00 400,000.00 1,456,580.00 6,677,280.00 6,677,280.00 1,456,580.00 20,000.00 200,000.00 6,000.00 6,000.00 20,000.00 6,000.00 6,000.00 160,000.00 200,000.00 200,000.00 63,001.34 160,000.00 96,998.66 160,000.00 160,000.00 96,998.66 20,000.00 20,000.00 150,000.00 150,000.00 20,000.00 150,000.00 30,000.00 2,700.00 30,000.00 30,000.00 120,000.00 2,500.00 30,000.00 90,000.00 1,010,380.00 120,000.00 8,000.00 5,200.00 54,000.00 250,000.00 4,000.00 334,380.00 1,015,580.00 1,015,580.00 334,380.00 Figure 3.9: Accounts <?page no="38"?> 30,000.00 30,000.00 97,500.00 7,500.00 30,000.00 90,000.00 97,500.00 97,500.00 90,000.00 90,000.00 7,500.00 7,500.00 990,000.00 270,000.00 7,500.00 720,000.00 990,000.00 990,000.00 990,000.00 1,190,000.00 200,000.00 1,190,000.00 1,190,000.00 1,190,000.00 600,000.00 13,500.00 12,500.00 12,500.00 450,000.00 600,000.00 40,000.00 26,000.00 270,000.00 1,250,000.00 20,000.00 3,242,500.00 3,256,000.00 3,256,000.00 3,242,500.00 3,242,500.00 16,200.00 16,200.00 16,200.00 16,200.00 16,200.00 1,750,000.00 500,000.00 250,000.00 250,000.00 2,000,000.00 250,000.00 2,000,000.00 2,000,000.00 500,000.00 500,000.00 2,000,000.00 2,000,000.00 400,000.00 400,000.00 5,051,900.00 5,051,900.00 Figure 3.9: Accounts (continued) <?page no="39"?> 80,000.00 80,000.00 60,000.00 60,000.00 80,000.00 60,000.00 100,000.00 100,000.00 9,500.00 9,500.00 100,000.00 9,500.00 37,500.00 37,500.00 15,600.00 15,600.00 37,500.00 15,600.00 5,000.00 5,000.00 322,251.50 332,251.50 5,000.00 332,251.50 3,242,500.00 5,051,900.00 2,000,000.00 2,461,751.50 80,000.00 90,000.00 60,000.00 30,000.00 100,000.00 6,000.00 9,500.00 335,751.50 37,500.00 2,461,751.50 2,461,751.50 15,600.00 100,725.45 335,751.50 5,000.00 235,026.05 332,251.50 335,751.50 335,751.50 2,461,751.50 12,500.00 5,704,251.50 5,704,251.50 2,461,751.50 2,461,751.50 235,026.05 235,026.05 100,725.45 100,725.45 200,000.00 235,026.05 100,725.45 35,026.05 235,026.05 235,026.05 63,001.34 63,001.34 63,001.34 35,026.05 35,026.05 35,026.05 Figure 3.9: Accounts (continued) <?page no="40"?> 5,051,900.00 332,251.50 5,384,151.50 (2,922,400.00) (2,000,000.00) (30,000.00) (90,000.00) 341,751.50 (6,000.00) 335,751.50 (100,725.45) 235,026.05 Figure 3.10: PENOR Ltd.’s income statement DR Retained Earnings............ 200,000.00 EUR CR Accounts Payables ........... 200,000.00 EUR DR Retained Earnings............ 35,026.05 EUR CR Earnings Reserves............ 35,026.05 EUR <?page no="41"?> 200,000.00 6,000.00 20,000.00 180,000.00 180,000.00 5,400.00 20,000.00 160,000.00 160,000.00 4,800.00 20,000.00 140,000.00 140,000.00 4,200.00 20,000.00 120,000.00 120,000.00 3,600.00 20,000.00 100,000.00 100,000.00 3,000.00 20,000.00 80,000.00 80,000.00 2,400.00 20,000.00 60,000.00 60,000.00 1,800.00 20,000.00 40,000.00 40,000.00 1,200.00 20,000.00 20,000.00 20,000.00 600.00 20,000.00 0.00 Figure 3.11: PENOR Ltd.’s bank loan calculation <?page no="42"?> 200,000.00 6,000.00 20,000.00 180,000.00 5,400.00 20,000.00 160,000.00 4,800.00 20,000.00 0.83 16,528.93 140,000.00 4,200.00 20,000.00 0.75 15,026.30 120,000.00 3,600.00 20,000.00 0.68 13,660.27 100,000.00 3,000.00 20,000.00 0.62 12,418.43 80,000.00 2,400.00 20,000.00 0.56 11,289.48 60,000.00 1,800.00 20,000.00 0.51 10,263.16 40,000.00 1,200.00 20,000.00 0.47 9,330.15 20,000.00 600.00 20,000.00 0.42 8,481.95 160,000.00 96,998.66 Figure 3.12: Discounting liabilities DR Interest Bearing Liabilities. 63,001.34 EUR CR Retained Earnings............ 63,001.34 EUR 120,000.00 400,000.00 35,026.05 63,001.34 639,851.50 96,998.66 16,200.00 1,544,380.00 7,500.00 1,456,580.00 100,725.45 2,240,131.50 2,240,131.50 Figure 3.13: PENOR Ltd.’s balance sheet <?page no="43"?> 6,062,280.00 (2,917,200.00) 15,000.00 (97,500.00) (1,100,000.00) (400,000.00) (500,000.00) 1,062,580.00 (180,000.00) (180,000.00) 400,000.00 200,000.00 (6,000.00) (20,000.00) 574,000.00 1,456,580.00 Figure 3.14: PENOR Ltd.’s statement of cash flows <?page no="44"?> 400,000.00 400,000.00 235,026.05 235,026.05 (200,000.00) (200,000.00) 35,026.05 (35,026.05) 0.00 63,001.34 63,001.34 400,000.00 35,026.05 63,001.34 498,027.39 Figure 3.15: PENOR Ltd.’s statement of changes in equity The item (C) Management Accounting is discussed in the next chapter. We’ll show the difference between Management Accounting and the preparation of financial statements in the next following chapter (4). Summary: The case study PENOR Ltd. is about a German production firm. The company produces doors and windows. It applies the International Financial Reporting standards IFRSs. 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. Notes have not been prepared in this chapter, you find notes covered by chapter (6) of the text book ‘Berkau, C.: Bilanzen’ or the translation thereof. Working Definitions: Calculation: The valuation of finished goods is called Calculation. Direct Costs: Direct costs are costs that occur for only one particular product. Bill of Materials: A bill of materials is a document that shows the part-structure of a product. Master Data: Master data are data of an enterprise resource planning system (ERM system), that have no link to the TIME data object. Enterprise Resource Planning System, ERP system: An ERM system is an integrated mostly computer based information system for the control of a business’s activities and resources, such as assets, human resources (staff) and relationships to business partners. 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 <?page no="45"?> stock release in the sequence of intakes. Batch: A batch is the amount of products produced by one internal job order. 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. <?page no="46"?> Learning Objectives: In this chapter, we discuss the same case study PENOR Ltd. from the Management Accounting point of view. We use the now known case study from the previous chapter in order to introduce the basic concepts of Managerial Accounting. The chapter helps to develop an understanding of Management Accounting. It is the aim to show how Management Accounting works. Management Accounting is Accounting for managers. In contrast to Financial Accounting it meets the information requirements of managers who control the business. In Germany, the expression Controlling is widely in use as technical term for Management Accounting. There is no difference between Management Accounting, Managerial Accounting or Controlling. We continue to study the company PENOR Ltd. as introduced in the previous chapter (3). The case study PENOR Ltd. is used to discuss only basic aspects of Management Accounting in this introduction chapter. A detailed discussion of the therein mentioned concepts is covered by the next following chapters in the text book. We continue the case study by its last item (C) which is about Management Accounting. (Note, (A) is inception, (B) is Financial Accounting) Ad (C): Management Accounting Financial Accounting and Managerial Accounting are similar but they follow different purposes. Managerial Accounting provides information about profitability in order to help managers to control the business. The question for many companies is: “Can we control our business by its financial statements? ”. The answer actually is yes, but only if the company is very small and the owner can overview it easily. The overview is frequently hampered by regulations for Financial Accounting, such as Bookkeeping requirements. It is no advisable approach to run a company of higher complexity based on financial statements. However, there is already good information that can be derived from the financial statements about the company. We mention a few thereof: (Note, whenever we calculate percentages of changes we put the initial amount into the denominator.) <?page no="47"?> (Note, this is no financial statement analysis but a first glance on financial statements in order to extract some relevant information for Controlling. For studying financial statement analysis read chapter (5) in ‘Berkau, C.: Bilanzen’ or its translation.) The information (1) … (5) can be taken from the financial statements and provides investors, owners and all other parties interested in the business with relevant information. I.e., if you want to invest in PENOR Ltd. the information will be useful. As an investor/ owner you want to know how the business performs and how risky your contribution to its equity will be. However, we cannot control complicated business operations by financial statements. For running the company, we have to understand how the business processes work in detail and what will affect the company’s profit and cash flow. Managers of PENOR Ltd. need more detailed information than the owners. They make short-term decisions and control the business. This requires Accounting information for management. At the same time, some aspects of financial statements are irrelevant and can be ignored. They distract (not distort) the view for company control. Controlling the business follows its economic goals. Most private and limited companies are in the pursuit of returns. This gives their owners a dividend which is their remuneration for investing money. Companies strive to increase their fair market value, in particular once the company is listed publically at a stock exchange. We call this concept the pursuit of value adding. (Note, we do not intend to cover non-profit organisations here.) From the investors’ perspective, high returns come from high performance measured by net operating profit or profit margins. A net operating profit is the profit before taxation that results from <?page no="48"?> normal operations which are continued. From the point of view of the shareholders, the profit after taxes attributable to dividends is called earnings. A ratio widely applied is earnings per share EPS. We refer to the EPS ratio in chapter (10). In contrast to dividend yield, EPS tells us how much is the highest dividend payable to shareholders. The dividend yield in contrast shows how much dividend per investment has actually been paid and depends on the decision about the appropriation of profits made by management of by owners on the annual meeting. The dividend yield is the actual return on shareholders’ investment whereas the EPS gives a performance measure. Management Accountants focus on the performance of the company and do not intervene nor support the decisions about declaring dividends. Finance does. Management Accounting provides managers with information about how to maximise the profit before taxes. (Note, the question about the profit after taxes might require some professional advice from the company’s tax attorney.) In order to increase profit some basic rules apply: - Produce goods at low costs and sell them on the market at a good price! - Use assets wisely, make sure the assets operate at high capacity! - Plan the company’s business processes and their costs precisely! - Avoid costly deviations from the budget, such as rework, waste and spoilage! Based on these rules, the basic questions managers will ask Accountants are: - Question 1: What does the product/ service cost? - Question 2: Is the business successful/ profitable? - Question 3: How much are future costs of production/ service rendering and administration? - Question 4: Does/ will the company generate cash? - Question 5: Are there any substantial deviations from the budget and what are reasons therefor? We keep these questions in mind as the major information requirements for Management Accounting. By the next steps we refer to the case study PENOR Ltd. again. We prepare a kind of parallel Accounting, but: (C1) We simplify some aspects of Accounting that are required by IFRSs but do not contribute to business control. Management Accounting is not regulated by law and is a ‘freestyle discipline’. The Business and Management doctrine only follows what is useful in order to meet the requirements of recipients which are the managers. (C2) We describe Management Accounting basic features that require more detailed information than Financial Accounting provides. In order to do so, we cover the Management Accounting <?page no="49"?> cost flow through cost centres, product and profit calculation and answer the Management Accounting questions once we reach the answers thereto. Ad (C1): Simplification of Accounting Data Equity Bank Loan Recognition 200,000.00 6,000.00 20,000.00 180,000.00 180,000.00 5,400.00 20,000.00 160,000.00 160,000.00 4,800.00 20,000.00 140,000.00 140,000.00 4,200.00 20,000.00 120,000.00 120,000.00 3,600.00 20,000.00 100,000.00 100,000.00 3,000.00 20,000.00 80,000.00 80,000.00 2,400.00 20,000.00 60,000.00 60,000.00 1,800.00 20,000.00 40,000.00 40,000.00 1,200.00 20,000.00 20,000.00 20,000.00 600.00 20,000.00 0.00 Figure 4.1: PENOR Ltd.’s bank loan <?page no="50"?> In Business and Management, the most relevant item is cost. A cost is a reduction of resources by operations intended by the company. One of the relevant characteristics of a cost is that there has to be a consumption of a resource. A company that buys materials but does not use them won’t record a cost. Only when the inventory is consumed costs apply. Furthermore, a cost has to be linked to the purpose of the business which is in the case of PENOR Ltd. the door/ window production. Prepaid Expenses Recognition Different Prices for Purchases/ Discounts Payment Terms <?page no="51"?> Labour Costs Without Taxes and Social Securities No Appropriation of Profits is Relevant (Note, we here consider cash/ bank and receivables and payables for aspects of cash flow statements and liquidity planning.) The next following Bookkeeping entries are identified by capital letters in order to distinguish them from Financial Accounting recording in the previous chapter (3). DR Cash/ Bank.................... 400,000.00 EUR CR Issued Capital............... 400,000.00 EUR DR Cash/ Bank.................... 200,000.00 EUR CR Interest Bearing Liabilities 200,000.00 EUR DR Interest..................... 6,000.00 EUR DR Interest Bearing Liabilities. 20,000.00 EUR CR Cash/ Bank.................... 26,000.00 EUR DR P, P, E saws................. 150,000.00 EUR DR VAT.......................... 30,000.00 EUR CR Cash/ Bank.................... 180,000.00 EUR <?page no="52"?> DR Depreciation Production Dep.. 30,000.00 EUR CR P, P, E saws................. 30,000.00 EUR DR Rent......................... 90,000.00 EUR CR Cash/ Bank.................... 90,000.00 EUR DR Purchase..................... 600,000.00 EUR DR VAT.......................... 120,000.00 EUR CR Cash/ Bank.................... 720,000.00 EUR DR Purchase..................... 450,000.00 EUR DR VAT.......................... 90,000.00 EUR CR Accounts Payables............ 270,000.00 EUR CR Cash/ Bank.................... 270,000.00 EUR DR Purchase..................... 600,000.00 EUR DR VAT.......................... 120,000.00 EUR CR Accounts Payables............ 720,000.00 EUR DR Purchase..................... 66,001.00 EUR DR VAT.......................... 13,200.20 EUR CR Cash/ Bank.................... 79,201.20 EUR DR Purchase..................... 256,500.00 EUR DR VAT.......................... 51,300.00 EUR CR Cash/ Bank.................... 307,800.00 EUR <?page no="53"?> DR Purchase..................... 1,237,500.00 EUR DR VAT.......................... 247,500.00 EUR CR Cash/ Bank.................... 1,485,000.00 EUR DR Purchase..................... 20,000.00 EUR DR VAT.......................... 4,000.00 EUR CR Cash/ Bank.................... 24,000.00 EUR DR Labour....................... 2,000,000.00 EUR CR Cash/ Bank.................... 2,000,000.00 EUR DR Cash/ Bank.................... 6,062,280.00 EUR CR VAT.......................... 1,010,380.00 EUR CR Revenue...................... 5,051,900.00 EUR 400,000.00 26,000.00 400,000.00 200,000.00 180,000.00 6,062,280.00 90,000.00 720,000.00 270,000.00 79,201.20 307,800.00 1,485,000.00 2,000,000.00 24,000.00 20,000.00 200,000.00 6,000.00 Figure 4.2: Management Accounting accounts <?page no="54"?> 150,000.00 30,000.00 30,000.00 1,010,380.00 120,000.00 90,000.00 120,000.00 13,200.20 51,300.00 247,500.00 4,000.00 30,000.00 90,000.00 600,000.00 270,000.00 450,000.00 720,000.00 600,000.00 66,001.00 256,500.00 1,237,500.00 20,000.00 2,000,000.00 5,051,900.00 Figure 4.2: Management Accounting accounts (continued) Ad (C2): Management Accounting Basic Features <?page no="55"?> (Note, the difference between the approaches for recording inventory movements is discussed in ‘Berkau, C.: Basics of Accounting, Part (1): Bookkeeping and Financial Accounting, chapter (26)’.) A Profitability Analysis is the income statement for Management Accounting. In contrast to the financial statements, the Profitability Analysis is based on Management Accounting data, it can be prepared for budgeted and actual figures and it often is for Accounting periods less than one year, i.e. monthly or quarterly. (Note, for the allocations we indicate the contra account in the account’s reference column.) DR Raw Materials (alu).......... 600,000.00 EUR CR Purchase..................... 600,000.00 EUR <?page no="56"?> DR Raw Materials (hin).......... 450,000.00 EUR CR Purchase..................... 450,000.00 EUR DR Raw Materials (pan).......... 600,000.00 EUR CR Purchase..................... 600,000.00 EUR DR Raw Materials (sht).......... 66,001.00 EUR CR Purchase..................... 66,001.00 EUR DR Raw Materials (str).......... 256,500.00 EUR CR Purchase..................... 256,500.00 EUR DR Raw Materials (fst).......... 1,237,500.00 EUR CR Purchase..................... 1,237,500.00 EUR DR Raw Materials (scr).......... 20,000.00 EUR CR Purchase..................... 20,000.00 EUR In Management Accounting, we distinguish between direct and indirect costs. Direct costs are those costs that can be assigned straight to the product, i.e. based on the bill of materials documents or working sheets. Indirect costs occur for different products and require cost allocations. Direct costs are allocated to the WIP-accounts whereas indirect costs are overheads. Most common direct costs are direct materials and direct labour. Overhead costs are costs that apply for more than one product. They cannot be traced to the product but are assigned to cost centres and allocated to products based on cost rates. Another term for overheads is indirect costs. Examples for overheads are labour for the supervisor, factory rent, security service, material procurement costs etc. <?page no="57"?> (Note, work-in-process and work-in-progress is used interchangeably. We don’t care much, as we mostly say WIP.) <?page no="58"?> DR MOH account.................. 1,200,000.00 EUR CR Labour....................... 1,200,000.00 EUR DR Admin Overheads.............. 800,000.00 EUR CR Labour....................... 800,000.00 EUR DR MOH Account.................. 15,000.00 EUR CR Raw Materials (scr).......... 15,000.00 EUR DR MOH Account.................. 90,000.00 EUR CR Rent......................... 90,000.00 EUR DR MOH Account.................. 30,000.00 EUR CR Depreciation................. 30,000.00 EUR <?page no="59"?> 400,000.00 26,000.00 400,000.00 200,000.00 180,000.00 6,062,280.00 90,000.00 720,000.00 270,000.00 79,201.20 307,800.00 1,485,000.00 2,000,000.00 24,000.00 20,000.00 200,000.00 6,000.00 150,000.00 30,000.00 30,000.00 1,010,380.00 120,000.00 120,000.00 150,000.00 150,000.00 90,000.00 120,000.00 120,000.00 13,200.20 51,300.00 247,500.00 4,000.00 30,000.00 30,000.00 90,000.00 90,000.00 600,000.00 600,000.00 270,000.00 450,000.00 450,000.00 720,000.00 600,000.00 600,000.00 66,001.00 66,001.00 256,500.00 256,500.00 1,237,500.00 1,237,500.00 20,000.00 20,000.00 2,000,000.00 1,200,000.00 5,051,900.00 800,000.00 2,000,000.00 2,000,000.00 Figure 4.3: Manufacturing Accounting’s accounts after 1 st allocation <?page no="60"?> 600,000.00 400,000.00 450,000.00 300,000.00 120,000.00 90,000.00 80,000.00 60,000.00 600,000.00 600,000.00 450,000.00 450,000.00 80,000.00 60,000.00 600,000.00 500,000.00 66,001.00 50,770.00 100,000.00 15,231.00 600,000.00 600,000.00 66,001.00 66,001.00 100,000.00 15,231.00 256,500.00 190,000.00 1,237,500.00 1,000,000.00 57,000.00 200,000.00 9,500.00 37,500.00 256,500.00 256,500.00 1,237,500.00 1,237,500.00 9,500.00 37,500.00 20,000.00 15,000.00 1,200,000.00 5,000.00 15,000.00 20,000.00 20,000.00 90,000.00 5,000.00 30,000.00 400,000.00 120,000.00 300,000.00 90,000.00 500,000.00 50,770.00 190,000.00 57,000.00 1,000,000.00 200,000.00 800,000.00 Figure 4.3: Manufacturing Accounting’s accounts after 1 st allocation (continued) The application of overheads is the transfer of costs from the Manufacturing Overheads account to the Work-in-Process account(s). The <?page no="61"?> Overhead application is recorded as debit entries in WIP-accounts and credit entries in MOH-accounts. The allocation is frequently based on cost rates, such as a EUR/ hour rate. As the cost rates are based on budgeted data, there can be overand under-absorbed overheads which means too many or too less costs are moved from the MOH-account to the WIP-accounts. In case of under-applied overheads a rest of overheads remains in the Manufacturing Overheads account. It will later be closed-off to the Profit and Loss account in order to assign the overheads to the Accounting period they occurred in. DR WIP-account Window ........... 800,000.00 EUR CR MOH Account.................. 800,000.00 EUR DR WIP-account Door............. 400,000.00 EUR CR MOH Account.................. 400,000.00 EUR DR WIP-account Window ........... 112,500.00 EUR CR MOH Account.................. 112,500.00 EUR DR WIP-account Door............. 22,500.00 EUR CR MOH Account.................. 22,500.00 EUR <?page no="62"?> Figure 4.4: Cost of manufacturing report (Note, we apply a Full Cost Accounting here, there might be lower prices possible based on variable cost calculations.) <?page no="63"?> DR FG Inventory Window .......... 3,302,500.00 EUR CR WIP-account Window ........... 3,302,500.00 EUR DR FG Inventory Door............ 940,270.00 EUR CR WIP-account Door............. 940,270.00 EUR A Cost of Goods Sold account records the unit costs of manufacturing times the amount for goods sold during the Accounting period as costs. Also, goods produced in a previous Accounting period can be released from stock and must be recorded as cost of goods sold once they are sold in the actual Accounting period. DR Profit and Loss.............. 3,910,674.71 EUR CR COS Account.................. 3,910,674.71 EUR <?page no="64"?> Figure 4.5: Cost of goods sold report 400,000.00 26,000.00 400,000.00 200,000.00 180,000.00 6,062,280.00 90,000.00 720,000.00 270,000.00 79,201.20 307,800.00 1,485,000.00 2,000,000.00 24,000.00 1,480,278.80 6,662,280.00 6,662,280.00 1,480,278.80 Figure 4.6: Management Accounting’s accounts <?page no="65"?> 20,000.00 200,000.00 6,000.00 6,000.00 180,000.00 200,000.00 200,000.00 180,000.00 150,000.00 30,000.00 30,000.00 1,010,380.00 120,000.00 120,000.00 150,000.00 150,000.00 90,000.00 120,000.00 120,000.00 13,200.20 51,300.00 247,500.00 4,000.00 334,379.80 1,010,380.00 1,010,380.00 334,379.80 30,000.00 30,000.00 90,000.00 90,000.00 600,000.00 600,000.00 270,000.00 450,000.00 450,000.00 990,000.00 720,000.00 600,000.00 600,000.00 990,000.00 990,000.00 66,001.00 66,001.00 990,000.00 256,500.00 256,500.00 1,237,500.00 1,237,500.00 20,000.00 20,000.00 3,230,001.00 3,230,001.00 2,000,000.00 1,200,000.00 5,051,900.00 5,051,900.00 800,000.00 2,000,000.00 2,000,000.00 Figure 4.6: Management Accounting’s accounts (continued) <?page no="66"?> 600,000.00 400,000.00 450,000.00 300,000.00 120,000.00 90,000.00 80,000.00 60,000.00 600,000.00 600,000.00 450,000.00 450,000.00 80,000.00 60,000.00 600,000.00 500,000.00 66,001.00 50,770.00 100,000.00 15,231.00 600,000.00 600,000.00 66,001.00 66,001.00 100,000.00 15,231.00 256,500.00 190,000.00 1,237,500.00 1,000,000.00 57,000.00 200,000.00 9,500.00 37,500.00 256,500.00 256,500.00 1,237,500.00 1,237,500.00 9,500.00 37,500.00 20,000.00 15,000.00 1,200,000.00 800,000.00 5,000.00 15,000.00 400,000.00 20,000.00 20,000.00 90,000.00 112,500.00 5,000.00 30,000.00 22,500.00 1,335,000.00 1,335,000.00 400,000.00 3,302,500.00 120,000.00 940,270.00 300,000.00 90,000.00 500,000.00 50,770.00 190,000.00 57,000.00 1,000,000.00 200,000.00 800,000.00 400,000.00 112,500.00 22,500.00 3,302,500.00 3,302,500.00 940,270.00 940,270.00 800,000.00 800,000.00 3,089,819.00 3,910,674.71 820,855.71 3,910,674.71 3,910,674.71 Figure 4.6: Management Accounting’s accounts (continued) <?page no="67"?> 3,302,500.00 3,089,819.00 940,270.00 820,855.71 212,681.00 119,414.29 3,302,500.00 3,302,500.00 940,270.00 940,270.00 212,681.00 119,414.29 3,910,674.71 5,051,900.00 800,000.00 6,000.00 335,225.29 5,051,900.00 5,051,900.00 335,225.29 Figure 4.6: Management Accounting’s accounts (continued) 5,051,900.00 (3,910,674.71) 1,141,225.29 (800,000.00) (6,000.00) 335,225.29 Figure 4.7: Profitability Analysis <?page no="68"?> 120,000.00 400,000.00 335,225.29 639,326.29 180,000.00 0.00 1,324,379.80 0.00 1,480,278.80 0.00 2,239,605.09 2,239,605.09 Figure 4.8: Pro forma balance sheet based on Management Accounting data <?page no="70"?> 2,575 2,575 2,830 2,830 480 480 530 530 2,317,500.00 2,317,500.00 2,830,000.00 2,830,000.00 768,000.00 768,000.00 901,000.00 901,000.00 3,088,555.00 3,088,555.00 3,734,360.00 3,734,360.00 Figure 4.9: Revenue plan 200,000.00 6,000.00 20,000.00 180,000.00 180,000.00 5,400.00 20,000.00 160,000.00 160,000.00 4,800.00 20,000.00 140,000.00 Figure 4.10: Interest and pay-off schedule 1,735,550.00 1,735,550.00 1,698,000.00 1,698,000.00 460,320.00 460,320.00 518,340.00 518,340.00 400,000.00 400,000.00 400,000.00 400,000.00 2,700.00 2,700.00 2,400.00 2,400.00 2,598,570.00 2,598,570.00 2,618,740.00 2,618,740.00 Figure 4.11: Cost plan <?page no="71"?> 3,088,555.00 3,088,555.00 3,734,360.00 3,734,360.00 (2,598,570.00) (2,598,570.00) (2,618,740.00) (2,618,740.00) 489,985.00 489,985.00 1,115,620.00 1,115,620.00 979,970.00 2,231,240.00 (146,995.50) (334,686.00) 832,974.50 1,896,554.00 832,974.50 1,896,554.00 Figure 4.12: Profitability plan <?page no="72"?> 120,000.00 90,000.00 60,000.00 639,326.29 639,326.29 639,326.29 1,145,899.00 2,035,301.41 4,129,545.91 1,905,225.29 2,764,627.70 4,828,872.20 400,000.00 400,000.00 400,000.00 234,657.70 1,067,632.20 2,964,186.20 180,000.00 160,000.00 140,000.00 990,000.00 990,000.00 990,000.00 100,567.59 146,995.50 334,686.00 1,905,225.29 2,764,627.70 4,828,872.20 Figure 4.13: Budgeted balance sheet (annual) <?page no="73"?> 2,575 2,575 2,830 2,830 480 480 530 530 2,317,500.00 2,317,500.00 2,830,000.00 2,830,000.00 768,000.00 768,000.00 901,000.00 901,000.00 3,088,555.00 3,088,555.00 3,734,360.00 3,734,360.00 1,735,550.00 1,735,550.00 1,698,000.00 1,698,000.00 460,320.00 460,320.00 518,340.00 518,340.00 400,000.00 400,000.00 400,000.00 400,000.00 2,700.00 2,700.00 2,400.00 2,400.00 2,598,570.00 2,598,570.00 2,618,740.00 2,618,740.00 3,088,555.00 3,088,555.00 3,734,360.00 3,734,360.00 (2,598,570.00) (2,598,570.00) (2,618,740.00) (2,618,740.00) 489,985.00 489,985.00 1,115,620.00 1,115,620.00 979,970.00 2,231,240.00 (146,995.50) (334,686.00) 832,974.50 1,896,554.00 832,974.50 1,896,554.00 n/ a 90,000.00 n/ a 60,000.00 n/ a 639,326.29 n/ a 639,326.29 n/ a 2,035,301.41 n/ a 4,129,545.91 n/ a 2,764,627.70 n/ a 4,828,872.20 n/ a 400,000.00 n/ a 400,000.00 n/ a 1,067,632.20 n/ a 2,964,186.20 n/ a 160,000.00 n/ a 140,000.00 n/ a 990,000.00 n/ a 990,000.00 n/ a 146,995.50 n/ a 334,686.00 n/ a 2,764,627.70 n/ a 4,828,872.20 Figure 4.14: Business plan for PENOR Ltd. <?page no="74"?> Summary: This chapter explained the intention and basic features of Managerial Accounting. In contrast to the previous chapter, IFRSs are ignored. Data from Financial Accounting are ‘cleared’ from requirements for financial statement preparation. After data simplification, product costs are calculated based on Manufacturing Accounting. The WIPand MOHaccounts apply to ascertain the cost of manufacturing based on the PENOR Ltd. case study. Costs are recorded for sold products by applying the Cost of Goods Sold account. Profit is calculated along the cost of sales format. The business plan is prepared as a result of Budgeting. The business plan contains an approved revenue plan, a cost plan and Profitability Analysis. A budgeted balance sheet can be added to the business plan, too. Management Accounting does not follow legal requirements and can be used in a way that is appropriate for the support of managers controlling the business. Mostly it is used to answer the basic questions in business: ‘What does the product/ service cost? ’, ‘Is the business successful/ profitable? ’, How much are future costs? ’, ‘Does the company generate cash? ’ and: ‘Are there substantial deviations from the budget? ’. Working Definitions: Net Operating Profit: A net operating profit NOP is the profit before taxation that results from normal operations which are continued. Cost: A cost is a reduction of resources by operations intended by the company. Manufacturing Accounting: The part of Management Accounting that deals with product calculation in an industrial environment called Manufacturing Accounting. Cost of Manufacturing: The cost of manufacturing are all costs that are directly or indirectly attributable to the product/ service. Profitability Analysis: A Profitability Analysis is the income statement for Management Accounting. Direct Costs: Direct costs are those costs that can be assigned straight to the product, i.e. based on the bill of materials documents or working sheets. Indirect costs occur for different products and require cost allocations. Overheads: Overhead costs are costs that apply for more than one product. Work-in-process Account: A WIPaccount is a product or service related account where all direct costs and portions of overheads are allocated to. Manufacturing Overhead Account: A Manufacturing Overhead account is used in production firms and service rendering companies in order to allocate all manufacturing overheads to products/ services. Overhead Application: The application of overheads is the transfer of costs from the Manufacturing Overheads account to the Workin-Process account(s). <?page no="75"?> Cost of Goods Sold Account: A cost of Goods Sold account records the unit costs of manufacturing times the amount for those goods that are sold during the Accounting period as costs. Business Plan: A business plan is the result of the annual planning of all activities of the company. <?page no="76"?> Learning Objectives: In this chapter, we summarise the main characteristics of Management Accounting and bring out the differences between Financial Accounting and Management Accounting. This gives us the chance to explain the basics of Management Accounting and to introduce its technical terms after we took a look at the case study PENOR Ltd. in the last chapters (3) and (4) already. The following aspects will be discussed as the main differences between Management Accounting and Financial Accounting. - Management Accounting comprises planning. - Management Accounting is not required by law. - Management Accounting is based on costs instead of expenses. - Management Accounting works on a different details level - Management Accounting is about allocations. - Management Accounting is shortterm: mostly for periods less than one fiscal year in Financial Accounting. - Management Accounting reports. Management Accounting Comprises Planning Financial Accounting is about reporting to owners and the authorities. It focusses on what happened during the last Accounting period. The company management reports on last Accounting period’s activities because it took responsibility for the resources that have been provided by investors and creditors. This is a justification and requires the approval on the annual meeting by vote. As a result, Financial Accounting is strictly based on the past. There is no variant for financial statements. There is only one truth. In contrast, Management Accounting plans the future of the business and compares actual data to budgeted amounts which is called Monitoring. A typical Management Accounting task is the preparation of budgets. A budget is the same as a business plan. It contains at least the approved revenue planning, cost planning, profit planning and liquidity planning. Budgets are not on entire company level but more in the details, i.e., cost centre related. The detail level determines the quality of cost information provided but also causes the consumption of Accounting resources. Management Accountants calculate the profit and cash flows based on the business operations, such as derived from production amounts and service rendering. Frequently, the business plan does not come out straight. It is more a kind of negotiation between all involved departments and requires coordination and compromising. The business plan is not to be seen as a forecast but as active planning of future economic activities based on product/ service mix decisions. The <?page no="77"?> process of preparing a business plan contains loops and considerations from all involved departments and leads to several business plan versions before the final one is calculated and approved. The final and valid version of the business plan is called the general budget. In contains partial plans, such as purchase budget, production budget, cash budget, A/ P budget etc. The business plan is normally presented by the CEO on the annual meeting. The annual meeting is the assembly of all owners of the business and held annually. It is a forum of what future operations of the company are and what will be the economic outcome thereof as well as the report of the last Accounting period’s result by the management. Management Accounting is not Required by Law In contrast to Financial Accounting, Management Accounting does not follow legal rules and/ or regulations. The reason is that Management Accounting is a discipline of Business and Management focussing on the support of managers. Its aim is to provide managers with useful information to control the business and make the best decisions in the interest of the entire company. No information of Management Accounting is discussed outside of the company. Note, that sometimes investors try to get hold take advantage of internal Management Accounting information for facilitating their own investment decisions. This would be seen as unethical and is forbidden. It is punishable as insider trading because it gives the investor an information advantage over others. Consider, a firm in the legal form of a limited company has to prepare financial statements and has to keep Bookkeeping records but there is no legal need for Management Accounting. Although, it is advised to control the business based on Management Accounting budgets and install a formal information system to gather actual data about the business processes and monitor costs. This means that profit calculations, business plans, monitoring results and product and service calculations as well as all reports fall under internal sources and are to remain strictly undisclosed. They are not intended for company comparisons (except in case of benchmarking) but for controlling and decision making inside of the business. The quality of Management Accounting calculations depends on the information needs of managers. It can even be that companies budget their processes on a kind of high aggregation level, i.e., based on product groups instead of single products. <?page no="78"?> Management Accountants often apply a standard price which might be close to the average cost price but there is no proof of equality of figures required for the standard price Calculation. A software solution, such as SAP, allows manually editing of the standard prices but strictly blocks the figures from disclosure on financial statements. Management Accounting is Based on Costs Instead of on Expenses 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 which is linked to the operations of a business. As a result, costs must be related to business operations. Management Accounting is based on cost information, i.e., for the cost plan, the Cost Monitoring and the profit and product Calculation. In most cases, costs are expenses at the same time. However, there are a few cases where costs are not expenses and where expenses are no costs. In contrast to costs, an expense does not need to be linked to business operations. An airline can support a soccer team and as a result records payments for the sponsoring in Financial Accounting. As the soccer team is not part of the airline’s operations the support is not regarded as costs. I.e., QATAR Airways supports FC Barcelona. As Management Accounting aims to the operating business activities, an expense that is not linked to the core business should not be considered as costs and is ignored for the control of the company. Although expenses which do not fall under costs have to be disclosed on the income statement as other comprehensive expenses for Financial Accounting. On the other hand, there are costs which are recorded as expenses, in particular once not being paid. I.e., a B&B hotel’s owner might not consider his own working shifts as costs because he/ she does not pay him-/ herself a salary. He/ she might try to cut costs on financial statements low in order to increase profit. As no payment was made this is legit and no expenses are recorded. Although no expense exists, for the calculation of room rates, it is advised that the equivalent for the <?page no="79"?> manager’s salary is considered. The same applies for the managerial calculation of profit. Other examples for only virtually calculated costs are interest, if the company lends from owners, calculated rent, if the company resides in buildings that belongs to its owners and does not pay rent, calculated labour if the owner works ‘for free’ in his/ her own business. With regard to the differences between Management Accounting and Financial Accounting we see, there are costs that do not appear on the Bookkeeping files as they do not fall under expenses. Furthermore, there are expenses that are not considered costs as they are not linked to the core business operations, such as sponsoring and donations. Management Accounting Works on a Different Details Level The level of precision differs between Financial Accounting and Management Accounting. Financial Accounting follows the regulations of recording business activities by Bookkeeping entries along the double entry system. In contrast, the Management Accountant can plan costs on aggregated levels. Management Accounting is About Allocations Management Accounting aims to help managers controlling the business. The company’s decisions are made by managers who in general are responsible for divisions, departments and cost centres. As a result, Management Accounting information must follow the decision structures. A cost centre is an organisational unit where costs are allocated to. The cost centre is controlled by a cost centre manager. If the cost centre manager also is responsible for revenue, we call it a profit centre. As a manager is responsible for the cost in his/ her cost centre, we call him the cost centre responsible. It is widely in use to pay managers incentives based on their departments performance. He/ she makes decisions which determine costs, such as resource allocations, or i.e. about direct spending as an expenditure or investment. For reasons of responsibility support, Management Accounting has to assign costs to particular cost centres and to cost objects, such as services and products. <?page no="80"?> Management Accounting is for Periods Less than a Fiscal Year Management Accountants provide information for management whereas Financial Accounting reports on the last Accounting periods. The periods are one year at least. Listed companies frequently prepare quarterly reports based on stock exchange regulations. In order to make decisions about (re- )directing resources and costs, the relevant data should preferably be provided real time. That is the reason why Management Accountants plan and monitor costs for periods less than a year. Very commonly, monthly cost information is generated. This gives for managers the chance for taking early corrective actions, once Monitoring reveals that business operations become too expensive. Management Accounting’s Focus is on Deviations One main reason to run a Management Accounting system is to detect deviations. A deviation means that cost occur to a different extent than scheduled. (Note, there is a chapter (15) Cost Monitoring in this text book that covers the efficiency checking of cost centres in this text book.) Before we discuss deviations, we consider the following: The planning procedure of Management Accounting strives to set up a budget that leads to a profitable performance. Private and public firms pursue profit and return maximisation. According to this goal, the approved cost plan shows the lowest realisable costs for production or service rendering based on product/ service mix decisions. The cost plan is in the details which means it shows for every cost centre the budgeted costs based on cost category level. Hence, once all costs in the company equal to the budget, the company will achieve its profitability goals. As a result, deviations cause under-achievements. Hence, every relevant deviation in costs will reduce profits and should be addressed. As the costs are under responsibility of the cost centre managers, they will compare the actual costs to the budget on a monthly basis. Detected deviations are checked with regard to their relevance and in case of <?page no="81"?> significance, the deviations are analysed in order to find reasons and measures to control or compensate costs. For this reason, one of the main tasks of Management Accounting is frequently monitoring costs and to run regularly and exceptionally triggered variance analysis. The comparison between targeted (budgeted) costs and actual costs only can be made according to the level of precision that is determined by the cost plan itemisation. Management Accounting Reports A main instrument for Management Accounting is to describe their findings in reports. 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. The report is based on budgeted and/ or data from the Bookkeeping records. A report can be a standard report or a report that is prepared on demand or triggered by exception, such as a significant cost deviation. Although a lot of detailed knowledge about the business processes is available and accurate cost information is given, Management Accountants aggregate cost information to meet the needs of the managers. Managerial Accounting is driven by requirements. In Management Accounting the term cockpit is very common. It means the Accountant provides all relevant information about the business in order to facilitate the manager’s instrument flying. The format of reports is based on the knowledge and Accounting understanding of the managers who receive them. We should keep in mind that not every manager holds a higher degree in Accounting. Often, Management Accountants run an information needs analysis in order to ascertain the way the individualised report should look like and what data it should contain. The information needs analysis is based on interviews and the job description of managers and considers their information needs in order to do a good managing job. Sometimes, for variance analysis more detailed data are required. The in-depth analysis in cost data is called drill-down-analysis and is outside of monthly standard reports provided by the Management Accounting department. The latter one will be called an exceptional reporting. The most detailed level of reporting is the level of Bookkeeping Entries, referred to as document level. How to Become a Management Accountant Management Accountants support managers. They work as chief financial officer and are responsible for Financial and Management Accounting. I.e., the median salary for a CFO in San Francisco is about 125,000.00 US$. In Germany, a Controller commonly needs a university degree on bachelor’s or master’s level. In case the Accountant works as a tax attorney and auditor additional degrees are required. In particular, <?page no="82"?> if the tax attorney is representing clients and/ or the auditor signs the statement of the auditors a degree as Steuerberater (StB) and Wirtschaftsprüfer (WP) is required. In many other countries, postgraduate studies are required for Management Accounting professions as well. In the US, a degree as CPA Chartered Professional Accountants is required. In South Africa, a degree issued by SAICA (South African Institute of Charted Accountants) is required. The Accountancy body in Malaysia is the MIA, Malaysian Institute of Accountants. Summary: - Management Accounting comprises planning. - Management Accounting is not required by law. - Management Accounting is based on costs instead of expenses. - Management Accounting works on a different details level. - Management Accounting is about allocations. - Management Accounting is shortterm: mostly for periods less than a fiscal year. - Management Accounting reports. - How to become an Accountant. Working Definitions: Budget/ Business Plan: A budget is the same as a budget. It contains at least the approved revenue planning, cost planning, profit planning and liquidity planning. Annual Meeting: The annual meeting is the assembly of all owners of the business and held annually. Expense: An expense is a consumption of resources which leads to an outflow of economic benefits. Cost: A cost is a consumption of resources which is linked to the operations of a business. Cost Centre: A cost centre is an organisational unit where costs are allocated to. The cost centre is controlled by a cost centre manager. 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. <?page no="83"?> Section (2): Accounting for General Management This section (2) covers Management Accounting for general managers. We call managers that hold responsibility for the entire company a general manager as he/ she is not responsible for single production, services of administration devisions in the company. In contrast to the section (3), we here do not cover the particular details of a Management Accounting system but provide information on the level of the entire business. This section starts with the planning of the company’s operations by chapter (6) Cost Planning / Business Plan. The case study in chapter 6 KIRSTENBOSCH (Pty) Ltd. is a fast food business. We discuss how to plan the activities for the company and how to prepare a revenue plan, a cost plan, a profit plan and a liquidity plan over 3 Accounting periods. With the case study McTOY GmbH, we cover a more complex case of a business plan for a production firm. McTOY GmbH produces different kind of toys and we study the planning process for different products and different prices during these periods. A third business plan SCHLUCHMAN is prepared in order to demonstrate changes in the legal form of a company. SCHLUCHMAN is a case study from Hospitality Management. In chapter (7) Cost Concepts, Cost Behaviour and Cost Separation, we study cost behaviour. We strive to determine what drives costs and to predict how costs change based on different output scenarios of the company. The output of a company means the amount of products produced or services rendered. The concept is important to plan future operations in the company. The techniques taught in this text books are the High-Low method, the Scatter Graph and the Regression method. All methods are studied and compared to each other based on the case study DANNING (Pty) Ltd. which is a tax attorney firm. The chapter (8) Cost Volume Profit Analysis (CVP-Analysis) teaches how many products/ services a business has to produce and sell in order to break-even. We further show that the CVP-analysis is more than to find the critical amount of products to be profitable. It is widely in use in order to decide about the launch of new products or to decide about changes in the service/ product mix of the company. We study the case of DEERFIELD TOURS (Pty) Ltd. which is a tour company that offers trips to South Africa and to Kuala Lumpur from the German airport Frankfurt/ Main. We also discuss effects on the profitability if certain amounts are still unknown but can be assumed of being normally distributed. The chapter (9) Degree of Operating Leverage (DOL) teaches an instrument required to make decisions about fixed assets. We study the flexibility of a business that depends on its investments. The degree of operating leverage gives answers to the question about how much profit or cash flow will change when revenue increases/ decreases. We study the effect by the case study of DEERFIELD TOURS (Pty) Ltd. again and introduce <?page no="84"?> the new case study of the production firm EMS KAYAK GmbH, which produces kayaks. The chapter (10) Performance Measurement 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 branches. In Chapter (11) Accounting for Mergers and Acquisitions we demonstrate how acquisitions and mergers are planned and how to determine a fair price for company’s sale transaction. We further show how hostile take-overs work and what impact they can have on the shareholders of the target company and the shareholders of the buying company. The case study OHIO FRIED CHICKEN is about a South African chicken restaurant and shows a private purchase, an acquisition by a Malaysian company, AYAM GORENG Sdn. Bhd. as a cross border acquisition, and a merger after an unfriendly take-over with LOS POLLOS ASADOS (Pty) Ltd., based in Johannesburg. In chapter (12) Risk Valuation we describe risks for companies and how to prepare a simulation model based on a MonteCarloSimulation. We study the case of ROCKS PLC., in order to understand what kind of financial situation requires the declaration of bankruptcy, and the case of the consultancy NAMGURO Ltd. for Risk Valuation by the value at risk model and for the calculation of the probability of an Accounting insolvency. <?page no="85"?> Learning Objectives In this chapter, we introduce planning tools for business. After studying this chapter, you should be able to understand the planning concept of Managerial Accounting. You should be able to prepare a business plan for a company and be able to understand the difference between profitability and liquidity planning. In order to plan a business, you have to anticipate and decide on the business activities of the upcoming Accounting periods. One way could be to predict all business activities separately and to make Bookkeeping entries for each of them. After that you can prepare financial statements as a balance sheet, an income statement and a statement of cash flows. Once you set up the future financial statements you can run a ratio analysis on them to access the business performance and its financial position and to compare it to other companies or to prior Accounting periods. In Managerial Accounting, the expression Budgeting for the preparation of a business plan and in particular a cost plan is much common. The difference between a plan and a budget is that the latter one is approved. The main problem of preparing the cost plan for a company is to deal with different resources. Departments compete for the allocation of company resources. Under decentralised planning, the single departments prepare their own plans and the Management Accountant’s task is the coordination of the partial plans. We here focus on easy company structures and discuss business planning for small case studies. This implies to ignore self-contradicting partial plans and to start-off with a case that is easy to overview. We assume central planning for business here. A better approach to prepare the business plan is to skip the Bookkeeping entry part. You predict future activities and determine their effects on the financial statements. A common structure is to split up the business plan in: (1) Revenue plan (2) Cost plan (3) Profit plan (4) Liquidity plan and/ or cash flow statement (5) Budgeted balance sheet. We follow the latter approach and study the company KIRSTENBOSCH (Pty) Ltd. We do not make any Bookkeeping entry for Budgeting. <?page no="86"?> Ad (1 KB ): Revenue Plan A revenue plan is an aggregated list of planned and budgeted revenues for a business displayed on revenue group level for a particular Accounting period. Companies can plan the revenue on different aggregation levels. It is not required to make plans for each and every product. Many companies plan on product group level. In contrast, the actual data are based on Bookkeeping entries and are on an elementary level. I.e., a restaurant can plan revenue and costs based on product groups, such as burgers, chicken, salad, beverage. The burger group then contains hamburgers, cheeseburgers, double burger etc. Actual data on elementary level means, that the restaurant calculates costs based on single Bookkeeping entries as occur, i.e., when Will visits the restaurant and orders three cheeseburgers and a large coke. Later the single Bookkeeping entries are aggregated <?page no="87"?> and used to ascertain the monthly amount of produced and sold cheeseburgers, for instance. Figure 6.1: KIRSTENBOSCH (Pty) Ltd.’s revenue plan Ad (2 KB ): Cost Plan KIRSTENBOSCH (Pty) Ltd.’s cost plan is the next one to prepare. The technical term cost differs from expenses slightly. Costs are deductions of resources caused by the business activities. Expenses that are not linked to business activities, will be classified as expenses but not as costs. On the other hand, there can be costs that are no expenses, as they are not derived from payments. Think of the previously mentioned entrepreneur who works for his own company. In case he doesn’t pay himself a salary it won’t be regarded as an expense. In this text book, we will only consider costs, which are expenses at the same time and to the same extent. (costs = expenses! ) The future costs are disclosed in a cost plan which is part of the business plan. A cost plan is a list of planned and budgeted costs for a business displayed on detailed costs or cost group level for a particular Accounting period. <?page no="88"?> Figure 6.2: KIRSTENBOSCH (Pty) Ltd.’s interest and pay-off schedule Figure 6.3: KIRSTENBOSCH (Pty) Ltd.’s cost plan Ad (3 KB ): Profit Plan A profit plan is a schedule where planned and budgeted costs are deducted from the revenues for a particular Accounting period. In some companies, the profit plan is referred to as the Profitability Analysis by Management Accountants. As income taxes depend on the profit for the period, tax expenses will be displayed on the profit plan, too. The appropriation of profits is also subject to the profit planning and is shown at the bottom line of the profit plan. <?page no="89"?> Figure 6.4: KIRSTENBOSCH (Pty) Ltd.’s profitability plan Ad (4 KB ): Liquidity Plan So far, we only considered profitability values. Profitability values determine profit. All revenues and costs/ expenses effect the profit of the company. However, besides of profit maximisation, companies aim to earn cash flows. A positive cash flow is the increase of cash/ bank. A cash flow results from a payment or money transfer. As higher the cash flow is, as higher becomes the probability for a company to be capable of paying its bills. We consider two kinds of amounts for the business plan: profit relevant ones and cash relevant ones. The latter one is discussed below. Later, we show differences and how to reconcile profit with operating cash flows. A company that has enough cash is called liquid. The liquidity depends on the absolute amount in cash/ bank and the cash flows of the period. A poor cash flow (negative cash flow) puts a company in financial distress because it might be difficult to fulfil payment obligations. For this reason, companies include a cash flow-/ liquidity planning in their business plan. In terms of closing down businesses, the term illiquidity describes a situation where the Cash/ Bank account is credit balanced and there are no assets for liquidation left and if no one is prepared to lend the company money anymore. For a business plan a situation of illiquidity is/ should be exceptional. In general, companies plan liquidity in terms of the balancing figure of the Cash/ Bank account. They do not include liquidation revenues in their planning. However, a company facing a crisis or under liquidation might do. Profitability values can differ from payment values. A company that pays for an investment creates a cash outflow in the first accounting period which is no cost. In the next following Accounting periods, the company depreciates the asset which causes a cost but no payment. As profit and liquidity do not equal, a liquidity plan is prepared in addition to a profitability plan. A liquidity plan is a list that shows the opening amount of the Cash/ Bank account, adds cash inflows and deducts cash outflows for a future Accounting period. The bottom line on the liquidity plan discloses the balancing <?page no="90"?> cash/ bank amount of a business. It is called liquidity. Figure 6.5: KIRSTENBOSCH (Pty) Ltd.’s liquidity plan <?page no="91"?> We call the amount liquidity because the amount of cash or its equivalent is available on short-term notice. Companies strive to guarantee the amount to be positive, but try to keep it low at the same time. Money as a cash reserve is not available for investments and drags down the company’s returns. As a consequence, keep the liquidity as low as possible but guarantee it above zero. In contrast, profit is to be maximised. Volatile businesses normally hold a higher reserve on cash, which means a higher liquidity, than companies where cash flows are surely predictable. In case the liquidity comes out negative, the Management Accountant has to amend the planning, for example by taking a higher bank loan or increasing selling prices or amounts into consideration. The latter one is subject to Marketing Research findings as higher prices do not directly increase the total revenues as the customers’ buying habits depend on the demanded prices, too. Ad (5 KB ): Budgeted Balance Sheet In order to analyse the business 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 for the last day of the period covered in a business plan. The budgeted balance sheet does not have to apply the formal requirements of a statement of financial position nor its detail level. <?page no="92"?> Figure 6.6: KIRSTENBOSCH (Pty) Ltd.’s pro-forma balance sheet (Note, you can compare the annual totals of assets and equity + liabilities in order to cross-check your business plan on consistency. It does not prove the correctness of the business <?page no="93"?> plan, but it indicates consistency with regard to the double entry system.) Ad (4 KB ): Cash Flow Statement We discuss liquidity again, however, this time from a more Financial Accounting point of view as a future cash flow statement. (Note, we do so deliberately after covering the budgeted balance sheet as we go through the items of the business plan in the sequence of importance.) Companies prepare a planned cash flow statement too. A planned cash flow statement is a list of future operating cash flows, investing cash flows and financial cash flows. The list is on cash flow group level mostly. Many companies ascertain the operating cash flow by reconciliation of the net operating profit with the operating cash flow. We do so here also. (Note, check for the reconciliation method: Berkau, C.: Bilanzen, chapter (10) or the translation thereof.) The cash flow statement contains similar data as the liquidity plan. In contrast, in a cash flow statement the structure of cash flows is based on cash flow triggers: operating activities, investing activities and financial activities. Figure 6.7: KIRSTENBOSCH (Pty) Ltd.’s statement of cash flows <?page no="94"?> How it is Done (Business Plan) (1) Determine the amount of goods/ services that are intended to be sold. (2) Ascertain net selling prices by Marketing Research. (3) Calculate the revenue by multiplying sales amounts × net selling prices. (4) Ascertain 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 arrive at the earnings before taxes. (7) Assume tax expenses occur in the period they are for. Deduct income tax expenses from earnings before taxes by multiplying the earnings before taxes × total tax rate (in the text book 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’s appropriation of 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 from cash inflows to arrive that the cash/ bank closing value. (11) Prepare a balance sheet as at the end of the last Accounting period of the business plan. <?page no="95"?> (12) Run a financial statement analysis for your future financial statements in order to access your business. (13) If the result of the business plan is unsatisfying change the business concept and start at step (1). A business plan for a production firm is more complicated, because there are materials that are parts of the finished goods and cause inventory movements. We present the case study McTOY GmbH, which is a German toy manufacturer. (Note, McTOY is a case study for Management Accounting used in classes as a MS Excel task. You should prepare the solution by a spreadsheet program! The case study is about a production firm with different products where amounts and prices change. Its solution might take 6 hours with MS-Excel support, otherwise fairly longer.) Ad (1 McT ): Revenue Plan Figure 6.8: McTOY GmbH’s revenue plan In case you prepare the revenue plan with MS Excel, we recommend preparing a master data sheet. That sheet should be structured that way that you only calculate one toy for one Accounting period and can determine the other data by the copy function. An example for how this kind of master data sheet could look like is given in Figure 6.9: <?page no="96"?> Figure 6.9: McTOY GmbH’s master data sheet Ad (2 McT ): Cost Plan <?page no="97"?> Figure 6.10: McTOY GmbH’s cost plan (partial) (Note, the total material costs disclosed on the bottom line do not contain start-up costs.) A routing is a document in a production firm that tells how much time a production step on which machine group takes to get processed. Figure 6.11: McTOY GmbH’s routing information (1) <?page no="98"?> Figure 6.12: McTOY GmbH’s routing information (2) Figure 6.13: McTOY GmbH’s cost plan (partial) <?page no="99"?> Figure 6.14: McTOY GmbH’s bank loan <?page no="100"?> Figure 6.15: McTOY GmbH’s aggregated cost plan Ad (3 McT ): Profit Plan (Note, the German tax law allows to deduct tax payments by carrying losses forward/ backward to other accounting periods based on § 10 EStG. We ignore tax impacts on loss transfers to other Accounting periods here due to simplicity reasons.) <?page no="101"?> (Note, along the German tax law, there is a tax exemption limit, which we ignore for the case study.) A residential tax payer, who earns 10,000.00 EUR on capital returns must pay 25 % tax thereon. He further has to pay 5.5 % based on the tax amount for the German reunion tax. The taxes on the 10,000.00 EUR dividend or interest income equal to: 2,500 × (1 + 5.5%) = 2,637.50 EUR. In case the residential tax payer is a church goer in the sense of the tax law 8 % or 9 % (depending on the federal state in Germany) will be added. (Note, for the case study we ignore church taxes.) Figure 6.16: McTOY GmbH’s profit plan The distributable amount is the earnings after taxes for the period, plus profit carried forward from previous Accounting periods, less loss carried forward, less preference dividend and less contributions to legal reserves based on § 150 II AktG. The latter ones do not apply for a company in the legal form of a GmbH. (Note, the total amount of taxes on McTOY GmbH’s earnings will be: 51,504.20 + 6,443.81 + 354.41 = 58,302.42 EUR.) <?page no="102"?> Ad (4 McT ): Liquidity Plan Figure 6.17: McTOY GmbH’s liquidity plan <?page no="103"?> Ad (5 McT ): Budgeted Balance Sheet <?page no="104"?> Figure 6.18: McTOY GmbH’s budgeted balance sheet (Note, we follow an IFRS balance sheet. Accordingly, tax liabilities are recognised as liability and not as a provision as along German HGB.) A business plan becomes important in cases when a company is incorporated and for legal form change situations. We now study the case of SCHLUCHMAN which is linked to Hospitality Management. The owner Mr Schluchman starts as a privatelyowned company and transfers his business into a public company in the legal form of a GmbH. two years later. Different to the previous business plans, we first explain the case and prepare and describe the business plan later. This procedure follows the planning process. <?page no="107"?> Ad (1 Sch ): Revenue Plan 45,000.00 45,000.00 200,000.00 237,500.00 64,800.00 64,800.00 240,000.00 285,000.00 109,800.00 109,800.00 440,000.00 522,500.00 Figure 6.19: Mr Schluchman’s/ MOBILE TARTE FLAMBEE GmbH’s revenue plan <?page no="108"?> Ad (2 Sch ): Cost Plan 750.00 750.00 2,500.00 2,500.00 750.00 750.00 60.00 40.00 240.00 160.00 120.00 120.00 120.00 400.00 500.00 5,000.00 5,000.00 5,100.00 5,100.00 2,160.00 2,160.00 8,000.00 9,500.00 24,060.00 24,060.00 91,133.33 106,758.33 14,400.00 14,400.00 144,000.00 171,000.00 2,400.00 40,000.00 45,000.00 48,950.00 46,530.00 292,243.33 341,268.33 Figure 6.20: Mr Schluchman’s / MOBILE TARTE FLAMBEE GmbH’s cost plan <?page no="110"?> Ad (3 Sch ): Profit Plan 109,800.00 109,800.00 440,000.00 522,500.00 (48,950.00) (46,530.00) (290,943.33) (339,968.33) 60,850.00 63,270.00 149,056.67 182,531.67 0.00 0.00 (44,717.00) (54,759.50) 60,850.00 63,270.00 104,339.67 127,772.17 52,169.83 63,886.08 52,169.83 63,886.08 65,668.00 63,264.00 13,266.80 12,305.20 Figure 6.21: Mr Schluchman’s/ MOBILE TARTE FLAMBEE GmbH’s profitability plan <?page no="111"?> Ad (4 Sch ): Liquidity Plan 10,000.00 9,651.20 40,000.00 243,800.00 109,800.00 109,800.00 440,000.00 522,500.00 88,000.00 104,500.00 (88,000.00) (21,200.00) 0.00 (11,200.00) (1,500.00) 0.00 (1,500.00) (6,000.00) 2,000.00 (60.00) (40.00) (240.00) (160.00) (500.00) (500.00) (2,000.00) (2,000.00) (120.00) (360.00) 0.00 (1,440.00) (360.00) 240.00 (2,190.00) (2,160.00) (9,750.00) (11,400.00) 1,625.00 (19,272.00) (24,066.00) (107,950.00) (126,550.00) 17,991.67 (14,400.00) (14,400.00) (144,000.00) (171,000.00) (2,400.00) 0.00 0.00 0.00 (40,000.00) (45,000.00) (52,169.83) (48,266.80) (47,305.20) (44,717.00) 9,651.20 30,980.00 243,800.00 351,299.83 Figure 6.22: Mr Schluchman’s/ MOBILE TARTE FLAMBEE GmbH’s liquidity plan <?page no="113"?> Ad (5 Sch ) Budgeted Balance Sheet 2,250.00 1,500.00 7,500.00 5,000.00 750.00 0.00 240.00 120.00 800.00 600.00 0.00 16,200.00 11,200.00 6,100.00 1,000.00 30.00 30.00 125.00 125.00 30.00 30.00 125.00 125.00 21,856.67 23,051.67 9,651.20 30,980.00 243,800.00 351,299.83 28,401.20 43,860.00 281,056.67 381,201.50 10,000.00 10,000.00 40,000.00 40,000.00 52,169.83 116,055.92 12,583.20 28,548.00 0.00 0.00 88,000.00 104,500.00 1,000.00 500.00 4,000.00 2,000.00 52,169.83 63,886.08 4,818.00 4,812.00 44,717.00 54,759.50 28,401.20 43,860.00 281,056.67 381,201.50 Figure 6.23: Mr Schluchman’s/ MOBILE TARTE FLAMBEE GmbH’s balance sheet <?page no="114"?> Summary: Companies plan their operations for the next upcoming Accounting periods as a business plan. The business plan contains the revenue plan, the cost plan, the profitability plan, the liquidity plan, the pro-forma budgeted balance sheet and future cash flows. Working Definitions: Revenue Plan: A revenue plan is a list of planned and budgeted revenues for a business displayed on revenue group level for a particular Accounting period. Cost Plan: A cost plan is a list of planned and budgeted costs for a business displayed on detailed costs or cost group level for a particular Accounting period. Profit Plan: A profit plan is a schedule where planned and budgeted costs are deducted from the revenues for a Accounting period. Liquidity Plan: A liquidity plan is a list that shows the opening amount of the Cash/ Bank account, adds cash inflows and deducts cash outflows for a future particular Accounting period Proceeds: Proceeds are payments received in exchange of selling products or services. 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. Bill of Materials: A bill of materials BOM is a document that gives the part structure of a product. Routing: A routing is a document in a production firm that tells how much time a production step on which machine group takes to get processed. <?page no="115"?> Learning Objectives In this chapter, we introduce the basic cost concepts for Management Accounting. The cost concept helps you to understand costs better. In contrast to Financial Accounting, Management Accountants also plan future costs. From studying cost behaviour, Management Accountants know what costs depend on and which costs are to be expected when the company produces certain amounts of goods or renders services. The knowledge about costs is necessary for the budget preparation. In this chapter, we demonstrate different cost behaviour patterns and study how to determine future costs based on planned outputs. We distinguish between fixed and variable costs. Variable costs depend on the output of the business whereas fixed costs remain unchanged no matter how much the output is. For management purposes, the concepts of incremental costs, sunk costs and opportunity costs are relevant too, and will be discussed farther below. We repeat and deepen our knowledge about costs below: Costs represent the consumption of company resources that are linked to the purpose of the business operations. Accordingly, materials only count as a cost, when used in production. We saw in the previous chapter (6) with the case of Mr Schluchman (check Figure 6.20) that the material costs for dough in 20X5 were estimated to be: 180 × 100 × 0.1 × 1.20 = 2,160.00 EUR. However, the expected purchases were: 2,160 + 30 = 2,190.00 EUR as illustrated by Figure 6.21. The difference to the extent of: 2,190 - 2,160 = 30.00 EUR comes from the dough which is not consumed (safety stock) and remains on stock at the end of the Accounting period. You can see the dough on stock in Figure 6.23 as inventory on the balance sheet. Costs represent the consumption of resources linked to the business activities. In contrast to expenditures, there can be resource consumption without producing goods or rendering services. Expenditures which are not linked to the purpose of the business are no costs. Management Accountants deal with costs which means there is always an association with the purpose of the business such as production or service rendering. Costs are caused by business operations or by past events. An example for a past event is the acquisition of machinery which is followed by depreciation. Depreciation is a cost. It represents the loss in value of assets by their deployment. The acquisition of the machine is the event and leads to a payment as shown in the statement of cash flows. As a result, only depreciation is a cost. Note, if the value does not drop by deployment, there is no depreciation, such as for land. In order to use a proper terminology, we introduce most common cost concepts and illustrate them by mini cases. You might know most of the cost concepts from the previous chapters already. The cost concepts explained in this chapter will be: <?page no="116"?> (1) Direct vs. indirect costs (2) Manufacturing vs. non-manufacturing costs (3) Product cost vs. period costs (4) Variable vs. fixed costs (5) Differential/ sunk/ opportunity costs. Ad (1): Direct vs. Indirect Costs Direct costs are direct materials and direct labour. The term direct is linked to the fact that the costs can be assigned straight to the product or service. The first one (direct materials) is recorded in the Raw Materials Inventory account and contains all materials bought from suppliers and used. Raw materials can be dough for a pizza restaurant or a full headlight component for a car manufacturer. Sometimes, the value of the direct materials is of low value and thus, of minor interest. The company will rather treat such materials, i.e. lubricants or cooling fluid, as indirect materials. Indirect materials won’t be assigned to the product but to divisions/ cost centres applying the Manufacturing Overhead account. In contrast to direct materials, indirect costs cannot be traced to the product/ service. Direct labour is labour costs that is assigned straight to the product/ service. Some manufacturers call direct labour ‘touch labour’ in order to indicate workers touch the product, such as fitting a door in a car at an assembly line. In contrast, indirect labour serves more/ all products and is i.e. supervisors’ salary, janitor costs, security service fees or warehouse management costs. Ad (2): Manufacturing vs. non-Manufacturing Costs Even as the term manufacturing-related indicates the costs occur in a factory, the cost concept is common in other industries too. However, trading company’s structures are simpler and require less effort for Management Accountants with regard to cost allocations. Manufacturing costs are costs linked to production. These costs contain direct materials, direct labour and manufacturing overheads. In contrast, non-manufacturing costs are not associated with the production but i.e. with selling and administration. Costs for selling goods and administration (SG&A) are not linked to the product/ service, and are costs such as advertising costs, costs for Public Relations, general Accounting costs, Human Resource costs etc. In Accounting, non-manufacturing costs shall not be added to the Manufacturing Overhead account but are recorded in separate accounts, such as Marketing account, Administration account etc. Along IAS 2, non-manufacturing costs are not supposed to be considered for inventory valuation of finished goods. In Management Accounting, two further technical terms are frequently in use: prime costs and costs of conversion. Prime costs are direct materials and direct labour. The costs of conversion contain direct labour and manufacturing overheads. The latter one represents the costs necessary to convert the materials into the finished product. Hence, material costs are excluded from cost of conversion. The total of prime costs and manufacturing overheads, <?page no="117"?> which equals to the sum of direct materials plus cost of conversion, is referred to as the cost of manufacturing. Ad (3) Product vs. Period Costs The classification in product and period costs is linked to the disclosure of costs on the financial statements. Product costs are assigned to products which can be put on stock. That way, product costs are deferred to the Accounting period when the sales transaction thereof takes place. In contrast, period costs are linked to the Accounting period they occur in. Period costs cannot be ‘parked’ as inventory as they elapse after the Accounting period is over. Accounts for period costs are closed-off to the Profit and Loss account at the year end therefore. DR Cash/ Bank.................... 1,000,000.00 ZAR CR Issued Capital............... 1,000,000.00 ZAR DR Raw Materials Inventory...... 800,000.00 ZAR CR Cash/ Bank.................... 800,000.00 ZAR DR Labour....................... 1,900,000.00 ZAR CR Cash/ Bank.................... 1,900,000.00 ZAR <?page no="118"?> DR P, P, E Account.............. 4,000,000.00 ZAR CR Cash/ Bank.................... 4,000,000.00 ZAR DR Depreciation................. 500,000.00 ZAR CR Acc. Depr.................... 500,000.00 ZAR DR Cash/ Bank.................... 8,500,000.00 ZAR CR Revenue...................... 8,500,000.00 ZAR 1,000,000.00 800,000.00 1,000,000.00 8,500,000.00 1,900,000.00 4,000,000.00 800,000.00 1,900,000.00 4,000,000.00 4,000,000.00 500,000.00 500,000.00 Figure 7.1: STAFFORD (Pty) Ltd.’s accounts <?page no="119"?> 1,000,000.00 800,000.00 1,000,000.00 1,000,000.00 8,500,000.00 1,900,000.00 1,000,000.00 4,000,000.00 2,800,000.00 9,500,000.00 9,500,000.00 2,800,000.00 800,000.00 640,000.00 1,900,000.00 1,600,000.00 160,000.00 220,000.00 800,000.00 800,000.00 80,000.00 160,000.00 1,900,000.00 1,900,000.00 4,000,000.00 4,000,000.00 8,500,000.00 8,500,000.00 4,000,000.00 500,000.00 500,000.00 500,000.00 500,000.00 500,000.00 640,000.00 2,960,000.00 220,000.00 720,000.00 1,600,000.00 500,000.00 720,000.00 720,000.00 720,000.00 2,960,000.00 2,960,000.00 Figure 7.2: STAFFORD (Pty) Ltd.’s accounts <?page no="120"?> 640,000.00 2,960,000.00 220,000.00 720,000.00 1,600,000.00 500,000.00 720,000.00 720,000.00 720,000.00 2,960,000.00 2,960,000.00 2,960,000.00 2,312,500.00 2,312,500.00 2,312,500.00 647,500.00 2,960,000.00 2,960,000.00 647,500.00 2,312,500.00 8,500,000.00 80,000.00 80,000.00 80,000.00 6,107,500.00 8,500,000.00 8,500,000.00 1,832,250.00 6,107,500.00 4,275,250.00 6,107,500.00 6,107,500.00 1,832,250.00 1,832,250.00 4,275,250.00 4,275,250.00 1,832,250.00 4,275,250.00 Figure 7.2: STAFFORD (Pty) Ltd.’s accounts (continued) <?page no="121"?> Figure 7.3: STAFFORD (Pty) Ltd.’s income statement Figure 7.4: STAFFORD (Pty) Ltd.’s balance sheet <?page no="122"?> Ad (4): Variable vs. Fixed Costs In Management Accounting, costs are classified based on their behaviour with regard to the output. The output of a company is the amount of products produced or services rendered. The behaviour of costs refers to how costs change based on their dependency on particular factors. The factors for variable costs depend on the output of a company. We acknowledge: Proportional costs depend directly on the output. The difference between variable and proportional is that variable means any dependency pattern whereas a proportional cost curve is a line in the cost-output-diagram. In order to understand the dependencies, take a look at an example: A car manufacturer records assembling costs for dash boards built into the cars. The factor, costs depend on, is the assembling time. With regard to cost behaviour, we know that the assembling time for two dash boards is double of the time for assembling one dash board. The time for three dash boards will be triple of the assembling time as for one dash board, and so on. Hence, the time for assembling dash boards depends proportionally on the amount of dash boards installed. Furthermore, the assembling costs depend proportionally on the assembling time. In total, we see that the assembling costs are proportional costs for this example. Management Accountants identify and plan factors like the assembling time in order to predict/ plan costs. In case costs depend proportionally on an output related factor, we refer to the factor as a reference unit. In the previous case the assembling time is the reference unit for the assembling cost centre. For now, we only distinguish between costs that depend on a reference unit and those that do not. The first ones are called proportional costs the latter ones are fixed. Fixed costs do not change with the output. An example for fixed costs is depreciation: No matter how many products are produced on the machine, its time-related depreciation remain the same. Other cost behavioural patterns are step-fixed costs. Those are costs that increase if a particular unit amount is manufactured. Think about a university, that runs an examination service department. There might be an administration officer who can serve 100 students per semester. In case the university enrols 200 students, it needs to employ 2 officers. In case of 284 students, there will be 3 admin officers etc. If you draw the cost function depending on the student amount, the diagram will look like a flair of stairs. For this reason, Management Accountants call this cost behaviour pattern stepfixed costs. Most of the cases are related to mixed cost functions, also referred to as semifixed costs. Mixed costs contain a portion that is proportionally depending on the output and another portion that is fixed. For cost planning, it is required to know how costs change based on different outputs. Hence, we have to isolate the portion that is fixed from the proportional costs. This procedure is called Cost Separation. <?page no="123"?> One 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. However, very often, hundreds of different cost categories apply in a company. Hence, there must be better ways and more efficient ways of Cost Separation. They all start with the total costs, which contain different cost categories, such as labour, depreciation etc. Methods of Cost Separations are: (a) High-low method (b) Scatter graph (c) Regression method. All methods result in a mathematical cost function described as: C = PC × RU + FC, with C = total costs, PC = proportional costs, RU = reference unit and FC = fixed costs. The cost function can be shown by a C(RU) diagram, which discloses the reference units on the x-axis and the costs on the y-axis. The costs fall under mixed costs and comprise proportional costs and fixed costs. With the knowledge of the slope of the proportional cost function and the total amount of its fixed costs a total cost function is determined. <?page no="124"?> Figure 7.5: DANNING (Pty) Ltd.’s cost volume records Ad (a): High-low Method The high-low method considers the highest and lowest observation with cost and factor amount and calculates a straight line that goes through these points as the cost function. Ad (b): Scatter Graph The scatter graph is based on a graphic diagram of the cost over factor observations and requires to manually draw a line in the diagram that way that most observation points are on or close to the line. <?page no="125"?> Figure 7.6: DANNING (Pty) Ltd.’s Cost Separation by scatter graph method Ad (c): Regression Method The regression method calculates the function’s parameter based on all plotted observations mathematically. It determines a function by minimising the difference between the square deviations and the function line that way that all observations are on the calculated cost function or closest thereto. <?page no="126"?> The cost formula to be determined comes with the common structure as: C (TS) = PC × TS + FC (with: C = total costs, TS = tax statements, PC = proportional costs, FC = fixed costs) The first equation for the Cost Separation is based on i rectangles, which have an area of: TS i × C i , with i = 1 … 4 for 4 monthly observations. i i i i i i i TS PC TS FC TS C (with: C = total costs, TS = tax statements, PC = proportional costs, FC = fixed costs) The second equation is based on the cost amounts only. There are 4 costamounts C i . The costs will be divided into a proportional portion and a fixed one. i i i i TS PC FC C For convenient calculations, we determine a few sums required by the equations by a MS Excel sheet as it goes quick and shows where the data come from. Consider the calculations as workings. Figure 7.7: Workings for regression analysis <?page no="127"?> Berkau: Basics of Accounting (Part II) 7-123 We insert the 2 nd equation into the 1 st one: => 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 EUR/ TS Now, we insert the proportional costs PC into the 2 nd equation and calculate the fixed costs FC: => FC = (127,500 - 500 × 155) / 4 = 12,500.00 EUR. As based on the high-low-method, the cost function for DANNING (Pty) Ltd. equals to: C (TS) = 5 500 × TS + 12,500. In case DANNING (Pty) Ltd. expects 48 tax statements in May, the planned costs will equal to: C (48) = 500 × 48 + 12,500 = 3 36,500.00 EUR. The common format for a regression method is based on the variables X and Y. The simple regression method determines a linear function Y(X) which has the form Y(X) = a × X + b. a is the slope of the line and b is the amount for X = 0. Y(0) = b. For n observations, indicated by i = 1 … n, the two equations will look as below: (1) n i i n i n i i i i X a X b Y X 1 2 1 1 (2) n i n i i i X a b n Y 1 1 After we applied the simple regression method, we want to explain it further. (Note, if you are familiar with regression method already skip the next paragraphs and move on with differential/ sunk and opportunity costs! ) (1) At first, the question might come up why call this method “simple” regression method. Regression methods help us to find and analyse dependencies between characteristics, such as prices, and independent figures. Assume you get hold of a data set of prices obtained for house sales during the last year in your neighbourhood. Your property manager might also provide you with characteristics of the sold houses, such as area in square metres, plot size, age, distance to the next school etc. In this case the regression method can be applied in order to ascertain a price function that depends on various parameters (square metres, plot size, age, distance to the next school etc.). Once you know the dependencies and your house’s parameters, you will be able to calculate its most likely selling price based on the observations made in the past. In contrast, in Accounting we only discuss the cost function which depends on one single variable: the output, such <?page no="128"?> as the tax statements at DANNING (Pty) Ltd. The simple regression method determines one dependency - not multiple ones. For that reason we refer to it as simple. (2) Secondly, we want to explain the graphical interpretation of the simple regression method: The aim is to determine 2 parameters of a linear function Y(X), which are the slope and the intersection with the Yaxis. It would be the parameters a and b, or with regard to the DANNING (Pty) Ltd. case study the proportional costs PC and the fixed costs FC. For the ascertainment of two parameters, 2 independent equations are necessary. The first one represents areas whereas the second equation is linked to the Yvalues, in DANNING (Pty) Ltd.’s case to the costs. The equations will be explained below based on the situation where only 2 observations exist. Accordingly, the parameter for the sum have been adjusted. n got replaced by 2. (1) i i i i i i i X a X b Y X On the left side of the equation there are two areas, which are in the form of rectangles. The total of the areas equals to: X 1 × Y 1 + X 2 × Y 2 . Figure 7.8: Marked areas in the linear function Y(X) In Figure 7.8 the areas X 1 × Y 1 is marked as a dotted line and a dark filling and the area X 2 × Y 2 by a light filling. In the diagram the function is drawn as a line and indicated by Y(X) = a × X + b. <?page no="129"?> a is the slope of the line. We describe the slope of the function Y(X) by a with: a = (Y 2 - Y 1 )/ (X 2 - X 1 ). As we can see in Figure 7.9 the slope is the tangent of the angle which is the opposite leg of the angle divided by its adjacent leg. Figure 7.9: Calculation of the slope of Y(X) By the next step we study the right hand side of equation (1). It contains 4 areas: A, B, C and D. We study the areas A and C at first which result from the first observation. Compare Figure 7.10: Figure 7.10: Areas A and C for the function Y(X) <?page no="130"?> The area A got the size: b × X 1 . With regard to the formula, the area C has the size: a × X 12 . The area A forms a square once a = tan becomes 1. This will be the case if: = 45° because tan 45° = 1. This means graphically that the length of (Y 1 - 0) equals to the one of (X 1 - 0). In cases the angle is less than 45° the tangent function will reduce the area. I.e., if = 30° a becomes: a = tan 30° = 0.57. As a result, the square area is multiplied by the factor 57%. This will squeeze the square and the area C becomes a flat rectangle. This applies for the area C in Figure 7.10. In all cases where the angle exceeds 45°, i.e. if = 60°, the slope is steep and the factor a will increase area C in a way of making it higher. As tan 60° = 1.73 the area C will be stretched so C will appear as an upright rectangle. The area C depends on the slope of the function. We expressed it by a. For the 2 nd observation the same rule applies. Compare Figure 7.11. The factor a applies for the area C and D calculation the same way. Figure 7.11: Areas A and C as well as B and D for the function Y(X) If you compare the sum of the areas A, B, C and D you will see easily that these areas equal to those depicted in Figure 7.8. As a result the equation below is valid: X 1 × Y 1 + X 2 × Y 2 = A + B + C + D = b × (X 1 + X 2 ) + tan × (X 12 + X 22 ) We now study the equation (2) for 2 observations too: (2) i i i i X a b Y <?page no="131"?> On the left hand side of the equation, the sum of Y 1 and Y 2 is calculated. In case of DANNING (Pty) Ltd., the Yamounts represent the costs for the monthly observations Y 1 and Y 2 . On the right hand side, there are two summands. The first one represents the portion of Y-amounts that does not depend on Y. Hence, the first summand got the height of: 2 × b. The second summand is the amount of (Y 1 - b) and (Y 2 - b) that depends proportionally on X i . Figure 7.12: Function Y(X) = a × X +b The slope of the function Y(X) is a and can be calculated as a = tan = (Y 1 - b) / X 1 . Check Figure 7.12. The same applies for the second mark on the function that represents the second observation: a = tan = (Y 2 - b)/ X 2 . If the slope of the function is positive the contribution for the second observation to the Y-amount will be higher than for the first one because Y i - b = a × X i = tan × X i . The equation below is valid: Y 1 + Y 2 = 2 × b + tan × (X 1 + X 2 ) The simple regression method is an instrument widely applied in Management Accounting in order to separate costs for cost functions that depend linear from a reference unit. It ascertains 2 parameters by 2 equations. Ad (5): Differential/ Sunk/ Opportunity Costs The three cost concepts below are not exclusive. Most of the management problems are linked to decisions which is why costs should be calculated for alternatives in order to support decision making. Differential costs are the costs for one <?page no="132"?> additional unit of product produced, service rendered or based on a reference unit at a situation of resources in progress already. If positive, we also refer to incremental costs and if negative to decremental costs. At DANNING (Pty) Ltd. it applies for the cost of one additional tax statement when the attorney works on a normal workload already. Differential costs refer to an already working environment as investments are excluded in the considerations. Differential costs refer to incremental costs. The increase or decrease of factors that cost depend on determines the costs. A restaurant that sells burgers will increase its cost for the meat patties by every additional burger flipped. If production drops, the consumption of meat patties will decrease. The cost per one meat patty will be seen as the incremental costs caused by one further unit of a burger. If the burger is a Big Mac the incremental costs are linked to two meat patties. As the differential costs depend on the future output, the knowledge about incremental costs is important for decision making and Budgeting. In contrast to differential costs, sunk costs are not linked to operational decisions. They depend on decisions already made. Frequently, they are called committed costs, as the company made a commitment, such as with regard to rent or interest. Sunk costs are costs that cannot be changed any more. They do not vary with future decisions. Opportunity costs are costs for an alternative given up on in order to perform an activity. They normally do not appear in Accounting records but they are important for decision making. Take a look at the attorney Dr MEPPEN. Summary: Management Accounting applies different cost terms. There is a distinction made between direct and indirect costs. Direct costs can be assigned straight to the product/ service. There is a distinction between manufacturing and non-manufacturing costs. Manufacturing costs are direct materials, direct labour and all manufacturing overheads linked to production. There is a distinction between product and period costs. Product costs are costs that are storable. They can be “parked” in inventory accounts. Once the goods are released from stock, their costs of manufacturing are expensed and become period costs. There is a distinction between variable and fixed costs. Variable costs depend on the amount of output measured by reference units. Fixed costs do not depend on the output. Cost Separation is a method to ascertain the amount of proportional <?page no="133"?> costs and fixed costs in a business, where mixed costs apply. The Cost Separation applies for Budgeting, as proportional costs will be calculated based on the output and fixed costs only change by management decisions. Differential costs are the increase/ decrease of costs caused by one further/ lesser unit produced without consideration of jump costs. Sunk costs are costs that do not depend on decisions. Opportunity costs are costs to the extent of the benefit of a forfeited alternative option. Working Definitions: Variable Costs: Variable costs depend on the output of the business whereas fixed costs remain unchanged no matter how much the output is. Prime Costs: Prime costs are direct materials and direct labour. Cost of Conversion: The costs of conversion contain direct labour and manufacturing overheads. Product Costs: Product costs are assigned to products which can be put on stock. Period Costs: Period costs are linked to the Accounting period they occur in. Output: The output of a company is the amount of products produced or services rendered. Proportional Costs: Proportional costs depend directly on the output. Reference Unit: In case costs depend proportionally on an output related factor, we refer to the factor as a reference unit. Fixed Costs: Fixed costs do not change with the output. Mixed Costs: Mixed costs contain a portion that is proportionally depending on the output and another portion that is fixed. Cost Separation: Cost Separation is the determination the proportional cost portions and fixed costs within mixed costs. High-Low Method: The high-low method considers the highest and lowest observation with cost and factor amount and calculates a straight line that goes through these points as the cost function. Scatter Graph: The scatter graph is based on a graphic diagram of the cost over factor observations and requires to manually draw a line in the diagram that way that most observation points are on or close to the line. Regression Method: The regression method calculates the function’s parameter based on all plotted observations mathematically. It determines a function by minimising the difference between the square deviations and the function line that way that all observations are on the calculated cost function or closest thereto. Differential/ Incremental Costs: Differential costs are the costs for one additional unit of product produced, service rendered or based on a reference unit at a situation of resources in progress already. Sunk Costs: Sunk costs are costs that cannot be changed any more. Opportunity Costs: Opportunity costs are costs for an alternative given up on in order to perform an activity. <?page no="134"?> Learning Objectives The cost volume profit analysis (CVPanalysis) requires a Cost Separation as discussed in the previous chapter (7). It helps managers to find the right level of activities for their business. Based on selling prices and costs, it shows from which activity level onwards the company earns profit. This chapter aims to explain the concept of a CVPanalysis. After studying the chapter, you should be able to apply and discuss the outcome of a CVP-analysis and be able to ascertain the product amount and/ or product mix that makes the company profitable. In this chapter, we ascertain the critical amount from which onwards the company becomes profitable. After preparing a break-even calculation we determine what happens if changes are made by a what-if analysis. The CVP-analysis is also known as break-even analysis. This expression meets the concept quite well: Once the company starts its operations, fixed costs apply. A business without investments is very seldom. Think about a taxi company. It must first by a car it intends to operate for rendering its transportation services. Without investments, the company has to rent the taxi car. Investments result from the acquisition of machinery and lead to fixed costs, such as depreciation. The first unit of products/ services won’t be able to cover all fixed costs. Only after the business produces a certain amount of goods or renders so many services that it covers its fixed costs, the company earns profit. Then revenue exceeds costs. We say, the company breaks-even. <?page no="135"?> Management Accountants of the company have to determine the right product/ service amount(s) in order to make the company profitable. Breaking-even depends on the product amounts or service amounts sold. A company’s revenue has first to cover all fixed costs and proportional costs to make the company start earning profit. The following assumptions are to be fulfilled to study a CVP-analysis: (1) The selling prices per unit are constant. In particular, there is no discount for high selling amounts, no “buy 10 - get one free”. (2) The unit cost function (cost as a function of the good/ service amounts) is constant. This means variable costs do not change. In case of constant unit costs, the cost diagram is a line. Proportional costs apply. Cost Separation must be possible. Furthermore, jump costs do not exist, which implies there are no step-fixed costs as the already existing resources can serve all product/ service requirements. (3) Companies that are selling numerous goods must sell a constant mix of goods. This requires that the ratio of good amounts is always the same, such as “for 3 oranges the business sells 2 bananas”. (4) There are no changes of inventories of finished goods. The production amount equals to the sales amount. This means, goods are not stored or released from stock. How it is Done (CVP Calculation) (1) Check the requirements for a CVP analysis as above. (2) Determine the budgeted costs for the planned output. (3) Calculate/ plan the portion of fixed costs. If only total costs are available run a cost separation (4) Ascertain the cost function that depends on the amount of products/ services. (5) Plan the budgeted revenue per unit(s) or consider actual revenues derived from the Financial Accounting system. (6) In case the company produces/ renders more than one product/ service determine the amount ratio the product/ service sales are expected to be. <?page no="136"?> (7) Prepare the revenue function that depends on the amount of products/ services (to be) sold. (8) Determine the amount of products where the revenue curve intersects the cost curve mathematically. We study the CVP analysis by the case study of DEERFIELD TOURS (Pty) Ltd., which is a tourist business. Figure 8.1: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (1) <?page no="137"?> Figure 8.2: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (2) The break-even point in a CVP analysis is the amount of goods or the activity level where the company earns a zero profit. The contribution margin is the sales less variable costs. Figure 8.3: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (3) What is the use of a CVP analysis for managers? It is actually more than just to find out the break-even point. It will support managers to make decisions with regard to finding the right business concept and to tell them whether <?page no="138"?> or not they improve the profit for the company. We study again the company DEERFIELD TOURS (Pty) Ltd. Figure 8.4: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (base case) Figure 8.5: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (internet) <?page no="139"?> Figure 8.6: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (bungee jumping) <?page no="140"?> Figure 8.7: DEERFIELD TOURS (Pty) Ltd.’s Calculation of the adjusted net selling price As we can observe, the CVP analysis can be used as a what-if analysis. A what-if analysis is no simulation. However, it is a calculation of the outcome by alternating particular variables. It is regarded as a helpful means for preparing the business plan of a company. The CVP analysis can even help us to combine changes in the business plan, such as DEERFIELD TOURS (Pty) Ltd. running the new bus and includes the bungee-jumping option in their tours offers. How does a company like DEERFIELD TOURS (Pty) Ltd. actually know, what will happen to the amount of customers, if it changes one of the parameters in the contribution income statement? The answer from the Accounting point of view is: It does not know. However, the experience will show and Marketing Research will provide answers. We take a look at DEERFIELD TOURS (Pty) Ltd. again: (Note, we keep Marketing Research on a low level here.) <?page no="141"?> (Note, we cover normal distributions in chapter (12).) Figure 8.8: Observations <?page no="142"?> The observations in Figure 8.8 can be transformed to a standard normal distribution. A standard normal distribution is normally distributed and the mean equals to 0 and the standard deviation equals to 1. There are tables available which can be used to read the probability for standard normal distributed amounts. We are going to use the table for the normal standard distributions which is given by Figure 8.10. Figure 8.9: DEERFIELD TOURS (Pty) Ltd.’s break-even point (internet campaign) <?page no="143"?> Figure 8.10: Standard normal distribution table <?page no="144"?> CVP-analysis applies for companies producing and selling more than one product too. In this case the breakeven point becomes a break-even line. In order to determine a certain point thereon, Accountants assume a fixed ratio for the product mix sold. This means per a certain amount of one product it will sell a certain amount of the other one. We apply the method for DEERFIELD (Pty) Ltd. Figure 8.11: DEERFIELD TOURS (Pty) Ltd. 2-product statement <?page no="145"?> Figure 8.12: DEERFIELD TOURS (Pty) Ltd.’s 2-product statement (2) As the MS Excel spreadsheet for the contribution income statement is wellstructured, an easy calculation option is MS Excel’s goal seek function again. Well-structured means, the cells in the spreadsheet are linked to each other and the calculation does not contain loops. (Note, well-structured is a term from artificial intelligence research and refers to a problem situation where no arbitrage results are possible, hence all judgements and individual decisions are excluded.) <?page no="146"?> Figure 8.13: Goal seek function break-even point calculation Figure 8.14: DEERFIELD TOURS 2-product statement (3) Summary: The Cost Volume Profit analysis ascertains the profit for different levels of products/ services/ activity levels. Frequently, the CVP analysis is applied in order to ascertain the break-even point. This is the output amount where the company does not earn a profit (profit equals zero). A valuable use of the CVP analysis is in business when different alterations of the business plan are tested in order to find the best profitable alternative. It is recommended to run CVP analysis on a spread sheet program such as MS Excel. Working Definitions: Break-Even Point: The break-even point in a CVP analysis is the goods amount or the activity level, where the profit equals zero. <?page no="147"?> Contribution Margin: The contribution margin is the sales deducted by variable costs. What-if analysis: A what-if analysis is a calculation of the outcome by alternating particular variables. 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 equals to 0 and the standard deviation equals to 1. <?page no="148"?> Learning Objectives: A company that breaks-even, earns with every incremental product/ service added a profit which equals to the contribution margin for these items. The reason is, that once fixed costs are covered completely, profit will increase by the net operating income. The Degree of Operating Leverage (DOL) is a concept that will tell managers how profit will change based on variations in revenue. The DOL is regarded as a measurement for the flexibility of a business too. After studying this chapter, you will be able to understand the DOL concept and can analyse the ratio DOL for a business. Managers strive to control the company’s financial position. In particular, they want to understand, how business reacts to certain changes. I.e., they want to understand how much profit will increase per one additional unit of product/ service sold. How it is Done (Calculation of DOL) (1) Ascertain the revenue for a particular output that is the reference case. Call the scenario A. (Note, as all the prices are to be constant you can calculate output changes based on revenue figures, too.) (2) Ascertain the revenue for another output. Call the scenario B (3) Determine the percentage of changes in output. The percentage increase/ decrease is: Output A,B = Output B / Output A - 1. (4) Determine the percentage of changes in profit. The percentage increase/ decrease is: EBIT A,B = EBIT B / EBIT A - 1. (5) Ascertain the Degree of Operating Leverage. It equals to: DOL A,B = EBIT A,B / Output A,B In order to familiarize ourselves with the concept of the degree of operating leverage, we refer to the already known example from the previous chapter (8) DEERFIELD TOURS (Pty) Ltd. <?page no="149"?> Figure 9.1: DEERFIELD TOURS (Pty) Ltd. break-even point The net operating income is the profit that remains after all operational costs are paid. The net operating income applies frequently for DOL calculations. The net operating income term is explained by a situation where the landlord rents out his property. If an investor buys property in order to rent it out, the net operating income will be his/ her rental income less all costs paid as stated by the rental agreement, such as renovation/ maintenance costs or maybe municipality rates. No overheads, such as administration, are deducted. The net operating income is similar to the contribution margin however contribution margin is an expression that comes from Calculation and is strictly linked to the difference between revenue and proportional costs. <?page no="150"?> Figure 9.2: DEERFIELD TOURS (Pty) Ltd.’s profit calculation (1 additional traveller) Figure 9.3: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (11 travellers) (Note, as sales are based on constant prices, we only calculate the changes in sales numbers. This goes for the whole chapter.) The factor between the changes in EBIT and in sales is called the degree of operating leverage DOL. The DOL equals to changes in terms of EBIT over changes in terms of sales. <?page no="151"?> Sales EBIT DOL Companies with a high DOL will experience high changes in profit if sales change. In order to make the effect more visible, we write the equation with an isolated EBIT: Sales DOL EBIT By this notation, we see that the DOL works as an amplifier for changes in sales. But, the DOL works in the opposite direction, for decreases, too. Any sales reduction will make the profit shrink DOS-times! Companies with high DOL are classified as risky. (Read for Risk Valuation chapter (12).) There are two factors that determine the degree of operating leverage. (1) DOL-degression effect (2) Fixed costs Ad (1): DOL-Degression Effect The DOL depends on the absolute amount of output. As the profit equals to zero at the break-even point and we measure changes as percentages, profit changes close to the break-even point are relatively high than farther away. The DOL-degression effect is of lower importance once the company earns a revenue farther away from the breakeven point, which might be quite often the case or at least it should. Ad (2): Fixed Costs The degree of operating leverage depends highly on the amount of fixed costs. Managers who change the cost structure, such as adding fixed costs by investments, should be aware that this won’t only change the Accounting situation but it has an impact on the flexibility of the company. Changes in the cost structure towards fixed costs make the company less flexible. Once fixed costs are covered, a high DOL works in favour of the business, because all net operating income will contribute to EBIT. However, the <?page no="152"?> coverage of fixed costs is achieved at higher output of products/ services. In other words: Investments push the break-even point in direction of higher outputs, so the company has to achieve higher amounts before breaking-even. Another aspect is, that shrinking sales and a high degree of operating leverage becomes dangerous, because the DOL works both ways. In times of a weak economy, a high DOL will decrease profit dangerously. In order to understand the concept clearly, we take a look at a new case study about a company that has higher potential to change its fixed costs. We also want to study how an increase of output determines changes of the operating cash flow. DEERFIELD TOURS (Pty) Ltd. case study only contains low fixed costs. The company is kind of risk-free as in case of no travellers only administration costs apply. Furthermore, DEERFIELD TOURS (Pty) Ltd. has the option to cancel a trip and so gets rid of almost all fixed costs. For understanding the DOL concept, we introduce a new company example about a manufacturer that operates at higher fixed costs. The company invests in production facilities over a period of 5 years and is stuck to the fixed costs for that period. For studying the DOL, we prepare an income statement and a cash flow statement that helps us to calculate the Accounting break-even point, the cash break-even point and the financial break-even point. <?page no="153"?> Figure 9.4: EMS KAYAK GmbH’s profit and cash flow Calculation (1) The Accounting break-even point is based on the output amount which makes the company earn a profit of zero. <?page no="154"?> Figure 9.5: EMS KAYAK GmbH’s Accounting break-even point The cash break-even point is based on the output amount which makes the operating cash flow become zero. The cash break-even point is only relevant for the Accounting periods when returns are received. <?page no="155"?> Figure 9.6: EMS KAYAK GmbH’s profit and cash flow Calculation (2) (Note, we delete the summands for taxation as no profit is earned.) 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 cases automatically and we do not have to delete tax-relevant summands manually as we did before. Figure 9.7: EMS KAYAK GmbH’s cash break-even point <?page no="156"?> The cash break-even point is important to know, if the company faces a situation of bankruptcy based on illiquidity and/ or wants to know, whether or not a project will contribute cash. Finally, we want to check on the financial break-even point. It is relevant for an investment decision. The question is: how many products/ services are to be produced/ rendered, in order to take an economical advantage of the investment. In contrast to the previous break-even point considerations, the financial cash flow is linked to investing and operating cash flows of all Accounting periods and considers the time value of money. The financial break-even point is at that output amount that makes the net present value become zero. Figure 9.8: EMS KAYAK GmbH’s financial break-even point <?page no="157"?> Figure 9.9: EMS KAYAK GmbH’s financial break-even point We now study the degree of operating leverage DOL for different output scenarios. The base case (1) is linked to 525 kayaks. We assume the base case applies and EMS KAYAK GmbH wants to increase production and sales by 200 kayaks. (The profit and cash flows for 525 kayaks can be read from Figure 9.4.) The situation is fairly far away from the break-even point. Hence, we can assume that the degree on operating leverage will only slightly change based on the DOL-degression effect. Figure 9.10: EMS KAYAK GmbH’s profit and cash flow Calculation (3) <?page no="158"?> (Note, the index at the DOL ratio is linked to the figure of the status as given by the figure titles. (1) indicates the base case with 525 kayaks. (3) is linked to Figure 9.10.) Figure 9.11: EMS KAYAK GmbH’s profit and cash flow Calculation (4) <?page no="159"?> Figure 9.12: EMS KAYAK GmbH’s profit and cash flow Calculation (5) <?page no="160"?> Figure 9.13: EMS KAYAK GmbH’s profit and cash flow Calculation (6) Figure 9.14: EMS KAYAK GmbH’s profit and cash flow Calculation (7) <?page no="161"?> Below, we show the situation in a costvolume-diagram which is not to scale with regard to the case study. 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 at fixed costs. The intersection of the cost line and the sales line marks the break-even point A. At this point, the business does not earn a profit as the sales equal to the costs. The arrow 1 indicates the reduction of fixed costs by disposal of the machinery as a result of farming out production steps, as in the case of EMS KAYAK GmbH the hull production. As a further impact of the outsourcing variable costs increase which lead 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 to lower volumes. This means the company has to produce and sell less products in order to break-even. Hence, the risk situation of the company improves. As the fix cost reduction (arrow 1) moves the break-even point in direction of lower volumes and the increase of variable costs moves it in direction of higher volumes the company has to calculate the effects properly in order to not overdoing outsourcing. In order to determine the variable costs that can be added to an existing production scenario we study EMS KAYAK GmbH again at the breakeven point as depicted by Figure 9.5. <?page no="162"?> Figure 9.16: EMS KAYAK GmbH’s profit and cash flow plan for farming out case We discussed break-even point shifting in order to show that the risks for a business depend on its flexibility to make changes with regard to the production and sales amounts. Investments cannot be made undone easily. If the company needs to cut costs, machinery invested in are to be disposed. In contrast to reductions of fixed cost, cost for current assets, such as supplies and materials, can easily be adjusted to order amounts. Thus, a company that farms out production steps actually shifts the risk (as well as profits) to its suppliers. <?page no="163"?> Figure 9.17: EMS KAYAK GmbH’s break-even point We finally 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 The result means that an increase of 1 % sales will make the operating cash flow increase by 101 %. <?page no="164"?> (The result does not surprise as most of the activities in this case study are on cash. The depreciation amount is quite low in comparison to the other costs.) Summary: The degree of operating leverage DOL measures the sensitivity of the profit (EBIT, or in some cases only NOI) to changes in sales. The DOL depends on the cost structure. High DOLs will be regarded as risk factors, as a company will react to sales reductions by DOL-times profit reductions. Working Definitions: Degree of Operating Leverage Concept: The Degree of Operating Leverage (DOL) is a concept that will tell managers how profit will change based on variations in revenue. Net Operating Income (NOI): The net operating income is the profit that remains after all operating costs are paid Degree of Operating Leverage: The factor between the changes in EBIT and in sales is called the degree of operating leverage DOL. The DOL equals to changes in terms of EBIT over changes in terms of sales. Accounting Break-Even Point: The Accounting break-even point is based on the output amount which makes the company earn a profit of zero. Cash Break-even Point: The financial break-even point is based on the output amount which makes the operating cash flow become zero Financial Break-even Point: The financial break-even point is that output amount that makes the net present value 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. <?page no="165"?> Berkau: Basics of Accounting (Part II) 10-161 10. Performance Measurement Learning Objectives: In this chapter, we discuss performance measurement in order to assess division managers or to support decision making about future investments. We cover different concepts of performance valuation. We also analyse the impacts of their application in order to read performance figures correctly. In order to make the company as efficient as possible it is required to apply Cost Monitoring and with regard to investments we should allocate resources where the best performance is expected. You should also understand performance ratios in order to know how performance monitoring of your division works and what impact ratios can have. Performance measurement refers to the achievements of an organisational unit, i.e. of a cost centre. In this chapter, we still call them divisions and assume a company has few divisions, say 2 - 10 ones. In contrast, companies might have hundreds of cost centres which all are subject to performance measurement. The management has to decide how much in the details performance measurement should be. We observe divisions and calculate which ones works best. In order to make our explanations easier to understand, we apply the case study VANHUIZEN BV from the beginning of our considerations on. VANHUIZEN BV is a Dutch automotive accessories company with branches in Geldern and Pieterburen. (Note, BV stands for besloten vennootschap met beperkte aansprakelijkheit which is the Dutch legal form for a public limited company.) These 2 branches are considered divisions. The company is specialised in tinting car windows. The firm’s headquarters is based in Kampen where no production facilities are located. Window tinting is a mostly manual process. Foils are ordered in different colours from the supplier OCTUPUS PLC and are cut manually by scalpel to fit on the windows of the customer’s car. The degree of automation for the tinting process is quite low, as most of the work is craftsmanship. With regard to the cost structure, the cost categories below apply: - Materials, foils - Miscellaneous, gloves, knives, soap - Labour - Rent for the store - Depreciation on the cutter-table. The cost structure of a service company that glues foils manually on car windows is typically dominated by proportional labour costs. The main activity of VANHUIZEN BV is that it employs workers and sells their services to its customers. The foils are materials added to business operations. Hence, most of the costs are linked to materials and labour, which we refer to as the prime costs. The company’s return is quite high as a percentage of the total assets is low in comparison to other costs. The fixed assets of the company are low in values as the business does not require a high amount of precious machinery. The relation could change, if VANHUIZEN BV stores huge values of inventory, i.e. in order to be independent from its supplier <?page no="166"?> Berkau: Basics of Accounting (Part II) 10-162 or for offering a high variety of foil colours or tinting levels. This situation of high performance based on low assets applies for many service companies, such as consultancies, doctor’s clinics or law firms. At VANHUIZEN BV, the price for a car window tinting per car is 400.00 EUR/ car. During the last years, the below disclosed amounts for revenue and costs were recorded in the two divisions of VANHUIZEN BV. In the GELDERN store, 2,080 cars were ‘tinted’, in contrast to 3,640 cars in the PIETERBUREN store. The profitability reports are displayed in Figure 10.1 and Figure 10.2. [EUR] Revenue 832,000.00 Other income 832,000.00 Materials (312,000.00) Miscellaneous (5,000.00) Labour, var (156,000.00) Labour, fixed (40,000.00) Depreciation (100,000.00) Other expenses (40,000.00) Earnings before int. & taxes (EBIT) 179,000.00 Vanhuizen BV - GELDERN's PROFITABILITY ANALYSIS for the year ended 31.12.20X1 Figure 10.1: Profitability Analysis for the GELDERN branch [EUR] Revenue 1,456,000.00 Other income 1,456,000.00 Materials (546,000.00) Miscellaneous (8,000.00) Labour, var (273,000.00) Labour, fixed (40,000.00) Depreciation (200,000.00) Other expenses (60,000.00) Earnings before int. & taxes (EBIT) 329,000.00 Vanhuizen BV - PIETERBUREN's PROFITABILITY ANALYSIS for the year ended 31.12.20X1 Figure 10.2: Profitability Analysis for the PIETERBUREN branch <?page no="167"?> Berkau: Basics of Accounting (Part II) 10-163 VANHUIZEN BV wants to know which division is performing best. In the first step, it compares the divisions’ profits before taxes. We acknowledge that profit in the PIETERBUREN division is higher than in GELDERN. However, the figures for depreciation and other costs gives reasons to believe the branch is just bigger which means it has higher capacity. We take this from higher revenue, higher labour costs and more depreciation. Along Drury, we divide out profit to portions that are controllable and non-controllable, to portions that are necessary for the operation of the division or not necessary. We furthermore consider costs that result from allocations of entire company costs, such as lawyer service, HR department and Accounting. In the case of VANHUIZEN BV, these costs fall under headquarters costs and are actually not caused by activities or decisions made by division managers. 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 equals to: 2,080 × 400 = 8832,000.00 EUR. In PIETERBUREN we calculate: 3,640 × 400 = 1 1,456,000.00 EUR. (Note, for the whole case study we ignore VAT.) For profit calculation, we deduct costs from the revenue. However, as we want to ascertain the performance of the divisions, costs are studied with regard to their dependency on managers’ decision and on their necessity for the existence of the division. Some costs only are caused by the headquarters. From studies in Organisation doctrine we learned that responsibility should only be pinpointed to managers for what they can decide on. As a result, it would be unfair to include headquarters cost allocations in a performance report for the division if it is used for the evaluation of managers. We calculate different profit levels by step-wise cost deductions from revenues. The calculations result in: (a) Short-run (variable) contribution margin (b) Controllable contribution margin (c) Divisional contribution margin (d) Divisional net profit. Compare the below calculations with Figure 10.3! Ad (a): Short-run (Variable) Contribution Margin In both divisions, the variable costs contain materials (foils) and direct labour costs. At VANHUIZEN BV, workers are only paid once they work on tinting car windows. As a result, labour is considered a direct cost which is completely variable with regard to the output. After deduction of variable costs from the sales revenues, we derive the variable and short-run contribution margin for both branches, in GELDERN and in PIETERBUREN. As the short-run contribution margin fully depends on the output (amount of window tinted cars), we call it a variable contribution margin. The variable contribution margin in GELDERN equals to: 832,000 - 2,080 × (150 + 75) = 3 364,000.00 EUR. In PIETERBUREN, the variable contribution <?page no="168"?> Berkau: Basics of Accounting (Part II) 10-164 margin equals to: 1,456,000 - 3,640 × (150 + 75) = 6 637,000.00 EUR. Ad (b): Controllable Contribution Margin By the next step, we deduct all controllable fixed costs from the short-run contribution margin. Fixed and controllable costs are for miscellaneous materials such as gloves, knives and soap as well as for fixed labour. The latter one is for the order management located inside of the stores. Controllable costs are required to run the divisions’ services but they are no variable costs because they do not depend directly on the amount of window tinted cars. They are classified as fixed costs and depend on the managers’ decisions. Deducting controllable fixed costs from the variable contribution margin results in the controllable contribution margin. In the GELDERN branch, the controllable contribution margin equals to: 364,000 - 40,000 - 5,000 = 3 319,000.00 EUR. In PIETERBUREN the controllable contribution margin equals to: 637,000 - 40,000 - 8,000 = 5589,000.00 EUR. Ad (c): Divisional Contribution Margin By the next step, further fixed costs are deducted. The deductions are linked to costs that become obsolete once the division is closed down. These costs cannot be decided on by local managers in the divisions. They are required to maintain the division and are determined by General Management. At VANHUIZEN BV, these costs are depreciation on the cutter tables and shop rental costs. After reduction of the costs for continuing operations in the divisions from the controllable contribution margin, we arrive at the divisional contribution margin. The divisional contribution margin in GELDERN equals to: 319,000 - 100,000 - 40,000 = 1 179,000.00 EUR. The divisional contribution margin in PIETERBUREN is: 589,000 - 200,000 - 60,000 = 3 329,000.00 EUR. Ad (d): Divisional Net Profit With the divisional contribution margin the profit before taxes has been calculated for both divisions. However, the headquarters costs still need to be addressed. Headquarters only provides administration service, as no car window tinting takes place in the headquarters. We do not consider the application of headquarters costs to divisions helpful for the performance measurement in the divisions. However, a total net profit is to be calculated in order to compare the divisions to alternative investments from the shareholders’ point of view. Headquarters costs are 500,000.00 EUR/ a and are allocated equally, at a 50 : 50 ratio, to the branches in GELDERN and PIETERBUREN. We derive the divisional profit before taxation by reduction of 250,000.00 EUR from the divisional contribution margins in GELDERN and PIETERBUREN. GELDERN branch’s net profit comes out negative. It equals to: 179,000 - 200,000 = - -21,000.00 EUR. The divisional net profit in PIETERBUREN is: 329,000 - 200,000 = 1 129,000.00 EUR. Observe the entire calculation of performance ratios in Figure 10.3: <?page no="169"?> Berkau: Basics of Accounting (Part II) 10-165 Geldern Pieterburen Total sales 832,000.00 1,456,000.00 less variable costs (468,000.00) (819,000.00) Variable short-run Contribution Margin 364,000.00 637,000.00 less controllable fixed costs (45,000.00) (48,000.00) Controllable Contribution Margin 319,000.00 589,000.00 less non-avoidable costs (140,000.00) (260,000.00) Divisional Contribution Margin 179,000.00 329,000.00 less HQ contribution (200,000.00) (200,000.00) Divisional NP before taxes (21,000.00) 129,000.00 Vanhuizen BV's PERFORMANCE REPORT for 20X1 Figure 10.3: Performance figures for VANHUIZEN BV The controllable contribution margin is regarded as the most appropriate measure for the departmental performance. The controllable contribution margin considers all costs in the power of the division manager. No depreciation on divisional assets nor costs for the shop rent are included as the managers do not change them by their decisions. They could be changed once the branch is closed down and as a consequence VANHUIZEN BV stops its rental payments and sells all the assets of the division. Before we calculate ratios, we take a look at the whole company and calculate the net operating profit after taxes. The profit earned in all divisions together is the taxable income for the firm. For VANHUIZEN BV we assume an income tax rate of 30 %/ a based on the conventions of this text book. Hence, the income taxes equal to: 108,000 × 30% = 32,400.00 EUR. The net profit after taxation equals to: 108,000 - 32,400 = 75,600.00 EUR. <?page no="170"?> Berkau: Basics of Accounting (Part II) 10-166 Geldern Pieterburen Total sales 832,000.00 1,456,000.00 less variable costs (468,000.00) (819,000.00) Variable short-run Contribution Margin 364,000.00 637,000.00 less controllable fixed costs (45,000.00) (48,000.00) Controllable Contribution Margin 319,000.00 589,000.00 less non-avoidable costs (140,000.00) (260,000.00) Divisional Contribution Margin 179,000.00 329,000.00 less HQ contribution (200,000.00) (200,000.00) Divisional NP before taxes (21,000.00) 129,000.00 Entire NP before taxes less income taxes Net operating profit after taxes NOPAT 108,000.00 (32,400.00) 75,600.00 Vanhuizen BV's PERFORMANCE REPORT for 20X1 Figure 10.4: Profit calculation VANHUIZEN BV By studying different performance measures for the case study VANHUIZEN BV, we could already see, that branches differ in size. This requires a more sophisticated performance measurement application. We discuss below: (1a) Return on investment (1b) Return on equity (2) Residual income (3) Economic value added EVA TM Ad (1a): Return on Investment The return on investment shows the profit as percentage of the investment. The consideration of different investments is useful to compare companies or divisions of different sizes. In the case of VANHUIZEN BV we consider the investments in the stores being 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 and (c) the divisional profit, can be used. As we are interested in the managers’ performance we calculate the return on investment based on the controllable contribution margin and derive the following returns: ROI GELDERN = 319,000 / 1,000,000 = 3 31.90 %/ a and: ROI PIETERBUREN = 589,000 / 2,000,000 = 2 29.45 %/ a. However, in case we intend to compare investments of the company in other opportunities, we should consider the divisional contribution margin for the nominator of the return on investment figure, which gives: ROI div,GELDERN = 179,000 / 1,000,000 = 1 17.90 %/ a and: ROI Div,PIETERBUREN = 329,000 / 2,000,000 = 16.45 %/ a. <?page no="171"?> Berkau: Basics of Accounting (Part II) 10-167 The return on investment comes with a disadvantage for decision making. Consider that the division manager is keen to invest only if the return on investment increases for his/ her division. In case the return figure available on similar investments is 17 %/ a, and the manager in GELDERN is offered an investment opportunity (store extension) that comes with an estimated return on investment of 17.5 %/ a, he/ she would not take the opportunity because it makes the total return figure of his division decrease. Remember, the return figure actually is 17.9 %/ a. The extension of his shop by an investment dilutes the performance in GELDERN. On the other side, the manager in PIETERBUREN would be happy to invest in an extension of his/ her shop which gives him/ her a 16.80 %/ a return because it helps him/ her to increase his/ her average return on investment. However, both investment decisions are wrong! As a return on investment of 17 %/ a is still available for investments, the manager in GELDERN should take the opportunity to extend his business at 17.5 %/ a of return and the manager in PIETERBUREN should deny the offer of a 16.8 %/ a investment. So, the mistakes are: The manager in GELDERN was offered an investment that exceeds the capital market’s return on investment but he/ she refused. The manager in PIETERBUREN invested in an extension of his/ her business although there were better options available. Hence, managers who are guided by the return on investment are likely to make wrong decisions if they only try to maximise the return on investment. Another disadvantage results from the denominator of the return on investment. The denominator either is the initial investment or the carrying amount of the division’s assets. In case the initial investment amount is in use, managers are motivated to reinvest continuously, as new investments do not have an impact on their performance measure. Let’s say a taxi driver sells his taxi every year. There is no reason to keep it as the performance measure is based on the initial payment at the time of acquisition. He/ she enjoys the privilege riding a brand-new taxi car at all times. In case the carrying amount is applied for the denominator of the return of investment figure, the taxi driver will lesser his/ her number of rides after a few years, as his/ her performance increases just due to the car depreciation which gives an automatic increase of performance. We assume the taxi comes with costs of acquisition of 50,000.00 EUR. The taxi profit in every year is 20,000.00 EUR/ a. Hence the first year’s return is: ROI 1 = 20,000 / (50,000 - 10,000) = 50.00 %/ a, the next one is: ROI 2 = 20,000 / (50,000 - 20,000) = 66.67 %/ a, the third year’s return is: ROI 3 = 20,000 / (50,000 - 30,000) = 100.00 %/ a, and so on. If the taxi driver is driven by the idea to keep his return on investment on a constant level, he/ she can reduce his/ her workload in the 2 nd year to 15,000.00 EUR of profit and in the 3 rd year to even 10,000.00 EUR. This means after 2 years of operation, the taxi driver works only half shifts, which gives him a ROI 3,half = 10,000 / (50,000 - 30,000) = 50.00 %/ a, same as in the first year. <?page no="172"?> Berkau: Basics of Accounting (Part II) 10-168 We study this effect with VANHUIZEN BV: We apply a return of investment calculation based on the controllable contribution margin in the nominator and the carrying amount of the cutter tables in the denominator. The carrying amount of the investments is regarded to as the fair value for the asset valuation. Hence, it gives us the correct input for the return figure. We consider the cutter tables are written-off over a period of 10 years and the ones in GELDERN are more than 6 years old and the ones in PIETERBUREN are more than 2 years old. Hence, the carrying amount of the tables in GELDERN is: CA cutter = 1,000,000 - 6 × 100,000 = 4 400,000.00 EUR. The return on investment for the division in GELDERN is: 179,000 / 400,000 = 4 44.75 %/ 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 increase only by the course of time. In the next year, the return in PIETERBUREN will ceteris paribus be: 329,000 / (2,000,000 - 3 × 200,000) = 23.5 %/ a. The return even increases progressively. However, aging of machinery is not what should drive the performance figures. As a result the return on investments is avoided as performance indicator for comparisons of divisions where machinery of different age are deployed. Ad (1b): Return on Equity The problem with regard to the denominator of the return on investment figure can be remedied by comparing returns on equity. However, this method does not apply for divisions, as there is no academically acceptable way of how 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 gives the owners a performance rate which is based on their investment. The owners hold the total of equity which includes reserves and retained earnings as well as the share capital. Hence, their input is the total book value of the company. The outcome of the company is the profit after taxes. It can be declared as a dividend to the shareholders. We consider the whole company VANHUIZEN BV and calculate its performance. The net operating profit after taxes equals to 75,600.00 EUR. This amount is divided by the book value of the company which we pretend to be 900,000.00 EUR. The return on equity equals to: 75,600 / 900,000 = 8 8.4 %/ a The application of the return on equity can be misleading as a result of the leverage effect. The leverage effect makes the return on equity increase based on the debt-to-equity ratio. The effect results from the margin between interest and the return on investments. In case the return on investment exceeds the capital costs (which it should do), a higher level of debts will increase the return on equity ratio. We take a look at VANHUIZEN BV again. We assume, the financing of the company is 900,000.00 EUR equity, 1,200,000.00 EUR bank loan at a rate of <?page no="173"?> Berkau: Basics of Accounting (Part II) 10-169 interest of 5.5 %/ a and 900,000.00 EUR bonds at a coupon rate of 4.5 %/ a. The interest of: 1,200,000 × 5.5% + 900,000 × 4.5% = 1 106,500.00 EUR would be included in the headquarters costs. We now change the capital structure for VANHUIZEN BV and assume the equity is 500,000.00 EUR but the bank loan equals to 1,600,000.00 EUR. This will increase the interest (before taxation) by: 1,600,000 × 5.5% + 900,000 × 4.5% - 106,500 = 2 22,000.00 EUR. We apply these changes in the divisional comparison as disclosed in Figure 10.5: Geldern Pieterburen Total sales 832,000.00 1,456,000.00 less variable costs (468,000.00) (819,000.00) Variable short-run Contribution Margin 364,000.00 637,000.00 less controllable fixed costs (45,000.00) (48,000.00) Controllable Contribution Margin 319,000.00 589,000.00 less non-avoidable costs (140,000.00) (260,000.00) Divisional Contribution Margin 179,000.00 329,000.00 less HQ contribution (adjusted) (211,000.00) (211,000.00) Divisional NP before taxes (32,000.00) 118,000.00 Entire NP before taxes less income taxes Net operating profit after taxes NOPAT 86,000.00 (25,800.00) 60,200.00 Vanhuizen BV's PERFORMANCE REPORT for 20X1 Figure 10.5: VANHUIZEN BV’s performance report (different capital structure) In Figure 10.5, the headquarters costs are in total 22,000.00 EUR higher than before. Check the table where the headquarters costs are indicated as ‘adjusted’. The return on equity now equals to: 60,200 / 500,000 = 1 12.04 %/ a. We acknowledge an increase of 3.64 % in return on equity only based on the change of capital structure. The company does not perform better. There are even more costs of capital to the extent of 22,000.00 EUR. Capital structure theory has first been published by Modigliani and Miller and is therefore referred to as ‘MM theory’. The leverage effect is based on the capital structure and makes the return on equity a weak performance ratio if companies are compared that have a different capital structure. For divisional comparisons, the return on equity requires an allocation of equity to divisions which only can be done by allocations, i.e., based on divisions’ asset values. An alternative to the return on equity is the Earnings per share ratio. It is based on IAS 33 and divides the earnings available for distribution <?page no="174"?> Berkau: Basics of Accounting (Part II) 10-170 to ordinary shareholders by the amount of ordinary shares outstanding. For the earnings calculation, the profit after taxation is adjusted with regard to required payments, i.e. preference dividends and additions to legal reserves (in Germany for companies based on shares), and hence not available for ordinary dividends. The earnings are divided by the amount of outstanding ordinary shares in order to compute the EPS figure. The earnings per share ratio gives an absolute amount of the highest possible dividend that can be declared to the ordinary shareholders. By multiplying the EPS figure by the number of shares, the earnings per book value of the company are calculated. This is very close to a return on equity ratio except of the fact that it is only for ordinary shareholders. Even as the EPS ratio is widely in use, it suffers from the capital structure impact as well as the return on equity. The only difference to a return on equity ratio lays in the adjustments. Furthermore, the allocation of company values to divisions is theoretical not possible and can only be made by rough allocations. Ad (2): 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 measured in EUR. In the case of VANHUIZEN BV, the residual income is calculated for the two branches based on cost of capital of 17 %/ a. For the GELDERN branch, the residual income is: 319,000 - 17% × 1,000,000 = 1 149,000.00 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 access of the controllable contribution margin over the capital costs on the market for similar investments. Ad (3): Economic Value Added (EVA™) 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. For the EVA TM calculation per 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. Many companies refer to the divisional profit as their net profit and make adjustments to spread once-off costs, such as for Marketing campaigns or product development, over the years the company benefits therefrom. The costs of capital are the weighted average costs of capital. Weighted Average Costs of Capital are the costs when different interest rates and opportunity costs for equity are considered proportionally to their portions of financing the business. We assume, that VANHUIZEN BV is financed by 30 % of equity, 40 % of a bank <?page no="175"?> Berkau: Basics of Accounting (Part II) 10-171 loan, with an annual rate of interest of 5.5 %/ a, and 30% by bonds, with a coupon rate of 4.5 %/ a. This is consistent with the previous assumption. The costs of equity are considered to be still 17 %/ a. According to the given figures, the weighted average costs of capital are: 30% × 17% + 40% × 5.5% + 30% × 4.5% = 8 8.65 %/ a. We assume the company owes the bank 1,200,000.00 EUR and pays: 5.5% × 1,200,000 = 6 66,000.00 EUR/ a on interest. The coupon per annum equals to another capital cost of: 900,000 × 4.5% = 4 40,500.00 EUR. The interest is already included in the headquarters’ contribution and requires adjustments. We reduce the headquarters costs by: 66,000 + 40,500 = 1 106,500.00 EUR. As a result, the headquarter costs equal to: 400,000 - 106,500 = 293,500.00 EUR. Every division would cover half thereof: 293,500/ 2 = 146,750.00 EUR. Check Figure 10.6 for the profit calculation: Geldern Pieterburen Total sales 832,000.00 1,456,000.00 less variable costs (468,000.00) (819,000.00) Variable short-run Contribution Margin 364,000.00 637,000.00 less controllable fixed costs (45,000.00) (48,000.00) Controllable Contribution Margin 319,000.00 589,000.00 less non-avoidable costs (140,000.00) (260,000.00) Divisional Contribution Margin 179,000.00 329,000.00 less HQ contribution (adjusted) (146,750.00) (146,750.00) Divisional NP before taxes 32,250.00 182,250.00 Entire NP before taxes less income taxes Net operating profit after taxes NOPAT 214,500.00 (64,350.00) 150,150.00 Vanhuizen BV's PERFORMANCE REPORT for 20X1 Figure 10.6: VANHUIZEN BV’s performance clear of interest/ coupon Now, the divisional net profit for GELDERN equals to: -21,000 + 66,000/ 2 + 40,500/ 2 = 3 32,250.00 EUR/ a. The divisional net profit for PIETERBUREN equals to: 129,000 + 66,000/ 2 + 40,500/ 2 = 1 182,250.00 EUR. (Note, we would not deduct interest/ coupon twice, however we make the adjustments to change the allocation to the asset structure of VANHUIZEN BV In order to keep the case simple, we apply the entire calculation, which gives us the adjusted earnings after taxes.) For further adjustment consideration, we assume, VANHUIZEN BV spent during the last year on advertising (posters) which results in an adjustment of 5,000.00 EUR/ a for the whole business. <?page no="176"?> Berkau: Basics of Accounting (Part II) 10-172 The amount is apportioned over the branches at a 1 : 1 ratio. 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 equals 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 by the GELDERN branch operations and increases in PIETERBUREN. In total, the company decreased in value to the extent of: 6,750 - 56,750 = - - 50,000.00 EUR. We cross-check the amount with the initial performance calculation of 108,000 EUR as indicated in Figure 10.3. We reduce this figure (net profit of both divisions) by the cost of equity to the extent of: 900,000 × 17% = 1 153,000.00 EUR and by the cost of advertising as considered as adjustment of 5,000.00 EUR. The EVA TM is now: 108,000 - 153,000 - 5,000 = - -50,000.00 EUR. For the next consideration, we assume an investor intends to buy VANHUIZEN BV We further assume, the investor buys the business clear of all debts and calculates the net operating profit after taxes based on Figure 10.6 to be 150,150.00 EUR. The costs of capital equal to 5 %/ a and apply for a fully bank loan financed purchase. The costs of capital are in this case: 5% × 3,000,000 = 1 150,000.00 EUR/ a. Hence, the EVA TM = 150,150 - 150,000 = 1 150.00 EUR. This amount indicates a positive performance and reflects the increase in value for the investor by the acquisition, even as the amount is quite low. Summary: For performance measurement, we studied different steps of contribution margin calculation in order to determine the right performance measure for decisions. Situations for performance measurement can be the assessment of the manager or decisions about resource allocations, mostly investment decisions. Most common performance ratios are: Return on investment, residual income and economic value added EVA TM . Working Definitions: Return on Investment: The return on investment shows the profit as percentage of the investment. Return on Equity: The return on equity shows the profit after taxation as percentage of the book value of the company. Leverage Effect: The leverage effect makes the return on equity increase based on the debt-to-equity ratio. Earnings per Share: EPS is based on IAS 33 and divides the earnings available for distribution to ordinary shareholders by the amount of ordinary shares outstanding Residual Income: The residual income is the profit or profit contribution after deduction of allocated capital costs Weighted Average Costs of Capital: Weighted average costs of capital (WACC) are capital costs when different interest rates and opportunity costs <?page no="177"?> Berkau: Basics of Accounting (Part II) 10-173 for equity are considered proportionally to their portions of financing the business. 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. <?page no="178"?> Learning Objectives: In this chapter, we demonstrate what Accounting information is required in order to support a merger with or an acquisition of another company. In particular, we consider a cross-border acquisition. We show what kind of due diligence needs to be conducted in order to support managers for the Mergers and Acquisitions (M&A) decision. It is our aim that you see the basic differences of purchases, acquisitions as a subsidiary and merging of companies and understand their consequences in terms of Accounting. M&As can be strategically motivated, i.e. in order to increase the economics of scale or the economics of scope. We do not cover the screening of the right company to buy, but we show Accounting instruments that are used in preparation of M&As. For this reason, we assume the company to acquire has been found already and there is a selling price demanded. The intention here is to demonstrate an Accounting due diligence for company buys. For teaching purposes, we study the case of OHIO FRIED CHICKEN in Worchester in the Western Cape Province of South Africa. We pretend the potential buyer asks us as Accountant for an expertise whether or not to invest in OHIO FRIED CHICKEN. (Note, the case study is fiction but we combine it with currency exchange rates. As a result, the Accounting periods are disclosed as actual figures in this chapter. The company is analysed in 2014 and bought on 1.01.2015.) The structure of the required expertise is as below: (1) General description of OHIO FRIED CHICKEN. (2) Reading the ‘financials’ (3) Business valuation (4) Investment appraisal (5) Financial statement analysis (6) Risk management. Ad (1): General Description of OHIO FRIED CHICKEN: <?page no="179"?> Ad (2): Reading the ‘Financials’ <?page no="180"?> Figure 11.1: ‘Financials’ provided by OHIO FRIED CHICKEN’s owner <?page no="182"?> Figure 11.2: OHIO FRIED CHICKEN’s refined data sheet <?page no="183"?> Figure 11.3: OHIO FRIED CHICKEN’s weekly calculation of cash profit <?page no="184"?> Figure 11.4: OHIO FRIED CHICKEN’s monthly operating cash flows Ad (3): Business Valuation: <?page no="185"?> Goodwill is the difference between the paid price for a company and its book value. Goodwill results frequently from company purchases when the buyer estimates the potential of the company higher than its book value. An alternative to the book value calculation is 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. In order to determine the present values, payments must be discounted based on the rate of interest on the capital market. It considers the total of all future discounted cash flow as value of the company. It tells us how much the owner benefits from the restaurant under consideration of the time value of money. The discounted cash flow method is based on all free cash flows which are available for distribution to the shareholders. The free cash flow is the operating cash flow plus the investing cash flow. It is called ‘free’ because the payments are free for paying dividends to the shareholders or for paying-off debts, such as for bank loans. Assuming the free cash flow always is paid to the proprietors, its sum indicates the benefits the proprietors receive from their ownership. We have to discount future payments in order to consider the time value of money concepts as the restaurant operations take place far in the future. In case we discount all free cash flows over the lifetime of the company and add them up, the sum tells us the value of the business based on discounted free cash flows. The present value (PV) of a constant payment A over T periods is: T T i i i A PV (with: PV = present value, A = annual payment, i = annual rate of interest, T = number of periods.) <?page no="186"?> i A PV (with: PV = present value, A = annuity, i = rate of interest) Ad (4): Investment Appraisal <?page no="187"?> Figure 11.5: OHIO FRIED CHICKEN’s payments discounted by 4.75% (Note, in the table in Figure 11.5, columns for the Accounting periods 2017 … 2022 are hidden which is indicated by the vertical line.) Figure 11.6: Calculation of the internal rate of return <?page no="188"?> Ad (5): Financial Statements Ad 5(a): Private Purchase 25,000.00 33,946.61 8,946.61 0.00 33,946.61 33,946.61 Figure 11.7: OHIO FRIED CHICKEN’s balance sheet <?page no="189"?> 1,797,000.00 1,797,000.00 (1,086,000.00) (88,000.00) (25,000.00) (245,000.00) 353,000.00 353,000.00 Figure 11.8: Budgeted income statement for OHIO FRIED CHICKEN <?page no="190"?> 0.00 386,946.61 8,946.61 378,000.00 386,946.61 386,946.61 Figure 11.9: OHIO FRIED CHICKEN’s budgeted balance sheet [ZAR] Ad 5(b): Acquisition by a company 25,000.00 35,000.00 8,946.61 1,053.39 35,000.00 35,000.00 Figure 11.10: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet <?page no="191"?> 400,000.00 400,000.00 400,000.00 400,000.00 Figure 11.11: AYAM GORENG Sdn. Bhd.’s opening balance sheet <?page no="192"?> 400,000.00 298,333.33 101,666.67 400,000.00 400,000.00 Figure 11.12: AYAM GORENG Sdn. Bhd.’s balance sheet after acquisition 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. Furthermore, the group prepares notes. Group statements contain consolidations. (Note, group accounting is covered in chapter (8) of the text book ‘Berkau, C.: Bilanzen’ and/ or the translation thereof.) <?page no="193"?> 8,333.33 11,666.67 2,982.20 351.13 11,666.67 11,666.67 Figure 11.13: OHIO FRIED CHICKEN (Pty) Ltd.’s adjusted balance sheet An aggregated balance sheet is an interim balance sheet in preparation of consolidated financial statements the items of which contains the sums of all group member’s balance sheet items. We can say, the balance sheet items are added per item. After summarising all balance sheet items to the aggregated balance sheet of the group, the consolidations are ready to start. A consolidation is a correction of figures on the balance sheet and/ or income statement that otherwise will be counted twice. <?page no="195"?> 400,000 11,667 411,667 (11,667) 400,000 (400,000) (11,667) (411,667) 11,667 (400,000) Figure 11.14: Consolidation worksheet [MYR] <?page no="196"?> 8,333.33 400,000.00 286,666.67 0.00 2,982.20 102,017.80 400,000.00 400,000.00 Figure 11.15: AYAM GORENG Sdn. Bhd. consolidated balance sheet 1,797,000.00 1,797,000.00 (1,086,000.00) (88,000.00) (25,000.00) (245,000.00) 353,000.00 353,000.00 (105,900.00) 247,100.00 Figure 11.16: OHIO FRIED CHICKEN (Pty) Ltd.’s budgeted I/ S <?page no="197"?> 0.00 35,000.00 247,100.00 8,946.61 379,053.39 105,900.00 388,000.00 388,000.00 Figure 11.17: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet 0.00 11,666.67 82,366.67 2,982.20 126,351.13 35,300.00 129,333.33 129,333.33 Figure 11.18: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet <?page no="198"?> 400,000 129,333 529,333 (11,666) 517,667 (400,000) (129,333) (529,333) 11,667 (517,667) Figure 11.19: Consolidation worksheet in MYR 0.00 400,000.00 286,666.67 82,366.67 0.00 2,982.20 228,018.00 35,300.00 517,666.87 517,666.67 Figure 11.20: AYAM GORENG holding’s B/ S as at 31.12.2015 <?page no="199"?> Ad 5(c): Merger In case two (or more) companies merge, the companies cease to exist as separate entities and become one legal entity. The new company prepares one set of single financial statements. Very often, equity is shared among the owners of the previous companies. Then the owners of both companies become shareholders of the new company. A merger requires a kind of capital consolidation as at the beginning of the new company. For this, the purchase method applies again. Hence all items are to be recognised at their fair value. A goodwill might exist too. With regard to the consequences in Accounting, we take a closer look at our case of the company OHIO FRIED CHICKEN (Pty) Ltd. We assume, the company is taken-over by LOS POLLOS ASADOS (Pty) Ltd. which is a fast food restaurant chain, based in Johannesburg. 4,000,000.00 1,000,000.00 6,500,000.00 0.00 2,000,000.00 1,000,000.00 2,500,000.00 0.00 8,500,000.00 8,500,000.00 Figure 11.21: LOS POLLOS ASADOS (Pty) Ltd.’s B/ S <?page no="200"?> 4,025,000.00 1,000,000.00 6,500,000.00 (860,000.00) 2,008,946.61 1,000,000.00 1,606,053.39 0.00 7,640,000.00 7,640,000.00 Figure 11.22: LOS POLLOS ASADOS (Pty) Ltd.’s B/ S after taking-over In case of public companies, mergers can be made without consideration of the target company and on a tender offer basis. A tender offer is an offer to the shareholders to take-over their company either in exchange of a price per share that exceeds the fair market value of the shares or in exchange of shares of the acquirer. <?page no="201"?> 4,025,000.00 1,000,000.00 6,500,000.00 (625.00) 2,008,946.61 1,000,000.00 2,465,428.39 0.00 8,499,375.00 8,499,375.00 Figure 11.23: LOS POLLOS ASADOS (Pty) Ltd.’s balance sheet after take-over <?page no="202"?> Ad (6): Financial Statement Analysis 25,000.00 35,000.00 8,946.61 1,053.39 35,000.00 35,000.00 Figure 11.24: OHIO FRIED CHICKEN (Pty) Ltd.’s B/ S <?page no="203"?> 1,797,000.00 1,797,000.00 (1,086,000.00) (88,000.00) (25,000.00) (245,000.00) 353,000.00 353,000.00 (105,900.00) 247,100.00 Figure 11.25: OHIO FRIED CHICKEN (Pty) Ltd.’s I/ S 0.00 35,000.00 247,100.00 8,946.61 379,053.39 105,900.00 388,000.00 388,000.00 Figure 11.26: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet <?page no="204"?> 12,500.00 35,000.00 123,550.00 8,946.61 190,053.39 52,950.00 211,500.00 211,500.00 Figure 11.27: Average B/ S for OHIO FRIED CHICKEN (Pty) Ltd. Ad (6): Risk Analysis <?page no="205"?> Ad 6(A): Reputation Risk An example of reputation risk is the video once published on youTube.com about the Chicken-Mc- Nugget production. It caused a significant decrease of Chicken-Mc-Nugget demands in McDonald’s Corp.’s restaurants worldwide for a while even as it was a set-up. Ad 6(B): Food Price Increase Risk Ad 6(C): Staff Fluctuation Risk <?page no="206"?> Ad 6(D): Competitor Risk Ad 6(E): Asset Structure Risk In order to explain the situation of low asset amounts, we compare OHIO FRIED CHICKEN to a property investment in Port Elizabeth, South Africa. Assume, an investor buys for a similar amount as paid for OHIO FRIED CHICKEN a 1 bedroom, kitchen, 1 bathroom apartment and invests 900,000.00 ZAR (= 300,000 MYR) with the intention to rent it out. If the tenant does not pay the rent, the landlord can evict his property and is still left with the apartment which can be liquidated at 900,000.00 ZAR. Hence, the investment in property is less risky than the purchase of a fast food restaurant with low tangible assets. That is the reason why in general investments in companies should come with a higher return. Ad 6(F): Risks Resulting from Government Restrictions There is a risk that the South African government will change the regulations for restaurants. This can be linked to the hygiene requirements for example. In case new requirements are <?page no="207"?> implemented the owner of the restaurant has to face further costs for certificates and examinations. Other risks result from unions with regard to minimum salaries, employee participation in decision-making etc. Ad 6(G): Currency Exchange Risk The following exhibit shows the 2 years-changes of the South African Rand against the Euro. In case the ZAR depreciates to the target currency, the EUR amount of the profit from an investment shrinks. Changes of the currency exchange rate have a direct impact on the profit of a South African investment as it is paid in ZAR. In the long-term run, we notice a high depreciation of the South African Rand to the Euro. The ZAR was 10 ZAR = 1 EUR in 2012 and 18 ZAR = 1 EUR in 2016. The depreciation is: 8/ 10 = 80%. Figure 11.28: Long-term currency exchange rate ZAR-EUR (OFX.com) In order to demonstrate, how the currency risk works, we assume an 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. An amount of 9,000.00 ZAR is calculated cost for property management and repairs. The EUR-amount of the rental profit is: 99,000 / 14 = 7,071.43 EUR. The return on investment in ZAR equals to: 99,000 / 1,000,000 = 9.9%. Now we take a look at January 2016. The profit is still 99,000.00 ZAR but it is now to be converted to an EUR amount of: 99,000 / 18 = 5,500.00 EUR. The investment payment is still to be considered at the 20Y4 currency exchange rate of 14.00 ZAR = 1.00 EUR. Hence, the investment payment is: 1,000,000 / 14 = 71,428.57 EUR. The investor calculates his return on <?page no="208"?> investments based on the current EUR-amounts. It gives him a return to the extent of: 5,500 / 71,428.57 = 7.7%. The return dropped by: 2.2% / 9.9% = 22.22%! For many investors, the decrease in revenue caused by the currency exchange rate leads to company closedowns as the South African subsidiaries became less profitable and some of them even turned into a loss case for their foreign investors. Summary: Mergers and Acquisitions require strategic and Accounting due diligence on the target firm. With regard to Accounting due diligence, methods of investment appraisal and Budgeting apply. As a result of the planning process a budgeted set of financial statements is prepared. In contrast to a merger where the companies are combined to one legal entity, Group Accounting applies for an acquisition because the purchased company stays legally independent and prepares its own singleentity financial statements. An important role plays risk analysis for the purchase decision which comprises the identification and evaluation of risks. Working Definitions: Goodwill: Goodwill is the difference between the paid price for a company and its book value. 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. Free Cash Flow: The free cash flow is the operating cash flow plus the investing cash flow. Profitability Index: The profitability index is the present value of payments divided by the initial investment cash outflow. Internal Rate of Return IRR: The internal rate of return is the rate of interest at which the present value is zero. Holding: A holding company is a company with the only purpose of holding other companies; it does not process any other business operations. Group: A group is a set of companies where the parent gains control over its subsidiary. Parent: A parent is the company controlling other group member companies. Subsidiary: A subsidiary is a company controlled by a parent. 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. Aggregated Balance Sheet: An aggregated balance sheet is an interim balance sheet in preparation of consolidated financial statements the items of <?page no="209"?> 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. Tender Offer: A tender offer is an offer to the shareholders to take-over their company either in exchange of a price per share that exceeds the fair market value of the shares or in exchange of shares of the acquirer. <?page no="210"?> Leaning Objectives: Risk Valuation and Risk Management are subject to Management Accounting. The aim is to calculate how risky a business can become for the investor. The highest damage is to completely lose the funds invested in a company. By risk identification, the major risks of the business come to light and it is a task of Strategic Controlling to find ways to minimise, avoid or compensate risks. In this chapter, we intend to show a method of risk evaluation. After studying this chapter, you can run a MonteCarloSimulation for risk combination and will be able to ascertain the risk of bankruptcy linked to Accounting insolvency and/ or illiquidity. We also teach the concept of the value at risk VaR. A business is to close-down by law once the company makes a loss that high that its debts exceed its total of assets. As a result, equity becomes negative. With a limited company, owners are not hold reliable for such a loss as they responsibility is limited to equity only. In such situations creditors can lose the money lent to the company. In order to understand bankruptcy situations, we take a look at the case study of ROCKS PLC. It shows the balance sheet as below in Figure 12.1 at the beginning of the Accounting period 20X1. 2,500.00 10,000.00 2,000.00 3,000.00 8,000.00 4,500.00 15,000.00 15,000.00 Figure 12.1: ROCKS PLC.’s balance sheet In the case ROCKS PLC. earns a loss that exceeds 12,000.00 GBP it has to file for bankruptcy. In order to keep the case study simple, we assume the following Bookkeeping entry in order to recap the loss of 13,000.00 GBP: DR Loss......................... 13,000.00 GBP CR Accounts Payables............ 13,000.00 GBP <?page no="211"?> The loss causes the equity to become negative. Take a look at the balance sheet below in Figure 12.2. 2,500.00 10,000.00 2,000.00 (13,000.00) 3,000.00 8,000.00 13,000.00 4,500.00 15,000.00 15,000.00 Figure 12.2: ROCKS PLC.’s balance sheet Why is the situation depicted in Figure 12.2 so bad? The answer can be given once we consider a liquidation. We assume, ROCKS PLC. sells all its assets at their fair value prices which add up to 15,000.00 GBP. This is the sum of assets on the balance sheet’s asset side. Next, ROCKS PLC. retires its debts. We ignore transaction costs and prepayment penalties, here. ROCKS PLC. has to pay: 3,000 + 13,000 = 16,000.00 GBP. As the funds from the liquidation are only able to cover 15,000.00 GBP of debts ROCKS PLC. is unable to settle the debts to the full extent. We assume, ROCKS PLC. pays a total amount of 15,000.00 GBP to creditors but still is left with notes payables to the extent of 16,000 - 15,000 = 1,000.00 GBP which cannot be settled. Now, the owners of ROCKS PLC. file for bankruptcy and are held liable to the extent of the company’s equity which was 12,000.00 GBP and is eaten by the loss. In this case, the owners lose their interest completely but they also get away for free leaving the creditors with a claim of 1,000.00 GBP against a bankrupt company that cease to exist. This way, the creditors lose money they lent to ROCKS PLC. We now understand, why a company cannot continue its operations once its equity turns negative. A situation like the one ROCKS PLC. finds itself in is called an Accounting insolvency. The law does not prevent bankruptcy but it forces the company to stop operations and requires an immediate start of insolvency procedure. At this stage of considerations, think about the opportunity to start a business based on a share capital of 1.00 EUR. At the first glance, the company seems to be quite cheap. However, it would be very vulnerable for losses as the smallest loss, i.e. 2.00 EUR during the first year when no reserves exist <?page no="212"?> gives reasons to close-down the company due to Accounting insolvency. Another reason for bankruptcy is illiquidity which means the company cannot fulfil its payment obligations anymore. This is caused by debts and negative cash flows. An insolvency occurs once the company has no or negative Cash/ Bank account balance and has no chance to lend money from creditors. Both, Accounting insolvency and illiquidity require the immediate initiation of bankruptcy procedures. The owners have to file for bankruptcy at court house in charge. A risk is an event by which something happens differently as foreseen or expected. Risks analysed in business are risks that can lead to a company’s bankruptcy. Risks can be considered as a plan/ forecast deviation. One characteristics of risks is that the reason for risks are found outside of the control of the business, such as customer behaviour or market development. However, situations in control, such as internal mismanagement is a risk factor too. For our risk consideration, no classification of risks in ‘good’ or ‘bad’ is relevant. I.e., a student who expects a 60 % for the Accounting exam has to take the risk that the exam is 40 % or 80 %. Both events are covered by the technical term risk, even as a deviation to the better exam mark would be seen as a chance along common understanding. Valuation of risks and Risk Management aims to control risks of a company. It calculates the probability to file for bankruptcy either with regard to Accounting insolvency or illiquidity or both. Taking risks is business. With regard to Risk Management, a company should ask itself the two questions below: (1) Should we take a risk bound with a particular business operation? - The answer is: Yes, if the chances linked to the risk outweigh its negative consequences. (2) How many risks should be taken? - The ability of risk taking depends on the financial position of the business. A company that has a high book value, as disclosed by the statement of financial position, can take more risks than a poor one. For a ‘rich’ company (we mean a company with a high value in equity), a probable loss won’t exceed equity. Hence, the equity level is regarded as a risk shield. High equity prevents from Accounting insolvency. Similar applies to the cash flows. A company with high liquidity is safer because negative cash flows resulting from risks won’t jeopardize the ability to fulfil future payment obligations. In a more academic way, a risk is understood as the random deviation and is valued by the probability (%) of the deviation from the foreseen or expected amount. In business and management, the risk term comprises favourable (chance) and adverse deviations (risks). This is referred to as the symmetric definition of risk. What is called a chance in common words is regarded as a risk by managers of a business. <?page no="213"?> In case a risk cannot be calculated by a probability (unknown probability) it will be referred to as an uncertainty. In order to deal with risks, Risk Valuations are required. A Risk Valuation determines the monetary amount of risks. Although in the chapter (11) we identified risks already, no proper Risk Valuation was covered there. The value of a risk is determined by the damage caused by the risk and the risk’s probability (%). The product of probability and damage gives the expected value of a risk. V(risk) = D × P (with: V = value, D = damage in [EUR], P = probability [%].) For instance, a risk that inventory gets stolen is its damage, i.e. 1,000.00 EUR, times the probability of theft which is 2 %. Hence, the risk’s value is: 1,000 × 2% = 20.00 EUR. Risk management is about the identification, calculation and controlling of risks taken by shareholders and creditors. The risk of these parties losing their funds depends on the variation of the business's profits and cash flows. In case of a bankruptcy, investors and creditors will probably suffer from the loss of their invested/ provided capital. A company applying effective risk management helps to avoid risks. In this way, Risk Management can be seen as a service for the funds providing parties of the company. In general, companies take more than one risk at a time. In order to calculate the whole risk for the shareholders and creditors, companies have to combine their risks. As risks can depend mutually on each other, risks can either have compound or compensating effects. For Risk Management, a combination of risks requires a complex calculation or simulation. We mention calculation shortly and focus on simulations thereafter. One way of risk combination is by pairing risks and to examine their mutual impacts. A company taking 10 single risks that depend on each other has than to consider (10 - 1)! = 362,880 risk combinations. For that reason, an examination of risk dependencies in detail is not applicable for Risk Management. The analysing procedure effort is too high in comparison to the information discovered as result of the risk study. As an alternative, risk simulations based on the mathematical method of 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 risks have together on a particular item, such as profit or cash flow of a company. The name MonteCarloSimulation refers to gambling. Monaco is famous for its casinos. The comparison to gambling is often made in Mathematics as it is assumed that a dice has 6 <?page no="214"?> equal sides - each number has exactly the same probability of appearance. We can say, diced numbers between 1 and 6 are equally distributed. An equal distribution is a distribution where every number has the same probability to appear. In order to explain risk simulation, we take a closer look at events and their probabilities. Every risk depends on a single event. The occurrence of an event is measured by a probability and is disclosed as a percentage. For further studies, we take a look at the case study WEATHERMAN. <?page no="215"?> Figure 12.3: Random figure generator on a calculator (Casio) The generator gives out figures between 0 and 1 which all appear at the same probability, such as 0.84. We multiply these random figures by 100 in order to get figures between 0 and 99. As a result, every figure's probability to be drawn is 1%. (Note, 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 %. We simplify the truth here in order to keep the calculation simple. You can assume the results of the random figure generator got multiplied by 100 and we deduct 0.5.) <?page no="216"?> Figure 12.4 WEATHERMAN’s profit simulation Figure 12.5: WEATHERMAN’s profit MS-Excel simulation In the real business world, there are many risks with an impact on profit and cash flows together. For Risk Management, we have to identify the risks and study what they depend on. Keep in mind: 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 random figures. <?page no="217"?> Figure 12.6: NAMGURO Ltd.’s statement of comprehensive income <?page no="218"?> Figure 12.7: Results of NAMGURO Ltd.‘s profit simulation In business, the distribution of profits is often assumed to be normally distributed. A normal distribution for profit is indicated by a bell-shaped curve as probability-over-profit-function. The peak of the curve is where the mean is. The amount at the average profit tells us the probability for the profit being the average. The equation of the normal distribution is: <?page no="219"?> (with: = mean, = standard deviation, f = probability, x = (here profit), e = Euler’s number) It can be seen that the amount of the probability (here: f) only depends on constant amounts and on the mean and the standard deviation . In other words: once we get to know about the mean and the standard deviation of a distribution we can calculate and draw a normal distribution. A normal distribution gives us the value at risk. The value at risk is the minimum profit that is achieved by 95 % of all cases. This is the profit amount at the right border of the first 5 % interval under the distribution curve. In order to deal with a normal distribution, it is transferred 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 text books of Mathematics and Statistic. See below the table for the right section of the standard normal distribution. The figures represent probabilities. As the normal distribution is symmetrical, the maximum amount is 50 %. This represents half of the probability for a certain event. <?page no="220"?> Figure 12.8: Probabilities for the standard normal distribution In order to read the table’s probabilities, it is first-off required to transfer the normal distribution into a standard normal distribution. This means to transfer the x-values (profit) to the zamounts as shown in the table. The transformation equation from a normal distribution towards a standard normal distribution is: x x z (with: z = z-amount, = mean, = standard deviation, x = x-amount) We apply the standard normal distribution for NAMGURO Ltd. in order to ascertain the value at risk with regard to the profit: <?page no="221"?> The value at risk based on a 5% quartile is the profit that is exceeded by a probability of 95 % of the distribution. Instead of the right section of the curve the left one is considered. The calculation is as follows: we read the zamount for a probability of 45 % from the table for a normal distribution and retransform it to the x-value that represents profit. The value at risk is the typical risk management indicator applied in business. It is the advantage of that indicator that the unit, such as EUR, is the same as the one of the figure under scrutiny. Furthermore, the VaR is easily to understand. We also can ascertain the probability for NAMGURO Ltd.’s Accounting insolvency as percentage. We now apply our knowledge in Risk Management in order to evaluate the risks for the company to buy, OHIO FRIED CHICKEN (Pty) Ltd. Based on the past data we already prepared a budgeted income statement as below in Figure 12.9. <?page no="222"?> 1,797,000.00 1,797,000.00 (1,086,000.00) (88,000.00) (25,000.00) (245,000.00) 353,000.00 353,000.00 (105,900.00) 247,100.00 Figure 12.9: Budgeted income statement for 20Y5 <?page no="223"?> x x z (with: z = z-amount, = mean, = standard deviation) Figure 12.10: Risk simulation (MonteCarloSimulation) <?page no="224"?> Figure 12.11: Profit and loss simulation <?page no="225"?> Summary: For management, risks must be valuated, which gives the value at risk or a mathematically calculated probability for bankruptcy. A bankruptcy applies in case of an Accounting insolvency of illiquidity. The case study ROCKS PLC. shows the bankruptcy situation from the Accounting point of view. The case study WEATHERMAN made the basics of risk simulation understood. The case study NAMGURO Ltd. demonstrated the combination of risks by a MonteCarloSimulation approach. We applied the MonteCarloSimulation on the case OHIO FRIED CHICKEN (Pty) Ltd. too where the demand is normally distributed. The probability for bankruptcy is calculated as percentage. Working Definitions: Risk: A risk is an event by which something happens differently as foreseen or expected. Uncertainty: In case a risk cannot be calculated by a probability (unknown probability) it will be referred to as an uncertainty. Risk Management: Risk management is about the identification, calculation and controlling of risks taken by shareholders and creditors. 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 of a company. Equal Distribution: An equal distribution is a distribution where every number has the same probability to appear. Value at Risk: The value at risk is the minimum profit that is achieved 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. <?page no="226"?> Section (3): Cost Accounting The third section of this text book is about Cost Accounting. Cost Accounting covers the functional structure of Management Accounting systems and the cost allocations and calculations made therein. The main features in Cost Accounting are the cost allocation to cost objects such as divisions, cost centres etc., and the Calculation of services and goods produced within a company. A Profitability Analysis and reporting fall under Cost Accounting as well and are covered by single chapters each. We will start the studies of Cost Accounting by chapter (13) Structure of Cost Accounting Systems which gives an overview of a Cost Accounting system. It shows the steps of Cost Category Accounting, the allocation of overheads to cost centres and the application of overheads to cost objects, such as products or services. The latter one is called the Calculation. We further prepare a Profitability Analysis. The chapter shows the structure step by step based on the case study GUILIO’s PIZZA&PASTA Ristorante. After every step, we indicate the state of cost allocations in the structure diagram for a Cost Accounting system for your convenient capturing of Accounting steps. The chapter (14) Flexible Budgeting/ Marginal Cost Accounting shows a Marginal Cost Accounting system that only considers variable costs for the same case study of GUILO’s PIZZA&PASTA Ristorante. We study marginal costs whereas the chapter (13) refers to a Full Cost Accounting system. In chapter (14), overheads are split in proportional and fixed portions referring to the Cost Separations known from chapter (7). You can study the different results by comparing the flexible budget and cost calculations as well as the Profitability Analysis of chapter (14) to the previous chapter’s (13) ones. The next following chapter (15) Cost Monitoring is based on flexible Cost Accounting and introduces to Cost Monitoring. The case study CROXTON Ltd. is about a laptop display production firm and we study the cost variances at the planned outcome of laptop displays in April 20X6, at a lower level in May 20X6 and at a higher level in June 20X6. Cost deviations, such as consumption and volume variances, are calculated and we explain the meaning thereof. Costs do not only get allocated straight from cost categories to cost centres and then to the products. It is very common, that cost centres interact with each other which requires internal cost allocations. The cost allocations are subject to chapter (16) Cost Allocations. We study the transport business CLYDBANK Ltd., which does cost allocations between its cost centres ‘City Logistics’, ‘Long Distance Logistics’, ‘Support’ and ‘Storage’. We study cost allocations based on one-directional exchanges with CLYDBANK Ltd. and with the easy case study TUSCAN (Pty) Ltd. and the more sophisticated case study HEISFELD Ltd. for mutual exchanges calculated by the equation method and iteration method. <?page no="227"?> As cost information is required by management, budgets, calculations, result of Cost Monitoring, profitability checks etc. have to be reported to the managers in charge. This is studied by chapter (17) Reporting on Manufacturing Accounting. We show the case study LEBUHRAYA Ltd. which is a production firm for wine bottles. You’ll see the Bookkeeping records and how to derive a report as the statement of cost of goods sold and the statement of profitability. Manufacturing Accounting is subject of the next chapter (18) Job Order Costing and (19) Process Costing. In Manufacturing Accounting, the unit costs per product are calculated. In chapter (18) we study MAHKOTA Pty Ltd. case study, a production firm for cell phone pouches. The company produces 2 different kind of pouches and applies job orders, which are factory-internal orders. We see how a Job Order Costing works and how it leads to the Calculation of pouch-A’s and pouch-B’s unit costs. We also provide a method of how to prepare a detailed profitability statement based on the cost of sales format which discloses the margin for the two products, pouch-A and pouch-B. Another case study WEIXDORF (Pty) Ltd. shows a more sophisticated Job Order Costing system with closing stock consideration. In chapter (19) we study Process Costing which applies for production line manufacturing. The case study EDEWECHT (Pty) Ltd. is a shoe production firm and we introduce Process Costing and how to apply equivalent units along the average method in order to evaluate inventory of work-inprocess. Besides of product calculation and profitability, fixed cost management is an important point of interest in companies. We cover this subject by two chapters. Chapter (20) Multi-Level Contribution Margin Accounting shows how a hotel company allocates fixed costs to different hotels at different locations, by the case study FLINDERS Ltd. We learn how to assign fixed costs to different levels of overheads and to charge the different hotels with these fixed costs. In chapter (21) Activity Based Costing we learn about a modern Controlling approach based on business process chains. We’ll introduce an Activity Based Costing-system for the airliner TORQUAY Ltd. and focus on their fixed costs in the Ticketing, Rescheduling and Advertising departments. In order to point out the differences, we’ll compare the costs to those calculated by a traditional Cost Accounting system. <?page no="228"?> Learning Objectives: Management Accounting systems form the internal part of Accounting. Management Accounting systems provide managers with relevant Accounting information that matches their information requirements. In this chapter, we explain the structure of Management Accounting systems. In particular, we discuss the cost flow through different steps of a Management Accounting system. After studying this chapter, you can describe the features of a Management Accounting system and you can recognise parts of the Management Accounting systems when you see them in a company. Most commonly, a Management Accounting system contains four major components: (1) Cost Category Accounting (2) Cost Centre Accounting (3) Calculation (4) Profitability Analysis. See Figure 13.1 in order to study the components and links thereof in a Cost Accounting structure design representation. Figure 13.1: Management Accounting system We explain the structure top-down with regard to Figure 13.1. A Management Accounting system is almost always linked to Financial Accounting. There is a data interface between the two Accounting systems Financial Accounting and Management Accounting as indicated by the arrow that goes <?page no="229"?> from the Financial Accounting box to the Management Accounting box. Through this link, time-based data for expenses/ costs and for revenue are transferred to the Management Accounting system. Time based-data means, information comes with a time stamp, such as ‘rent for January 20X1’. (Note, from the point of view of data structuring, these data are represented by a relationship type between the entity type Rent and Time.) The data transfer does not work as an original Management Accounting step. Once the Accountant makes a Bookkeeping entry for i.e. rent in an integrated Accounting system, the debit entry will be copied straight to the Management Accounting system. However, other data won’t. If the Bookkeeping entry is: DR Rent......................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR Only the debit entry with the costs is recorded for Management Accounting purpose if it actually represents costs. The cash/ bank item is of lower interest for Management Accounting. The deriving of data is different to the case study PENOR Ltd. in chapter (4), where we pretended to run a secondary Bookkeeping system for Management Accounting. In real world business, Management Accounting data are derived from the same data base as indicated above which is referred to as an integrated system that is based on a coordinated data structure. Besides costs, revenues are transferred to the Management Accounting system too. In the box for the Financial Accounting system you see a reference to the General Ledger. Management Accounting data are mostly only transferred on an aggregated level. I.e., rent for different buildings result in one or several room cost figures bus the open-item feature in a Bookkeeping system to check on rental payments is not relevant for Management Accounting. It is rather a Bookkeeping feature. As a result, subordinated accounts, such as data from the purchase or sales ledger, do not matter. Exceptions apply for Payroll Accounting and Asset Management. The question how to transfer Bookkeeping entries and how to transform expenses to cost information for Management Accounting is subject to the customising procedure with regard to the EPR system. Ad (1): Cost Category Accounting In Cost Category Accounting, data are checked whether or not they fall under cost and revenue, i.e. expenses are checked for cost relevance by studying their relevance for the business. (Note, remember, there are expenses that are no costs if i.e. there is no relationship with the business operations given, such as a company’s donation to RedCross.) All costs are divided in direct costs and overheads. This classification depends on the product the data are for. In particular, the Cost Separation applies as <?page no="230"?> discussed in chapter (7) of this text book. Ad (2): Cost Centre Accounting Cost Centre Accounting is linked to the organisational structure of a business. Many companies are way too big for control as a whole. As a result, Management Accounting breaks the company in cost centres. A cost centre is an organisational unit within a company, where a manager is responsible for costs. We call the person the cost centre responsible or cost centre manager. Along KILGER/ PLAUT, it is required that there is preferably only one reference unit the costs of the Cost Centre depend on proportionally, and Accountants must be able to allocate costs to cost centres directly. Cost centre structures very often are structured as a hierarchy. This means, cost centres are aggregated to superordinate cost centres on certain aggregation levels. A hierarchy is a recursive 1 : n-relationship of an data object, here the cost centre. Although we say the cost centre structure is an organisational structure, cost centres differ from departments. The top level of the organisational chart is the board of directors or management. In contrast, the top level of a cost centre hierarchy is the entire company. Cost Centre Accounting takes all the overheads from Cost Category Accounting. It can be seen as the Manufacturing Overhead Account. Compare to chapter (4). The main objective of Cost Centre Accounting is the calculation of cost rates and Cost Monitoring. For the calculation of the cost centre rates, the total of the cost centre overheads is divided by the amount of its output measured in reference units. Cost rates are calculated for the future (budgeted costs) as the predetermined overhead allocation rate POR. Cost allocations to products/ services are made based on the POR. Also, actual costs are allocated based on the actual amount of the reference unit times the POR. As actual and budgeted data are both available in the cost centre the target-performance comparison, which is a budgeted cost to actual cost comparison, takes place in the cost centres. This is referred to as Cost Monitoring. It is covered by chapter (15) in this text book. The calculations are provided by the computer based Management Accounting system and reported to cost centre managers as efficiency report. See chapter (17) in this text book for details. As cost centres also exchange performance among each other, the cost rate calculation requires internal cost allocations too. This can get quite complex, once companies have mutual and multiple cost centres relationships. Ad (2): Calculation Calculations determine the unit costs of the products/ services. The unit costs contain direct costs multiplied by their amounts, such as 4 wheels for a Volkswagen Golf, and the overheads. The amounts for the product structure come from the bill of materials. The applied overheads are calculated as cost centre rates time usage factor. Let us assume, the Volkswagen Golf dash board assembly cost rate equals to 150.00 EUR/ h and the assembling time for one dash board takes 10 min., then the cost allocated to the product <?page no="231"?> are: 10 × 150/ 60 = 25.00 EUR. The sum of all direct costs and overhead portions in the cost centres results in the product/ service calculation. Ad (4): Profitability Analysis The last step, the Profitability Analysis, is very similar to the profit and loss calculation in Financial Accounting. It can be based on the Nature of Expense method or the Cost of Sales format. The Cost of Sales format is preferred in Management Accounting because it provides managers with information needed to make product mix decisions. Along the Cost of Sales format, the margin between all revenues and all product/ service costs (cost of sales) is calculated. Often the margin is calculated product-/ service-wisely. Later in the calculation procedure, overheads not linked to products/ services, in particular non-manufacturing overheads, are deducted in order to ascertain the net operating profit. In contrast to Financial Accounting, tax expenses are not subject to Management Accounting. Management Accountants calculate “down to” the earnings before taxes EBT or even stop their considerations already at the earnings before interest and taxes EBIT. Below, we study the Management Accounting system with a case study from Hospitality Management. The case study is about an Italian Restaurant, named GIULIO’s PIZZA&PASTA RISTORANTE in Milano, Italy. The EUR currency applies. As in Management Accounting taxes do not matter, the legal form of the restaurant is irrelevant. Consider the restaurant being in private ownership. <?page no="232"?> Figure 13.2: GIULIO’s PIZZA&PASTA Ristorante’s BOM Overheads are indirect costs which cannot be traced to a certain product or service. For Management Accounting considerations, we, in general, ignore VAT.) <?page no="233"?> Figure 13.3: GIULIO’S PIZZA&PASTA RISTORANTE’s direct costs based on products <?page no="234"?> Ad (1): Cost Category Accounting <?page no="235"?> Figure 13.4: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (1) Ad (3a): Calculation (Note, we split the calculation item in two parts, one before (3a), the other one after Cost Centre Accounting (3b).) Unit costs are costs based on one unit of the product/ service. <?page no="236"?> Figure 13.5: GIULIO’S PIZZA&PASTA RISTORANTE’s direct costs Ad (2): Cost Centre Accounting Kitchen <?page no="237"?> (Note, in GIULIO’S PIZZA&PASTA RISTORANTE, the chef must do the dishes to keep the story simple.) Restaurant/ Order Management Delivery Figure 13.6: GIULIO’S PIZZA&PASTA RISTORANTE Management Accounting system (2) <?page no="238"?> The cost rate is costs of a cost centre divided by its output related reference unit. (Note, as the rates are rounded, we stick to the cost rate measured in EUR/ h for further calculations.) Figure 13.7: GIULIO’S PIZZA&PASTA RISTORANTE Management Accounting system (3) <?page no="239"?> Ad (3b): Calculation (Note, in the accounts below, the ID-numbers (1) … (10) refer to the text items above and not to the Bookkeeping entry sequence.) 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 Cost tracing is the assignment to Work-in-Process accounts without calculations. 40,000.00 10,000.00 50,000.00 25,000.00 75,000.00 16,000.00 30,000.00 195,000.00 20,000.00 71,000.00 195,000.00 195,000.00 71,000.00 71,000.00 195,000.00 71,000.00 5,000.00 24,000.00 24,000.00 10,000.00 24,000.00 7,200.00 10,000.00 32,200.00 32,200.00 32,200.00 32,300.00 Figure 13.8: GIULIO’S PIZZA&PASTA RISTORANTE’s manufacturing accounts (1) <?page no="240"?> 3,600.00 33,600.00 360.00 3,000.00 48,000.00 4,000.00 15,000.00 2,000.00 12,000.00 Figure 13.9: GIULIO’S PIZZA&PASTA RISTORANTE’s manufacturing accounts (2) DR WIP Kitchen.................. 9,000.00 EUR DR WIP Restaurant/ OM............ 27,000.00 EUR CR Rent......................... 36,000.00 EUR <?page no="241"?> 3,600.00 33,600.00 360.00 3,000.00 48,000.00 27,000.00 63,600.00 4,000.00 63,600.00 63,600.00 9,000.00 64,960.00 63,600.00 64,960.00 64,960.00 64,960.00 15,000.00 36,000.00 9,000.00 2,000.00 27,000.00 12,000.00 29,000.00 36,000.00 36,000.00 29,000.00 29,000.00 29,000.00 Figure 13.10: GIULIO’S PIZZA&PASTA RISTORANTE’s manufacturing accounts (3) Pizza 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 Lasagne <?page no="242"?> 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 Cannelloni DR WIP Cannelloni............... 6,186.67 EUR CR MOH Kitchen.................. 6,186.67 EUR DR WIP Cannelloni............... 6,900.00 EUR CR MOH Restaurant/ OM............ 6,900.00 EUR Chianti DR WIP Chianti.................. 8,280.00 EUR CR MOH Restaurant/ OM............ 8,280.00 EUR <?page no="243"?> 40,000.00 10,000.00 50,000.00 25,000.00 75,000.00 16,000.00 30,000.00 195,000.00 20,000.00 71,000.00 195,000.00 195,000.00 71,000.00 71,000.00 195,000.00 71,000.00 46,400.00 12,373.33 34,500.00 275,900.00 13,800.00 97,173.33 275,900.00 275,900.00 97,173.33 97,173.33 275,900.00 97,173.33 5,000.00 24,000.00 24,000.00 10,000.00 24,000.00 7,200.00 8,280.00 32,280.00 10,000.00 32,200.00 32,280.00 32,280.00 32,200.00 32,200.00 32,280.00 32,200.00 6,186.67 6,900.00 45,286.67 45,286.67 45,286.67 45,286.67 3,600.00 33,600.00 360.00 3,000.00 48,000.00 27,000.00 63,600.00 4,000.00 63,600.00 63,600.00 9,000.00 64,960.00 63,600.00 34,500.00 64,960.00 64,960.00 13,800.00 64,960.00 46,400.00 6,900.00 12,373.33 8,280.00 6,186.67 120.00 64,960.00 64,960.00 63,600.00 63,600.00 120.00 15,000.00 36,000.00 9,000.00 2,000.00 27,000.00 12,000.00 29,000.00 36,000.00 36,000.00 29,000.00 29,000.00 29,000.00 Figure 13.11: GIULIO’S PIZZA&PASTA RISTORANTE’s manufacturing accounts (4) <?page no="244"?> Figure 13.12: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (4) Ad (4): Profitability Analysis Study chapter (28) in ‘Berkau, C: Basics of Accounting, Part 1: Bookkeeping and Financial Accounting’ for the difference between cost of sales format and the nature of expense method. A cost of sales format is based on the cost of manufacturing allocated to the sold goods/ services. The costs of sales are deducted from the revenue to determine the margin. Further down in the calculation, mostly non-manufacturing costs, are deducted for the calculation of the net operating profit. <?page no="245"?> Figure 13.13: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (5) <?page no="246"?> How it is Done (Cost Accounting) (1) Copy expenses from the Financial Accounting systems to the Management Accounting system. (2)’Test’ expenses for cost characteristics. Check further whether or not costs apply that are no expenses. In the latter case add them to costs. (3) Transfer the direct costs to products’/ job orders’ WIP-accounts (4) Add manufacturing-related overheads to the cost centre accounts. Split costs in case they apply for more than one cost centre, i.e. based on the rule of three based on characteristics of cost centres, such as square metres, machine values, head count etc. (5) Run a cost separation in a Marginal Cost Accounting systems. In an Absorption Cost Accounting system pass step (5) and go straight to step (6). (6) In case non-manufacturing overheads, such as Marketing and Distribution costs, appla 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 text book. (8) Calculate cost rates by dividing (final) costs of cost centres by their output. (9) Apply overheads based on cost rates and usage factors. Add them to the WIP-accounts. (10) Divide the total of costs of job orders/ products/ services by the lot size for batch costs or the unit amounts for products/ services costs of manufacturing. (11) Transfer revenues for Financial Accounting to Management Accounting. Close of the Revenue account to the Profit and 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/ services run step (11), (12) for single products or product groups. Summary: A Management Accounting system takes costs from Financial Accounting system and divides them in direct costs and overheads. The direct costs are traced to the products/ services whereas overheads are allocated to cost centres. In the cost centre, cost <?page no="247"?> rates are determined for calculation. The unit costs of a product/ service contain its direct costs plus portions of the overheads. The latter ones are allocated based on the cost centre cost rates. The Profitability Analysis calculates the net operating profit of the business. Working Definitions: Overheads: Overheads (= overhead costs) are indirect costs which cannot be traced to a certain product or service. Unit Costs: Unit costs are costs based on one unit of the product/ service. Cost Rate: The cost rate is costs of a cost centre divided by its output related reference unit. Cost Tracing: Cost tracing is the assignment to Manufacturing Accounts without calculations. Cost Allocation: A cost allocation is the assignment of costs to cost objects - such as cost centres or products based on at least one dividing-calculation operation. <?page no="248"?> Learning Objectives: So far in this text book, we presented Management Accounting systems based on full costs. Full costs, or by another technical term: Absorption Costing, means we do not separate overheads in variable and fixed costs. In this chapter, we take advantage of the Cost Separation as discussed about in the chapter (7). This offers a better way of cost and profit planning, as overheads can be predicted based on the budgeted output which means for different levels of activities. After studying this chapter, you will be able to distinguish between flexible Budgeting and Full Cost Accounting system and you can apply calculations in cost planning based on separated costs. The expression ‘fixed costs’ is a quite misleading term. The term fixed costs only refers to the relationship to the output. This does not imply it is impossible to make changes. Fixed costs can be changed by management decisions. However, we stick to the expression fixed as it is widely used in Management Accounting. Proportional costs depend directly on the output and require planning as a linear cost function with the output described as the x-axis and the costs depending thereon scaled on the yaxis. Hence, changes in output cause changes in costs. (Note, in the IFRSs vocabulary, the word fixed has been banned and got replaced by “non-current” since the revision of IAS 1 in 2010.) With regard to Management Accounting, fixed costs refer to cost categories that do not vary with the output of the business. In contrast, proportional costs depend on the output. Hence, the Budgeting of proportional costs is to be based on output amounts. The output of a business is the amount of products/ services. For output measurement, Accountants apply reference units or the activity level. The reference units depend proportionally on the output, such as the amount of goods manufactured or services rendered. A reference unit depending proportionally on the output is for example the time spent working on goods or physical units measuring the output amount, such as kilogram or metre. It is important to emphasis the word proportionally. The criterion proportional applies in Management Accounting, because Accounting periods are short-term (months) and the range of product/ service amounts is normally considered between particular borders close to the previous actual amounts for a given operating system. Given system stands for: no major changes of capacity are discussed. In case significant changes in capacity are intended, methods of Investment Appraisal apply instead of Cost Accounting. The limitation of the value range results in cost diagrams considered as linear functions. Once we can draw the cost over reference unit function as a line, its costs will depend proportionally on the reference unit. Hence, the slope of the cost curve is constant. It is represented by proportional costs <?page no="249"?> per unit, called incremental costs. Flexible Budgeting considers cost functions we refer to as mixed costs. They consist of a fixed cost portion and a portion represented by a cost function with the output or reference unit as variable. This makes costs behaviour considerable for Budgeting. The planned cost depending on the output are referred to as standard costs. The process of the planning is called flexible Budgeting. (Note, standard costs is a cost function not a single amount.) In Management Accounting, different principles for cost allocations apply. They come with different qualities of cost accuracy. We mention the 3 most important principles for cost allocation starting by the best one. The preferable rule of allocation is called the cost-by-cause principle, meaning a cost object that causes costs is charged with costs. This implies a fair cost allocation. Management Accounting targets to ascertain fair costs for proper decision making and strives to describe the cost function as realistic and accurate as possible. In private life, you follow the cost-bycause principle too: Who orders the beer in the pub pays. There can be alternative cost allocation principles. One of them is the average principle and another one is the carrying capacity principle. Once you follow the average principle all costs are divided to all objects on average. You apply this principle when you have dinner with your friends and share the bill equally - no matter what and how much everyone had. The carrying capacity principle is based on the idea charging primary the strongest cost object. For instance, you assign all overheads to the product, which sells best or got the highest margin. When you go out with your family and your father pays the bill, the cost allocation principle of the carrying capacity applies. In a sophisticated Management Accounting system, the cost-by-cause principle is preferred. This guarantees fairness with regard to cost allocations for flexible Budgeting. By pinning costs to cost objects you can control costs. Changes of the cost objects will result in realistic cost adjustments if the cost-by-cause principle applies: We summarise: the best allocation principle for cost planning is the cost-bycause principle. All other principles are only worse substitutes. For cost assignments, we distinguish two cases: direct costs and overheads. Direct costs are traced to the product straight. When it comes to overheads, proportional overheads are allocated to cost objects along the cost-by-cause principle. However, fixed overheads are not caused by cost objects and therefore, shall not be allocated to products nor services. This is the major principle of flexible Budgeting. Let us see how costs can become distorted, if fixed costs are allocated to products: Think about a hotel with 100 rooms. The costs for the hotel in this example only would be depreciation on the hotel building. We assume, there is only one room occupied during the Accounting period. If the manager allocates fixed overheads - here: depreciation to the guests, the only guest in the hotel has to cover all costs. This is obviously not right and leads to <?page no="250"?> biased cost information. The costs per stay will become extremely high. Hence, the profit assigned to that guest becomes negative and the manager would do exactly the wrong thing: chasing away the last customer he/ she has got, as the Accountant told him/ her, the guest is causing a loss. As an alternative, the manager can increase the price significantly with the same result: The guest runs away! Hence, the application of a full Cost Accounting system can calculate you out of your business. We now want to study cost allocation based on a flexible Budgeting linked to GIULIO’s PIZZA&PASTA RISTORANTE case study. We split overheads in proportional and fixed items. Based on the Cost Separation, we apply Cost Centre Accounting, Calculation and Profitability Analysis. With regard to the case study, all direct costs are the same as in the previous chapter: With regard to the overheads, the case study is modified as below: Artificial overheads can be allocated to products by the cost-bycause principle. However, they won’t, because the effort for correct calculations is not justified by its outcome, which is the accurate cost information. (Note, the costs of the chef actually do not depend directly on the product amounts, but on the preparation time.) <?page no="251"?> Stand-by costs are costs, which occur, when a company provides resources, without consideration of their use. Take as an example for stand-by costs fire fighters. They get paid no matter whether there is a fire or not. The cost centre planning is based on mixed costs, which means, there are proportional and fixed costs. Every cost centre i, gets its particular cost function in the form: C i (X) = PC i × X + FC i , with PC being the slope of the cost line and FC the fixed costs. Kitchen Mixed costs contain portions of proportional and fixed costs. Restaurant/ Order Management <?page no="252"?> Delivery The Management Accounting system design for GIULIO’s PIZZA&PASTA RISTORANTE looks as depicted by Figure 14.1. Figure 14.1: GIULIO’s PIZZA&PASTA RISTORANTE’s Management Acccouting We take a closer look at the Profitability Analysis. In contrast to the unit cost calculation in Figure 13.12 and Figure 13.13, the unit costs now are based on proportional costs only. No fixed costs must be added to unit costs. All fixed costs of the cost centres are transferred to the fixed cost section of the Profitability Analysis. We run a calculation - based on flexible Budgeting below: Pizza <?page no="253"?> (Note, cost allocations in the Delivery department are partially based on the average principle as per tour 5 dishes are delivered.) Lasagne Cannelloni Chianti The difference between revenue and proportional costs is called the contribution margin. The budgeted contribution margin can be displayed as per unit too. This is helpful for product mix decisions. <?page no="254"?> (Note, in case you want to check the figures with Figure 13.4, where an amount of 322,200.00 EUR for direct 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.) Figure 14.2: GIULIO’s PIZZA&PASTA RISTORANTE’s Management Accounting system <?page no="255"?> The advantage of flexible Budgeting model is a more realistic cost planning which is based on the budgeted performance. The profit can be calculated by a formula with the structure below: m j n i i j j j FC X CM X P (with: j = index for the product/ service, j = 1 … m, i = index for the cost centre, i = 1 … m, P = profit, CM = contribution margin, X j = amount of products/ services, FC i = fixed costs) <?page no="256"?> Figure 14.3: GIULIO’s PIZZA&PASTA RISTORANTE’s profit planning Flexible Budgeting allows a more realistic profit calculation that is based on different product/ service amounts. Managers can study different output scenarios and check the consequences on the profit straight away. They can also study the impact of product mix alterations with regard to profit. The impact of flexible Budgeting is even more important for companies that put finished goods on stock, or releases manufactured goods from stock for sale. However, this aspect is not relevant for service providers. In order to explain cost effects resulting from changes in stock, we study another case study LOGA (Pty) Ltd., which is a CD manufacturer actually, it is a kind of record label. As we demonstrate by the LOGA (Pty) Ltd. case study, a production firm, applying a Full Cost Accounting system, makes mistakes with regard to the profit calculation, once it puts finished goods on stock. The reason for cost biasing lies in the deferment of fixed costs. In a Full Cost Accounting system, finished goods put on stock, contain fixed costs. The fixed costs assigned to the finished goods on stock, only count for the profit calculation, once the goods are released from stock. As a consequence, a manager, who studies the Profitability Analysis, receives and considers distorted cost information. The profit is too high, if the company transfers finished goods to stock that contain fixed costs. It will be too low, if the company releases goods from stock, which contain fixed costs. A better cost planning can be achieved, if Cost Separation takes place and no fixed costs are allocated to products. A Management Accounting system, based on separated proportional and fixed costs elements is called a marginal costing system. The expression marginal results from the fact, that the system is able to disclose cost changes, resulting from a one-unit increase/ decrease of <?page no="257"?> output figures. We call them incremental cost changes. A company that applies a Marginal Cost Accounting system, does not distort profit when it puts finished goods on stock or releases finished goods from stock. A cost planning based on marginal costs, is referred to as Flexible Budgeting. (Note, for Financial Accounting along IFRSs and HGB, a Full Cost Accounting system is required only. This is the lowest standard of Calculation. The damage with regard to profit and loss calculation is limited to temporary differences, as long as all goods put on stock will be released later.) Ad (1): Absorption Costing <?page no="258"?> Figure 14.4: LOGA (Pty) Ltd.’s Profitability Analysis based on Absorption Costing Ad (2): Marginal Costing (Note, applying a Marginal Cost Accounting system, the gross margin becomes the contribution margin.) <?page no="259"?> Figure 14.5: LOGA (Pty) Ltd.’s Profitability Analysis based on Marginal Costing <?page no="260"?> Summary: A flexible Budgeting is a Budgeting based on the amount of products/ services. The amounts will determine the costs and profit. For unit cost Calculation and for the Profitability Analysis it is strongly recommended to only consider proportional costs. This way, the cost allocation is based on the costby-cause principle and provides managers with fair and unbiased information. A Marginal Cost Accounting system provides correct cost information for the profit calculation, as no fixed costs are deferred by including them in the Finished Goods account. Adding goods to stock does not distort the profit calculation, as only proportional costs are considered. Proportional costs are linked to the goods at a 1 : 1 relationship whereas fixed costs allocations are based on the average principle. Working Definitions: Artificial Overheads: Artificial overheads can be allocated to products by the cost-by-cause principle. However, they won’t, because the effort to calculate correctly is not justified by its outcome. Stand-by Costs: Stand-by costs are costs, which occur, when a company provides resources, without consideration of their use. Contribution Margin: The difference between revenue and proportional costs is called the contribution margin. Marginal Costing: A Management Accounting system, based on separated proportional and fixed costs elements is called a marginal costing system. Flexible Budgeting: A cost planning based on marginal costs, is referred to as flexible Budgeting. <?page no="261"?> Learning Objectives: Cost Monitoring is about checking the efficiency of cost centres, processes or products by comparing the actual costs to the budgets. Other technical terms are target-performance check or variance analysis. A company performs well once the profit planned by the managers and Accountants is realised. This way, the company works as scheduled. In order to make sure the performance is achieved as budgeted, it is required to monitor the entire company. Efficiency checks take place in all cost centres. Every cost centre has a manager who is responsible for the costs therein. Management Accounting reports to the cost centre managers a detailed (per cost category) report that discloses actual costs, the budgeted amounts and the variances between them. The variances frequently are divided in volume and consumption variances. By this proficiency report, managers see whether they reach their cost centre goals in terms of cost consumption. In this chapter, we show how to monitor cost centres, in particular how to calculate the cost variances therein. After studying this chapter, you can understand the information provided by a cost centre efficiency report. Furthermore, you can monitor cost centres yourself and you know what data are required therefor. For the following considerations, we apply a Marginal Cost Accounting system. The cost of a cost centre are planned based on proportional and fixed costs. Proportional costs depend on the reference unit of the cost centre and vary with the output. Once the cost centre is in operation, the actual costs are recorded and can be compared to their budgeted amounts. If costs match, we say the cost centre works efficiently. You might ask yourself, why not planning costs rather generously, as by doing so the actual costs meet the budget easily? An add-on to budgeted costs might works as a cushion with regard to efficiency checks. The answer lies in the business plan. Managers try to plan costs as exact and at lowest amounts as possible, as the goods and services are sold on competitive markets, where competitors try to sell the same or similar goods at a low price too. Hence, low cost consumption makes the company competitive and profitable. Companies who plan their product/ service costs sloppy, will likely be overtaken by their competitors, who can produce and sell cheaper. At the first glance, the cost comparison in a cost centre is very straight forward. The actual costs should match with the budgeted ones. A difference in costs is an indicator for a negative deviation, which might have been caused by rework, wrong resource application, delays etc. The variance analysis that follows the Cost Monitoring directly is about the investigation of cost deviations. Cost comparisons become more complicated, once costs are recorded at different volume/ output levels than budgeted because this <?page no="262"?> means deviations in volume/ output occur too. We take a look at a case study from the manufacturing business and are going to study deviations at the same volume than budgeted, then at a lower level and at last at a higher one. For this reason we study three Accounting periods which are months: Before we start to explain the monthly cost situations at CROXTON Ltd., we describe the technical terms in use for cost-volume diagrams. The volume in a cost centre is its input variable. It is the planned and recorded performance therein, i.e. how many units are produced. Cost Accountants measure volume in reference units which are proportionally depending on the output. The output is the portion of performance that is for the products/ services the company produces/ renders. The output link is required for cost planning as it is based on reverse Budgeting. As a result, the cost centres performance depends on the product/ service amounts under consideration on the product mix. In case cost centres support each other further performance is required. In this cases, the performance of the cost centre contains output plus performance provided other cost centres with. You will learn further details in the next chapter (16). At this stage we acknowledge that the costs depend on the volume. It is linked to the entire performance no matter whether it is for production of internal support. For checking costs always both, the volume and the cost, matter. In case costs are transferred to other cost centres, Cost Monitoring should consider the costs where they occur. This means that cost checking takes place in the performing cost centres and before further cost centres are charged with costs. Hence, we measure deviations where they occur. A supported cost centre cannot be held responsible for cost deviations caused in previous cost centres which only get passed through. <?page no="263"?> Figure 15.1: CROXTON Ltd.’s cost variance in April 20X6 <?page no="264"?> Figure 15.2: CROXTON Ltd.’s variance in May 20X6 The consumption variance is the difference between actual costs and the planned costs based on the actual volume. The consumption variance is caused by resource deviations. The cost centre manager is held responsible for consumption variances. A second variance relevant for Managerial Cost Accounting is called the volume variance v. The volume variance is the difference between planned costs at actual volume and total planned costs on average, based on the actual volume. The volume difference actually is a cost difference caused by changes in volume and, hence, called volume difference by Management Accountants. In order to understand the concept, we refer to the overhead application discussed with the PENOR (Pty) Ltd. case study in chapter (4). (Note, we allocated labour to the extent of 1,200,000.00 EUR to the doors and windows based on the workload and further manufacturing overheads to the extent of 135,000.00 EUR based on piece count to the same target cost objects: doors and windows.) In contrast to the simple calculation in the case study PENOR (Pty) Ltd., the application of overheads is frequently based on a predetermined overhead allocation rate (POR-rate). The PORrate is calculated as the planned cost divided by the planned performance. We cover overhead applications in detail in the Manufacturing Accounting chapters (18) and (19). <?page no="265"?> For overhead application, the Accountant multiplies the actual performance by the POR-rate. In other words, the applied overheads are represented by the line which goes from the point (0/ 0) to the budgeted cost mark, in the case of CROXTON Ltd at (12,000/ 160,000). This line is dotted in Figure 15.2. Hence, the volume difference will result in overor underabsorbed overheads. For better understanding consider the dotted line as the ‘refunded costs’ for the cost centre in the diagram. It receives these costs when ‘selling’ the goods to finished goods inventory. In contrast, the volume difference v should not be transferred to the products but is added to the Cost of Sales account which later on is closed-off to the Profit and Loss account. As a result, deviations cannot no increase inventory valuations. Along IAS 2, allocations are to be based on a similar volume than the normal capacity only. In other cases, the volume variance is to be closed-off to profit and loss. In general, only the consumption variance c applies for the assessment of performance in cost centres. We say, in case the consumption variance is close to zero, the cost centre works efficiently. The cost centre efficiency report shows consumption variances recorded in the cost centres. <?page no="266"?> Figure 15.3: CROXTON Ltd.’s cost efficiency report May 20X6 We now study a case where the output exceeds the budgeted performance. Due to the Budgeting process in the cost centres we keep in mind that this case is rather seldom as cost centre manager tend to plan their output amounts preferably low. <?page no="267"?> Sometimes managers are tempted to cook their efficiency report, i.e., in order to earn incentives based on the cost centre performance. They try to increase budgeted costs in order to be safe with regard to variances. This should be seen as an attempt of deception because as a consequence cost deviations are difficult to detect and make the manager look good and probably classify him/ her for an incentive. This problem is quite serious in business and is subject to principleagent theory which deals with information advantages between negotiating parties. In terms of Budgeting, the cost centre manager is in a privileged position in contrast to the general management as he/ she knows the cost centre and its cost behaviour better. It is the task of Management Accountants to strive to correct (realistic) budgets. We refer to this as the coordination task of Controlling. . Figure 15.4: CROXTON Ltd.’s variance in June 20X6 <?page no="268"?> Figure 15.5: CROXTON Ltd.’s cost efficiency report June 20X6 Summary: A cost centre efficiency report gives information about the performance of a cost centre. The cost centre works well, as long as the consumption variance stays low. A negative consumption variance indicates a poor level of Budgeting quality. Working Definitions: Consumption variance: The consumption variance is the difference between actual costs and the planned costs based on the actual volume. Volume variance: The volume variance is the difference between planned costs at actual volume and total planned costs on average, based on the actual volume. <?page no="269"?> Learning Objectives: Management Accounting provides information linked to cost objects. In order to calculate the costs of a particular cost object, the Accountant has to assign costs thereto. In this chapter, we focus on the procedure of assigning costs. We demonstrate by 3 case studies how to apply cost allocations in different situations. After studying this chapter, you understand how cost allocation works and can distinguish different steps in the allocation process. Furthermore, you will be able to apply different cost allocation methods. In order to make cost allocations understood easily we show them in tables as well as in the account format. At the beginning of this chapter, we define 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. Cost allocations reduce costs at one or more cost objects and assigns these costs to one or several other cost objects. An example is the cost allocation from cost centre costs to products in Manufacturing Accounting. In Management Accounting, cost allocations are relevant at 3 stages of the calculation process. (1 st allocation) Costs are derived from expense accounts in Financial Accounting, such as labour, materials etc., and assigned to cost centres. At this stage, differences between cost and expenditures are considered for Management Accounting. (2 nd allocation) Costs are transferred from one cost centre (sender) to another one (receiver) in order to consider internal exchanges between cost centres that occur once one or several cost centres support other ones. (3 rd allocation) Costs are credited to the providing cost centre and added to products/ services for Calculation. Mostly, the debit entry is made in the WIP-account. The method of cost allocations is to divide costs based either on a real most physical unit, such as kWh, m, min etc., or based on values, such as unit costs of manufacturing, cost of purchase etc. Cost allocations work in Full Cost Accounting systems as well as for Marginal Cost Accounting. In case of the latter one, only variable costs are considered for the allocations and fixed costs remain in the cost centre accounts. These accounts get closed-off to the Profit and Loss account at the end of the Accounting period. We study a simple cost allocation process by a case study from Logistics. <?page no="270"?> Figure 16.1: CLYDBANK Ltd.’s cost centre characteristics 4,120,000.00 555,000.00 282,000.00 120,000.00 Figure 16.2: CLYDBANK Ltd.’s accounts <?page no="271"?> 1 st Allocation How it is done (cost allocation) (1) Ascertain the amount of the base figures of the cost objects the costs are to be assigned to. (2) Write the figures as an a : b : c ratio. If possible divide the a-, band c-amounts by a constant figure (cancellation). (3) Calculate the percentages of the cost objects by dividing the base figure of one cost object by the sum of all base figures: a / (a + b + c) (4) Multiply the total costs with the percentages. <?page no="272"?> DR MOH CC 03.................... 2,000.00 EUR CR Insurance ................... 2,000.00 EUR 4,120,000.00 920,000.00 555,000.00 135,000.00 2,250,000.00 330,000.00 350,000.00 30,000.00 600,000.00 60,000.00 4,120,000.00 4,120,000.00 555,000.00 555,000.00 282,000.00 80,000.00 120,000.00 27,600.00 150,000.00 60,000.00 2,000.00 8,400.00 50,000.00 24,000.00 282,000.00 282,000.00 120,000.00 120,000.00 920,000.00 2,250,000.00 135,000.00 330,000.00 80,000.00 150,000.00 27,600.00 1,162,600.00 60,000.00 2,790,000.00 1,162,600.00 1,162,600.00 2,790,000.00 2,790,000.00 1,162,600.00 2,790,000.00 Figure 16.3: CLYDBANK Ltd.’s accounts <?page no="273"?> 350,000.00 600,000.00 30,000.00 60,000.00 2,000.00 50,000.00 8,400.00 390,400.00 24,000.00 734,000.00 390,400.00 390,400.00 734,000.00 734,000.00 390,400.00 734,000.00 Figure 16.3: CLYDBANK Ltd.’s accounts (continued) Figure 16.4: CLYDBANK Ltd.’s cost allocations to cost centres 2 nd Allocation The second cost allocation is caused by performance exchanges between cost centres. In case one cost centre delivers a service to another one, the receiving cost centre reimburses the sending cost centre for its support. For these exchanges, Bookkeeping entries will be made in accounts for cost centres <?page no="274"?> involved in internal support relationships. The sending cost centre is reimbursed by a credit entry and the receiving cost centres are charged for the costs by debit entries. This way, the costs follow the way of the performance exchanged. Mutual supports between cost centres can become complicated, which is the reason for us, to explain further methods for internal cost allocations at the end of this chapter. For now, we stick to the CLYDBANK Ltd. case study and discuss only an unidirectional exchange of performance between the cost centres. In some cases, a cost centre delivers its performance completely to other cost centres. A cost centre that performs only for the support of other cost centres is called an auxiliary cost centre. As a result, auxiliary cost centres’ accounts get completely closedoff to receiving cost centre accounts by the cost allocation process. DR MOH CC 01.................... 78,080.00 EUR CR MOH CC 03.................... 78,080.00 EUR 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 <?page no="275"?> 920,000.00 2,250,000.00 135,000.00 330,000.00 80,000.00 150,000.00 27,600.00 1,162,600.00 60,000.00 2,790,000.00 1,162,600.00 1,162,600.00 2,790,000.00 2,790,000.00 1,162,600.00 2,790,000.00 78,080.00 1,240,680.00 273,280.00 3,063,280.00 1,240,680.00 1,240,680.00 3,063,280.00 3,063,280.00 1,240,680.00 3,063,280.00 350,000.00 600,000.00 30,000.00 60,000.00 2,000.00 50,000.00 8,400.00 390,400.00 24,000.00 734,000.00 390,400.00 390,400.00 734,000.00 734,000.00 390,400.00 78,080.00 734,000.00 273,280.00 39,040.00 773,040.00 39,040.00 773,040.00 773,040.00 390,400.00 390,400.00 773,040.00 Figure 16.5: CLYDBANK Ltd.’s accounts after internal cost allocations <?page no="276"?> Figure 16.6: CLYDBANK Ltd.’s spreadsheet with internal cost allocations 3 rd Allocation The last cost allocation is for the product Calculation. Products and services are charged by the cost centres for the performance received therein. The cost allocations are based on the output of the cost centre. Hence, all products cover a proportional amount of the cost centre costs. The output of the cost centres is measured by its reference unit. In contrast, auxiliary cost centres do not contribute directly to the production of goods or to customer service rendering. They only facilitate other cost centres’ performance. As a result, there is no output related reference unit for auxiliary cost centres required. The table indicates this by ‘n/ a’ in the cost rate cell. An output cost centre is a cost centre that works directly for the product/ service. The cost rate for the cost allocation is determined by dividing the final costs (last row) of the cost centres by the reference unit’s amount. <?page no="277"?> Figure 16.7 discloses the cost rates per cost centre as result of a 3-step cost allocation. Figure 16.7: CLYDBANK Ltd.’s cost centre rates Cost allocations can be based on actual as well as on budgeted data. The 2 nd cost allocations at CLYDBANK Ltd. is in one direction only. Cost centre CC 03 provides other cost centres with performance, but none of these cost centres supports CC 03. In such cases, the receiving cost centre gets charged and the sending cost centre is refunded by the cost allocation. We define a few technical terms with regard to the internal cost allocations before we study more complex and mutual allocations. Check Figure 16.7 when reading the upcoming explanations. Primary costs are costs of a cost centre that will be assigned directly. (Note, do not confuse prime and primary costs! ) Once costs are assigned by 2 nd allocations, further costs are added to the costs in the cost centre. Total costs are primary costs plus all costs assigned to the cost centre by internal cost allocation (2 nd allocation). <?page no="278"?> Secondary costs are costs charged to a cost centre as a result from internal cost allocations (2 nd allocation). After a cost centre got refunded by other cost centres for internal performance support - the Accountant makes a credit entry for the costs covered - the remaining costs are called final costs. Final costs are primary costs plus secondary costs less discharged costs from internal cost allocations (2 nd allocation). The internal cost allocation (2 nd allocation) is more difficult, when the performance exchange is mutual between the cost centres. This means one cost centre supports another one and receives support from exactly the same cost centre in return. In those cases, two similar cost allocation methods apply. (1) Equation method and (2) Iteration method. Ad (1): Equation Method The equation method is based on the concept that all costs are charged and discharged simultaneously. There are two equations for every cost centre, one for the total costs TC i and another one about the final costs FC j . The index for the cost centres is i and j. i stands for the receiving cost centre and j for the provider. 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 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, BA = 35%. n j j ij i i TC PC TC n i ij j j TC FC (with: TC = total costs, PC = primary costs, = percentage of allocation, FC = final costs, i, j = index for cost centres) In order to study internal cost allocations by the equation method, we take a look at a new case study TUSCAN (Pty) Ltd. <?page no="280"?> We now take a look at a further case study HEISFELD Ltd., which got more cost centres than TUSCAN (Pty) Ltd. <?page no="281"?> (Note, when planning performance and preparing the equations you have to consider arrows heading out of the cost centre boxes.) Figure 16.8: HEISFELD Ltd.’s performance structure <?page no="282"?> Figure 16.9: HEISFELD Ltd.’s primary costs (Note, when you prepare equations for cost allocations the arrows that point to the cost centre boxes count.) <?page no="283"?> (Note, in an Accounting exam, you can run the same test to cross-check your calculations.) After calculating final costs per cost centre, we can determine the cost rates for overhead application. The cost rates are calculated in advanced before the Accounting period that is why they are referred to as predetermined overhead allocation rates POR. The formula for calculating the rates is POR i = FC i / output i . 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 <?page no="284"?> The case HEISFELD Ltd. is rather simple as only 6 exchange relationships take place between 4 cost centres. However, with full mutual exchanges there will be 12 exchanges between 4 cost centres which can make our equation solving more extensive. Ad (2): Iteration Method The above discussed equation method works for all situations. However, the calculations can become quite extensive due to the complexity of the case: A company can have a few thousands of cost centres - all exchanging performance mutually. In those cases, the equation method leads to thousands of equations with thousands of variables to ascertain. It is actually possible, but no one runs an allocation based on equation solving like that in business for those cases. One of the reasons is, that the computers, on which we apply the cost allocations, do not solve equations. However, the computer is good at computing, that is why it is called a computer. We now present a cost allocation method, called iteration, derived from the Latin word ire (= to walk). It works similar to the equation method, however, the cost allocations are made step by step. This means we start the cost Calculation of total costs by the primary costs and add secondary costs stepwise. The first step is based on the primary costs and later steps are based on the previously allocated costs. After the total cost Calculation, final costs will be calculated. In order to perform the iteration process efficiently, we prepare an MS Excel spreadsheet. It is shown in Figure 16.10 and the following Figures for the HEISFELD Ltd. case. JA = 10/ 148 = 6.76% WJ = 100/ 200 = 50% WA = 100/ 148 = 67.57% WC = 50/ 950 = 5.26% CA = 38/ 148 = 25.68%. JC = 400/ 950 = 42.11%. <?page no="285"?> Figure 16.10: HEISFELD Ltd.’s cost centre support structure <?page no="286"?> The iteration process continues that way. As more iteration steps are performed as more accurate become the allocated costs. Although an approach that contains a lot of iteration steps becomes very accurate, we are aware that after a while the figures that are disclosed at 2 digits after the decimal point do not change significantly. We stop the iteration process after 3 rounds. Due to the case study design the process for HEISFELD Ltd. comes to a stop after 3 stels anyway. This results from the low amount (= 6) of cost allocations between the cost centres. After the ascertainment of total costs, the final costs are calculated as total costs less step-by-step wisely sent costs. This is a similar approach to the equation method. Study the figures depicted by Figure 16.11. You will understand, the iteration process calculates the same final costs as the equation method. Figure 16.11: HEISFELD Ltd.’s iteration process <?page no="288"?> (Note, as we rounded to two digits after the decimal point we experience a rounding difference of 0.01 EUR here.) Figure 16.12: HEISFELD Ltd.’s iteration process based on proportional costs <?page no="289"?> How it is Done (Performance Planning) (1) Determine the output of the cost centres, such as products/ services for reverse Budgeting. (2) Find an appropriate reference unit which is proportionally depending on the output and on the costs in a cost centre. (3) Plan or observe rules of mutual performance exchanges between cost centres, such as for one output unit cost centre A needs support from cost centre B to the extent of x reference units linked to the performance of cost centre B. (4) Prepare equations per cost centre about the total performance. The performance is the sum of the output plus support of other cost centres. Write the support of other cost centres as factor × performance of the receiving cost centre. (5) In easy cases find a smart sequence to easily calculate the total performances. In more complex cases calculate the performance by equation method or iteration process. (6) Divide the exchanged support by the total performance of a cost centre in order to calculate the percentage of performance exchange 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 centres. In a Marginal Cost Accounting system only proportional costs apply. (2) Write 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: AB × TC B . (3) Prepare an equation system for the total costs of every cost centre that contains all primary costs PC and the sum of percentages of receiving costs. (4) Solve the equation system to the total costs of the cost centres TC i . In case mutual cost allocations exist <?page no="290"?> 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 of total costs that are for support of other cost centres in order to get the final costs FC j . (6) Divide final costs FC by the output of the cost centres in order to calculate the cost rates. No cost rates for auxiliary cost centres apply. Summary: Management Accounting systems consider cost allocations in order to determine costs for particular cost objects. There is a 1 st allocation required in order to assign overheads to cost centres. The 2 nd cost allocation is to consider the performance exchange between cost centres. Mutual support relationships require an equation method or can be calculated by iteration. The 3 rd cost allocation is based on cost centre cost rates. The allocation charges products with costs and discharges the cost centres where the product has been manufactured or the service been rendered. Cost allocations do not change the sum of costs in a company. Working Definitions: 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. Auxiliary Cost Centre: A cost centre that performs only for the support of other cost centres is called an auxiliary cost centre. Output Cost Centre: An output cost centre is a cost centre that works directly for the product/ service. Primary Costs: Primary costs are costs of a cost centre that will be assigned directly. Total Costs: Total costs are primary costs plus all costs assigned to the cost centre by internal cost allocation. Secondary Costs: Secondary costs are costs charged to a cost centre as a result from internal cost allocations. Final costs: Final costs are primary costs plus secondary costs less discharged costs from internal cost allocations. <?page no="291"?> Learning Objectives: The role of Management Accountants in a company can be described as the one of an internal consultant. Accountants support managers with information. They calculate appropriate cost information for the control of the business and report them to managers. For the reporting quality, the form of the reports matters. Reports can be calculations, business graphics or ratios. Reports are often compared to instruments in an aircraft’s cockpit. We explain in this chapter an example of a report for a production firm on the costs of manufacturing. After studying this chapter, you understand how reports are prepared and how to read them. You can apply reporting in other business situations than discussed in this chapter. Within a company, a lot of information about costs is available. It results from cost planning and from recording actual business activities. The latter information is derived from Bookkeeping records. Management Accountants’ task is to filter available data. Furthermore, Management Accountants prepare management information based on cost allocations to cost objects of interest, by providing comparisons and by calculating ratios, such as for performance and liquidity. The field of reporting is wide. In this text book, we demonstrate an example for a report linked to a case study of a production firm. The subject of our report is the cost of sales of manufactured and sold goods. Two reports apply: - COS report and - Profitability statement Before we prepare the reports mentioned above, we study the case of the production firm LEBUHRAYA Ltd. <?page no="292"?> 20,000.00 5,000.00 Figure 17.1: LEBUHRAYA Ltd.’s opening amounts 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 DR Depreciation................. 80,000.00 EUR CR Accumulated Depreciation..... 80,000.00 EUR <?page no="293"?> 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 DR WIP-account.................. 150,000.00 EUR CR MOH Account.................. 150,000.00 EUR DR Finished Goods Inventory..... 300,000.00 EUR CR WIP-account.................. 300,000.00 EUR DR Cash/ Bank.................... 225,000.00 EUR CR Revenue...................... 225,000.00 EUR <?page no="294"?> DR COS Account.................. 150,000.00 EUR CR FG Inventory................. 150,000.00 EUR 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 20,000.00 55,000.00 5,000.00 300,000.00 100,000.00 50,000.00 55,000.00 15,000.00 180,000.00 120,000.00 120,000.00 150,000.00 90,000.00 15,000.00 390,000.00 390,000.00 90,000.00 100,000.00 100,000.00 ... 100,000.00 225,000.00 200,000.00 50,000.00 10,000.00 200,000.00 180,000.00 80,000.00 80,000.00 20,000.00 200,000.00 200,000.00 Figure 17.2: LEBUHRAYA Ltd.’s accounts <?page no="295"?> 300,000.00 150,000.00 225,000.00 225,000.00 150,000.00 300,000.00 300,000.00 150,000.00 150,000.00 150,000.00 50,000.00 50,000.00 10,000.00 10,000.00 150,000.00 225,000.00 50,000.00 10,000.00 15,000.00 225,000.00 225,000.00 15,000.00 Figure 17.2: LEBUHRAYA Ltd.’s accounts (continued) <?page no="296"?> Figure 17.3: LEBUHRAYA Ltd.’s statement of COS Ad (1): Calculation of Materials <?page no="297"?> Ad (2): Calculation of Labour Ad (3): Application of Overheads Ad (4): Adjustments <?page no="298"?> Figure 17.4: LEBUHRAYA Ltd.’s Profitability Analysis Summary: Management Accountants provide information by reports. The reports contain Calculations, ratios and/ or comparisons, which are useful for managers to make decisions. Reports are prepared on monthly and annual basis. Besides of standard reports, Management Accountants provide exceptional reports too. Often business graphics, such as charts and pie diagrams are added to the reports. <?page no="299"?> Learning Objectives: Manufacturing Accounting is a field that is relevant for Financial Accounting (inventory valuation) as well as for Management Accounting (Calculation). You got already a first glance on Job Order Costing in chapter (4) where we covered the product calculation for PENOR Ltd.’s doors and windows on an easy level. We now present a Job Order Costing method that is more in the details and that will refer to the concept of Management Accounting as discussed in chapter (13). Another method for particular production firms will be introduced in the next following chapter (19). After studying this chapter, you understand the account structure underlying a Cost Accounting system. You are able to apply a Job Order Costing system. One of the main purposes in Management Accounting is product Calculation. Calculations provide the unit cost of manufacturing for goods/ services. For production firms that organise prodtion of their goods based on internal job orders, a Job Order Costing system is appropriate. A job order is an internal order for production of goods or parts thereof. A job order is represented by the Job Order account or its reconciliation account: Work-in-Process account. In this chapter, the overhead allocation is based on a predetermined overhead allocation rate. A predetermined overhead allocation rate (POR) is a cost rate for charging products/ services with cost centre overheads that is based on budgeted overheads and budgeted cost centre outputs. It refers to the 3 rd allocation with regard to the structure given in chapter (16). In production firms, there are Manufacturing Overheads accounts, preferably, for every cost centre. The Budgeting procedure covers or the total of overheads all cost centres and their output as volume, such as 500 production-hours. The predetermined overhead allocation rate is calculated as the total of budgeted overheads divided by the planned output of the cost centre, the latter one is metered in reference units. The output often is referred to as the performance. Applying overheads is charging job orders with overheads caused by them. Overheads are added to job orders and credited to the Manufacturing Overheads account. The application of overheads is shown as an arrow from cost centre Accounting to Calculation in the structure of a Management Accounting system in Figure 13.1. A company that applies a Marginal Cost Accounting system, will only apply proportional costs. Production firms that apply an Absorption Costing apply full overheads. According to that decision, the predetermined overhead allocation rate is based on either proportional costs or full costs. You might ask yourself at this stage, why not apply the actual cost rates. The answer is quite simple. At the time of Calculation, the actual data for overheads are not yet available for cost allocations and cost rate calculations. <?page no="300"?> Applying the predetermined overhead allocation rate, likely results in differences between actual overheads and applied overheads. This is visible as a deviation of manufacturing overheads. In the Manufacturing Overheads account the deviation remains after the application of overheads as its balancing figure. A debit balanced Manufacturing Overheads account indicates under-applied overheads - a credit balanced Manufacturing Overheads account indicates over-applied overheads. In both cases, the Manufacturing Overheads account will be closedoff to the Cost of Sales account. Hence, the deviation changes the profit/ loss. How it is done (Job Order Costing) (1) Record Bookkeeping entries for nominal accounts, such as labour, depreciation, administration etc. (2) Classify costs in manufacturing costs and non-manufacturing costs. (3) Prepare Job Order accounts for internal job orders, mostly linked to certain products. (4) Prepare Manufacturing Overhead accounts per cost centre. Plan cost rates for cost centres by dividing budgeted overheads by planned output of the cost centre. (5) Allocate direct costs, such as direct labour and direct materials, to the job orders. Make debit entries in the applicable Job Order account. (6) Add manufacturing overheads to the applicable Manufacturing Overhead account. (Note, applicable means applying the MOH account for the correct cost centre.) (7) Apply overheads based on the predetermined overhead allocation rate per job order. Ascertain the amount for the transferred manufacturing overheads by multiplying the actual job order amount by the predetermined overhead allocation rate. Make debit entries in the applicable 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 amount 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. <?page no="301"?> (10) Close-off the Manufacturing accounts to the Cost of Goods Sold COS account. (11) Once goods are sold, debit 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. (12) Record the revenue. (13) Add all non-manufacturing costs to the Profit and Loss account. We now introduce a higher sophisticated example for a Job Order Costing system, which is about a manufacturer, MAHKOTA Pty Ltd. DR Cash/ Bank.................... 50,000.00 AUD CR Issued Capital............... 50,000.00 AUD 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 <?page no="302"?> 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 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 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 DR MOH Account.................. 74,000.00 AUD CR Inventory.................... 74,000.00 AUD <?page no="303"?> DR MOH Account.................. 40,000.00 AUD CR Depreciation ................. 40,000.00 AUD 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 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 <?page no="304"?> DR COS Account.................. 4,000.00 AUD CR MOH Account.................. 4,000.00 AUD DR FG Inventory A............... 110,500.00 AUD CR WIP Pouch-A.................. 110,500.00 AUD DR FG Inventory B............... 78,750.00 AUD CR WIP Pouch-B.................. 78,750.00 AUD DR COS Account.................. 88,400.00 AUD CR FG Inv A..................... 88,400.00 AUD DR COS Account.................. 51,187.50 AUD CR FG Inv B..................... 51,187.50 AUD <?page no="305"?> DR Cash/ Bank.................... 208,000.00 AUD CR Revenue...................... 208,000.00 AUD DR Cash/ Bank.................... 163,800.00 AUD CR Revenue...................... 163,800.00 AUD 50,000.00 10,500.00 50,000.00 50,000.00 300,000.00 200,000.00 50,000.00 208,000.00 120,000.00 163,800.00 300,000.00 91,300.00 721,800.00 721,800.00 91,300.00 300,000.00 300,000.00 10,500.00 10,500.00 300,000.00 200,000.00 200,000.00 40,000.00 40,000.00 200,000.00 40,000.00 40,000.00 120,000.00 120,000.00 40,000.00 Figure 18.1: MAHKOTA Pty Ltd.’s accounts <?page no="306"?> 120,000.00 12,000.00 74,000.00 158,000.00 17,000.00 40,000.00 158,000.00 74,000.00 206,000.00 4,000.00 17,000.00 320,000.00 320,000.00 120,000.00 120,000.00 4,000.00 4,000.00 17,000.00 12,000.00 110,500.00 17,000.00 78,750.00 158,000.00 59,500.00 158,000.00 96,250.00 170,000.00 170,000.00 175,000.00 175,000.00 59,500.00 96,250.00 300,000.00 94,000.00 94,000.00 94,000.00 206,000.00 300,000.00 300,000.00 4,000.00 143,587.50 110,500.00 88,400.00 88,400.00 22,100.00 51,187.50 110,500.00 110,500.00 143,587.50 143,587.50 22,100.00 78,750.00 51,187.50 371,800.00 208,000.00 27,562.50 163,800.00 78,750.00 78,750.00 371,800.00 371,800.00 27,562.50 143,587.50 371,800.00 123,712.50 123,712.50 94,000.00 123,712.50 10,500.00 123,712.50 371,800.00 371,800.00 123,712.50 123,712.50 Figure 18.1: MAHKOTA Pty Ltd.’s accounts (continued) <?page no="307"?> Figure 18.2: MAHKOTA Pty Ltd.’s Profitability Analysis <?page no="308"?> Figure 18.3: MAHKOTA Pty Ltd.’s pro-forma balance sheet We discuss below a more detailed case from Hospitality Management. It is important to study a company that got more products and more cost centres in order to understand the concept of Job Order Costing. The company WEIXDORF (Pty) Ltd. produces 3 different sorts of ice creams in 2 cost centres: Production and Filling. DR Cash/ Bank.................... 5,000.00 EUR CR Issued capital............... 5,000.00 EUR <?page no="309"?> DR Cash/ Bank.................... 50,000.00 EUR CR Interest Bear. Liabilities... 50,000.00 EUR DR Interest Bear. Liabilities... 2,000.00 EUR CR Cash/ Bank.................... 1,000.00 EUR CR Accounts Payables A/ P ........ 1,000.00 EUR DR Interest..................... 1,250.00 EUR CR Cash/ Bank.................... 1,250.00 EUR DR P, P, P Account.............. 20,000.00 EUR DR VAT.......................... 4,000.00 EUR CR Cash/ Bank.................... 24,000.00 EUR DR P, P, E Account.............. 14,500.00 EUR DR VAT.......................... 2,900.00 EUR CR Cash/ Bank.................... 17,400.00 EUR DR Depreciation ................. 5,000.00 EUR CR Acc. Depr. .................. 5,000.00 EUR DR Depreciation ................. 2,900.00 EUR CR Acc. Depr.................... 2,900.00 EUR <?page no="310"?> DR Purchase..................... 43,200.00 EUR DR VAT.......................... 8,640.00 EUR CR Cash/ Bank.................... 51,840.00 EUR DR Purchase..................... 84,000.00 EUR DR VAT.......................... 16,800.00 EUR CR Cash/ Bank.................... 100,800.00 EUR DR Purchase..................... 24,000.00 EUR DR VAT.......................... 4,800.00 EUR CR Cash/ Bank.................... 28,800.00 EUR DR Labour....................... 270,000.00 EUR CR Cash/ Bank.................... 270,000.00 EUR DR Administration............... 70,000.00 EUR CR Labour....................... 70,000.00 EUR DR MOH Ice Cream Making......... 150,000.00 EUR CR Labour....................... 150,000.00 EUR DR MOH Filling.................. 50,000.00 EUR CR Labour....................... 50,000.00 EUR (Note, the amount is rounded based on the conventions in this text book.) <?page no="311"?> (Note, the amount is rounded based on the conventions in this text book.) DR MOH Ice Cream Making......... 5,000.00 EUR CR Depreciation ................. 5,000.00 EUR DR MOH Filling .................. 2,900.00 EUR CR Depreciation ................. 2,900.00 EUR DR Maintenance .................. 12,375.00 EUR DR VAT.......................... 2,475.00 EUR CR Cash/ Bank.................... 14,850.00 EUR DR MOH Ice Cream Making......... 7,173.91 EUR CR Maintenance .................. 7,173.91 EUR DR MOH Filling .................. 5,201.09 EUR CR Maintenance .................. 5,201.09 EUR DR Raw Materials Container...... 43,200.00 EUR CR Purchase..................... 43,200.00 EUR DR Raw Materials Milk........... 84,000.00 EUR CR Purchase..................... 84,000.00 EUR DR Raw Materials Fruits......... 24,000.00 EUR CR Purchase..................... 24,000.00 EUR <?page no="312"?> DR WIP Banana................... 13,200.00 EUR CR Raw Materials Containers..... 13,200.00 EUR DR WIP Lemon.................... 15,000.00 EUR CR Raw Materials Containers..... 15,000.00 EUR DR WIP Strawberry............... 15,000.00 EUR CR Raw Materials Containers..... 15,000.00 EUR DR WIP Banana................... 25,666.67 EUR CR Raw Materials Milk........... 25,666.67 EUR DR WIP Lemon.................... 29,166.67 EUR CR Raw Materials Milk........... 29,166.67 EUR DR WIP Strawberry............... 29,166.67 EUR CR Raw Materials Milk........... 29,166.67 EUR DR WIP Banana .................. 7,333.33 EUR CR Raw Materials Fruits......... 7,333.33 EUR DR WIP Lemon.................... 8,333.33 EUR CR Raw Materials Fruits......... 8,333.33 EUR <?page no="313"?> DR WIP Strawberry............... 8,333.33 EUR CR Raw Materials Fruits......... 8,333.33 EUR DR WIP Banana................... 47,520.00 EUR CR MOH Ice Cream Making......... 47,520.00 EUR DR WIP Lemon.................... 54,000.00 EUR CR MOH Ice Cream Making......... 54,000.00 EUR DR WIP Strawberry............... 54,000.00 EUR CR MOH Ice Cream Making......... 54,000.00 EUR DR WIP Banana................... 16,940.00 EUR CR MOH Filling .................. 16,940.00 EUR DR WIP Lemon.................... 19,250.00 EUR CR MOH Filling .................. 19,250.00 EUR DR WIP Strawberry............... 19,250.00 EUR CR MOH Filling .................. 19,250.00 EUR DR Cost of Goods Sold........... 6,653.91 EUR CR MOH Ice Cream Making......... 6,653.91 EUR DR Cost of Goods Sold........... 2,661.09 EUR CR MOH Filling .................. 2,661.09 EUR <?page no="314"?> DR FG Inventory Banana.......... 110,660.00 EUR CR WIP Banana................... 110,660.00 EUR DR FG Inventory Lemon........... 125,750.00 EUR CR WIP Lemon.................... 125,750.00 EUR DR FG Inventory Strawberry...... 125,750.00 EUR CR WIP Strawberry............... 125,750.00 EUR DR Cash/ Bank.................... 695,058.00 EUR CR VAT.......................... 115,843.00 EUR CR Revenue...................... 579,215.00 EUR DR Cost of Goods Sold........... 108,145.00 EUR CR FG Inventory Banana.......... 108,145.00 EUR DR Cost of Goods Sold........... 119,663.70 EUR CR FG Inventory Lemon........... 119,663.70 EUR DR Cost of Goods Sold........... 125,750.00 EUR CR FG Inventory Strawberry...... 125,750.00 EUR <?page no="315"?> DR Waste ........................ 1,886.25 EUR CR FG Inventory Banana.......... 1,886.25 EUR DR Waste ........................ 4,564.73 EUR CR FG Inventory Lemon........... 4,564.73 EUR 5,000.00 1,000.00 5,000.00 5,000.00 50,000.00 1,250.00 5,000.00 695,058.00 24,000.00 17,400.00 51,840.00 100,800.00 28,800.00 270,000.00 14,850.00 240,118.00 750,058.00 750,058.00 240,118.00 1,000.00 50,000.00 1,250.00 1,250.00 1,000.00 50,000.00 1,250.00 1,250.00 20,000.00 20,000.00 5,000.00 5,000.00 20,000.00 20,000.00 5,000.00 5,000.00 20,000.00 5,000.00 4,000.00 115,843.00 5,000.00 5,000.00 2,900.00 2,900.00 2,900.00 8,640.00 7,900.00 7,900.00 16,800.00 4,800.00 2,475.00 76,228.00 115,843.00 115,843.00 76,228.00 Figure 18.4: WEIXDORF (Pty) Ltd.’s accounts <?page no="316"?> 43,200.00 43,200.00 579,215.00 579,215.00 84,000.00 84,000.00 579,215.00 579,215.00 24,000.00 24,000.00 151,200.00 151,200.00 270,000.00 70,000.00 70,000.00 70,000.00 150,000.00 50,000.00 270,000.00 270,000.00 70,000.00 70,000.00 14,500.00 14,500.00 2,900.00 2,900.00 14,500.00 14,500.00 2,900.00 2,900.00 14,500.00 2,900.00 150,000.00 47,520.00 50,000.00 16,940.00 5,000.00 54,000.00 2,900.00 19,250.00 7,173.91 54,000.00 5,201.09 19,250.00 6,653.91 2,661.09 162,173.91 162,173.91 58,101.09 58,101.09 12,375.00 5,201.09 43,200.00 13,200.00 7,173.91 15,000.00 15,000.00 12,375.00 12,375.00 43,200.00 43,200.00 84,000.00 25,666.67 24,000.00 7,333.33 29,166.67 8,333.33 29,166.67 8,333.33 84,000.00 84,000.00 24,000.00 24,000.00 Figure 18.4: WEIXDORF (Pty) Ltd.’s accounts (continued) <?page no="317"?> 13,200.00 110,660.00 15,000.00 125,750.00 25,666.67 29,166.67 7,333.33 8,333.33 47,520.00 54,000.00 16,940.00 19,250.00 110,660.00 110,660.00 125,750.00 125,750.00 15,000.00 125,750.00 6,653.91 362,873.70 29,166.67 2,661.09 8,333.33 108,145.00 54,000.00 119,663.70 19,250.00 125,750.00 125,750.00 125,750.00 362,873.70 362,873.70 110,660.00 108,145.00 125,750.00 119,663.70 1,886.25 4,564.73 628.75 1,521.57 110,660.00 110,660.00 125,750.00 125,750.00 628.75 1,521.57 125,750.00 125,750.00 1,886.25 6,450.97 4,564.73 125,750.00 125,750.00 6,450.98 6,450.97 362,873.70 579,215.00 97,048.23 97,048.23 6,450.97 97,048.23 97,048.23 70,000.00 97,048.23 1,250.00 138,640.33 579,215.00 579,215.00 41,592.10 138,640.33 97,048.23 41,592.10 41,592.10 138,640.33 138,640.33 41,592.10 1,000.00 1,000.00 1,000.00 Figure 18.4: WEIXDORF (Pty) Ltd.’s accounts (continued) <?page no="318"?> Figure 18.5: WEIXDORF (Pty) Ltd.’s income statement Figure 18.6: WEIXDORF (Pty) Ltd.’s balance sheet Summary: A Job Order Costing system applies for the Calculation of products manufactured by a company. The Job Order Costing system is based on Work-in- Process WIP-accounts and Manufacturing Overheads MOH accounts. The allocation of overheads leads to charge the cost objects with that portion of overheads they have caused in the cost <?page no="319"?> centre(s). It results in a debit entry in the Work-in-Process WIP-account(s) and a credit entry in the Manufacturing Overheads MOH account(s). The overhead allocation is based on predetermined overhead allocation rates. A possible difference between overheads and applied overheads is closed-off to the Cost of Sales account and changes the operational profit for the period. Working Definitions: Job Order: A job order is an internal order for production of goods or parts thereof. Predetermined Overhead Allocation Rate: A predetermined overhead allocation rate (POR) is a cost rate for charging products/ services with cost centre overheads that is based on budgeted overheads and budgeted cost centre outputs. <?page no="320"?> Learning Objectives: This chapter introduces another structure for Calculation. It only applies if all production steps are in a line and all products are manufactured in the same sequence of production steps. A Process Costing system is based on a similar account structure as Job Order Costing. However, the meaning of the accounts is different. Process Costing shows that with the flow of units through production the unit costs of goods increase. After studying this chapter, you will be able to understand and apply a Process Costing system and you can calculate goods produced in a line of production steps. You can distinguish a Job Order Costing system from a Process Costing system. Despite of the similar name, a Process Costing system is not related to the German concept of Prozesskostenrechnung, which is a special form of Activity Based Costing. We cover Activity Based Costing in the chapter (21) and (26). Process Costing is based on a multistep Calculation. Within every step of production, the total costs of the cost centres are allocated to all goods produced therein. The unit costs per production step are added to the unit costs from previous steps. This way, the unit costs increase production step by production step. The last production step results in the total unit costs of manufacturing. Process Costing systems apply only when manufacturing is organised along a straight sequence of production steps, such as in industries, where raw materials are converted into homogeneous products. Examples are brick production, paper production or breweries. It is required that the company produces them in a continuous flow of units. Units are often indistinguishable. In these situations, it makes no sense to identify materials, labour and overheads with particular orders. Actually, no job orders are defined, as the material flow is constant. Hence, the special structure of the production layout leads to a simplification of product Calculation. 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 batch of units goes from one production step to the next one. It leaves the previous step of production after completion and is transferred to the next one. In a Process Costing system, the Work-in-Process account is linked to the department/ cost centre. Overheads are added at first to the Workin-Process accounts and later to the units of production. The cost allocation to the departments is the same as in a Job Order Costing system. Costs are debited to the WIPaccounts. Overheads can be allocated straight to the WIP-account as it represents the cost centre already. However, some companies gather overheads in a Manufacturing Overhead account at first and apply all overheads together. That only requires one cost allocation per cost centre and is easy to apply. <?page no="321"?> In a Process Costing system, costs ‘stick to the units of production’. After leaving a cost centre, the costs of that cost centre are assigned to the products and added to the unit costs. The costs are carried forward to the next cost centre. This leads to discharging the previous cost centre and charging the next following cost centre in line of production. After the costs of the last production step are added, the costs of the products are debited to the Finished Goods Inventory account by closing-off the last cost centre’s WIP-account. How it is done (Process Costing) (1) Record Bookkeeping entries in nominal accounts, such as labour, depreciation, administration etc. (2) Classify 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 the manufacturing overheads to the Work-in-Process accounts directly. (5a) If the products are finished within a production step, divide the total costs of the Work-in-Process account by the amount of products completed therein. (5b) If the products are not finished completely within a production step, transform the product amount to equivalent units. Calculate the equivalent unit as percentage of completion × amount of unfinished goods. For finished goods, the equivalent unit per product 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 amount (not by equivalent units! ) Not completed goods are not transferred to the next production step and become the balancing figure (debit balanced) of the Work-in-Process account. Completed products are transferred to the next Work-in-Process account. (6) Transfer completed (with regard to the production step) products to the Work-in-Process account that represents the next following production step. Product values are amounts × unit costs. (7) Once the products are finished with regard to all production steps, transfer them to the Finished Goods Inventory account. Make a debit entry in the Finished Goods Inventory account and credit the amount to the Work-in-Process. For unit cost Calculation, divide the <?page no="322"?> total costs of the finished goods by the amount of goods finished during the Accounting period. (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 and Loss account. We illustrate the concept by a case study of a shoe manufacturer. We observe the first production steps of shoe manufacturer EDEWECHT (Pty) Ltd., in order to understand the basics of a Process Costing system. 160,000.00 160,000.00 160,000.00 540,000.00 120,000.00 Figure 19.1: EDEWECHT (Pty) Ltd.’s accounts <?page no="323"?> ... 160,000.00 120,000.00 540,000.00 Figure 19.1: EDEWECHT (Pty) Ltd.’s accounts (continued) DR CC-001 ....................... 40,000.00 EUR DR CC-002 ....................... 80,000.00 EUR DR CC-003 ....................... 40,000.00 EUR CR Raw Materials Inventory...... 160,000.00 EUR DR CC-001 ....................... 30,000.00 EUR DR CC-002 ....................... 30,000.00 EUR DR CC-003 ....................... 30,000.00 EUR CR Labour....................... 90,000.00 EUR DR CC-001 ....................... 270,000.00 EUR DR CC-002 ....................... 90,000.00 EUR DR CC-003 ....................... 90,000.00 EUR CR Labour....................... 450,000.00 EUR DR CC-003 ....................... 120,000.00 EUR CR Depreciation ................. 120,000.00 EUR <?page no="324"?> 160,000.00 160,000.00 160,000.00 160,000.00 540,000.00 90,000.00 120,000.00 120,000.00 450,000.00 540,000.00 540,000.00 ... 160,000.00 120,000.00 540,000.00 40,000.00 80,000.00 30,000.00 30,000.00 270,000.00 90,000.00 340,000.00 200,000.00 40,000.00 30,000.00 90,000.00 120,000.00 280,000.00 Figure 19.2: EDEWECHT (Pty) Ltd.’s accounts <?page no="325"?> DR WIP CC-002................... 340,000.00 EUR CR WIP CC-001................... 340,000.00 EUR DR WIP CC-003................... 540,000.00 EUR CR WIP CC-002................... 540,000.00 EUR 40,000.00 340,000.00 80,000.00 540,000.00 30,000.00 30,000.00 270,000.00 90,000.00 340,000.00 340,000.00 540,000.00 40,000.00 30,000.00 90,000.00 120,000.00 540,000.00 820,000.00 Figure 19.3: EDEWECHT (Pty) Ltd.’s WIP-accounts So far, the case study EDEWECHT (Pty) Ltd. shows the basics of a Process Costing system. Once all production steps are completed, the last WIP-account for cost centre CC-003 will be closed-off to the <?page no="326"?> Finished Goods Inventory account. Here, to the extent of 820,000.00 EUR. We now take the calculations along the Process Costing system to its next level: In particular, we study what happens, if a production firm does not complete a production step. For the illustration thereof, we complete the WIP CC-003 account on the credit side and continue the case study EDEWECHT (Pty) Ltd. with the recording in the 3 rd cost centre Leather Treatment. We assume, the last production step is not completed during in the Accounting period 20X4. Not completed means, the leather treatment has begun for all 10,000 units, but is not yet finished. In a situation like this, companies ascertain a percentage of completion in order to indicate the process of production. If the production is only completed to a certain degree, unit costs are to be added only based on their level of completion. We study EDEWECHT (Pty) Ltd.: In a Process Costing system non-completed products are represented by equivalent units. An equivalent unit is the amount of products calculated as amount of units × percentage of completion. Equivalent units apply in order to assign costs to not yet finished goods. Costs are not supposed to be assigned to the full amount of products regardless to their level of completion. This means, for the cost allocation of half finished goods only half of the amount counts, products completed to a degree of 10 % will count 1/ 10 etc. The equivalent unit actually replaces two half completed products by one completed one or 10 products completed at a rate of 10 % by one completed product. We apply the concept of cost allocation by equivalent units for EDEWECHT (Pty) Ltd.: <?page no="327"?> DR FG Inventory................. 790,115.00 EUR CR WIP CC-003................... 790,115.00 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 160,000.00 160,000.00 160,000.00 160,000.00 540,000.00 90,000.00 120,000.00 120,000.00 450,000.00 540,000.00 540,000.00 Figure 19.4: EDEWECHT (Pty) Ltd.’s accounts <?page no="328"?> ... 160,000.00 120,000.00 1,400,000.00 540,000.00 40,000.00 340,000.00 80,000.00 540,000.00 30,000.00 30,000.00 270,000.00 90,000.00 340,000.00 340,000.00 540,000.00 40,000.00 790,115.00 790,115.00 665,360.00 30,000.00 124,755.00 90,000.00 790,115.00 790,115.00 120,000.00 124,755.00 540,000.00 29,885.00 820,000.00 820,000.00 29,885.00 1,400,000.00 1,400,000.00 665,360.00 665,360.00 665,360.00 1,400,000.00 734,640.00 1,400,000.00 1,400,000.00 734,640.00 Figure 19.4: EDEWECHT (Pty) Ltd.’s accounts (continued) Summary: In a Process Costing system, the Calculation is based on the value added to units per cost centre. The value is carried forward to the next following production step’s cost centre. In a Process Costing system, cost centres are represented by Work-in-Process accounts. All direct costs and overheads are charged to the Work-in-Process accounts at first. The value added to every unit is the cost of a cost centre divided by the amount of units completed therein. The last WIP-account is <?page no="329"?> closed-off to the Finished Goods Inventory account, once all units are completed. If units are not completed, their Calculation is based on equivalent units. Working Definition: Equivalent Unit: An equivalent unit is the amount of products calculated as amount of units × percentage of completion. <?page no="330"?> Learning Objectives In the recent decades, management of fixed costs became an important task in Management Accounting, as fixed costs nowadays dominate the cost mix. Frequently, companies struggle to find cost categories that are proportionally depending on the output. In a Marginal Cost Accounting system, fixed costs are excluded from cost rates. Hence, companies applying Marginal Cost Accounting have to manage their fixed costs. Fixed costs can be structured and assigned to particular cost centre levels. The assignment is required to study dependencies and responsibilities for fixed costs. After studying this chapter, you understand the problem of fixed costs and you can run a multi-level Contribution Margin Accounting system. In a multi-level Contribution Margin Accounting system the Profitability Analysis is conducted step by step and in more detail. The company does not deduct fixed costs all together but assigns costs to certain products, product groups, locations, distribution channels etc. Hence, fixed costs for those cost objects are deducted from the first contribution margin CM 1 step-wise, and are called CM 2, CM 3 etc. By this approach fix costs to cost object matches can be identified and allow a detailed what-if analysis. This is the main purpose of Fixed Cost Management. Hence, cost allocations based on the average principle are avoided for fixed costs. I.e., a car dealer can calculate how much is the profit from selling C-class Mercedes in the region of Osnabrück in Germany. The dealer deducts the purchase price for the cars and all costs linked to the c-class cars and labour for the sales person in Osnabrück from the revenues. Multi-level Contribution Margin Accounting is to be seen as an extension of a Marginal Cost Accounting system. In accordance to Marginal Cost Accounting without Contribution Margin Accounting, cost centres would closeoff their fixed costs accounts to the Profitability Analysis, namely to the Profit and Loss account. Hence, fixed costs would be allocated to all products together. Companies applying the cost of sales format for their profit and loss calculation and extend the calculations by a Contribution Margin Accounting, assign fixed costs to particular cost objects, such as products, product groups, sales areas etc. With these allocations, Marketing is provided with valuable cost information about the fixed costs linked to cost objects and groups thereof for product mix decisions. The main idea of a multi-level Contribution Margin Accounting is to identify cost objects the fixed costs are for. In case the company does not continue operations, such as selling a product on a particular market, i.e., PCs in Malaysia, the fixed costs, such as for the sales office in Kuala Lumpur can be reduced or cancelled. We study multi-level Contribution Margin Accounting with a case study from Hospitality Management. <?page no="331"?> Figure 20.1: FLINDERS Ltd.’s sales information for 7/ 20X6 <?page no="332"?> The idea of a Contribution Margin Accounting is more than to calculate the operating profit. The purpose is to assign fixed costs to cost objects in order to understand, what happens, in case the cost objects change or are given up. We study the FLINDERS Ltd.’s hotel case more in the details. <?page no="333"?> Figure 20.2: FLINDERS Ltd.’s multi-level CMA Contribution Margin Accounting does not apportion costs that result from shared resources (no cost allocations for fixed costs apply). There is no overhead allocation of the fixed costs towards cost objects (hotels). For example, the fixed costs for the Procurement office are not distributed to the hotels in Berlin but stay in a cost object group that covers the 4 hotels in Berlin. By Contribution Margin Accounting, managers can study the overheads assigned to particular cost objects and to groups thereof. Summary: Contribution Margin Accounting assigns fixed costs to cost objects. No allocation based on the average principle of fixed costs towards cost objects takes place. The managers can study what the fixed costs are for, which gives them valuable information for Fixed Cost Management. By a what-if analysis, managers win valuable information in order to decide about changes of the product mix with regard to possible deductions of fixed costs. <?page no="334"?> Learning Objectives: Activity Based Costing (ABC) became a very popular Management Accounting instrument over the last decades, too. The concept is assigning costs to business processes, which cross departmental borders. The most important aspect about Activity Based Costing is, that costs are allocated via cost drivers. Hence, portions of fixed costs are assigned to business processes too. Activity Based Costing is no alternative concept to a Marginal Cost Accounting system but to Fixed Cost Management. Its allocations are on the average principle which makes the cost rates less useful for cost whatif analysis. We recommend the application of Activity Based Costing in cases where no proportional costs exist and for Business Process Reengineering. For the latter one, see: ‘Berkau, C.: Vernetztes Prozeßkostenmanagement.’ We introduce an Activity Based Costing system in this chapter and demonstrate its cost allocations. After studying this chapter, you can discuss concepts of Activity Based Costing in comparison to traditional (cost centre based) Accounting systems. You will be able to design an Activity Based Costing system on case study level. The main reason for the introduction of Activity Based Costing is today’s cost structure in the companies. Many overheads are almost completely fixed costs. This development is caused by the kind of work performed in companies. More and more machinery is deployed and replaces direct work. Product costs nowadays contain less direct work but more costs resulting from machinery, such as maintenance, depreciation and supervision. The application of a Marginal Cost Accounting system with a percentage of variable costs down to 2 …5 % of the total costs, becomes less helpful for supporting management decisions. Management Accountants look for factors that influence costs. Most costs are driven by activities runs. We like to become very specific in order to show the difference to traditional Cost Accounting systems, here. In a traditional Marginal Cost Accounting system, costs are assigned and allocated based on the cost-bycause principle. The question is: Is the production unit the reason for the cost? This allows only to allocate proportional costs. In contrast, an Activity Based Costing system assigns costs to cost drivers based on the average allocation principle. The question then is: Does the cost driver increase or decrease the amount of process/ activity runs? This means, we do not ask about the existence of costs but about the impact of cost drivers. Hence, the Activity Based Costing is based on fixed costs already allocated as stand-by costs for process/ activity runs. Costs are apportioned to cost objects. Hence we cannot study a what-if analysis as we are used from the application of a Marginal Cost Accounting system together with a Contribution Margin Accounting. For that reason, we do not endorse price calculations based on Activity Based Costing. <?page no="335"?> I.e., in a Procurement division of a manufacturing company, the costs for order management are regarded as fixed costs. They are fixed labour and fixed office costs, such as depreciation, room costs etc. No costs in the procurement division depend on the output of the goods manufactured by the factory. As they do not depend on the output, no reference unit can be found. As a result, all purchase costs are classified as fixed costs. However, the activity amount in the Procurement division depends on the amount of orders and active suppliers which are identified as cost drivers. Although the costs in the procurement division do not depend on the output, they can be controlled and budgeted by cost drivers. A cost driver (CD) is a factor process costs depend on. In contrast to a reference unit, cost drivers do not depend proportionally on the output. Fixed costs are not changed by cost drivers but the management makes decisions about the allocation of resources to, i.e. the Procurement division, based on the CD order amount. An Activity Based Costing system assigns costs to cost centres similar to a traditional Cost Accounting system. When we refer to a traditional Cost Accounting system, we mean a structure as described in chapter (13). A traditional Cost Accounting system is in the best case a combination of a Marginal Cost Accounting and a Contribution Margin Accounting. Unlike a traditional Cost-Accounting system, there is no internal cost allocation in an Activity Based Costing system. Costs of the cost centre are structured along 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 allocation of costs to cost pools is often based on the time spent in a cost centre for that particular activity. Later costs allocated to cost pools are divided by the process amounts, measured in cost driver units, in order to determine a process cost rate. The currency of the process cost rate is, i.e., EUR/ CD. We take a look at an example from the university. Think about costs in a professors’ department. The 1 st cost allocation contains salary, office costs and computer costs which are allocated to the cost centre. This one is followed by the allocation to cost pools. The Accountant interviews the professors and finds out business processes they contribute to and how much time they spend thereon. The answer could be that the professors tell the Accountant, that for teaching and class preparation they spend 60 % of their workload, 30 % is for research and 10 % is spent on administration work. In that case, the Accountant defines three cost pools, (1) for teaching, which depends on the cost driver weekly classed, (2) for research, which depends on the number of research projects, and (3) for administration, which depends on the number of meetings the professors have to attend. Based on the interview data, the cost pool Teaching gets 60 % of the cost centre costs, i.e. The next step is the calculation of the process cost rate per activity, by dividing the allocated costs by the cost driver amounts. A process cost rate is the total of costs assigned to an activity divided by the activity’s CD-amount. A process rate represents the costs spent on average on a <?page no="336"?> one-time-execution of an activity/ business process. We now calculate a process cost rate for a class taught 4 lessons per week: Assume, the costs allocated to the cost centre sum up to 500,000.00 EUR/ a. The amount is based on different cost categories such as salary, office and computer costs. Teaching receives: 60% × 500,000 = 300,000.00 EUR. All professors together teach 200 classes/ week during the semester, which is their workload. The data gives a process cost rate (2 nd cost allocation) for teaching of: 500,000 × 60% / 200 = 1,500 EUR/ weekly classes. Calculating an Accounting class requires to ascertain the weekly hours. This is the 3 rd cost allocation. A class taught 4 lessons per week during one semester costs: 4 × 1,500 = 6,000.00 EUR. The number of 4 lessons is the usage factor. The mathematical steps for Activity Based Costing Calculations are very similar to traditional Cost Accounting systems. However, the meaning of the cost objects is different. Traditional Cost Accounting systems are based on proportional cost information. However, the major part of costs in service and administration departments (indirect departments) is classified as fixed costs. The fixed costs, which form the major part of the costs, are closed-off to the Profit and Loss account and won’t be assigned to cost objects. Hence, fixed costs cannot be allocated to cost objects which is the reason why in general a Marginal Cost Accounting system is combined with a Contribution Margin Accounting. In contrast, an Activity Based Costing system assigns fixed costs that can be allocated by cost drivers, to cost pools. In the cost pools, process cost rates for activities are calculated which apply for process calculations. An Activity Based Costing system shall not be used for product/ service Calculations as it refers to existing fixed costs and only apportions them based on cost drivers to products/ service units. Hence, the amount of fixed costs and portions thereof that are allocated to goods/ services depend on decisions made by management and not on the output. A business process is a sequence of activities in order to serve for a product or service. Examples for business processes are treatment of complaints at a department store, rescheduling at an airline, exam enrolment at the university etc. Activities are the elements of business processes. Actually, the difference between activities and business process is not perfectly clear as it depends on the itemisation level of the business process modelling. However, a business process has to have more than one activity at least. 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 taking place in cost centres. (3) Find cost drivers for activities. <?page no="337"?> (4) Define cost pools which contain activities that all 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 the managers responsible for cost centres. In the interviews, the workload per cost pool is ascertained. Use percentages provided by the experts or time measurement in order to determine a cost allocation ratio between cost pools. Allocate costs based on the ratios. (6) Measure/ plan the activity amounts and express them by cost driver units. (7) Divide the costs per cost pool by the cost driver amounts in order to calculate the process cost rate PCR. The unit of the process cost rate is EUR/ CDamount. (8) Measure/ plan the cost driver amount per product/ service. Call that cost driver amount the usage factor of an activity. (9) Aggregate activities to business processes based on the business process models. (10) Calculate products/ services that apply the activities/ business process by multiplying the process cost rates × usage factor. (11) Add the process costs of business processes over the activities therein. <?page no="338"?> Figure 21.1: TORQUAY Ltd.’s revenue (Note, the 2 or 3 letter code represents the cost category in the accounts.) Traditional Cost-Accounting System <?page no="339"?> 1,100,000.00 322,494.02 720,000.00 3,000,000.00 5,897,505.98 600,000.00 2,000,000.00 322,494.02 1,642,494.02 120,000.00 1,642,494.02 1,642,494.02 6,220,000.00 6,220,000.00 1,642,494.02 1,380,000.00 2,100,000.00 5,897,505.98 9,377,505.98 9,377,505.98 9,377,505.98 9,377,505.98 Figure 21.2: TORQUAY Ltd.’s accounts Figure 21.3: TORQUAY Ltd.’s Calculation based on a traditional Cost Accounting system Activity Based Costing (partial) <?page no="340"?> Figure 21.4: TORQUAY Ltd.’s ABC cost centre Sales Office <?page no="341"?> Figure 21.5: TORQUAY Ltd.’s route Calculation on a partial ABC system Caution! Activity Based Costing provides cost rates for activities, which make you think, more activities will lead to higher costs and less activity runs will reduce costs. This is not the case. As the cost rates of an activity only contain allocated fixed costs, a change of process amounts does not change the costs automatically. For cost management based on an ABCsystem, costs must be changed by decisions, followed by a new ABC- Calculation. Activity Based Management (ABM) is a management process based on Activity Based Costing information. In Activity Based <?page no="342"?> Management, cost decisions come at first. After making a decision about costs, cost pooling, calculation of process cost rates for activities and business process Calculation follow. This procedure is different to Marginal Cost Accounting system. In a Marginal Cost Accounting system, the manager has to change the business process, for instance, avoiding double work, re-runs of activities etc. Costs, then change automatically according to the process amounts. Twice the amount of processes will cause double of its costs. In contrast, with an Activity Based Management system, business process runs and cost occurrences are not interrelated. If the manager ceteris paribus halves the process runs, but does not make any cost decision, the cost rate per process will double. An increase of process runs reduces costs per process, known as its process cost rate. The reason is, that Activity Based Costing Calculations are based on the average principle. Process cost rates merely reflect the capacity situation in the operating cost pools. This aspect of Activity Based Costing is important for the understanding of Activity Based Management. For this reason, we do not stop our considerations for this chapter here, but we add an Activity Based Management example for TORQUAY Ltd., which makes the activity based management concept clearer. 1 st Scenario: <?page no="343"?> Figure 21.6: TORQUAY Ltd.’s alternative activity analysis Figure 21.7: TORQUAY Ltd.’s alternative Profitability Analysis <?page no="344"?> 2 nd Scenario: Figure 21.8: TORQUAY Ltd.’s process cost rates, 2 nd amendment (Note, if the process cost rate for opening a bank account in Frankfurt, branch Auf der Zeil is 10.00 EUR, the rate in Bad Soden should be 10.00 EUR too.) <?page no="345"?> Figure 21.9: TORQUAY Ltd.’s Profitability Analysis, 2 nd amendment Summary: Activity Based Costing and Activity Based Management are concepts that are based on the assignment of fixed costs to business processes activities. This gives the company transparency of its activities’ cost structure. The cost allocation along an Activity Based Costing is helpful for the management of fixed costs. Decisions about the business processes and resource allocations thereto, should be based on Activity Based Costing if there are only few proportional costs. However, Activity Based Costing does not work as an alternative to a Marginal Cost Accounting system. As Activity Based Costing allocates fixed costs to products, it should not be applied for product/ service Calculations. <?page no="346"?> Activity Based Management focusses on changes of processes and products/ services based on Activity Based Costing information. Working Definitions: Cost Driver: A cost driver is a factor unit process costs depend on. In contrast to a reference unit, cost drivers do not have a proportional relationship to the output. Cost Pool: A cost pool is a portion of costs which depends on the same cost driver. Process Cost Rate: A process cost rate is the total of costs assigned to an activity divided by the activity’s CDamount. Business Process: A business process is a sequence of activities in order to serve for a product or service. Activity: Activities are the elements of business processes. Activity Based Management: Activity Based Management is a management process based on Activity Based Costing information. <?page no="347"?> ABC Activity Based Costing ABM Activity Based Management AC Airport company costs (for check-in) Acc Accounting Acc Accumulated Acc Depr Accumulated Depreciation, in accounts: AcD Acc IL Accumulated Impairment Loss Adj Adjustment alu Aluminium AP Airport fees A/ P Accounts Payables A/ R Accounts Receivables / a per annum, per year AUD Australian Dollar Bal Balance BCE Business Car Expenses BE Break-even Bhd. Berhad BoE Books of original Entry 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 CB Cash Book C-BE Cash-Break-even C/ B Cash/ Bank CC Cost Centre CD Cost Driver CEO Chief Executive Officer c/ d Balance carried down c/ f carried forward (Profit) CFO Chief Financial Officer, Accountant CFS Statement of Cash Flows CM Contribution Margin CMA Contribution Margin Accounting CMRatio Contribution Margin Ratio CPA Chartered Professional Accountant COS Cost of Sales, Cost of Goods Sold <?page no="348"?> CR Credit Recorded, Credit Entry CVP Cost Volume Profit CVPA Cost Volume Profit Analysis, CVP-analysis D damage D Debit / d per day DcE Decoration Costs PC Delta Proportional Costs Dep Department Depr, Dpr Depreciation DOL Degree of Operating Leverage DR Debit Recorded, Debit Entry Drw Drawing Dst Distribution e Euler’s number EarnRes Earnings Reserves EAT Earnings After Taxes EBIT Earnings Before Interest and Taxes EBT Earnings Before Taxes EPS Earnings Per Share ERP Enterprise Resource Planning Eur Europe 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 FGl Finished Goods, lemmon FGs Finished Goods, strawberry Fin Finance FIM Faculty of Industrial Management fst 90° fastener Fue Fuel costs GP Gross Profit GR Garden Route GST Goods and Service Tax, same as Value Added Tax VAT HGB Handelsgesetzbuch hin Hinge HRC Hengyuan Refining Company Bhd. IAS International Accounting Standards IASB International Accounting Standards Board <?page no="349"?> IBL Interest Bearing Liabilities iCF Cash Flow from Investing Activities ID Identifier, Identification Number IFG Inventory of finished goods IFRS International Financial Reporting Standards IL Impairment Loss Inc. Incorporation (USA) Inv Inventory IRM Inventory of raw materials I/ S Income Statement 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 Liab Liability, Liabilities Lst Loss on settlement Ltd. Limited company LoD Loss on Disposal m Metre MA Management Accounting MASB Malaysian Accounting Standards Board Mat Materials, Material Costs McD McDonals’s Corporation McT Mc Toy GmbH MG Merchandise Goods MHIL Malaysia Hengyuan International Limited MIA Malaysian Institute of Accounting MoF Manufacturing Overheads for the Filling department MOI Memorandum of Incorporation Moh Manufacturing Overheads, also: Manufacturing Overheads account / m per month 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 MYR Malaysian Ringgit NoE Nature of Expense method NOP Net Operating Profit NOPAT Net Operating Profit After Taxes NP Net Profit <?page no="350"?> NPO Non-Profit Organisation NSP Net Selling Price oCF Cash Flow from Operating Activities OE Owners Equity OTH Other Costs out Outsourcing P Probability P Profit P out Profit for outsourcing screnario pan Pane P&L Profit and Loss PC Proportional costs PCB Petty Cash Book PE Physical Education P.I. Profitability Index PoD Profit on Disposal P, P, E Property, Plant and Equipment Pch Purchases PLC Public Limited Company (in the UK) PRT Pro Rata Temporis (Pty) Ltd. Proprietary limited company (in Australia, South Africa) PTO Public Tender Offer PV Present Value R South African Rand R/ D Refer to Drawer R/ E Retained Earnings Res Reserves Rev Revenue, Sales RI Residual Income RM Malaysian Ringgit (currency in Malaysia) Rnt Rent RoA Register of non-current Assets RU Reference Unit SAICA South African Institute of Chartered Accountants Sal Salary 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 SHPC Shandong Hengyuan Petrochemical Company Limited SFP Statement of Financial Position ShD Shareholder for Dividend <?page no="351"?> sht Sheet SOH Service Overheads, Service Overheads account SPA Sales and Purchase Agreement SRC Shell Refining Company (Federation of Malaya) Bhd. StB Steuerberater, tax attorney StE Stationary Expenses str Strip T/ A Trading Account Tkt Ticketing TS Tax Statement (used in a case study as reference unit) TT Time Ticket / u per unit UMP Universiti Malaysia Pahang V Value VAT Value Added Tax, same as Goods and Service Tax GST VDI Verein Deutscher Ingenieure / w per week WIP Work in Progress, Work-in-Process WP Wirtschaftsprüfer, auditor Wst Waste ZAR South African Rand Standard deviation Mean <?page no="357"?> Berkau, C. [2017]: Basics of Accounting. 4th edition, Konstanz, München Berkau, C. [2013]: Bilanzen, 3. Aufl. Konstanz, München. Berkau, C.; Lecholo, K.S. [2014]: Accounting-2-Go. Konstanz, München. Brigham, E.F.; Houston, J.F. 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