Management Accounting and Asian Perspectives
1018
2021
978-3-7398-3188-6
UVK Verlag
Carsten Berkau
Keabetswe Sylvia Berkau
Mohd Ridzuan Darun
The book starts with a comparison of financial accounting and management accounting - both discussed based on the production firm PENOR Ltd. It further demonstrates accounting work in support of general management (CVP-analysis, DOL, performance measurement, risk management and M&A) as well as cost accounting (structures for absorption and marginal cost accounting systems, internal cost allocations, reporting, monitoring, manufacturing accounting/calculation, contribution margin accounting and activity based costing). The content is explained by detailed case studies. This Asia edition also includes real case studies about companies in Malaysia.
All chapters outline the learning objectives, provide an overview, include case studies and how-it-is-done-paragraphs. They end with a summary, the explanation of new technical terms and a question bank with solutions for checking your learning progress. On the internet, you can find more than 300 exam tasks with solutions as well as youtube-videos from the authors.
<?page no="0"?> Management Accounting and Asian Perspectives 2 nd Edition Carsten Berkau, Keabetswe Sylvia Berkau, Mohd Ridzuan Darun <?page no="1"?> Basics of Management Accounting and Asian Perspectives <?page no="2"?> Professor Berkau teaches Accounting and Management Accounting at the University of Applied Sciencen in Osnabrück and other Universities in South Africa, China and South Korea. Keabetswe S. Berkau graduated in business and management at Cape Peninsula University of Technology in Cape Town majoring in Accounting. She has practical experience in Management and is native English speaker. Mohd Ridzuan is an associate professor of accounting at Faculty of Industrial Management (FIM), Universiti Malaysia Pahang (UMP). Prior to academic career, he was the Chief Accountant at the Salvation Army of Illinois, USA. <?page no="3"?> Carsten Berkau Keabetswe Sylvia Berkau Mohd Ridzuan Darun Basics of Management Accounting and Asian Perspectives 2 nd , revised and extended Edition UVK Verlag · München <?page no="4"?> Bibliografische Information der Deutschen Nationalbibliothek Die Deutsche Nationalbibliothek verzeichnet diese Publikation in der Deutschen Nationalbibliografie; detaillierte bibliografische Daten sind im Internet über <http: / / dnb.dnb.de> abrufbar. 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. 2 nd , revised and extended Edition 2021 1 st Edition 2017 © UVK Verlag 20 21 - ein Unternehmen der Narr Francke Attempto Verlag GmbH + Co. KG , xxDischingerweg 5 · D-72070 Tübingen Internet: www.narr.de eMail: info@narr.de Umschlagmotiv : © iStockphoto · matdesign24 ISBN 978-3-7398-3188-6 (ePDF) <?page no="5"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 1-5 Contents I. Contents ......................................................................................... 1-5 II. Introduction..................................................................................1-15 1. Conventions ..................................................................................1-16 1.1. Accounting Periods....................................................................................1-16 1.2. Accounting Technical Terms ...................................................................1-16 1.3. Account Names..........................................................................................1-16 1.4. Alphabetic Order .......................................................................................1-16 1.5. Basics ...........................................................................................................1-16 1.6. Bookkeeping Entries .................................................................................1-16 1.7. Bookkeeping Entry Format ......................................................................1-16 1.8. Calculations.................................................................................................1-17 1.9. Case Studies ................................................................................................1-17 1.10. Case Study Text..........................................................................................1-17 1.11. Cash Flow Separation................................................................................1-17 1.12. Companies ..................................................................................................1-17 1.13. Cost-Expense-Congruence .......................................................................1-17 1.14. Country........................................................................................................1-17 1.15. Currency Unit .............................................................................................1-17 1.16. Data Format in Tables ..............................................................................1-18 1.17. Data Sheets .................................................................................................1-18 1.18. Prepayments of Income Taxes .................................................................1-18 1.19. How it is Done ...........................................................................................1-18 1.20. Income Taxes .............................................................................................1-18 1.21. Financial Statements for Taxation ...........................................................1-18 1.22. Names..........................................................................................................1-18 1.23. Language .....................................................................................................1-18 1.24. Learning Objectives ...................................................................................1-18 1.25. Legal Forms of a Business ........................................................................1-18 1.26. Length of a Month/ Year ..........................................................................1-18 1.27. Level of Precision ......................................................................................1-18 1.28. Links ............................................................................................................1-19 1.29. Literature .....................................................................................................1-19 1.30. Non-existing Items ....................................................................................1-19 1.31. Online Materials .........................................................................................1-19 1.32. Payment Terms ..........................................................................................1-19 1.33. Presentation of Accounts..........................................................................1-19 1.34. Pro-Rated Depreciation/ Interest.............................................................1-19 1.35. Quotation of Law Texts/ Standards.........................................................1-20 1.36. Sequence of Bookkeeping Entries ...........................................................1-20 <?page no="6"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 1-6 1.37. Tax on Capital Returns (Dividend Tax) ................................................. 1-20 1.38. Transaction Costs ...................................................................................... 1-20 1.39. Value Added Tax, Goods and Service Tax ............................................ 1-20 1.40. VAT Reduction.......................................................................................... 1-20 1.41. Working Definitions ................................................................................. 1-20 1.42. Work-in-Process Account ........................................................................ 1-21 1.43. Writing Management Terms .................................................................... 1-21 1.44. WWW.......................................................................................................... 1-21 1.45. Youtube Videos ......................................................................................... 1-21 1.46. 10-20-30 Rule ............................................................................................. 1-21 2. Introduction to Managerial Accounting ..................................... 2-22 2.1. Purpose of a Management Accounting System ..................................... 2-22 2.2. Management Accounting and Financial Accounting ............................ 2-23 2.3. Management Accounting for General Management............................. 2-23 2.4. Cost Accounting ........................................................................................ 2-24 2.5 Asian Perspectives ..................................................................................... 2-24 3. Case Study PENOR PLC - Financial Accounting ..................... 3-27 3.1. What is in the Chapter? ............................................................................. 3-27 3.2. Leaning Objectives .................................................................................... 3-27 3.3. C/ S PENOR PLC..................................................................................... 3-27 3.4. Inception (A) .............................................................................................. 3-28 3.5. Financial Accounting (B) .......................................................................... 3-29 3.6. Purchases .................................................................................................... 3-33 3.7. Labour......................................................................................................... 3-38 3.8. Proceeds...................................................................................................... 3-38 3.9. Finished Goods Valuation........................................................................ 3-38 3.10. Profit Calculation....................................................................................... 3-41 3.11. Accounts ..................................................................................................... 3-41 3.12. Statement of Profit or Loss...................................................................... 3-45 3.13. Loan Disclosure......................................................................................... 3-45 3.14. Statement of Financial Position ............................................................... 3-48 3.15. Statement of Cash Flows .......................................................................... 3-48 3.16. Statement of Changes in Equity .............................................................. 3-49 3.17. Summary ..................................................................................................... 3-50 3.18. Working Definitions ................................................................................. 3-50 3.19. Question Bank ........................................................................................... 3-51 3.20. Solutions ..................................................................................................... 3-51 4. Case Study PENOR PLC - Managerial Accounting ................. 4-52 4.1. What is in the Chapter? ............................................................................. 4-52 4.2. Learning Objectives .................................................................................. 4-52 4.3. Management Accounting (C) ................................................................... 4-52 4.4. Control Information from Financial Statements................................... 4-53 <?page no="7"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 1-7 4.5. Profit and Business Operations ...............................................................4-54 4.6. Shareholders’ Perspective .........................................................................4-54 4.7. Five Management Accounting Questions...............................................4-55 4.8. C/ S PENOR PLC - Management Accounting .....................................4-55 4.9. Accounting Cuts (C1) ................................................................................4-56 4.10. Bookkeeping Entries after Accounting Cuts..........................................4-58 4.11. Accounting Add-ons (C2).........................................................................4-62 4.12. Direct Costs Recording .............................................................................4-64 4.13. Manufacturing Overhead Application.....................................................4-69 4.14. Further Reports ..........................................................................................4-70 4.15. Profitability Analysis ..................................................................................4-71 4.16. Checking Calculation by a Balance Sheet................................................4-77 4.17. Business Plan ..............................................................................................4-78 4.18. Summary .....................................................................................................4-83 4.19. Working Definitions ..................................................................................4-83 4.20. Question Bank: ...........................................................................................4-84 4.21. Solutions......................................................................................................4-84 5. Management Accounting vs. Financial Accounting .................. 5-85 5.1. What is in the Chapter? .............................................................................5-85 5.2. Learning Objectives ...................................................................................5-85 5.3. Differences to Financial Accounting.......................................................5-85 5.4. Management Accounting Focusses on Planning/ Budgeting ...............5-85 5.5. Management Accounting is not Required by Law.................................5-86 5.6. Management Accounting is Based on Costs Instead of Expenses ......5-86 5.7. Management Accounting Works on a Different Details Level............5-87 5.8. Management Accounting is About Allocations .....................................5-87 5.9. Management Accounting is for Periods Less than a Fiscal Year.........5-88 5.10. Management Accounting’s Focus is on Deviations ..............................5-88 5.11. Management Accounting Reports ...........................................................5-88 5.12. How to Become a Management Accountant? ........................................5-89 5.13. Summary .....................................................................................................5-89 5.14. Working Definitions ..................................................................................5-90 5.15. Question Bank............................................................................................5-90 5.16. Solutions......................................................................................................5-90 6. Cost Planning / Business Plan ................................................... 6-92 6.1. What is in the Chapter? .............................................................................6-92 6.2. Learning Objectives ...................................................................................6-92 6.3. Business Plan ..............................................................................................6-92 6.4. C/ S KIRSTENBOSCH (Pty) Ltd. ..........................................................6-92 6.5. Revenue Plan - C/ S Kirstenbosch (Pty) Ltd. ........................................6-94 6.6. Cost Plan - C/ S Kirstenbosch (Pty) Ltd. ............................................... 6.94 6.7. Profit Plan - Kirstenbosch (Pty) Ltd....................................................... 6.95 6.8. Liquidity Plan - Kirstenbosch (Pty) Ltd. ................................................ 6.96 <?page no="8"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 1-8 6.9. Budgeted Balance Sheet - Kirstenbosch (Pty) Ltd. .............................. 6-98 6.10. Cash Flow Statement - Kirstenbosch (Pty) Ltd. ....................................6.99 6.11. C/ S McTOY GmbH............................................................................... 6.102 6.12. Revenue Plan - McTOY GmbH........................................................... 6.102 6.13. Profit Plan - McTOY GmbH................................................................ 6-107 6.14. Liquidity Plan - McTOY GmbH .......................................................... 6-108 6.15. Budgeted Balance Sheet - McTOY GmbH......................................... 6-110 6.16. C/ S Schluchman...................................................................................... 6-111 6.17. Liquidity Plan - MTF GmbH ................................................................ 6-118 6.18. Summary ................................................................................................... 6-121 6.19. Working Definitions ............................................................................... 6-121 6.20. Question Bank ......................................................................................... 6-122 6.21. Solutions ................................................................................................... 6-122 7. Cost Concepts, Cost Behaviour and Cost Separation ...............7-123 7.1. What is in the Chapter? ........................................................................... 7-123 7.2. Learning Objectives ................................................................................ 7-123 7.3. Cost Concepts .......................................................................................... 7-123 7.4. Direct vs. Indirect Costs ......................................................................... 7-124 7.5. Manufacturing vs. non-Manufacturing Costs ...................................... 7-124 7.6. Product vs. Period Costs ........................................................................ 7-125 7.7. C/ S STAFFORD (Pty) Ltd.................................................................... 7-125 7.8. Variable vs. Fixed Costs.......................................................................... 7-130 7.9. C/ S DANNING (Pty) Ltd..................................................................... 7-132 7.10. High-low Method - DANNING (Pty) Ltd. ........................................ 7-132 7.11. Scatter Graph - DANNING (Pty) Ltd. ............................................... 7-133 7.12. Regression Method - DANNING (Pty) Ltd....................................... 7-134 7.13. Common Format for the Simple Regression Method ........................ 7-136 7.14. Differential/ Sunk/ Opportunity Costs ................................................. 7-141 7.15. Summary ................................................................................................... 7-142 7.16. Working Definitions ............................................................................... 7-143 7.17. Question Bank ......................................................................................... 7-143 7.18. Solutions ................................................................................................... 7-144 8. Cost Volume Profit Analysis (CVP-Analysis) ............................8-145 8.1. What is in the Chapter? ........................................................................... 8-145 8.2. Learning Objectives ................................................................................ 8-145 8.3. Basics of Cost-Volume-Profit Analysis ................................................ 8-145 8.4. C/ S Ameer - GRAB Driver .................................................................. 8-146 8.5. Benefit from CVP-Analysis.................................................................... 8-146 8.6. C/ S DEERFIELD TOURS (Pty) Ltd.................................................. 8-147 8.7. CVP-Analysis for Changing Business Model....................................... 8-150 8.8. Online-Shop for DEERFIELD TOURS (Pty) Ltd. ........................... 8-150 8.9. Bungee Jumping - DEERFIELD TOURS (Pty) Ltd......................... 8-151 8.10. Revenue Calculation - DEERFIELD TOUR (Pty) Ltd. ................... 8-152 <?page no="9"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 1-9 8.11. What-if-Analysis .......................................................................................8-152 8.12. Statistics - DEERFIELD TOURS (Pty) Ltd. ......................................8-153 8.13. Multiple Product CVP-Analysis .............................................................8-156 8.14. 2-Tour-Case - DEERFIELD TOURS (Pty) Ltd. ...............................8-156 8.15. Summary ...................................................................................................8-159 8.16. Working Definitions ................................................................................8-159 8.17. Question Bank..........................................................................................8-159 8.18. Solutions....................................................................................................8-160 9. Degree of Operating Leverage (DOL).......................................9-161 9.1. What is in the Chapter? ...........................................................................9-161 9.2. Learning Objectives .................................................................................9-161 9.3. Profit and Output Relationship..............................................................9-161 9.4. C/ S DEERFIELD TOURS (Pty) Ltd. .................................................9-162 9.5. DOL-Degression Effect .........................................................................9-164 9.6. Fixed Costs Effect ...................................................................................9-164 9.7. C/ S EMS KAYAK GmbH ....................................................................9-165 9.8. 3 Break-Even Points - EMS KAYAK GmbH ....................................9-166 9.9. DOL-Studies - EMS KAYAK GmbH.................................................9-170 9.10. Fixed Cost Effect - EMS KAYAK GmbH .........................................9-171 9.11. DOL for Cash Flows...............................................................................9-176 9.12. Summary ...................................................................................................9-176 9.13. Working Definitions ................................................................................9-176 9.14. Question Bank: .........................................................................................9-177 9.15. Solutions....................................................................................................9-177 10. Performance Measurement ...................................................... 10-178 10.1. What is in the Chapter? .........................................................................10-178 10.2. Learning Objectives ...............................................................................10-178 10.3. What is Performance? ............................................................................10-178 10.4. C/ S VANHUIZEN BV........................................................................10-178 10.5. Short-run (Variable) Contribution Margin..........................................10-181 10.6. Controllable Contribution Margin .......................................................10-181 10.7. Divisional Contribution Margin ...........................................................10-182 10.8. Divisional Net Profit .............................................................................10-182 10.9. Return on Investment ...........................................................................10-184 10.10. Return on Equity....................................................................................10-186 10.11. Residual Income.....................................................................................10-188 10.12. Economic Value Added (EVA™).......................................................10-188 10.13. Summary .................................................................................................10-190 10.14. Working Definitions ..............................................................................10-190 10.15. Question Bank........................................................................................10-191 10.16. Solutions..................................................................................................10-192 <?page no="10"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 1-10 11. Accounting for Mergers and Acquisitions............................... 11-193 11.1. What is in the Chapter? ......................................................................... 11-193 11.2. Learning Objectives .............................................................................. 11-193 11.3. M&A - Overview................................................................................... 11-193 11.4. General Description of OHIO FRIED CHICKEN ........................ 11-194 11.5. Reading the “Financials” ...................................................................... 11-194 11.6. Business Valuation ................................................................................ 11-199 11.7. Investment Appraisal ............................................................................ 11-201 11.8. Financial Statements.............................................................................. 11-204 11.9. Private Purchase (5-1) ........................................................................... 11-204 11.10. Acquisition by a Company (5-2) .......................................................... 11-206 11.11. Merger (5-3)............................................................................................ 11-214 11.12. Financial Statement Analysis................................................................ 11-217 11.13. Risk Analysis .......................................................................................... 11-220 11.14. Summary ................................................................................................. 11-223 11.15. Working Definitions ............................................................................. 11-223 11.16. Question Bank ....................................................................................... 11-224 11.17. Solutions ................................................................................................. 11-224 12. Risk Valuation ..........................................................................12-225 12.1. What is in the Chapter? ......................................................................... 12-225 12.2. Leaning Objectives ................................................................................ 12-225 12.3. Bankruptcy due to Over-Indebtedness............................................... 12-225 12.4. C/ S ROCKS PLC ................................................................................. 12-225 12.5. Bankruptcy due to Illiquidity................................................................ 12-227 12.6. Risks ........................................................................................................ 12-228 12.7. Risk Management .................................................................................. 12-228 12.8. Multiple Risk Taking ............................................................................. 12-229 12.9. C/ S WEATHERMAN ......................................................................... 12-230 12.10. Simulation of Multiple Risks ................................................................ 12-232 12.11. C/ S NAMGURO Ltd........................................................................... 12-232 12.12. Normal Distributions............................................................................ 12-234 12.13. Bankruptcy Probability ......................................................................... 12-237 12.14. C/ S OHIO FRIED CHICKEN (Pty) Ltd. ....................................... 12-237 12.15. Summary ................................................................................................. 12-241 12.16. Working Definitions ............................................................................. 12-241 12.17. Question Bank ....................................................................................... 12-241 12.18. Solutions ................................................................................................. 12-242 13. Structure of Cost Accounting Systems.....................................13-244 13.1. What is in the Chapter? ......................................................................... 13-244 13.2. Learning Objectives .............................................................................. 13-244 13.3. Components of Cost Accounting Systems ........................................ 13-244 13.4. Cost Category Accounting ................................................................... 13-246 13.5. Cost Centre Accounting ....................................................................... 13-246 <?page no="11"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 1-11 13.6. Calculation ..............................................................................................13-247 13.7. Profitability Analysis ..............................................................................13-248 13.8. C/ S GIULIO'S PIZZA&PASTA RISTORANTE...........................13-248 13.9. Cost Category Accounting - C/ S ........................................................13-251 13.10. Calculation - C/ S...................................................................................13-252 13.11. Calculation - C/ S...................................................................................13-256 13.12. Profitability Analysis - C/ S ..................................................................13-261 13.13. Summary .................................................................................................13-263 13.14. Working Definitions ..............................................................................13-264 13.15. Question Bank........................................................................................13-264 13.16. Solutions..................................................................................................13-265 14. Flexible Budgeting / Marginal Cost Accounting ...................14-266 14.1. What is in the Chapter? .........................................................................14-266 14.2. Learning Objectives ...............................................................................14-266 14.3. Marginal Cost Accounting Systems .....................................................14-266 14.4. Allocation Principles..............................................................................14-267 14.5. C/ S GIULIO'S PIZZA&PASTA RISTORANTE...........................14-268 14.6. Storing Goods that Include Fixed Costs.............................................14-274 14.7. C/ S LOGA (Pty) Ltd. ...........................................................................14-274 14.8. Summary .................................................................................................14-277 14.9. Working Definitions ..............................................................................14-277 14.10. Question Bank........................................................................................14-278 14.11. Solutions..................................................................................................14-278 15. Cost Monitoring .......................................................................15-279 15.1. What is in the Chapter? .........................................................................15-279 15.2. Learning Objectives ...............................................................................15-279 15.3. Cost Deviations ......................................................................................15-279 15.4. C/ S CROXTON Ltd. ...........................................................................15-280 15.5. The Cost-Volume Relationship............................................................15-281 15.6. Actual Volume Equals Budgeted Volume: April 20X6 ....................15-281 15.7. Actual Volume is below Budgeted Volume: May 20X6....................15-282 15.8. Actual Volume Exceeding Budgeted Volume: June 20X6 ...............15-285 15.9. Summary .................................................................................................15-286 15.10. Working Definitions ..............................................................................15-287 15.11. Question Bank........................................................................................15-287 15.12. Solutions..................................................................................................15-287 16. Cost Allocations ........................................................................16-288 16.1. What is in the Chapter? .........................................................................16-288 16.2. Learning Objectives ...............................................................................16-288 16.3. Cost Allocations .....................................................................................16-288 16.4. The 1 st Allocation...................................................................................16-288 16.5. The 2 nd Allocation ..................................................................................16-288 <?page no="12"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 1-12 16.6. The 3 rd Allocation .................................................................................. 16-289 16.7. C/ S CLYDBANK Ltd. ........................................................................ 16-289 16.8. The 1 st Allocation - C/ S....................................................................... 16-290 16.9. The 3 rd Allocation - C/ S ...................................................................... 16-295 16.10. Technical Terms for Cost Allocations ................................................ 16-296 16.11. Equation Method (1)............................................................................. 16-297 16.12. C/ S TUSCAN (Pty) Ltd. ...................................................................... 16-297 16.13. C/ S HEISFELD Ltd. ........................................................................... 16-298 16.14. Iteration Method (2).............................................................................. 16-302 16.15. Summary ................................................................................................. 16-309 16.16. Working Definitions ............................................................................. 16-309 16.17. Question Bank ....................................................................................... 16-309 16.18. Solutions ................................................................................................. 16-310 17. Reporting .................................................................................. 17-311 17.1. What is in the Chapter? ......................................................................... 17-311 17.2. Learning Objectives .............................................................................. 17-311 17.3. Providing Information as an Accounting Task ................................. 17-311 17.4. C/ S LEBUHRAYA .............................................................................. 17-312 17.5. Calculation of Materials (1) .................................................................. 17-317 17.6. Calculation of Labour (2) ..................................................................... 17-318 17.7. Application of Overheads (3)............................................................... 17-318 17.8. Adjustments (4)...................................................................................... 17-318 17.9. COS-Report............................................................................................ 17-318 17.10. Summary ................................................................................................. 17-319 17.11. Question Bank ....................................................................................... 17-319 17.12. Solutions ................................................................................................. 17-320 18. Job Order Costing (Manufacturing Accounting) .................... 18-321 18.1. What is in the Chapter? ......................................................................... 18-321 18.2. Learning Objectives .............................................................................. 18-321 18.3. Calculations ............................................................................................ 18-321 18.4. C/ S MAHKOTA (Pty) Ltd.................................................................. 18-323 18.5. C/ S WEIXDORF Ltd. ......................................................................... 18-330 18.6. Summary ................................................................................................. 18-340 18.7. Working Definitions ............................................................................. 18-341 18.8. Question Bank ....................................................................................... 18-341 18.9. Solutions ................................................................................................. 18-342 19. Process Costing (Manufacturing Accounting)........................19-343 19.1. What is in the Chapter? ......................................................................... 19-343 19.2. Learning Objectives .............................................................................. 19-343 19.3. Principle of Process Costing ................................................................ 19-343 19.4. C/ S EDEWECHT (Pty) Ltd. .............................................................. 19-345 19.5. Uncompleted Production Steps........................................................... 19-349 <?page no="13"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 1-13 19.6. Equivalent Units Calculation ................................................................19-349 19.7. Profit Calculation - C/ S .......................................................................19-350 19.8. Summary .................................................................................................19-352 19.9. Working Definition................................................................................19-352 19.10. Question Bank........................................................................................19-352 19.11. Solutions..................................................................................................19-353 20. Multiple-Level Contribution Margin Accounting .................. 20-354 20.1. What is in the Chapter? .........................................................................20-354 20.2. Learning Objectives ...............................................................................20-354 20.3. The Structure of a Profitability Analysis System................................20-354 20.4. C/ S FLINDERS Ltd. ............................................................................20-355 20.5. Summary .................................................................................................20-358 20.6. Question Bank........................................................................................20-358 20.7. Solutions..................................................................................................20-359 21. Activity Based Costing .............................................................21-360 21.1. What is in the Chapter? .........................................................................21-360 21.2. Learning Objectives ...............................................................................21-360 21.3. Theoretical Background for ABC ........................................................21-360 21.4. How does ABC Work? ..........................................................................21-361 21.5. Activity Costs for a Professor ..............................................................21-362 21.6. Business Process Calculation................................................................21-362 21.7. Case Study TORQUAY Ltd.................................................................21-363 21.8. Traditional Cost-Accounting System - C/ S.......................................21-364 21.9. Activity Based Costing (partial) - C/ S ................................................21-366 21.10. Activity-based Management .................................................................21-368 21.11. 1 st Scenario - C/ S ..................................................................................21-368 21.12. 2 nd Scenario - C/ S .................................................................................21-370 21.13. Summary .................................................................................................21-371 21.14. Working Definitions ..............................................................................21-371 21.15. Question Bank........................................................................................21-371 22. Business Plan - ZAMZAM Restaurant ................................... 22-374 23. CVP-Analysis - POTO Travel&Tours Sdn. Bhd. ....................23-381 24. M&A - Hengyuan Refining Company Bhd............................ 24-386 25. Process Costing - MTBE Malaysia Sdn. Bhd......................... 25-390 26. Activity Based Costing - CAHAYA BAKERY ........................ 26-398 27. Abbreviations ........................................................................... 27-404 28. Table of Figures........................................................................28-410 <?page no="14"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 1-14 29. Literature ..................................................................................29-416 <?page no="15"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 1-15 Introduction to the 2 nd Edition This textbook is an extended version of the Management Accounting textbook. It contains case studies we prepared together with our students in Malaysian during winter semester 2016/ 2017. In comparison to the first edition, we made some structural changes and added a question bank. Due to the new IFRS standards about financial instruments we adjusted the case study PENOR Ltd. Managerial Accounting is a textbook on the bachelor’s and master’s degree level. For its understanding, a basic level of Accounting knowledge is required. We refer at our other textbooks: "Berkau: Basics of Accounting" and "Berkau: Financial Statements". In cases you start studying Accounting with Management Accounting, we begin this textbook with a case-based description of Financial Accounting. We explain the basics of Bookkeeping and financial statement preparation by the case study PENOR PLC. This helps you to take quick tour through Financial Accounting. As Managerial Accounting is supports two major fields of management, we show 2 different angles in the chapters of this textbook: (1) Accounting for General Management. (2) Cost Accounting. In this Asia edition we added a third perspective linked to real Asian case studies: (3) Asian Perspectives. We write this textbook as an international team of Accountants and professors. Its first edition was published after Keabetswe's and Carsten's visiting professorship in Kuantan. We prepared this edition in summer 2021 in preparation of the upcoming online classes for Malaysian and German students. We thank Dr. Jürgen Schechler from UVK Verlag in Munich for his support. Due to the limited target reader group of our international students at Universiti Malaysia Pahang and Osnabrück university UAS, we publish this textbook as eBook only. A print version of this textbook will be published as Management Accounting 7e shortly. We support our readers by preparing video materials for the cases found in the book. Links to the videos can be found on Twitter, @CBerkau. Under www.uvk.digital/ 9783739830933, we provide you with further study materials (more than 380 tasks with detailed solutions). Hands on Accounting! Cape Town/ Kuantan/ Osnabrück, in August 2021 Keabetswe Sylvia Berkau Prof. Dr. Carsten Berkau Prof. Dr. Mohd Ridzuan Darun <?page no="16"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 1-16 1. Conventions The below listed conventions apply merely to simplify the case. These conventions are about legal forms, tax rates, formats etc. They apply for this textbook, for our Basics of Accounting, for our Management Accounting and for all online study materials. At this stage of studying Accounting, you might not understand the conventions completely. We only put them at the beginning of the textbook for you to find them upfront. 1.1. Accounting Periods Accounting periods start on 1.01.20XX and end on 31.12.20XX. Furthermore, to keep the examples transferable to later years, we write the decades with an X, as in 20X4. X is followed by Y, then Z. 1.2. Accounting Technical Terms At the end of every chapter, we explain new technical terms. They help you to easily understand the content. These are simple explanations if you are beginners in Accounting. The Accounting technical terms are not as formal and precise as the definitions provided by the IASB. 1.3. Account Names All account names are written with capital letters in the text, such as ‘Cash/ Bank account’. However, an account not subjected to our recordings is written in small letters. Assume there is a bank account with Deutsche Bank, and we refer thereto. The writing is with small letters: bank account. We do not make Bookkeeping entries therein, but Deutsche Bank AG does. However, the Cash/ Bank account applicable to calculate the item cash/ bank on the balance sheet is part of our Accounting work. 1.4. Alphabetic Order For all lists, we apply an alphabetic order. 1.5. Basics Our Basics refers to the textbook Berkau: Basics of Accounting. You must read our basics before you start reading our Financial Statements. It introduces you to Bookkeeping and major Accounting concepts without consideration of International Accounting standards IFRSs. We frequently quote the Basics. 1.6. Bookkeeping Entries All Bookkeeping entries are printed in bold and cover a whole page’s width. 1.7. Bookkeeping Entry Format We write debit entries and credit entries. DR stands for debit recorded and CR for credit recorded. See, e.g., a Bookkeeping entry for the acquisition of a motor vehicle: <?page no="17"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 1.17 DR Motor Vehicle................ 20,000.00 EUR DR VAT.......................... 4,000.00 EUR CR Cash/ Bank.................... 24,000.00 EUR The identifier for Bookkeeping entries in the text, like “Bookkeeping entry (1)” can be found in the accounts as “(1)”, as well. 1.8. Calculations For calculations, we only show the units with the results. E.g., 10 + 20.50 = 30.50 EUR. Furthermore, the figures in calculations come without digits after the decimal point in case they equal zero. Results are printed in bold to find calculated figures easily. All calculations are exact to the EURcent or any other currency as 1/ 100amounts. 1.9. Case Studies We keep case studies in this textbook as easy as possible even as they might look unrealistic. Teaching Accounting is our priority. 1.10. Case Study Text We write case studies in a different text format than the normal text (Italic fonts). 1.11. Cash Flow Separation Interest payments in this textbook are always considered financing cash flows, even as IAS 7.33 allows their recognition as operating as well as financing cash flows. This applies for all case studies. 1.12. Companies For the textbook, the legal form of companies does not matter. Legal forms are not part of our Accounting syllabus. They are covered by our Basics. We only assure that companies prepare financial statements. This is the attitude of the IASB, too. In contrast to IFRSs, we do not refer to companies as “entities”. Once you read the expression entity in the standards, remember they are referring to companies. We apply the technical terms “business”, “firm” and “company”. Most companies are limited companies in this textbook, like GmbH, AG, Pty Ltd., PLC, Inc. etc. 1.13. Cost-Expense-Congruence By default, costs are expenses and vice versa. 1.14. Country All cases take place in countries where IFRSs apply for single entity financial statements. For our teaching in Cape Town, many examples refer to South African companies. 1.15. Currency Unit For all examples, the reporting currency is based on the country of the case study. We use the common 3 letter codes for abbreviation, like ZAR for South African Rand or GBP for British Pound Sterling. <?page no="18"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 1-18 1.16. Data Format in Tables In tables, negative figures are shown in brackets. E.g., (7.50) equals -7.50 EUR. 1.17. Data Sheets WWe show the most important data for case studies in their data sheets. 1.18. Prepayments of Income Taxes No provisional tax payments are made to the national revenue service in our case studies. Taxes are calculated at the year-end and added to short-term liabilities, mostly to the Income Tax Liabilities account. For German companies, § 249 HGB applies, and income taxes are shown as provisions. 1.19. How it is Done (1) You find How-it-is Done sections in this textbook. (2) They offer you very short and clear instructions for your Accounting work. 1.20. Income Taxes For our textbooks and the IFRSs, a simplified income tax model applies. Income taxes amount to 30 % of the pre-tax profit EBT. 1.21. Financial Statements for Taxation We do not cover tax calculations. Tax statements are relevant for us to determine income taxes (simplified calculation) and deferred taxes. 1.22. Names We name companies and mark them with capital letters. E.g., SCHULZE- BRAMMELKAMP Ltd. No links to actual existing persons or companies are intended. The names work as identifiers, so you can use them for your communication with your classmates. 1.23. Language This textbook is written in South African English. With the 5 th edition, a German version is available, too. The translation from the English text is sentence-by-sentence (not word by word). 1.24. Learning Objectives Every chapter starts by the learning objectives and ends by a summary. We also give you a short overview by our What is in the Chapter? -paragraphs. 1.25. Legal Forms of a Business For this textbook, we use Ltd., (Pty) Ltd., Sdn. Bhd., Bhd., AG, GmbH, UG, PLC, Inc. etc. If no legal form has been mentioned, assume the company is privately-owned, such as SANDPIPER BOOKS for a privatelyowned bookstore. 1.26. Length of a Month/ Year 1 month = 21.5 days = 4.3 weeks. 1 year = 12 evenly long months = 365 days = 52 weeks. 1.27. Level of Precision We work exact to 2 digits after the decimal point. Results from workings are <?page no="19"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 1-19 rounded, too. We calculate sometimes in MS-Excel; hence, calculations in the background are more precise than they appear. All financial statements show figures rounded to the nearest full currency amount. 1.28. Links Links in the book direct you to further explanations and readings. 1.29. Literature The main source of preparing financial statements are the standards issued by the International Accounting Standard Board IASB. At the end of the textbook, we recommend further readings for you. 1.30. Non-existing Items In case something has not been mentioned it does not exist. 1.31. Online Materials The online materials are at the time of printing this textbook 354 exam tasks with solutions. Their names refer to the chapter and contain a counting figure, like Task_A10.14-Sunlands, which is linked to the Financial Statements (A), chapter 10 and is the 14 th exam task. As higher the count as newer the task is. 1.32. Payment Terms In this textbook, payments/ receipts for taxation and for dividends are due in the next following Accounting period. 1.33. Presentation of Accounts Accounts are displayed in the T-format. They have a 3-letter indicator column used for Bookkeeping entry identification or contra-entry references. Nominal accounts show the Accounting periods as a suffix, such as Depreciation-20X4. See the accounts for the car acquisition’s Bookkeeping entry: D C D C (1) 20,000.00 (1) 4,000.00 D C (1) 24,000.00 Cash/ Bank C/ B Property, plant, equipment PPE Value added tax VAT Figure 1.1: Accounts 1.34. Pro-Rated Depreciation/ Interest Although given as annual rates, depreciation and interest are calculated proportionally accurate to the full month. Monthly depreciation is calculated as annual depreciation divided by 12. In case a company owns an asset for a shorter period than a full year, a month will count for depreciation <?page no="20"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 1-20 charge if the asset is owned for the major duration thereof. Interest rates are given per annum (/ a) and compounded annually (no compounded interest calculation within a year). For loans taken for shorter periods than a full year, interest is calculated per rate accurate to the month, too. For a bank loan of 100,000.00 EUR taken on 9.06.20X4 with an annual rate of interest of 10 %/ a, the interest paid at the end of the year equals: 7 × 100,000 × 10%/ 12 = 5,833.33 EUR. If dates are not at the beginning or end of the Accounting period, the month is underlined to direct your attention thereto, as in 11.06.20X4. By default, pay-off payments take place at the end of the Accounting period. Interest is only calculated for debts, such as bank loans, bonds etc. Overdrafts of bank account are ignored. An exception is chapter (37) in our Basics. 1.35. Quotation of Law Texts/ Standards Law texts/ standards are quoted like ‘§ 266 HGB’ or ‘IAS 1.68’. We use the original law names. Note, that IFRS paragraphs can be subjected to changes. 1.36. Sequence of Bookkeeping Entries The sequence of Bookkeeping entries comes along the logical process defined by the text. Bookkeeping identifiers, like “(1), (2), (3) …” do not indicate nor prescribe a sequence of recording. 1.37. Tax on Capital Returns (Dividend Tax) The tax on capital returns is an income tax. The rate on capital returns is 25 % based on the capital gain for this textbook. Note, the tax on capital returns is no company tax, although it is owed by the company. It is a withholding tax in most countries levied from persons. 1.38. Transaction Costs We ignore transaction costs, like costs for selling goods/ services, taking and repaying bank loans, issuing shares or bonds etc. 1.39. Value Added Tax, Goods and Service Tax VAT stands for value added tax and GST for Goods and Service Tax. Except in, e.g., United Arabic Emirates or some U.S. states like Delaware, Alaska etc., consumers pay VAT - or sometimes referred to as sales tax when buying goods or services. In this textbook, we apply one single VAT account for input-VAT and output- VAT. The VAT rate in our textbooks is 20 %. We ignore reduced VAT rates as levied in many countries for food, books etc. 1.40. VAT Reduction It is assumed that every company discussed in this textbook is registered for VAT reduction. 1.41. Working Definitions At the end of every chapter, you find short and easily understandable definitions for new Accounting terms. They <?page no="21"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 1-21 are merely a glossary and should support your understanding. For enforceable and more precise definitions study IFRSs! 1.42. Work-in-Process Account We apply the Work-in-Process account as reconciliation account for all job orders and call it Work-in-Process WIP. We also apply a Work-in-Process account for single job orders but then add the job order ID thereto, like “Work-in-Process 4711” for job order 4711. 1.43. Writing Management Terms We write academic disciplines, like Accounting, Marketing, Management etc., with capital letters. 1.44. WWW We provide you with a lot of exercises and further materials. Pls., check the website: www. uvk.digital/ 9783739830933. Most of the exercises are our exam tasks from Hochschule Osnabrück or its partner universities, in South Africa, China, South Korea and Malaysia. 1.45. Youtube Videos On our Youtube channel (Carsten Berkau) we publish video materials which are based on the case studies on this textbook. Find their links on Twitter and on the UVK website. 1.46. 10-20-30 Rule In this textbook, the 10-20-30 rule applies. If not mentioned otherwise, the interest rate is 10 %/ a, the VAT rate is 20 % and the total income tax rate is 30 %/ a. <?page no="22"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 2-22 2. Introduction to Managerial Accounting 2.1. Purpose of a Management Accounting System Managerial Accounting is Accounting for managers. The design of Management Accounting systems depends on their information requirements. We divide this book in two major parts, management Accounting for general management and cost Accounting starting with Accounting for general management. General management focusses on the whole company. E.g., Management Accounting calculates and reports a return figure based on a company’s annual profit as percentage of its total assets. In contrast, the calculation of a cost rate within a cost centre is regarded as cost Accounting because it is not linked to the entire company. In contrast to Financial Accounting, which aims to inform investors and creditors about past Accounting periods, Management Accounting addresses future activities, like in budgeting, and monitors and adjusts actual data to keep the business on track. No legal requirements, like the IFRSs, apply for Management Accounting. Management Accounting is merely based on production theory and cost theory. The information managers need to know to control the business are different to findings derived from financial statements. Only few small businesses can be controlled with Financial Accounting information, but most companies install a Management Accounting system supporting managers by setting objectives, planning future activities, monitoring actual activities and calculating profitability and cash flows on a short-term basis. Most information in Management Accounting is linked to periods shorter than a year to reduce reaction time. Most managers plan and monitor their business monthly. As a further difference to Financial Accounting, Management Accounting works on an organisational unit’s base. Therefore, companies are divided in units, e.g., cost centres, which are controlled separately. Companies run hundreds of responsibility centres which are budgeted and monitored. We understand the role of Management Accountants 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 tasks including Financial Accounting - Bookkeeping record keeping and financial and tax statement preparation 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 true and relevant data which enables them to make good economic decisions. We cover the below described chapters, allocated to three sections in the book: <?page no="23"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 2-23 Section (1): Management Accounting and Financial Accounting. Section (2): Management Accounting for general management. Section (3): Cost Accounting. 2.2. Management Accounting and Financial Accounting In the first section, we use the case study PENOR PLC for speeding you up with the preparation of financial statements. We demonstrate the differences between Management Accounting and Financial Accounting. Chapter (3) discusses how financial statements are prepared for PENOR PLC in compliance with IFRSs. The company is based in the UK and reports in British Pound Sterling GBP. In chapter (4), the same case study PENOR PLC which is a manufacturer for aluminium windows and doors gives you an understanding of Management Accounting, such as cost planning, product calculation (job order costing), business plan preparation and reporting. After the case study, chapter (5) summarizes the characteristics of Management Accounting and discusses the major differences to Financial Accounting. 2.3. Management Accounting for General Management In chapter (6), a business plan which was already shown in the PENOR PLC case study is covered. Different cases from Hospitality Management and Industrial Management are discussed. A business plan contains a revenue plan, a cost plan, a profitability plan and a liquidity plan. After approval, the business plan is referred to as the (master) budget. It shows detailed plans for all departments. Chapter (6) covers budgeting applying a full cost Accounting system. Chapter (7) introduces major cost terms and shows the difference between proportional and fixed costs as well as common 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 determines the break-even-point which is the quantity of products the company earns a zero profit with. Passing through that performance mark the company starts to earn profit. As costs start at fixed costs (costs that apply when the output is zero) and revenue passes the point (0/ 0) of the cost curve, revenues initially exceed costs. At the break-even point the cost curve cuts the revenue curve. Thereafter the revenue exceeds costs. The chapter shows how to apply a what-if analysis to facilitate output volume and product mix decisions and to predict the profitability when adjusting the business model. In chapter (9), we cover the degree of operational leverage (DOL) which tells managers how much the profit or cash flow increase in response to increasing outputs and/ or revenues. The chapter (10) describes methods of performance measurement. All major performance ratios are explained and demonstrated for the case study VANHUIZEN BV. Problems of interpretations are shown in chapter (9). The next following chapters are linked to mergers and acquisitions. Mergers <?page no="24"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 2-24 occur when 2 companies are combined. An acquisition is the purchase of another company for holding. In chapter (11) we present Accounting due diligence work for company valuations in preparation for take-overs and/ or mergers. In chapter (12), we study a modern approach for risk valuation based on MonteCarloSimulation. The technical term value at risk (VaR) is introduced as well as the calculation of probabilities for companies to fail. 2.4. 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 to refer to the Accounting principles 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. We discuss the cost flow through a Management Accounting system. By the case study GIULIO'S PIZZA&PASTA RISTORANTE we explain each step in cost Accounting. The chapter (14) covers cost Accounting systems and is linked closely to the previous one. It demonstrates the difference between a full cost Accounting system and flexible budgeting. To compare the systems, we apply the same Italian restaurant case study in both chapters. We cover cost monitoring in chapter (15) and show how to calculate and read cost deviations to analyse their reasons. The chapter (16) is about cost allocations. Cost allocations is a major concept regarding Management Accounting. When departments exchange performance, cost allocations apply to refund the rendering department and charge the receiver. We cover methods for performance planning and internal cost allocations, such as the equation method and iteration. In chapter (17), we introduce reporting in Industrial Management and discuss the cost of sales report in a production firm. Manufacturing Accounting is important for Industrial Management. It was shown by the PENOR PLC case study already and is subject to the chapters (18) and (19) in more detail, which are linked to the job order costing for calculating batch costs - chapter (18), and process costing - chapter (19). In chapter (20), we study contribution margin Accounting for managing fixed costs. The chapter (21) is about activity based costing. We’ll show the differences between a traditional cost Accounting system based on cost centres and ABC by an example from aviation. 2.5. Asian Perspectives The chapters (22) to (26) show the Asian case studies prepared by our students at Universiti Malaysia Phang UMP. The upcoming chapters in this textbook are as follows: <?page no="25"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 2-25 ( 0) Introduction. ( 1) Conventions. Section (1): Management Accounting and Financial Accounting ( 2) Introduction to Management Accounting. ( 3) Case Study PENOR PLC - Financial Accounting. ( 4) Case Study PENOR PLC - Managerial Accounting. ( 5) Characteristics of Management Accounting and Major Differences to Financial Accounting. Section (2): Accounting for General Management ( 6) Cost Planning / Business Plan. ( 7) 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) Multiple-Level Contribution Margin Accounting. (21) Activity Based Costing. Section (4): Asian Perspectives (22) Business Plan - ZAMZAM Restaurant (23) CVP Analysis - POTO Travel&Tours Sdn. Bhd. (24) M&A - Hengyuan Refining Company Bhd. (25) Process Costing - MTBE Malaysia Sdn. Bhd. (26) Activity Based Costing - CAHAYA BAKERY <?page no="26"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 2-26 Section (1): Management Accounting and Financial Accounting <?page no="27"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-27 3. Case Study PENOR PLC - Financial Accounting 3.1. What is in the Chapter? In this chapter (3), we discuss a manufacturer for aluminium windows and doors in the UK. The case study starts with its Bookkeeping entries. We prepare financial statements in compliance with IFRSs. We deliberately focus on those aspects that are specific for the preparation of commercial financial statements, like changes in purchase prices, special payment terms and prepaid expenses. We also cover the disclosure of liabilities following IAS 1 and IFRS 9. By the case study PENOR PLC, we repeat Financial Accounting preparing a full set of financial statements following IAS 1.10 that comprises a statement of financial position, a statement of comprehensive income, a statement of changes in equity and a statement of cash flows. 3.2. Leaning Objectives We show how companies prepare financial statements and what information can be derived therefrom for the use in Management Accounting. In real businesses, financial statements are available and Managerial Accounting is derived from Accounting records. For understanding Management Accounting, basic knowledge about Accounting concepts is required. 1 In case you know how to prepare financial statements, skip the next pages and move to the financial statements in Figure 3.10, Figure 3.14, Figure 3.15 and Figure 3.16. After studying this chapter, you learned/ repeated Financial Accounting and you see what information can be used for controlling the business. You also achieve a good awareness of the differences between Financial Accounting and Management Accounting. As the case-study-chapters (3) and (4) are much in the details, we recommend them for self-study. We start-off from Financial Accounting. Financial Accounting is required by national law and makes a company report to its owners and to other parties its financial position, its profit and its cash flows. All traders and all limited companies must prepare a set of financial statements in compliance with IAS 1.10. 3.3. C/ S PENOR PLC We cover the story of PENOR PLC from its establishment on and observe its activities during the first Accounting period. 1 We cover three aspects about PENOR PLC in the next two chapters: (A) Inception. (B) Financial Accounting. (C) Management Accounting. <?page no="28"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-28 3.4. Inception (A) PENOR PLC is a privately-owned limited company that manufactures aluminium windows and doors in York, UK. PENOR PLC applies the IFRSs. The company is a legal entity; the responsibility of the proprietors is limited to equity, which is their contribution at the time of inception. Later, the equity also includes various reserves and retained income earned by operations. PENOR PLC chose the legal form of a limited company, therefore, no creditors can go after the owners’ personnel assets. For the incorporation of the business on 1.01.20X1, the 8 founding proprietors contribute 50,000.00 GBP each. Hence, the issued capital equals: 50,000 × 8 = 4 400,000 GBP. The funds are paid into the company’s bank account. The memorandum of incorporation (MOI) 2 -for PENOR PLC states that the owners’ equity is 400,000.00 GBP at the time of establishment. Every owner holds the same share in the company and receives an equal portion of the profit distribution. The memorandum of incorporation is prepared by the attorney who submits it at the York courthouse for registration. The Bookkeeping entry (1) is for the establishment of PENOR PLC. DR Cash/ Bank.................... 400,000.00 GBP CR Issued Capital............... 400,000.00 GBP At the time of incorporation, an opening balance sheet must be prepared for PENOR PLC to be added to the memorandum of incorporation. This falls under the establishment procedures carried out by the attorney. The balance sheet contains the company’s issued capital and shows that the proprietors paid in their contributions in full. The company discloses one asset only: cash/ bank. See below the balance sheet in Figure 3.1. 2 In the US called ‘Articles’. <?page no="29"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-29 A C, L Non-current assets [GBP] Equity [GBP] P, P, E Share capital 400,000 Intangibles Reserves Financial assets Retained earnings Current assets Liabilities Inventory Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 400,000 Tax liabilities Total assets 400,000 Total equity and liab. 400,000 Penor PLC STATEMENT of FINANCIAL POSITION as at 1.01.20X1 Figure 3.1: PENOR PLC’s statement of financial position as at 1.01.20X1 3.5. Financial Accounting (B) Next, we study the Bookkeeping record keeping at PENOR PLC. In preparation for reporting financial statements, the company is obliged to record all economic business activities in its accounts. IFRSs require keeping Bookkeeping records and the Accountants to prepare financial statements. In the UK, International Financial Reporting Standards IFRSs apply. On 2.01.20X1, PENOR PLC takes a bank loan to the extent of 200,000.00 GBP. The bank loan comes with an annual rate of interest of 3 %/ a. The interest is due at the end of every fiscal year. The interest in the first Accounting period 20X1 equals: 3% × 200,000 = 6 6,000.00 GBP/ a. The pay-off amount equals 20,000.00 GBP/ a and must be paid at the yearends, too. Additionally, the bank charges 1,500.00 GBP once-off fees for the bank loan. Those fees determine the bank loan’s valuation and its disclosure on the balance sheet as the bank loan is carried at amortised costs. The effective interest method applies. We discuss the fees further below (at the end of the Accounting period) together with the bank loan’s valuation. For now, we only acknowledge that the bank loan has not been paid out in full (nominal amount, principal) but after fee deduction by the lending bank. The Bookkeeping entries (2 … 4) are recorded on 2.01.20X1 and 31.12.20X1. DR Cash/ Bank.................... 198,500.00 GBP CR Interest Bearing Liabilities. 198,500.00 GBP DR Interest..................... 6,000.00 GBP CR Cash/ Bank.................... 6,000.00 GBP DR Interest Bearing Liabilities. 20,000.00 GBP CR Cash/ Bank.................... 20,000.00 GBP <?page no="30"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-30 The disclosure of liabilities follows IAS 1.69 which requires dividing liabilities in current and non-current liability portions: For studying the standards, you can register at www.IFRS.org and then download all IFRSs standards. As a student you should enter as industry ‘university/ academia’ and as role ‘student’ in the registration window. The IASB won’t charge you for standard downloads then. Figure 3.2: IFRSs website for standards download In accordance with IAS 1.69, the pay-off amount of 20,000.00 GBP, due on 31.12.20X2, is classified as a current liability and must be taken out of the Interest Bearing Liabilities account for transfer to short term liabilities by the following Bookkeeping entry (5) which is recorded on 31.12.20X2. DR Interest Bearing Liabilities. 20,000.00 GBP CR Short-term Liabilities....... 20,000.00 GBP The Figure 3.3 displays the accounts as far as discussed and not yet balancedoff at this stage. <?page no="31"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-31 D C D C (1) 400,000.00 (3) 6,000.00 (1) 400,000.00 (2) 198,500.00 (4) 20,000.00 D C D C (4) 20,000.00 (2) 198,500.00 (3) 6,000.00 (5) 20,000.00 D C (5) 20,000.00 Interest bearing liabilities IBL Interest-20X1 INT Short-term liabilities A/ P Cash/ Bank C/ B Issued Capital ISS Figure 3.3: PENOR PLC’s accounts For an overview of the case study, you’ll find a data sheet below. Data Sheet for PENOR PLC CClassification: Manufacturing; Issued capital: 400,000.00 GBP; Bank loan: 200,000.00 GBP; bank loan fees: 1,500.00 GBP, interest: 3 %/ a, payoff: 20,000.00 GBP; effective interest method applies; Saws’ cost of acquisition: 5 × 30,000 GBP, Useful life: 5 years; Rent for factory building: 7,500.00 GBP/ m; Material prices: see Figure 3.5 Labour: 2,000,000.00 GBP; Production: 5,000 windows; 1,000 doors; Sales: 4,678 windows; 873 doors; Net selling prices: 800.00 GBP/ window; 1,000.00 GBP/ door; VAT 20%. PENOR PLC produces windows and doors from aluminium profiles and sheets as well as from glass panes. For production, profiles and sheets are cut by saws. On 3.01.20X1, PENOR PLC buys 5 highprecision saws at 30,000.00 GBP/ u (net amount) each. The above given costs of acquisition for the saws are the net values. PENOR PLC is registered for VAT reduction and pays the gross amount which includes input-VAT and equals: 5 × 30,000 × 120% = 1 180,000.00 GBP. The price is paid instantly to the supplier. Observe the Bookkeeping entry (6), as recorded on 3.01.20X1: DR P, P, E ...................... 150,000.00 GBP DR VAT.......................... 30,000.00 GBP CR Cash/ Bank.................... 180,000.00 GBP The deployment of machinery is considered as a cost, as their value declines by use. This leads to depreciation disclosed on the financial statements. The saws have a useful life of five years. Straightline method for depreciation applies. 150,000.00 GBP is the depreciable value. Thus, the annual depreciation on saws equals: 150,000 / 5 = 3 30,000.00 GBP/ a. <?page no="32"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-32 As part of the adjustments, PENOR PLC’s Accountant records the Bookkeeping entry (7) for depreciation on the saws on the 31.12.20X1. DR Depreciation................. 30,000.00 GBP CR Acc. Depr. CNC-Saws.......... 30,000.00 GBP The Bookkeeping entry shows that an Accumulated Depreciation account has been linked to machinery. This is common procedure for Asset Management. Asset Management keeps Bookkeeping records for every single item of property, plant and equipment. The saws are installed in the factory building which is rented by PENOR PLC. The monthly rent equals 7,500.00 GBP/ m and must be paid one month in advance. During 20X1, PENOR PLC makes 13 monthly rent payments which in total equal: 13 × 7,500 = 9 97,500.00 GBP. See the simplified Bookkeeping entry (8) which considers all payments for factory rent together. Rent is not subjected to VAT because the landlord is a private person. DR Rent......................... 97,500.00 GBP CR Cash/ Bank.................... 97,500.00 GBP The last rental payment is for the January 20X2’s factory rent. To accrue the rent to the next year's expenses, the Accountant credits the Rent account and makes a debit entry in the Prepaid Expenses account. This is Bookkeeping entry (9) made on 31.12.20X1. DR Prepaid Expenses............. 7,500.00 GBP CR Rent......................... 7,500.00 GBP Observe the accounts at this stage as displayed in Figure 3.4. <?page no="33"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-33 D C D C (1) 400,000.00 (3) 6,000.00 (1) 400,000.00 (2) 198,500.00 (4) 20,000.00 (6) 180,000.00 (8) 97,500.00 D C D C (4) 20,000.00 (2) 198,500.00 (3) 6,000.00 (5) 20,000.00 Cash/ Bank C/ B Issued Capital ISS Interest bearing liabilities IBL Interest-20X1 INT D C D C (5) 20,000.00 (6) 150,000.00 D C D C (6) 30,000.00 (7) 30,000.00 Short-term liabilities A/ P Property, plant, equipment PPE Value added tax VAT [20 %] Depreciation-20X1 DPR D C D C (7) 30,000.00 (8) 97,500.00 (9) 7,500.00 D C (9) 7,500.00 Acc depr ACC Rent-20X1 RNT Prepaid expenses PRE Figure 3.4: PENOR PLC’s accounts 3.6. Purchases During the Accounting period 20X1, PENOR PLC buys materials to produce windows and doors. The materials’ net purchase prices are as listed below: - Aluminium profiles 20.00 GBP/ kg. - Hinges at 30.00 GBP/ u. - Glass panes at 100.00 GBP/ u. - Aluminium sheets first at 50.00 GBP/ u and later at 52.00 GBP/ u. - Sealing strips at 10.00 GBP/ m. - 90°-fasteners at 25.00 GBP/ u. During the Accounting period 20X1, PENOR PLC buys 30t aluminium profiles which cost: 30,000 × 20 = 6 600,000.00 GBP. The gross purchase price equals: 600,000 × 120% = 7 720,000.00 GBP. The Bookkeeping entry (10) is made in the Purchase account. We only make one Bookkeeping entry and pretend that all profiles are bought together on 4.01.20X1. <?page no="34"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-34 DR Purchase..................... 600,000.00 GBP DR VAT.......................... 120,000.00 GBP CR Cash/ Bank.................... 720,000.00 GBP PENOR PLC buys 15,000 hinges. The purchase costs (net value) equal: 15,000 × 30 = 4 450,000.00 GBP. The gross purchase price is: 450,000 × 120% = 540,000.00 GBP. PENOR PLC pays half of the due amount in 20X1 and the other half in the next Accounting period. The Bookkeeping entry (11) shows the hinges recording. DR Purchase..................... 450,000.00 GBP DR VAT.......................... 90,000.00 GBP CR Accounts Payables............ 270,000.00 GBP CR Cash/ Bank.................... 270,000.00 GBP PENOR PLC orders from its supplier 6,000 glass panes. The costs of purchase are: 6,000 × 100 = 6 600,000.00 GBP. The gross purchase price is: 600,000 × 120% = 7 720,000.00 GBP. It is recorded by Bookkeeping entry (12). PENOR PLC pays for the glass panes in the next Accounting period. DR Purchase..................... 600,000.00 GBP DR VAT.......................... 120,000.00 GBP CR Accounts Payables............ 720,000.00 GBP On 5.01.20X1, PENOR PLC orders 800 aluminium sheets at 50.00 GBP/ u. The costs of purchase are: 800 × 50 = 40,000.00 GBP. The gross purchase price is paid instantly and equals: 40,000 × 120% = 448,000.00 GBP. On 4.03.20X1, PENOR PLC orders another batch of 500 aluminium sheets at 52.00 GBP/ u. The costs of purchase now are: 500 × 52 = 26,000.00 GBP. Its gross value equals: 26,000 × 120% = 3 31,200.00 GBP. Observe Bookkeeping entry (13a) and (13b) for the purchases of aluminium sheets. DR Purchase..................... 40,000.00 GBP DR VAT.......................... 8,000.00 GBP CR Cash/ Bank.................... 48,000.00 GBP DR Purchase..................... 26,000.00 GBP DR VAT.......................... 5,200.00 GBP CR Cash/ Bank.................... 31,200.00 GBP On 5.01.20X1, PENOR PLC orders 27,000 m sealing strips at 10.00 GBP/ m from its supplier. The costs of purchase equal: 27,000 × 10 = 2 270,000.00 GBP. The gross purchase price is transferred to the supplier’s bank account: 270,000 × 120% = 324,000.00 GBP. The Bookkeeping entry (14) is displayed below. <?page no="35"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-35 DR Purchase..................... 270,000.00 GBP DR VAT.......................... 54,000.00 GBP CR Cash/ Bank.................... 324,000.00 GBP On 10.01.20X1, the supplier for the sealing strips offers PENOR PLC a 5 % discount on all its purchases from 20X1, which includes the purchase from 5.01.20X1. The discount is recorded as a deferred discount by Bookkeeping entry (15). PENOR PLC receives a voucher worth: 324,000 × 5% = 1 16,200.00 GBP. The voucher is added to the Accounts Receivables account. The discount reduces the valuation of raw materials and needs a VAT adjustment. The adjusted costs per metre of sealing strip is: 10 × (1 - 5%) = 99.50 GBP/ m. Check Bookkeeping entries (15, 16). DR Accounts Receivables......... 16,200.00 GBP CR Discount Received ............ 16,200.00 GBP DR Discount Received ............ 16,200.00 GBP CR VAT.......................... 2,700.00 GBP CR Purchase..................... 13,500.00 GBP On 5.01.20X1, PENOR PLC buys 50,000 90°-fasteners from its supplier at 25.00 GBP/ u. The costs of purchase are: 50,000 × 25 = 1 1,250,000.00 GBP. The gross purchase price equals: 1,250,000 × 120% = 1 1,500,000.00 GBP. The Accountant records Bookkeeping entry (17). DR Purchase..................... 1,250,000.00 GBP DR VAT.......................... 250,000.00 GBP CR Cash/ Bank.................... 1,500,000.00 GBP 500 of the 90°-fasteners are faulty as detected on receipt. PENOR PLC returns the 500 damaged 90°-fasteners and receives a check from the supplier. The value equals: 500 × 25 × 120% = 15,000.00 GBP. The return outward is recorded by Bookkeeping entry (18). DR Cash/ Bank.................... 15,000.00 GBP CR VAT.......................... 2,500.00 GBP CR Return Outwards.............. 12,500.00 GBP PENOR PLC buys 4,000 containers with 100 self-tapping-screws at 5.00 GBP/ u. The costs of acquisition equal: 4,000 × 5 = 2 20,000.00 GBP. The gross purchase price equals: 20,000 × 120% = 2 24,000.00 GBP. See Bookkeeping entry (19) below. DR Purchase..................... 20,000.00 GBP DR VAT.......................... 4,000.00 GBP CR Cash/ Bank.................... 24,000.00 GBP <?page no="36"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-36 See the total purchases listed in the table in Figure 3.5. purchase amount unit costs purchase costs gross amount [GBP] [GBP] [GBP] aluminium profiles 30,000 20.00 600,000.00 720,000.00 hinges 15,000 30.00 450,000.00 540,000.00 glass panes 6,000 100.00 600,000.00 720,000.00 sealing strips 27,000 9.50 256,500.00 307,800.00 90°-fasteners 50,000 25.00 1,250,000.00 1,500,000.00 alu sheets 800 50.00 40,000.00 48,000.00 alu sheets 500 52.00 26,000.00 31,200.00 self-tapping-screws 400,000 0.05 20,000.00 24,000.00 Figure 3.5: PENOR PLC’s purchases in 20X1 Observe the accounts in Figure 3.6: D C D C (1) 400,000.00 (3) 6,000.00 (1) 400,000.00 (2) 198,500.00 (4) 20,000.00 (18) 15,000.00 (6) 180,000.00 (24) 6,062,280.00 (8) 97,500.00 (10) 720,000.00 (11) 270,000.00 (12) 720,000.00 (13a) 48,000.00 (13b) 31,200.00 (14) 324,000.00 (17) 1,500,000.00 (19) 24,000.00 Cash/ Bank C/ B Issued Capital ISS D C D C (4) 20,000.00 (2) 198,500.00 (3) 6,000.00 (5) 20,000.00 Interest bearing liabilities IBL Interest-20X1 INT D C D C (5) 20,000.00 (6) 150,000.00 Short-term liabilities A/ P Property, plant, equipment PPE Figure 3.6: PENOR PLC’s accounts <?page no="37"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-37 D C D C (6) 30,000.00 (16) 2,700.00 (7) 30,000.00 (10) 120,000.00 (18) 2,500.00 (11) 90,000.00 (24) 1,010,380.00 (12) 120,000.00 (13a) 8,000.00 (13b) 5,200.00 (14) 54,000.00 (17) 250,000.00 (19) 4,000.00 Value added tax VAT [20 %] Depreciation-20X1 DPR D C D C (7) 30,000.00 (8) 97,500.00 (9) 7,500.00 D C D C (9) 7,500.00 (11) 270,000.00 Acc depr ACC Rent-20X1 RNT Prepaid expenses PRE Accounts payables A/ P D C D C (10) 600,000.00 (16) 13,500.00 (18) 12,500.00 (11) 450,000.00 (12) 600,000.00 (13a) 40,000.00 (13b) 26,000.00 (14) 270,000.00 (17) 1,250,000.00 (19) 20,000.00 Purchase-20X1 PUR Returns Outwards R.O. D C D C (16) 16,200.00 (15) 16,200.00 (15) 16,200.00 D C D C (20) 1,750,000.00 (22) 500,000.00 (20) 250,000.00 (21) 250,000.00 (21) 250,000.00 D C D C (23) 400,000.00 (20) 400,000.00 (24) 5,051,900.00 Labour-20X1 LAB Social securities/ p A/ P Payroll tax PRT Revenue-20X1 REV Discount received DIS Accounts receivables A/ R Figure 3.6: PENOR PLC’s accounts (continued) The unit costs in Figure 3.5 consider the discount on the sealing strips. Hence, <?page no="38"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-38 the unit costs for the sealing strips are 9.50 GBP/ m. In comparison to the Purchase account (no discount disclosure) the value for the sealing strips is: 270,000 - 13,500 = 2 256,500.00 GBP. 3.7. Labour During the Accounting period 20X1, PENOR PLC pays 2,000,000.00 GBP for labour. The net salary is 1,100,000.00 GBP. The gross salary equals 1,750,000.00 GBP and contains the payroll tax to the extent of 400,000.00 GBP and social securities of 250,000.00 GBP linked to the employees. At the end of the Accounting period, the Accountant records labour by Bookkeeping entries (20 ... 23). DR Labour....................... 1,750,000.00 GBP CR Social Security / p........... 250,000.00 GBP CR Payroll tax.................. 400,000.00 GBP CR Cash/ Bank.................... 1,100,000.00 GBP DR Labour....................... 250,000.00 GBP CR Social Security / p........... 250,000.00 GBP DR Social Security / p........... 500,000.00 GBP CR Cash/ Bank.................... 500,000.00 GBP DR Payroll tax.................. 400,000.00 GBP CR Cash/ Bank.................... 400,000.00 GBP So far, we recorded all initial Bookkeeping entries. 3.8. Proceeds During the Accounting period 20X1, PENOR PLC produces 5,000 windows and 1,000 doors. The company sells 4,678 windows at 800.00 GBP/ u and 873 doors at 1,500.00 GBP/ u. The remainders are added to stock of finished goods. The revenue equals: 4,678 × 800 + 873 × 1,500 = 55,051,900.00 GBP. The proceeds are: 5,051,900 × 120% = 6,062,280.00 GBP. All customers pay instantly on cash or by bank transfer. See the proceeds are recorded by Bookkeeping entry (24). DR Cash/ Bank.................... 6,062,280.00 GBP CR VAT.......................... 1,010,380.00 GBP CR Revenue...................... 5,051,900.00 GBP 3.9. Finished Goods Valuation As PENOR PLC does not sell all windows and doors a valuation of its finished goods is required. The valuation is the basis for the disclosure of finished goods on the balance sheet. The valuation is for: 5,000 - 4,678 = 3 322 windows and: 1,000 - 873 = 1 127 ddoors. Not yet sold goods are disclosed as current assets under the item finished goods inventory. The valuation of finished goods is referred to as calculation. <?page no="39"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-39 The calculation counts all direct costs and allocated manufacturing overheads which are (here) labour and depreciation. Direct costs are costs for one product only. In most production firms, direct costs are direct labour and direct materials. At PENOR PLC, no direct labour applies, hence, direct costs are the materials only. The material input amounts per product can be taken from the bill of materials. A A bill of materials is a document that shows the part-structure of a product. The material master data contain information about the unit costs of the materials. M Master data are data of an enterprise resource planning system (ERM system), that have no link to the TIME. This means the information is fixed. A 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. PENOR PLC got 2 bills of materials linked to its products, one for windows and another one for doors. Check Figure 3.7 and Figure 3.8. DIRECT MATERIALS windows unit costs / window costs aluminium profile [kg] 20.00 4 80.00 hinge [u] 30.00 2 60.00 glass pane [u] 100.00 1 100.00 sealing strip [m] 9.50 4 38.00 90°-fastener [u] 25.00 8 200.00 478.00 Figure 3.7: Direct materials for windows The units in Figure 3.7 are kg for kilogram, u for unit and m for metres. By multiplying the amount per window with its unit costs, we calculate the cost per item. E.g., the calculation of aluminium profile input is: 20 × 4 = 8 80.00 GBP. The total material costs per window equal: 80 + 60 + 100 + 40 + 200 = 4 478.00 GBP. DIRECT MATERIALS doors unit costs / door costs aluminium profile [kg] 20.00 6 120.00 hinge [u] 30.00 3 90.00 alu sheet [u] 50.00 1 50.00 alu sheet [u] 52.00 1 52.00 sealing strip [m] 9.50 6 57.00 90°-fastener [u] 25.00 8 200.00 Figure 3.8: Direct materials for doors We do not disclose the total of the material input for doors in Figure 3.8 on the bottom line because the prices for the aluminium sheets differ from order to order. <?page no="40"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-40 All unit costs are derived from the Bookkeeping records. PENOR PLC applies the first-in-first-out cost formula for inventory movements as the materials are interchangeable. T The first-infirst-out cost formula applies for inventory that cannot be distinguished and it pretends a stock release in the sequence of intakes. For the materials calculation, the screws must still be added. Although the screws are displayed on the bill of materials, the screw consumption is not recorded by piece at PENOR PLC. We only apply a periodic inventory system for the screw consumption. We take stock on 31.12.20X1 to determine the screws left. The stock taking results in a box amount of 1,000 with each box containing 100 self-tapping-screws. This means, the total screw consumption is: (400,000 - (1,000 × 100)) × 0.05 = 1 15,000.00 GBP. The material expenses for screws are allocated by piece count towards windows and doors. Here, the number of screws are the same for doors and windows. We consider the production amounts of 5,000 windows and 1,000 doors. This results in screw costs of: 15,000 / (5,000 + 1,000) = 2 2.50 GBP/ u. Per unit here refers to windows or doors. At this stage of the calculation, the unit costs per window are: - Direct materials: 478.00 GBP/ u. - Screws: 2.50 GBP/ u. The costs per door are for the first batch of 800 doors (based on the first order of aluminium sheets) manufactured: - Direct materials: 517.00 GBP/ u. - Screws: 2.50 GBP/ u. The costs per door for the next batch of 200 doors (based on the second order of aluminium sheets) manufactured are: - Direct materials: 519.00 GBP/ u. - Screws: 2.50 GBP/ u. A batch is the quantity of products produced by one job order. A batch mostly is used in Industrial Management. Next, we add labour, depreciation and rent to the product calculations: Labour is divided at a 60: 40 ratio between production workforce and administration. Hence, 1,200,000.00 GBP is for labour in the manufacturing department. 2/ 3 of the manufacturing labour costs is for window production: 1,200,000 × 2/ 3 = 8 800,000.00 GBP. The remainder of: 1,200,000 - 800,000 = 400,000.00 GBP is for door manufacturing. The labour costs per window are: 800,000 / 5,000 = 1 160.00 GBP/ u. The labour costs per door are: 400,000 / 1,000 = 4400.00 GBP/ u. Depreciation on the manufacturing facilities (saws) is divided based on the numbers of production. As a result, in 20X1, depreciation assigned to all windows equals: 30,000 × 5,000 / (1,000 + 5,000) = 2 25,000.00 GBP. Depreciation per window is: 25,000 / 5,000 = 5 5.00 GBP/ u. Depreciation allocated to one door is: (30,000 - 25,000) / 1,000 = 5 5.00 GBP/ u. Rent is for the factory building. It is allocated to goods based on piece count. Hence, the rent to be allocated to one window/ door equals: 90,000 / 6,000 = 15.00 GBP/ u. Now, the calculation of the finished goods can be completed: <?page no="41"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-41 The unit costs per window are: - Direct materials: 478.00 GBP/ u. - Screws: 2.50 GBP/ u. - Labour: 160.00 GBP/ u. - Depreciation: 5.00 GBP/ u. - Partial rent: 15.00 GBP/ u. A window’s unit costs of manufacturing are: 478 + 2.50 + 160 + 5 + 15 = 6 660.50 GBP/ u. Per door the following unit costs occur: - Direct materials: 517.00 GBP/ u for the first 800 doors manufactured and for the next 200 units 519.00 GBP/ u. - Screws: 2.50 GBP/ u. - Labour: 400.00 GBP/ u. - Depreciation: 5.00 GBP/ u. - Partial rent: 15.00 GBP/ u. A door’s unit costs of manufacturing for the first batch of 800 doors are: 517 + 2.5 + 400 + 5 + 15 = 9 939.50 GBP/ u. A door’s unit costs of manufacturing for the next batch of 200 doors are: 519 + 2.5 + 400 + 5 +15 = 9 941.50 GBP/ u. 3.10. Profit Calculation The profit calculation at PENOR PLC follows the Trading account. Therefore, we consider only opening values and closing stock for the materials and finished goods. A A Trading account calculates the gross profit by deducting opening values for inventory and purchases from revenue and closing stock, adjusted for returns. The closing stock of aluminium profiles 3 is: (30,000 - (5,000 × 4) - (1,000 × 6)) × 20 = 8 80,000.00 GBP. The closing stock of hinges 4 is: (15,000 - (5,000 × 2) - (1,000 × 3)) × 30 = 6 60,000.00 GBP. The closing stock of glass panes 5 is: (6,000 - 5,000) × 100 = 1100,000.00 GBP. The closing stock of sealing strips 6 is: (27,000 - (5,000 × 4) - (1,000 × 6)) × 10 × (1 - 5%) = 99,500.00 GBP. The closing stock of 90°fasteners 7 requires an adjustment for the return of 500 units to the supplier. It is: (50,000 - 500 - ((5,000 + 1,000) × 8)) × 25 = 337,500.00 GBP. The closing stock of aluminium sheets 8 contains the ones bought at 52.00 GBP/ u only due to the FIFO application and equals: (1,300 - 1,000) × 52 = 1 15,600.00 GBP. The value of the remaining screws 9 has been calculated to be 15,000.00 GBP already. The closing stock of finished goods inventory 10 equals: 322 × 660.50 + 127 × 941.50 = 3 332,251.50 GBP. The valuation of the remaining doors is based on the first-in-first-out cost formula. According to the formula, all doors left contain the higher priced aluminium sheets which leads to unit costs of 941.50 GBP/ u. 3.11. Accounts Observe the accounts for details. The profit calculation therein is based on the nature of expense format. We will study in chapter (4) a better method for product and profit calculation. As the Bookkeeping entries are almost completed, accounts got balanced-off in Figure 3.9. 3 Abbreviated by alu. 4 Abbreviated by hin. 5 Abbreviated by pan. 6 Abbreviated by str. 7 Abbreviated by fst. 8 Abbreviated by sht. 9 Abbreviated by scr. 10 Abbreviated by FG <?page no="42"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-42 D C D C (1) 400,000.00 (3b) 6,000.00 c/ d 400,000.00 (1) 400,000.00 (2) 198,500.00 (4) 20,000.00 b/ d 400,000.00 (18) 15,000.00 (6) 180,000.00 (24) 6,062,280.00 (8) 97,500.00 (10) 720,000.00 (11) 270,000.00 (13a) 48,000.00 (13b) 31,200.00 (14) 324,000.00 (17) 1,500,000.00 (19) 24,000.00 (20) 1,100,000.00 (22) 500,000.00 (23) 400,000.00 c/ d 1,455,080.00 6,675,780.00 6,675,780.00 b/ d 1,455,080.00 Cash/ Bank C/ B Issued Capital ISS D C D C (4) 20,000.00 (2) 198,500.00 (3a) 6,260.61 c/ d 6,260.61 (5) 20,000.00 (3a) 6,260.61 b/ d 6,260.61 P&L 6,260.61 (3b) 6,000.00 c/ d 158,760.61 204,760.61 204,760.61 b/ d 158,760.61 Interest bearing liabilities IBL Interest-20X1 INT D C D C c/ d 20,000.00 (5) 20,000.00 (6) 150,000.00 c/ d 150,000.00 b/ d 20,000.00 b/ d 150,000.00 Short-term liabilities A/ P Property, plant, equipment PPE D C D C (6) 30,000.00 (16) 2,700.00 (7) 30,000.00 c/ d 30,000.00 (10) 120,000.00 (18) 2,500.00 b/ d 30,000.00 (11) 90,000.00 (24) 1,010,380.00 (12) 120,000.00 (13a) 8,000.00 (13b) 5,200.00 (14) 54,000.00 (17) 250,000.00 (19) 4,000.00 c/ d 334,380.00 1,015,580.00 1,015,580.00 b/ d 334,380.00 Value added tax VAT [20 %] Depreciation-20X1 DPR Figure 3.9: Accounts <?page no="43"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-43 D C D C c/ d 30,000.00 (7) 30,000.00 (8) 97,500.00 (9) 7,500.00 b/ d 30,000.00 c/ d 90,000.00 97,500.00 97,500.00 b/ d 90,000.00 P&L 90,000.00 Acc depr ACC Rent-20X1 RNT D C D C (9) 7,500.00 c/ d 7,500.00 c/ d 990,000.00 (11) 270,000.00 b/ d 7,500.00 (12) 720,000.00 990,000.00 990,000.00 b/ d 990,000.00 c/ d 1,190,000.00 (25) 200,000.00 1,190,000.00 1,190,000.00 b/ d 1,190,000.00 Prepaid expenses PRE Accounts payables A/ P D C D C (10) 600,000.00 (16) 13,500.00 T/ A 12,500.00 (18) 12,500.00 (11) 450,000.00 (12) 600,000.00 (13a) 40,000.00 (13b) 26,000.00 (14) 270,000.00 (17) 1,250,000.00 (19) 20,000.00 c/ d 3,242,500.00 3,256,000.00 3,256,000.00 b/ d 3,242,500.00 T/ A 3,242,500.00 Purchase-20X1 PUR Returns Outwards R.O. D C D C (16) 16,200.00 (15) 16,200.00 (15) 16,200.00 c/ d 16,200.00 b/ d 16,200.00 D C D C (20) 1,750,000.00 (22) 500,000.00 (20) 250,000.00 (21) 250,000.00 c/ d 2,000,000.00 (21) 250,000.00 2,000,000.00 2,000,000.00 500,000.00 500,000.00 b/ d 2,000,000.00 P&L 2,000,000.00 Labour-20X1 LAB Social securities/ p A/ P Discount received DIS Accounts receivables A/ R D C D C (23) 400,000.00 (20) 400,000.00 T/ A 5,051,900.00 (24) 5,051,900.00 Payroll tax PRT Revenue-20X1 REV Figure 3.9: Accounts (continued) <?page no="44"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-44 D C D C T/ A 80,000.00 c/ d 80,000.00 T/ A 60,000.00 c/ d 60,000.00 b/ d 80,000.00 b/ d 60,000.00 RM aluminum profiles (alu) RM hinges (hin) D C D C T/ A 100,000.00 c/ d 100,000.00 T/ A 9,500.00 c/ d 9,500.00 b/ d 100,000.00 b/ d 9,500.00 D C D C T/ A 37,500.00 c/ d 37,500.00 T/ A 15,600.00 c/ d 15,600.00 b/ d 37,500.00 b/ d 15,600.00 RM panes (pan) RM sealing strips (str) RM 90°-fasteners (fst) RM aluminum sheets (sht) D C D C T/ A 5,000.00 c/ d 5,000.00 T/ A 322,251.50 c/ d 332,251.50 b/ d 5,000.00 b/ d 332,251.50 D C D C PUR 3,242,500.00 REV 5,051,900.00 LAB 2,000,000.00 T/ A 2,461,751.50 alu 80,000.00 RNT 90,000.00 hin 60,000.00 DPR 30,000.00 pan 100,000.00 INT 6,260.61 str 9,500.00 EBT 335,490.89 fst 37,500.00 2,461,751.50 2,461,751.50 sht 15,600.00 ITL 100,647.27 b/ d 335,490.89 scr 5,000.00 R/ E 234,843.62 FGI 332,251.50 335,490.89 335,490.89 GP 2,461,751.50 R.O. 12,500.00 5,704,251.50 5,704,251.50 P&L 2,461,751.50 b/ d 2,461,751.50 Trading account-20X1 T/ A Profit and Loss-20X1 P&L RM self-tapping-screws (scr) Finished goods inventory (FGI) D C D C c/ d 234,843.62 P&L 234,843.62 c/ d 100,647.27 P&L 100,647.27 (25) 200,000.00 b/ d 234,843.62 b/ d 100,647.27 (26) 34,843.62 c/ d 234,843.62 234,843.62 D C c/ d 34,843.62 (26) 34,843.62 b/ d 34,843.62 Retained earnings R/ E Income tax liabilities ITL Earnings reserves RES Figure 3.9: Accounts (continued) <?page no="45"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-45 3.12. Statement of Profit or Loss From the profit calculation, we derive the income statement directly. See Figure 3.10: [GBP] Revenue 5,051,900 Changes in FG inventory 332,252 5,384,152 Materials (2,922,400) Labour (2,000,000) Depreciation (30,000) Other expenses (90,000) Earnings before int. & taxes (EBIT) 341,752 Interest (6,261) Earnings before taxes (EBT) 335,491 Income tax expenses (100,647) Deferred taxes Earnings after taxes (EAT) 234,844 Penor PLC STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X1 Figure 3.10: PENOR PLC’s income statement For the appropriation of profits, PENOR PLC declares a dividend to the proprietors of 25,000.00 GBP each. The remainder is added to the Earnings Reserves account. The Bookkeeping entry (25) records the appropriation of profits. PENOR PLC has 8 owners. DR Retained Earnings............ 200,000.00 GBP CR Accounts Payables ........... 200,000.00 GBP DR Retained Earnings............ 34,843.62 GBP CR Earnings Reserves............ 34,843.62 GBP 3.13. Loan Disclosure Next, we prepare the balance sheet. In compliance with IFRSs regulations, PENOR PLC must disclose long-term liabilities based on the effective interest method. In preparation for its liability valuation, PENOR PLC prepares an interest and pay-off schedule as in Figure 3.11: You see therein for every year the amount of interest and the pay-offs. The interest is calculated by multiplying the rate of interest with the amount owing <?page no="46"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-46 at the beginning of the Accounting period. Annual interest is paid at the end of the Accounting periods. E.g., the interest for 20X2 is: 180,000 × 3% = 5 5,400.00 GBP. The pay-off is constantly 20,000.00 GBP/ a following the bank loan agreement. 0.03 rate of interest Year Opening amount Interest Pay-off Rest [GBP] [GBP] [GBP] [GBP] 20X1 200,000 6,000 20,000 180,000 20X2 180,000 5,400 20,000 160,000 20X3 160,000 4,800 20,000 140,000 20X4 140,000 4,200 20,000 120,000 20X5 120,000 3,600 20,000 100,000 20X6 100,000 3,000 20,000 80,000 20X7 80,000 2,400 20,000 60,000 20X8 60,000 1,800 20,000 40,000 20X9 40,000 1,200 20,000 20,000 20Y0 20,000 600 20,000 0 Penor PLC - INTEREST and PAY-OFF PLAN Figure 3.11: PENOR PLC’s bank loan calculation Interest is an annual cost. In contrast, pay-off payments are settlements of liabilities and are not considered as costs. The sum of all pay-off payments gives nominal value of the bank loan (principal): 10 × 20,000 = 2 200,000.00 GBP. In the case of PENOR PLC’s bank loan, the bank loan is paid-off in 10 steps. The first payment does not count for the first balance sheet because it was paid on 31.12.20X1 already. The second payment is classified as a short-term liability and recorded under payables. The next following pay-off payments are shown in the bank loan’s account and require a fair value presentation following IFRS 9. As bank loans are unlikely retired before maturity, the effective interest method applies. Following the effective interest method, an internal rate of return is calculated and applies for the loan’s disclosure (only long-term liabilities). At PENOR PLC, the deduction of the bank loan fees gives us some extra work in Financial Accounting: To simplify the bank loan’s calculation, we prepare a payment vector. It is: L(t) = {198,500; -26,000; -25,400; - 24,800; -24,200; -23,600; -23,000; - 22,400; -21,800; -21,200; -20,600}. For the sake of simplification, we place the first payment into the previous Accounting period, which means the payment of the loan to PENOR PLC is considered as received on 31.12.20X0 already, not on 2.01.20X1. The internal rate of return of PENOR PLC’s bank loan is 3.15 3959 % (Use Excel for calculation! ). The bank fees for the loan are 1,500.00 GBP, which is a onceoff payment in 20X0 (more precise: 2.01.20X1). To demonstrate the valuation of the bank loan, we prepare a financial schedule as in Figure 3.12. Note that the columns for 20X4 - 20X8 are omitted in the exhibit due to book layout. <?page no="47"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-47 In the 1 st line, the bank loan vector is disclosed. The effective rate of interest is its internal rate of return. For better understanding we assume that the bank loan’s free funds are invested and earn exactly the effective interest. This gives us the absolute interest earned, e.g., in period 20X1: 204,760.61 - 198,500 = 66,260.61 GBP. The amount is higher as the interest paid as it considers the lower pay-out of the bank loan’s principal, 198,500.00 GBP instead of 200,000.00 GBP. The bank loan’s fees are considered as an addition to the rate of interest and are distributed over the time to maturity. Therefore, the effective interest is considered in the profit and loss calculation but not in the cash flow statement. 0.03153959 20X0 20X1 20X2 20X3 […] […] 20X9 20Y0 L(t) 198,500 (26,000) (25,400) (24,800) (21,200) (20,600) cash/ bank (198,500) 204,761 cash/ bank (178,761) 184,399 cash/ bank (158,999) 164,013 cash/ bank (139,213) cash/ bank cash/ bank cash/ bank cash/ bank cash/ bank 41,170 cash/ bank (19,970) 20,600 total - - - - - (0) Penor PLC FINANCIAL SCHEDULE for the BANK LOAN 20X0-20Y0 Figure 3.12: PENOR PLC’s bank loan’s financial schedule The disclosure of the bank loan’s values is shown in Figure 3.13. opening amt eff interest int+pay-off closing amt 20X1 198,500 6,261 (26,000) 178,761 20X2 178,761 5,638 (25,400) 158,999 20X3 158,999 5,015 (24,800) 139,213 20X4 139,213 4,391 (24,200) 119,404 20X5 119,404 3,766 (23,600) 99,570 20X6 99,570 3,140 (23,000) 79,710 20X7 79,710 2,514 (22,400) 59,825 20X8 59,825 1,887 (21,800) 39,911 20X9 39,911 1,259 (21,200) 19,970 20Y0 19,970 630 (20,600) (0) Penor PLC BANK LOAN DISCLOSURE (based on Effective Interest Rates) 20X0 - 20Y0 Figure 3.13: Disclosure of PENOR PLC’s bank loan <?page no="48"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-48 3.14. Statement of Financial Position After recording the Bookkeeping entries above and the loan valuation following IFRSs, the balance sheet can be prepared. All values are disclosed on a fair value presentation. The balance sheet is displayed in Figure 3.14. Note, the disclosure of values is to the nearest Pound Sterling. A C, L Non-current assets [GBP] Equity [GBP] P, P, E 120,000 Share capital 400,000 Intangibles Reserves 34,844 Financial assets Retained earnings Current assets Liabilities Inventory 639,852 Interest bear liab 158,761 Accounts receivables 16,200 Accounts payables 1,544,380 Prepaid expenses 7,500 Provisions Cash/ Bank 1,455,080 Tax liabilities 100,647 Total assets 2,238,632 Total equity and liab. 2,238,632 PENOR PLC STATEMENT of FINANCIAL POSITION as at 31.12.20X1 Figure 3.14: PENOR PLC’s balance sheet The bank loan is disclosed on the balance sheet at a valuation as at 31.12.20X1 less 20,000.00 GBP for payoff in the next Accounting period: 178,760.61 - 20,000 = 1 158,760.61 GBP. 3.15. Statement of Cash Flows For financing the business, information about cash flows during the Accounting period is relevant. IAS 7.10 requires a business to present its cash flows classified in operating, investing and financing activities. The statement of cash flows for PENOR PLC is prepared following the direct method which means it is derived from the Cash/ Bank account. See the statement of cash flows in Figure 3.15: <?page no="49"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-49 Cash flow from operating acitivities [GBP] [GBP] Proceeds 6,062,280 Purchase (2,917,200) Refund for returns 15,000 Rent payment (97,500) Net salary payment (1,100,000) Payroll tax (400,000) Social securities payment (500,000) ... 1,062,580 Cash flow from investing activities Investments (180,000) … (180,000) Cash flow from financing activities Share issue 400,000 Bank loan received 198,500 Interest (6,000) Pay-off (20,000) … 572,500 Total cash flow 1,455,080 PENOR PLC STATEMENT of CASH FLOWS for the period ended 31.12.20X1 Figure 3.15: PENOR PLC’s statement of cash flows Check the payment for interest. The interest on the income statement is different due to the effective interest method, see above. 6,000.00 GBP in interest have been paid by PENOR PLC on 31.12.20X1. 3.16. Statement of Changes in Equity As part of a full set of financial statements, PENOR PLC prepares a statement of changes in equity too. It shows how the book value of the company changes based on the last Accounting period’s activities. The book value of the company is its equity. It represents the company’s value under the assumption of a liquidation at fair values. As all values are taken from the Bookkeeping records, the valuation is referred to as ‘book value’. The statement of changes in equity discloses the opening equity value and any changes thereto. PENOR PLC’s equity changes during 20X1 because of the profit added to retained earnings and additions to reserves due to the appropriation of profits. See the statement of changes in equity in Figure 3.16: <?page no="50"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-50 Share capital Reserves Retained earnings total [GBP] [GBP] [GBP] [GBP] as at 1.01.20X1 400,000 400,000 Profit 20X1 234,844 234,844 Dividend 20X1 (200,000) (200,000) Additions to reserves 34,844 (34,844) 0 as at 31.12.20X1 400,000 34,844 0 434,844 PENOR PLC STATEMENT of CHANGES in EQUITY as at 31.12.20X1 Figure 3.16: PENOR PLC’s statement of changes in equity With notes omitted for the sake of textbook space, PENOR PLC provides a full set of financial statements. The way how to prepare financial statements, the recognition and valuation of items is subject to IFRSs regulations. Not all information disclosed by the financial statements is required for controlling a company. Some items that look difficult are not relevant for Management Accounting. 3.17. Summary The case study PENOR PLC is about a British 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; you find notes covered in chapter (6) of our textbook Financial Statements. 3.18. Working Definitions Batch: A batch is the quantity of products produced by one internal job order. Bill of Materials: A bill of materials is a document that shows the part-structure of a product. 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 stock release in the sequence of intakes. Master Data: Master data are data of an enterprise resource planning system (ERM system), that have no link to the TIME data object. 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="51"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 3-51 3.19. Question Bank (1) A company buys 50 hinges (materials) at 100.00 EUR/ u, then 70 hinges at 110.00 EUR/ u. During the Accounting period, 85 hinges are used for production. Weighted average method applies for inventory valuation. How much is the closing stock? (Round figures to the nearest EUR.) 1. 3,500 EUR . 2. 3,675 EUR . 3. 3,704 EUR . 4. 3,860 EUR . (2) A company pays rent 2 months in advance. The rent is 1,200.00 EUR/ m. Accordingly, 2,400.00 EUR are added to the Rent account from prepaid expenses. From 1.07.20XX onwards, rent increases to 1,400.00 EUR/ m. How much is the balancing figure in the Rent account before adjustments? 1. 2,800.00 EUR . 2. 16,800.00 EUR . 3. 15,600.00 EUR . 4. 18,400.00 EUR . (3) On 1.01.20X2, a company takes a bank loan which is an annuity. The principal is 100,000.00 EUR and the rate of interest is 2.5 %/ a. The annuity agreed on is amounting to 5,000.00 EUR. How much is interest to be paid on 31.12.20X4 rounded to the nearest EUR? 1. 2,500 EUR . 2. 2,373 EUR . 3. 2,737 EUR . 4. 5,000 EUR . (4) A company earns 100,000.00 EUR before taxes and carries forward a loss to the extent of 50,000.00 EUR. Half of the distributable amount is paid to the shareholders. How much would that be? 1. 50,000.00 EUR . 2. 25,000.00 EUR . 3. 20,000.00 EUR . 4. 10,000.00 EUR . (5) A bill of materials is… 1. … a price list of materials. 2. … a document that shows the production steps to manufacture a product. 3. … a document which shows how many parts of which kind belong to a product. 4. … an invoice for purchased parts of a product. 3.20. Solutions 1-3; 2-4; 3-2; 4-4; 5-3. <?page no="52"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-52 4. Case Study PENOR PLC - Managerial Accounting 4.1. What is in the Chapter? In contrast to the previous chapter, we discuss the case PENOR PLC now from the point of view of Managerial Accounting. The chapter (4) shows what aspects of Financial Accounting can be neglected for business control and where new aspects become relevant. We also demonstrate that a company cannot be controlled by its financial statements only as detailed data for departments and for single periods shorter than a year are necessary. We give an overview of Management Accounting and explain budgeting, Cost Monitoring and calculation of products and profit. As the case of PENOR PLC is linked to Industrial Management, our calculations follow Manufacturing Accounting. We also introduce Reporting and show a statement of cost of goods manufactured and cost of goods sold, and we prepare a business plan for PENOR PLC. 4.2. Learning Objectives In this chapter, you will achieve an overview of Management Accounting. The chapter helps you to develop a full understanding of Management Accounting based on the case study PENOR PLC. After reading this chapter, you understand the principles of Management Accounting and have seen how to apply them for the case of PENOR PLC. We introduce major technical terms and concepts. This chapter helps you to get well-prepared through the rest of the textbook. 11 We avoid the term Controlling. Management Accounting is Accounting for managers. In contrast to Financial Accounting, it meets the information needs of managers who control of the business. In Germany, the expression Controlling is widely used as technical term for Management Accounting. Unfortunately, the word sounds like the German word ‘kontrollieren’, which emphasis monitoring aspects of Management Accounting too much. 11 Besides of the German technical term we refer here to Management Accounting or Managerial Accounting. Both terms mean the same and are used interchangeable. We continue to study the company PENOR PLC as introduced in the previous chapter (3). The case study PENOR PLC is used for basic aspects of Management Accounting. A detailed discussion follows. We continue the case study by step (C) based on the sequence announced in chapter (3). 12 4.3. Management Accounting (C) Financial Accounting and Managerial Accounting are similar regarding recording and calculations - even applied formulas and Bookkeeping entries look alike, but both Accounting concepts follow different purposes. Managerial Accounting provides information about profitability to help managers to control the business. For that reason, Management Accounting is more detailed in terms of organisational units and periods. Financial Ac- 12 (A) is inception, (B) is Financial Accounting; compare to chapter (3). <?page no="53"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-53 counting reports to owners and creditors based on legal requirements every year and focusses on the entire business (firm, company, entity). The question you might ask yourself is: ‘Can we not just control a business by financial statements only? ’. The answer surprisingly is: Yes, but only if the company is small and the owner maintains a good overview to make her/ his management decisions. To proof the point, we discuss an easy example: Assume a company is divided into 2 departments and allows its managers a budget of 500.00 EUR/ m. The budget is the maximum of the monthly expenses and is based on a performance analysis. The rule for the managers in charge of each department is: Do not spend more and once you exceed your budget you must request approval from the financial director 13 . On the financial statements the company reports annually all expenses for both departments, say 11,576.31 EUR during the last Accounting period. In contrast, Management Accounting budgets 2 × 500.00 EUR/ m and compares those budgets to the actual costs. If one manager spent 3,500.00 EUR in March, the financial statements would not show. Only at the end of the year the total expenses are reported. In contrast, a Management Accounting system rings all Accounting alarm bells after March, most probably on 10.04.20XX, which would be the reporting day. For the control of the business, we need detailed and monthly information about budgeted and actual costs which is more useful than just an item on the annual income statement 13 We call that person chief financial officer CFO. of, e.g., 11,576.31 EUR. With no Management Accounting system in operation, someone must watch every activity in the company, which might only work for a very small and owner controlled enterprise. Managerial Accounting "programs the managers" and checks threshold values not to be exceed on a monthly basis. 4.4. Control Information from Financial Statements Financial statements are a good and by the Auditing process proven source of information about the business. Below, we list a few Management conclusions derived from commercial financial statements. We refer to PENOR PLC. You find its financial statements in the previous chapter for reference. (1) We know the book value of the business from the balance sheet and how it changed as indicated by the statement of changes in equity. The book value of PENOR PLC was 400,000.00 GBP, now it is 498,027.39 GBP. This is an increase of: (498,027.39 - 400,000) / 400,000 - 1 = 224.51 %. 14 (2) We know the profit of the period before taxation from the income statement. At PENOR PLC, it is 234,843.62 GBP after taxes. It tells us how profitable the company PENOR PLC is. (3) We know the asset situation of PENOR PLC from the balance sheet. The company has 120,000.00 GBP in longterm assets and 1,410,131.50 GBP in short-term assets, most of the latter one 14 As per convention, whenever we calculate percentages of changes the initial amount is in the denominator. <?page no="54"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-54 is inventory of finished goods and materials. The asset structure is important to deal with a crisis. Inventories can be reduced by a decline or stop of purchases and by slowing down production. In contrast, non-current assets, such as machinery, are more difficult to adjust in an over-capacity situation. 15 (4) We know the capital structure of PENOR PLC. The company got 434,843.62 GBP in equity and debts to the extent of 1,803,787.88 GBP. This gives a debt-to-equity ratio of: 1,803,787.88 / 434,843.62 = 4 4.15. However, long-term capital, like issued capital and bank loans, covers all its non-current assets. (5) We know from reading the cash flow statement, the company increased cash. PENOR PLC generated cash to the extent of 1,455,080.00 GBP. 1,062,580.00 GBP thereof result from operations and are likely to repeat in the next Accounting period if the business model is continued. In contrast, the investments (saws) only come back in 20X6, when replacements take place. The above statements (1) … (5) can be derived from the financial statements and are available to investors, owners and all other parties interested in the business. 4.5. Profit and Business Operations For running a business, we must understand how the business operations work and how the company earns profit and cash flows. Managers need detailed information; and they must 15 We get back to that discussion in chapter (9). know them as early as possible to react to changes (different to plan). 4.6. Shareholders’ Perspective Next, we check the benefits a shareholder expects form her/ his ownership of company shares and how to measure it. The owners (all together) put management in charge to achieve their financial objectives. Management Accounting supports managers to fulfil their investors’ requirements. To control a business to the benefit of its owners purely follows economic goals. Companies are in pursuit of returns and business value. A return is a ratio that calculates profit as percentage of investments - as input divided by output. The investors’ benefit is the dividend which reflects a profit portion. The value of a share is the money others are prepared to pay for it. Companies must strive to maximise dividends and the fair market values of the business shares, in particular when they are listed publicly. Commonly, a company’s value is high when it is profitable, when it declares high dividends and the shares are in high demand. Profitable investments increase demand and, thus, a company’s market value. Profitability means high performance measured by net operating profits. A net operating profit is the profit before taxation that results from normal operations which are continued. 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). <?page no="55"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-55 In contrast to the dividend yield, EPS tells us the highest dividend per share possible (if the company declares the maximum dividend without contribution of reserves and profit carried forward). In contrast, the dividend yield indicates how much dividend per investment has actually been paid. The latter one may contain dissolved reserves and portions of profits carried forward from prior Accounting periods. In case of PENOR PLC, the earnings per share are based on a 1.00 GBPinvestment, meaning one share’s nominal value is 1.00 GBP/ s. The total earnings in 20X1 equal 235,026.05 GBP which is the profit after income taxes. Hence, the earnings per share are: 234,843.62 / 400,000 = 5 58.71%. Its dividend yield is based on actually paid dividends and is amounting to: 200,000 / 400,000 = 5 50.00 %. Management Accounting must advice managers how to maximise the pre-tax profit. 16 For profit maximisation some basic rules apply: - Produce goods at low costs and sell them on the market at high prices. - Use assets wisely, make sure the assets operate at high capacity loads! Make good investment decisions. - Plan the company’s business operations and their costs precisely and at lowest costs possible. - Avoid costly deviations from plans, like rework expenses, delays and penalties thereof, waste and spoilage. 16 We leave tax calculations to the tax professionals. It is not covered in this textbook. 17 We do not answer questions for strategic controlling here. 4.7. Five Management Accounting Questions Based on the above considerations, we formulate basic questions for Management Accountants who support operational 17 management to answer: - Question 1: What does the product/ service cost (unit cost of manufacturing)? - Question 2: Is the business profitable? - Question 3: How much are future costs of operations (production/ service rendering) and costs for administration? - Question 4: Does/ will the company generate cash (flow)? - Question 5: Are there any substantial deviations from the budget and if so: for what reason? We keep these questions in mind as the major information requirements for Management Accounting. 4.8. C/ S PENOR PLC - Management Accounting Next, we study PENOR PLC again. We run a kind of parallel Accounting 18 , but there are two differences: (C1) We simplify aspects relevant for Financial Accounting in compliance with IFRSs but are of no or minor interest for business control - (Financial) Accounting cuts. (C2) We describe Management Accounting which additionally considers cost allocations. Therefore, we follow 18 In a real business, Financial Accounting and Management Accounting access the same data base. The idea of a redundant Accounting is helpful only for teaching purposes. <?page no="56"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-56 the cost flow through cost centres towards the products, calculate unit costs and profits. We answer the five Management Accounting questions once we obtain the answers thereto. For that approach we need to enhance the Accounting done so far in chapter (3) - allocation-add-ons for Management Accounting. 4.9. Accounting Cuts (C1) Accounting cuts means a simplification of Accounting Data. This is linked to aspects required by IFRSs but of no management relevance for operational management at PENOR PLC. These are: EEquity: The recording of the contribution to capital by the owners is about Finance. It is not covered by Management Accounting. The same applies for additions to reserves as result of the appropriation of profits. 19 Bank loan recognition: in compliance with IFRSs, bank loans are disclosed at amortised costs (effective interest method). This supports a true and fair view on the bank loan’s value. Business control and decision making are shortterm and in general do not advice financing of the business. In case of financial aspects becoming relevant, the Management Accountant applies dynamic methods of Finance and Investment Appraisal, like present value concept. PENOR PLC’s bank loan is displayed for Management Accounting purpose in Figure 4.1. Note, that this valuation is much simpler than for Financial Accounting in chapter (3). No effective interest calculation takes place as for Management Accounting we disclose loans at settlement values. This means, loans are shown as cash is paid or received. 0.03 rate of i nteres t Year Opening amount Interest Pay-off Rest [GBP] [GBP] [GBP] [GBP] 20X1 200,000 6,000 20,000 180,000 20X2 180,000 5,400 20,000 160,000 20X3 160,000 4,800 20,000 140,000 20X4 140,000 4,200 20,000 120,000 20X5 120,000 3,600 20,000 100,000 20X6 100,000 3,000 20,000 80,000 20X7 80,000 2,400 20,000 60,000 20X8 60,000 1,800 20,000 40,000 20X9 40,000 1,200 20,000 20,000 20Y0 20,000 600 20,000 0 Penor PLC INTEREST and PAY-OFF PLAN Figure 4.1: PENOR PLC’s bank loan 19 Finance is part of Management Accounting. It is taught as a separate subject and not covered by this textbook. <?page no="57"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-57 In terms of Management Accounting, the long-term data about the future payments do not matter. E.g., for the next year’s planning, only the interest of 5,400.00 GBP is relevant which gives a monthly interest of: 5,400 / 12 = 4 450.00 GBP/ m. About the capital structure, the figure of 180,000.00 GBP represents the actual liability of PENOR PLC at its settlement value. It does not matter how much thereof is disclosed as short-term or as long-term debts on the balance sheet. In Management Accounting the major focus is on costs. Therefore, the income statement is relevant. Items on the balance sheet only matter when preparing a budgeted balance sheet. A cost is a reduction of resources by operations intended by the company. E.g., a company that pays for materials but does not use them does not record a cost but a payment. Only when materials are consumed costs apply. Therefore, for Management Accounting the major focus lays on profit or loss. In contrast to financial statements that deal with expenses, a cost is linked to the purpose of the business which in the case of PENOR PLC is the production of doors and windows. Following our conventions, we pretend all costs are expenses and vice versa. Interest: interest equals 5,400.00 GBP/ a at PENOR PLC for the next Accounting period 20X2. It is a cost as money is paid to the bank as compensation for lending the company money. The bank loan is linked to the business operations of PENOR PLC because it finances production. The effective interest rate does not matter. Management Accountants focus on the paid and scheduled interest. Prepaid Expenses Recognition: The time of payments does not matter for returns. Those payments made in prior periods only count once they become costs. Hence, prepaid expenses are ignored in Management Accounting - except from Liquidity Planning. The accrual principle is a fundamental concept in Accounting theory to assign costs to the period they belong to. This allows a meaningful profit calculation. The allocation to a period is based on the time of consumption no matter when a payment is made. We call this the accrual basis of Accounting. Hence, PENOR PLC’s rent is considered for the months January to December which gives a total annual rent of: 12 × 7,500 = 9 90,000.00 GBP/ a. This is the same rent as disclosed on the income statement following IFRSs. We ignore prepaid expenses in Management Accounting. Volatile Prices for Purchases and Discount Considerations: Financial Accounting requires a calculation based on actual purchase prices. The reason is that financial statements disclose values derived from actual payments to provide outsiders, such as shareholders and investors, with a correct view on the financial situation of the business. Proven means, the valuation is taken from receipts and can be checked by auditors. For IFRSs, the discount received on the sealing strips is relevant and is recorded in the Discount Received account. Also, the different prices for the aluminium sheets are recorded at 50.00 GBP/ u and <?page no="58"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-58 52.00 GBP/ u as paid. The return of the 90°-fasteners is relevant for inventory valuation, too. In contrast, for the purpose of Management Accounting, none of those purchase details matters. Therefore, we skip a few Bookkeeping entries made in chapter (3) and record simplified purchase Bookkeeping entries at average costs, see below: - Aluminium profiles at 600,000.00 GBP. - Hinges at 450,000.00 GBP. - Glass panes at 600,000.00 GBP. - Aluminium sheets at an average unit cost of 50.77 GBP/ u which gives 50.77 × 1,300 = 6 66,001.00 GBP. - Sealing strips at 270,000 × (1 - 5%) = 256,500.00 GBP. - 90°-fasteners at: (50,000 - 500) × 25 = 1,237,500.00 GBP. - Self-tapping-screws at 20,000.00 GBP. Payment Terms: For purchases or revenues, the payment method is irrelevant. For profitability, payments do not matter. Labour Costs without Taxes and Social Security Contribution Details: Regarding labour, only the total labour costs matter. Labour includes the net salary, social securities and payroll tax. As Management Accounting refers to the cost allocation to products and services, we only distinguish between manufacturing and non-manufacturing labour which results in an alternative itemisation of costs. No Relevance of the Appropriation of Profits: For Management Accounting, the appropriation of profits is irrelevant. 4.10. Bookkeeping Entries after Accounting Cuts After we cut short items of no relevance for Management Accounting, we rework our Bookkeeping entries to meet the (so far) lower requirements. We consider the following Bookkeeping entries for Management Accounting: 20 The next following Bookkeeping entries are identified by capital letters to distinguish them from Financial Accounting records in the previous chapter (3). (A) Establishment of the business: DR Cash/ Bank.................... 400,000.00 GBP CR Issued Capital............... 400,000.00 GBP (B) Taking the bank loan: DR Cash/ Bank.................... 200,000.00 GBP CR Interest Bearing Liabilities 200,000.00 GBP (C) Payment for interest and pay-off: 20 Note, we consider cash/ bank and receivables and payables for aspects of cash flow statements and liquidity planning further below. <?page no="59"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-59 DR Interest..................... 6,000.00 GBP DR Interest Bearing Liabilities. 20,000.00 GBP CR Cash/ Bank.................... 26,000.00 GBP (D) Acquisition of the saws: DR P, P, E saws................. 150,000.00 GBP DR VAT.......................... 30,000.00 GBP CR Cash/ Bank.................... 180,000.00 GBP (E) Depreciation on the saws. We do not run an asset management and credit the P, P, E-account although it is regarded old-fashioned amongst Bookkeepers. DR Depreciation Production Dep.. 30,000.00 GBP CR P, P, E saws................. 30,000.00 GBP (F) Rent: DR Rent......................... 90,000.00 GBP CR Cash/ Bank.................... 90,000.00 GBP (G) Purchase of aluminium profiles: DR Purchase..................... 600,000.00 GBP DR VAT.......................... 120,000.00 GBP CR Cash/ Bank.................... 720,000.00 GBP (H) Purchase of hinges: DR Purchase..................... 450,000.00 GBP DR VAT.......................... 90,000.00 GBP CR Accounts Payables............ 270,000.00 GBP CR Cash/ Bank.................... 270,000.00 GBP (I) Purchase of glass panes: DR Purchase..................... 600,000.00 GBP DR VAT.......................... 120,000.00 GBP CR Accounts Payables............ 720,000.00 GBP (J) Purchase of aluminium sheets at a standard price of 50.77 GBP/ u. The total value equals: 50.77 × 1,300 = 6 66,001.00 GBP. <?page no="60"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-60 DR Purchase..................... 66,001.00 GBP DR VAT.......................... 13,200.20 GBP CR Cash/ Bank.................... 79,201.20 GBP (K) Purchase of sealing strips at the discounted price of: 27,000 × 10 × (1 - 5%) = 2256,500.00 GBP: DR Purchase..................... 256,500.00 GBP DR VAT.......................... 51,300.00 GBP CR Cash/ Bank.................... 307,800.00 GBP (L) Purchase of 90°-fastener at the number that takes returns into account: (50,000 - 500) × 25 = 1 1,237,500.00 GBP: DR Purchase..................... 1,237,500.00 GBP DR VAT.......................... 247,500.00 GBP CR Cash/ Bank.................... 1,485,000.00 GBP (M) Purchase of self-tapping-screws: DR Purchase..................... 20,000.00 GBP DR VAT.......................... 4,000.00 GBP CR Cash/ Bank.................... 24,000.00 GBP (N) Labour including social security contribution by PENOR PLC to the extent of: 1,750,000 + 250,000 = 2 2,000,000.00 GBP. DR Labour....................... 2,000,000.00 GBP CR Cash/ Bank.................... 2,000,000.00 GBP (O) Revenue recognition: DR Cash/ Bank.................... 6,062,280.00 GBP CR VAT.......................... 1,010,380.00 GBP CR Revenue...................... 5,051,900.00 GBP Below, we provide you with the adjusted data sheet for PENOR PLC based on Management Accounting data. Data Sheet for PENOR PLC Classification: Manufacturing; Bank loan: 200,000.00 GBP; bank loan fees: 1,500.00 GBP, interest: 3 %/ a, Payoff: 20,000.00 GBP; settlement values apply; Saws’ cost of acquisition: 5 × 30,000 GBP, useful life: 5 years; <?page no="61"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-61 RRent for factory building: 7,500.00 GBP/ m; Material prices: see Figure 3.5 Labour: 2,000,000.00 GBP; Production: 5,000 windows; 1,000 doors; Sales: 4,678 windows; 873 doors; Net selling prices: 800.00 GBP/ window; 1,000.00 GBP/ door; VAT 20%. Find below in Figure 4.2 the accounts recorded for Managerial Accounting. D C D C (A) 400,000.00 (C) 26,000.00 (A) 400,000.00 (B) 200,000.00 (D) 180,000.00 (O) 6,062,280.00 (F) 90,000.00 (G) 720,000.00 (H) 270,000.00 (J) 79,201.20 (K) 307,800.00 (L) 1,485,000.00 (N) 2,000,000.00 (M) 24,000.00 D C D C (C) 20,000.00 (B) 200,000.00 (C) 6,000.00 Cash/ Bank C/ B Issued capital ISS Interest bearing liabilities IBL Interest-20X1 INT D C D C (D) 150,000.00 (E) 30,000.00 (D) 30,000.00 (O) 1,010,380.00 (G) 120,000.00 (H) 90,000.00 (I) 120,000.00 (J) 13,200.20 (K) 51,300.00 (L) 247,500.00 (M) 4,000.00 D C D C (E) 30,000.00 (F) 90,000.00 P, P, E saws PPE Value added tax VAT [20%] Depreciation production department DPR Rent-20X1 RNT Figure 4.2: Management Accounting accounts <?page no="62"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-62 D C D C (G) 600,000.00 (H) 270,000.00 (H) 450,000.00 (I) 720,000.00 (I) 600,000.00 (J) 66,001.00 (K) 256,500.00 (L) 1,237,500.00 (M) 20,000.00 D C D C (N) 2,000,000.00 (O) 5,051,900.00 Purchase-20X1 PUR Accounts payables A/ P Labour-20X1 LAB Revenue-20X1 REV Figure 4.2: Management Accounting accounts (continued) In contrast to the recordings in chapter (3), we acknowledge a substantial simplification in the accounts. Accounts relevant only for the legit preparation of financial statements do not show anymore. We even could ignore more real accounts, like Interest Bearing Liability account, the Accounts Payables account, the P, P, E account and the VAT account as information is redundant to Financial Accounting. We merely disclose these accounts for teaching purposes and to show complete Bookkeeping entries based on the double entry system. 4.11. Accounting Add-ons (C2) Next, we describe a Management Accounting system which provides cost allocations. We therefore must separate costs, allocate cost to cost centres and products/ services and calculate profit for PENOR PLC. We demonstrate that more detailed information is provided which allows us to answer to the above prepared five Management Accounting questions. As you will see, most of our Accounting work is about allocations. The features of the Management Accounting system depend on the questions we are asking. The first one was about the unit costs of the finished goods. To answer the question, we calculate PENOR PLC’s products, which are windows and doors. The unit costs are for internal purposes only, like for price calculations and product mix decisions - but not for inventory valuations as we don’t prepare a balance sheet in Management Accounting. Following the account approach, all calculations are recorded "inside of the accounts". We trust you find this easier than calculations in workings as applied in the previous chapter (3). T The part of Management Accounting that deals with product calculation in an industrial environment is called Manufacturing Accounting. It gives the total and unit costs of manufacturing. T The cost of manufacturing are all costs that are directly or indirectly attributable to the product/ service. Non-manufacturing costs such as Marketing, Accounting or Human Resource costs are not allocated to goods/ services. The reason for this is simple. If the number of production amounts changes the apportioned <?page no="63"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-63 costs per product vary and unit costs become volatile, which we do not want. Our product calculation requires a perpetual inventory system for materials. 21 That way, materials are recorded once received and at the time of stock releases. In contrast, PENOR PLC’s Financial Accounting follows the periodic approach. Under the periodic system, stock additions are recorded but only once per Accounting period, PENOR PLC takes stock to measure materials consumption. The perpetual system in Management Accounting requires to immediately add purchased goods to the Inventory accounts. We provide inventory accounts for each material (aluminium profiles, glass panes, hinges etc.). We also need to know inventory levels at any time for precise production planning and to avoid delays caused by missing parts. For product calculation, we apply one Work-in-Process accounts per product (door, window) and Manufacturing Overhead accounts for the cost centres. Below, we discuss the procedure of product calculation for PENOR PLC. We assume, the company only has 2 departments (cost centres), Production department and an Administration Office. Our records support a profit calculation based on the cost of sales format. 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, hence, it is prepared for budgeted and actual values, and it frequently is linked to monthly Accounting periods. At PENOR PLC, the first step is assigning materials to the Raw Materials Inventory accounts. The same Inventory accounts apply as in chapter (3). We use the same abbreviations. 22 Observe adding aluminium profiles to the Raw Materials (alu) account: DR Raw Materials (alu).......... 600,000.00 GBP CR Purchase..................... 600,000.00 GBP Adding hinges to the Raw Materials (hin) account: DR Raw Materials (hin).......... 450,000.00 GBP CR Purchase..................... 450,000.00 GBP Adding glass panes to the Raw Materials (pan) account: DR Raw Materials (pan).......... 600,000.00 GBP CR Purchase..................... 600,000.00 GBP 21 Check our Basics, chapter (26). 22 For internal allocations we indicate the contra account by its 3-letter-code. <?page no="64"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-64 Adding aluminium sheets to the Raw Materials (sht) account: DR Raw Materials (sht).......... 66,001.00 GBP CR Purchase..................... 66,001.00 GBP Adding sealing strips to the Raw Materials (str) account: DR Raw Materials (str).......... 256,500.00 GBP CR Purchase..................... 256,500.00 GBP Adding 90°-fasteners to the Raw Materials (fst) account: DR Raw Materials (fst).......... 1,237,500.00 GBP CR Purchase..................... 1,237,500.00 GBP Adding self-tapping-screws to the Raw Materials (scr) account: DR Raw Materials (scr).......... 20,000.00 GBP CR Purchase..................... 20,000.00 GBP In Management Accounting, we distinguish direct and indirect costs. Direct costs are those costs that can be assigned straight to the product, e.g., based on the bill of materials documents or working sheets. Indirect costs occur for different products and are called overheads. They require cost allocations. Direct costs are debited to the WIP-accounts whereas indirect costs are recorded as overheads. Most common direct costs are direct materials and direct labour. Overhead costs are costs that apply for more than one product. They are assigned to cost centres and are later allocated to products based on cost rates. Examples for overheads are supervisor’s salary, factory rent, security service, material procurement costs etc. 4.12. Direct Costs Recording At PENOR PLC, the aluminium profiles, the hinges, the glass panes, the sealingstrips, the 90°-fasteners and the aluminium sheets are direct materials. Screws are not. Consider screws provided in a box without recording the consumption. No cost tracing takes place - we get back to that later. Next, we assign raw materials to products based on the recorded inventory movements in the factory. The WIP-Window account receives in total: - Aluminium profiles worth 400,000.00 GBP. - Hinges worth 300,000.00 GBP. - Glass panes worth 500,000.00 GBP. - Sealing strips worth 190,000.00 GBP. <?page no="65"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-65 - 90°-fasteners worth 1,000,000.00 GBP. The WIP-Door account receives in total: - Aluminium profiles worth 120,000.00 GBP. - Hinges worth 90,000.00 GBP. - Aluminium sheets worth: 1,000 × 50.77 = 5 50,770.00 GBP. - Sealing strips worth 57,000.00 GBP. - 90°-Fasteners worth 200,000.00 GBP. We do not record the self-tappingscrews in an extra inventory account but carry them in the Purchase account. We do so as the self-tapping-screws are regarded as indirect materials consumed in the production process. The movements of self-tapping-screws are not registered and, therefore, are not recorded. The screw consumption is calculated based on a periodical inventory system where we close off the purchases and closing stock to a kind of Trading account. The reason is that the value of the self-tapping-screws does not rectify the extra effort of record keeping. Similar reasons apply for further supplies, like cooling liquids, water, oil, petrol etc. We get back to the self-tapping-screws once we discuss manufacturing overheads further below. For now, we ignore their consumption and keep in mind to take care of them at the period’s end. For batch calculation the Work-in- Process account (WIP-account) applies. 23 A WIP-account is a product or service related account where all direct costs and portions of overheads are allocated to. It applies in production and service rendering firms. The terms work-in-process and 23 Read our textbook Basics of Accounting, chapter (25). work-in-progress are used interchangeably in literature. We mostly say WIP. PENOR PLC applies two WIP-accounts, one for the windows and another one for the doors. By the next step, the direct materials, such as aluminium profiles, hinges, glass panes, aluminium sheets, sealing strips and 90°-fasteners, are allocated to the goods manufactured which means they are debited either to the WIP-Window-account or WIP-Dooraccount. At PENOR PLC, no direct labour applies because all workers work on doors and windows as well. All overheads are allocated to Production or the Administration Office. We call the Overhead account for Production ‘Manufacturing Overheads account’. The Manufacturing Overheads account is common in production firms. A Manufacturing Overhead account is used in production firms and service rendering companies in order to allocate all manufacturing overheads to products. Manufacturing Overhead accounts are closed-off to the WIP-accounts. This is referred to as overhead application. Non-manufacturing overhead accounts take overheads too, but those accounts are closed-off directly to the Profit and Loss account. As the nonmanufacturing overheads go straight to profit or loss a company cannot allocate them to products. They fall under period costs. At PINOR PLC, labour is added to an extent of 60 % to the Manufacturing Overheads account (MOH) and to 40 % to the Administration Overheads account (given). <?page no="66"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-66 DR MOH Account.................. 1,200,000.00 GBP CR Labour....................... 1,200,000.00 GBP DR Admin Overheads.............. 800,000.00 GBP CR Labour....................... 800,000.00 GBP Next, we deal with the screws: At PINOR PLC, self-tapping-screws are considered overheads. No documentation, such as a material release form, is recorded when self-tapping-screws are taken out of their containers. The supervisor looks after the self-tapping-screws. PENOR PLC records the consumption of the self-tapping-screws taking inventory. At the end of the Accounting period 20X1, stock amounts to 5,000.00 GBP (= 1,000 containers). Hence, the consumption of selftapping-screws was: 20,000 - 5,000 = 1 15,000.00 GBP. 24 DR MOH Account.................. 15,000.00 GBP CR Raw Materials (scr).......... 15,000.00 GBP Rent is for the factory building only and, hence, is fully added to the Manufacturing Overheads account. At PENOR PLC, the Administration Office is not in the factory building. DR MOH Account.................. 90,000.00 GBP CR Rent......................... 90,000.00 GBP Depreciation is fully allocated to the Manufacturing Overheads account. It is for the saws in the Production department only. DR MOH Account.................. 30,000.00 GBP CR Depreciation................. 30,000.00 GBP Look at the accounts for checking the calculation so far: 24 Note, in a real case, a company takes stock every month, we keep this case study simple. <?page no="67"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-67 D C D C (A) 400,000.00 (C) 26,000.00 (A) 400,000.00 (B) 200,000.00 (D) 180,000.00 (O) 6,062,280.00 (F) 90,000.00 (G) 720,000.00 (H) 270,000.00 (J) 79,201.20 (K) 307,800.00 (L) 1,485,000.00 (N) 2,000,000.00 (M) 24,000.00 D C D C (C) 20,000.00 (B) 200,000.00 (C) 6,000.00 Cash/ Bank C/ B Issued capital ISS Interest bearing liabilities A/ P Interest-20X1 INT D C D C (D) 150,000.00 (E) 30,000.00 (D) 30,000.00 (O) 1,010,380.00 c/ d 120,000.00 (G) 120,000.00 150,000.00 150,000.00 (H) 90,000.00 b/ d 120,000.00 (I) 120,000.00 (J) 13,200.20 (K) 51,300.00 (L) 247,500.00 (M) 4,000.00 D C D C (E) 30,000.00 Dpr 30,000.00 (F) 90,000.00 Rnt 90,000.00 P, P, E saws PPE Value added tax VAT [20%] Depreciation production DPR Rent-20X1 RNT D C D C (G) 600,000.00 alu 600,000.00 (H) 270,000.00 (H) 450,000.00 hin 450,000.00 (I) 720,000.00 (I) 600,000.00 pan 600,000.00 (J) 66,001.00 sht 66,001.00 (K) 256,500.00 str 256,500.00 (L) 1,237,500.00 fst 1,237,500.00 (M) 20,000.00 scr 20,000.00 Purchase-20X1 PUR Accounts payables A/ P Figure 4.3: Manufacturing Accounting’s accounts after 1 st allocation <?page no="68"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-68 D C D C (N) 2,000,000.00 MOH 1,200,000.00 (O) 5,051,900.00 AOH 800,000.00 2,000,000.00 2,000,000.00 Labour-20X1 LAB Revenue-20X1 REV D C D C PUR 600,000.00 WPw 400,000.00 PUR 450,000.00 WPw 300,000.00 WPd 120,000.00 WPd 90,000.00 c/ d 80,000.00 c/ d 60,000.00 600,000.00 600,000.00 450,000.00 450,000.00 b/ d 80,000.00 b/ d 60,000.00 D C D C PUR 600,000.00 WPw 500,000.00 PUR 66,001.00 WPd 50,770.00 c/ d 100,000.00 c/ d 15,231.00 600,000.00 600,000.00 66,001.00 66,001.00 b/ d 100,000.00 b/ d 15,231.00 Raw materials (alu) Raw materials (hin) Raw materials (pan) Raw materials (sht) D C D C PUR 256,500.00 WPw 190,000.00 PUR 1,237,500.00 WPw 1,000,000.00 WPd 57,000.00 WPd 200,000.00 c/ d 9,500.00 c/ d 37,500.00 256,500.00 256,500.00 1,237,500.00 1,237,500.00 b/ d 9,500.00 b/ d 37,500.00 Raw materials (str) Raw materials (fst) D C D C scr 20,000.00 MOH 15,000.00 LAB 1,200,000.00 c/ d 5,000.00 scr 15,000.00 20,000.00 20,000.00 RNT 90,000.00 b/ d 5,000.00 DPR 30,000.00 Raw materials (scr) Manufacturing Overheads MOH D C D C alu 400,000.00 alu 120,000.00 hin 300,000.00 hin 90,000.00 pan 500,000.00 slb 50,770.00 str 190,000.00 str 57,000.00 fst 1,000,000.00 fst 200,000.00 D C Lab 800,000.00 WIP window (WPw) WIP door (WPd) Admin overheads (AOH) Figure 4.3: Manufacturing Accounting’s accounts after 1 st allocation (continued) <?page no="69"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-69 4.13. Manufacturing Overhead Application Next, we apply the overheads, meaning we allocate overheads, like labour, screw consumption, depreciation and rent (all together), to PENOR PLC’s products, windows and doors. The application of overheads is the transfer of costs from the Manufacturing Overheads account to the Work-in-Process account(s). The Overhead application is recorded as debit entry in a WIP-account and credit entry in a MOH-account. The overhead application frequently is based on cost rates, such as a GBP/ hour rate. The concept is to collect overheads first in the Manufacturing Overhead accounts and to apply them all together. As the cost rates are based on budgeted data, they are calculated as budgeted costs divided by the planned output (performance). Actual data are likely to differ from the predetermined overhead allocation rate which results in differences, referred to as overand under-applied overheads. In those cases, too many or too less costs are transferred from a MOH-account to a WIP-account. In case of under-applied overheads, the remainder stays in the Manufacturing Overheads account. The account later is closed-off to the Profit and Loss account or to the Cost of Sales account to assign the overheads to the Accounting period they occurred in. For the case study’s cost allocation, PENOR PLC allocates labour based on the measured throughput time and all other manufacturing overheads by piece count, see below: The costs for labour are allocated based on a measured 1 : 2 ratio between door and window throughput time (given). Hence, (2/ 3) × 1,200,000 = 8 800,000.00 GBP are allocated to all windows and: 1,200,000 - 800,000 = 4 400,000.00 GBP to all doors. DR WIP Account Window ........... 800,000.00 GBP CR MOH Account.................. 800,000.00 GBP DR WIP Account Door............. 400,000.00 GBP CR MOH Account.................. 400,000.00 GBP All other overheads, together to the extent of: 1,335,000 - 1,200,000 = 135,000.00 GBP, are allocated on piece count basis. This means: (135,000 × 5,000) / 6,000 = 1 112,500.00 GBP are allocated to the WIP-Window account and: 135,000 - 112,500 = 2 22,500.00 GBP are allocated to the WIP-Door account. No predetermined overhead allocation rate applies for PENOR PLC (simplification). All manufacturing overheads are allocated based on given ratios or on piece count. This is a very simple method of applying overheads. This way, no overor under-application of overheads can happen. However, costs vary by the product numbers. In contrast, a manufacturer who calculates a predetermined overhead allocation rate <?page no="70"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-70 adds constant overheads to the products but also is likely to overor underapply overheads. 25 DR WIP Account Window........... 112,500.00 GBP CR MOH Account.................. 112,500.00 GBP DR WIP Account Door............. 22,500.00 GBP CR MOH Account.................. 22,500.00 GBP Thereafter, the two WIP-accounts show all manufacturing costs. The balance of the WIP-account is referred to as batch costs. Dividing the batch costs by the lot size, we calculate the unit costs of manufacturing. At PENOR PLC, the unit costs of manufacturing per window equal: 3,302,500 / 5,000 = 6 660.50 GBP/ u. The unit costs of manufacturing per door are: 940,270 / 1,000 = 9 940.27 GBP/ u. The costs per door slightly differs from the calculated unit costs in chapter (3) as we now calculate the product based on standard prices. The average price per aluminium sheet is 50.77 GBP/ u, instead of 50.00 25 Check the case study RIEBEECK-KASTEEL (Pty) Ltd. in our textbook Financial Statements, chapter (9). GBP/ u or 52.00 GBP/ u. By applying standard prices instead of actual ones, we ‘smoothed’ calculation but also make it inappropriate for use in Financial Accounting. No inventory valuation disclosed on financial statements is accepted if based on standard price calculations. 4.14. Further Reports Management Accounting reports to managers about special items. One of those reports is the cost of manufacturing COM report. See PENOR PLC’s COMreport in Figure 4.4. <?page no="71"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-71 Item Amount [GBP] OV Raw materials 0 Purchases 3,230,001 3,230,001 Closing stock raw materials (307,231) indirect materials (15,000) Total direct materials 2,907,770 Direct labor 0 Prime cost 2,907,770 Applied overheads 1,335,000 4,242,770 OV Work in process WIP 0 4,242,770 Closing stock work in process WIP 0 COST of MANUFACTURING 4,242,770 Penor PLC REPORT on COST of MANUFACTURING as for the period ended 31.12.20X1 Figure 4.4: Cost of manufacturing report The door-costs and window-costs are the answer to question 1: How much does the product/ service cost? The answer is at PENOR PLC: a window costs 660.50 GBP/ u and a door costs 940.27 GBP/ u. The sales department needs to know unit costs for pricing products and services. 4.15. Profitability Analysis After we answered one major question of Accounting, we continue our procedure to calculate PENOR PLC’s operational profit. We compare the revenue to the cost of sold products. This will give us the net operating profit. For the calculation of the goods sold, a Finished Goods account applies. We add finished goods when production is completed. The WIIP account is credited then. Once goods are released from stock, they are debited to the Cost of Goods Sold account (COS-account) and we make a credit entry in the Finished Goods Inventory account. Below, we firstly transfer the finished goods to their Finished Goods Inventory accounts (for doors and windows). This Bookkeeping entry is triggered by the storage manager receiving the goods. DR FG Inventory Window .......... 3,302,500.00 GBP CR WIP Account Window ........... 3,302,500.00 GBP <?page no="72"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-72 DR FG Inventory Door............ 940,270.00 GBP CR WIP Account Door............. 940,270.00 GBP Most of PENOR PLC’s costs for production have now been assigned to finished goods inventory. Once sold, the goods become expenses, referred to as costs of sales. For the Profitability Analysis, we apply a Cost of Goods Sold account. A Cost of Goods Sold account records the unit costs of manufacturing times the number of goods sold during the Accounting period as costs. Also, goods produced in previous Accounting periods can be released from stock and become cost of goods sold of the actual Accounting period. In 20X1, PENOR PLC sells 4,678 windows and 873 doors. The cost of manufacturing for the products sold are: 4,678 × 660.50 = 3 3,089,819.00 GBP for the windows and: 873 × 940.27 = 8 820,855.71 GBP for the doors. We debit these costs to the Cost of Goods Sold (COS) account: 3,089,819 + 820,855.71 = 3 3,910,674.71 GBP. DR COS Account.................. 3,089,819.00 GBP CR FG Inventory Window.......... 3,089.819.00 GBP DR COS Account.................. 820,855.71 GBP CR FG Inventory Door............ 820,855.71 GBP DR Profit and Loss.............. 3,910,674.71 GBP CR COS Account.................. 3,910,674.71 GBP The cost of manufacturing report gets now prolonged to include the cost of sales section and is shown by Figure 4.5. <?page no="73"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-73 Item Amount [GBP] OV Raw materials 0 Purchases 3,230,001 3,230,001 Closing stock raw materials (307,231) indirect materials (15,000) Total direct materials 2,907,770 Direct labor 0 Prime cost 2,907,770 Applied overheads 1,335,000 4,242,770 OV Work in process WIP 0 4,242,770 Closing stock work in process WIP 0 COST of MANUFACTURING 4,242,770 OV FG inventory 0 Closing stock of FG inventory (332,095) COST of GOODS SOLD 3,910,675 Penor Ltd. REPORT on COST of GOODS SOLD as for the period ended 31.12.20X1 Figure 4.5: Cost of goods sold report Observe the profit calculation in the accounts: <?page no="74"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-74 D C D C (A) 400,000.00 (C) 26,000.00 (A) 400,000.00 (B) 200,000.00 (D) 180,000.00 (O) 6,062,280.00 (F) 90,000.00 (G) 720,000.00 (H) 270,000.00 (J) 79,201.20 (K) 307,800.00 (L) 1,485,000.00 (N) 2,000,000.00 (M) 24,000.00 c/ d 1,480,278.80 6,662,280.00 6,662,280.00 b/ d 1,480,278.80 Cash/ Bank C/ B Issued capital ISS D C D C (C) 20,000.00 (B) 200,000.00 (C) 6,000.00 P&L 6,000.00 c/ d 180,000.00 200,000.00 200,000.00 b/ d 180,000.00 Interest bearing liabilities IBL Interest-20X1 INT D C D C (D) 150,000.00 (E) 30,000.00 (D) 30,000.00 (O) 1,010,380.00 c/ d 120,000.00 (G) 120,000.00 150,000.00 150,000.00 (H) 90,000.00 b/ d 120,000.00 (I) 120,000.00 (J) 13,200.20 (K) 51,300.00 (L) 247,500.00 (M) 4,000.00 c/ d 334,379.80 1,010,380.00 1,010,380.00 b/ d 334,379.80 D C D C (E) 30,000.00 Dpr 30,000.00 (F) 90,000.00 Rnt 90,000.00 P, P, E saws PPE Value added tax VAT [20%] Depreciation production DPR Rent-20X1 RNT Figure 4.6: Management Accounting’s accounts <?page no="75"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-75 D C D C (G) 600,000.00 alu 600,000.00 (H) 270,000.00 (H) 450,000.00 hin 450,000.00 c/ d 990,000.00 (I) 720,000.00 (I) 600,000.00 pan 600,000.00 990,000.00 990,000.00 (J) 66,001.00 sht 66,001.00 b/ d 990,000.00 (K) 256,500.00 str 256,500.00 (L) 1,237,500.00 fst 1,237,500.00 (M) 20,000.00 scr 20,000.00 3,230,001.00 3,230,001.00 D C D C (N) 2,000,000.00 MOH 1,200,000.00 P&L 5,051,900.00 (O) 5,051,900.00 AOH 800,000.00 2,000,000.00 2,000,000.00 Purchase-20X1 PUR Accounts payables A/ P Labour-20X1 LAB Revenue-20X1 REV D C D C PUR 600,000.00 WPw 400,000.00 PUR 450,000.00 WPw 300,000.00 WPd 120,000.00 WPd 90,000.00 c/ d 80,000.00 c/ d 60,000.00 600,000.00 600,000.00 450,000.00 450,000.00 b/ d 80,000.00 b/ d 60,000.00 D C D C PUR 600,000.00 WPw 500,000.00 PUR 66,001.00 WPd 50,770.00 c/ d 100,000.00 c/ d 15,231.00 600,000.00 600,000.00 66,001.00 66,001.00 b/ d 100,000.00 b/ d 15,231.00 Raw materials (alu) Raw materials (hin) Raw materials (pan) Raw materials (sht) D C D C PUR 256,500.00 WPw 190,000.00 PUR 1,237,500.00 WPw 1,000,000.00 WPd 57,000.00 WPd 200,000.00 c/ d 9,500.00 c/ d 37,500.00 256,500.00 256,500.00 1,237,500.00 1,237,500.00 b/ d 9,500.00 b/ d 37,500.00 D C D C scr 20,000.00 MOH 15,000.00 LAB 1,200,000.00 WPw 800,000.00 c/ d 5,000.00 scr 15,000.00 WPd 400,000.00 20,000.00 20,000.00 RNT 90,000.00 WPw 112,500.00 b/ d 5,000.00 DPR 30,000.00 WPd 22,500.00 1,335,000.00 1,335,000.00 Raw materials (str) Raw materials (fst) Raw materials (scr) Manufacturing Overheads Figure 4.6: Management Accounting’s accounts (continued) <?page no="76"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-76 D C D C alu 400,000.00 FGw 3,302,500.00 alu 120,000.00 FGd 940,270.00 hin 300,000.00 hin 90,000.00 pan 500,000.00 sht 50,770.00 str 190,000.00 str 57,000.00 fst 1,000,000.00 fst 200,000.00 MOH 800,000.00 MOH 400,000.00 MOH 112,500.00 MOH 22,500.00 3,302,500.00 3,302,500.00 940,270.00 940,270.00 D C D C LAB 800,000.00 P&L 800,000.00 FGw 3,089,819.00 P&L 3,910,674.71 FGd 820,855.71 3,910,674.71 3,910,674.71 WIP window (WPw) WIP door (WPd) Admin overheads (AOH) Cost of goods sold-20X1 COS D C D C WPw 3,302,500.00 COS 3,089,819.00 WPd 940,270.00 COS 820,855.71 c/ d 212,681.00 c/ d 119,414.29 3,302,500.00 3,302,500.00 940,270.00 940,270.00 b/ d 212,681.00 b/ d 119,414.29 D C COS 3,910,674.71 REV 5,051,900.00 AOH 800,000.00 INT 6,000.00 EBT 335,225.29 5,051,900.00 5,051,900.00 b/ d 335,225.29 FG inventory window (FGw) FG inventory door (FGd) Profit and Loss-20X1 P&L Figure 4.6: Management Accounting’s accounts (continued) The Profit and Loss account in Management Accounting is referred to as profitability analysis. See Figure 4.7: <?page no="77"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-77 [GBP] Revenue 5,051,900 Cost of Sales (3,910,675) 1,141,225 Administration (800,000) Interest (6,000) Profit for the period (operating) 335,225 Penor PLC PROFITABILITY ANALYSIS for the year ended 31.12.20X1 Figure 4.7: Profitability Analysis Now we got the answer to question 2: Is the business successful/ profitable? The answer is: Yes. The company operates profitably as it is earning a net operating profit (before taxes) of 335,225.20 GBP. The earnings (after taxes) per 1.00 GBP invested by the owners is: (335,225.29 - 100,725.45) / 400,000 = 5 58.63%. We cross-check our results by comparison to Financial Accounting’s calculations in chapter (3). The pre-tax profit exceeds the one calculated along IFRS. The difference equals: 335,225.29 - 335,751.50 = 5 526.21 GBP. At the same time, there are differences regarding the inventory valuation of finished goods to the extent of: 212,681 + 119,414.29 - 332,251.50 = - -156.21 GBP, the inventory valuation of self-tapping-screws to the extent of: 15,231 - 15,600 = - -369.00 GBP, and a 66,001 - 66,000 = 1 1.00 GBPdifference regarding the purchases of aluminium sheets. The cross-check gives: 156.21 + 369 + 1 = 5 526.21 GBP. This means our calculation is correct. 4.16. Checking Calculation by a Balance Sheet We check consistency by a balance sheet. A balance sheet is not required in Management Accounting by default. However, as we made correct Bookkeeping entries for Management Accounting, we can check our calculations against the double entry system. A balance sheet prepared based on our Management Accounting data is disclosed in Figure 4.8: <?page no="78"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-78 A C, L Non-current assets [GBP] Equity [GBP] P, P, E 120,000 Share capital 400,000 Intangibles Reserves Financial assets Retained earnings 335,225 Current assets Liabilities Inventory 639,326 Interest bear liab 180,000 Accounts receivables Accounts payables 1,324,380 Prepaid expenses Provisions Cash/ Bank 1,480,279 Tax liabilities Total assets 2,239,605 Total equity and liab. 2,239,605 Penor PLC STATEMENT of FINANCIAL POSITION for Management Accounting as at 31.12.20X1 Figure 4.8: Pro forma balance sheet based on Management Accounting data Comparing the balance sheet to the previous chapter (3), we notice differences which are caused by simplifications made for Management Accounting. The reason for the difference in inventory is the valuation of finished goods (doors) and the closing stock of the aluminium sheets. The difference in cash results from prepayments mostly. On the credit side, the appropriation of profits is omitted for Management Accounting, and we stopped the profit calculation "down to earnings before taxes". Hence, no income taxes apply. After we cross-checked the balance sheet, we take a closer look at the item cash/ bank. We deduct the financing cash flow of: 400,000 + 200,000 - 26,000 = 6 626,000.00 GBP. If we deduct the financing cash flow from the total cash flow, we arrive at the free cash flow before taxation, which is: 1,480,000 - 626,000 = 8 854,000.00 GBP. As the income taxes are calculated to be 100,725.45 GBP and the difference on output-VAT and input-VAT is 334,379.80 the free cash flow equals: 854,000 - 100,725.45 - 334,379.80 = 4 434,251.25 GBP. This is the answer to question 4: Does the company generate cash? The answer is: Yes. PENOR PLC earns a free cash flow of 434,251.25 GBP as we considered income taxes and VAT to be paid from cash flows. 4.17. Business Plan By the next step, we plan future costs for PENOR PLC. Management Accountants refer to this procedure as budgeting or the preparation of the business plan. We stick to the expression business plan. A A business plan is the result of the annual planning of all activities of the company. The planning takes place every year. To get the technical terms straight: A cost plan is the result of performance planning and calculating departmental <?page no="79"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-79 and unit costs. It can be prepared in different versions (for different stages or different scenarios). A budget is the approved cost plan and is binding. There can only be one budget. A business plan does not require to be as much in the details as actual costs. However, its itemisation determines the quality of Monitoring. A business plan is based on time periods shorter than one year, mostly on a monthly basis. To keep the PENOR PLC case study simple, we plan for 6-months-periods. The business plan is prepared for 2 years hence, we work on 4 planning periods. The business plan consists of: - Revenue plan. - Cost plan. - Profit plan. - Liquidity plan. - Budgeted balance slab. The complete business plan is displayed in Figure 4.14. We start with the revenue plan below: For 20X2, PENOR PLC plans to increase prices every year by 100.00 GBP per product. Accordingly, is sells the windows at: 800 + 100 = 9 900.00 GBP/ u and the doors at: 1,500 + 100 = 1 1,600.00 GBP/ u in 20X2 and in the next year windows at: 900 + 100 = 1 1,000.00 GBP/ u and doors at: 1,600 + 100 = 1 1,700.00 GBP/ u. The sales numbers are planned to increase every year by 10 % and rounded to the nearest 10 units. Regarding the windows, the actual number is 4,678. In 20X2, the number is: 4,678 × (1 + 10%) = 5 5,145.80 units which according to the rounding rule gives 5,150 windows. In the next year, it is: 4,678 × (1 + 10%) 2 = 55,660.38 units which gives 5,660 windows in 20X3. The quantity of doors is: 873 × (1 + 10%) = 9 960.3 units which gives 960 doors in 20X2 and: 873 × (1 + 10%) 2 = 11,056.33 units which gives 1,060 windows in 20X3. The revenue plan is displayed in Figure 4.9: [GBP] REVENUE PLAN I-VI 20X2 VII-XII 20X2 I-VI 20X3 VII - XII 20X3 amount of windows [#] 2,575 2,575 2,830 2,830 amount of doors [#] 480 480 530 530 revenue windows [GBP] 2,317,500 2,317,500 2,830,000 2,830,000 revenue doors [GBP] 768,000 768,000 901,000 901,000 Total revenue 3,088,555 3,088,555 3,734,360 3,734,360 Figure 4.9: Revenue plan The next step is cost planning. PENOR PLC considers that the costs of manufacturing increase every year by 2 % on average. The calculation is based on the unit cost of manufacturing rounded to the nearest GBP. Hence, the windows’ costs are: 661 × (1 + 2%) = 6 674.22 GBP/ u which gives 674.00 GBP/ u and: 661 × (1 + 2%) 2 = 6687.70 GBP/ u which gives 688.00 GBP/ u. The doors’ costs are: 940 × (1 + 2%) = 9958.80 GBP/ u which gives 959.00 GBP/ u and: 940 × (1 + 2%) 2 = 977.98 GBP/ u which gives 978.00 GBP/ u. <?page no="80"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-80 Administration costs do not change in the next Accounting periods. Interest is calculated on the interest and pay-off schedule. See below the interest and pay-off schedule in Figure 4.10: Year Opening amount Interest Pay-off Rest [GBP] [GBP] [GBP] [GBP] 20X1 200,000 6,000 20,000 180,000 20X2 180,000 5,400 20,000 160,000 20X3 160,000 4,800 20,000 140,000 Penor PLC INTEREST and PAY-OFF PLAN Figure 4.10: Interest and pay-off schedule To keep the case simple, we assume selling the same numbers of products as produced. This means that closing stock remains unchanged. For the consideration of cost of sales, we apply the last-infirst-out cost formula to keep the case study simple. This means, the 322 windows and the 127 doors from the first Accounting period remain on stock for the entire planning periods. 26 [GBP] COST PLAN I-VI 20X2 VII-XII 20X2 I-VI 20X3 VII - XII 20X3 COM windows 1,735,550 1,735,550 1,698,000 1,698,000 COM doors 460,320 460,320 518,340 518,340 Administration 400,000 400,000 400,000 400,000 Interest 2,700 2,700 2,400 2,400 Total costs 2,598,570 2,598,570 2,618,740 2,618,740 Figure 4.11: Cost plan The tax planning is made annually as taxes are due. See below the profitability plan, which contains the difference between revenue and costs as operating profit. The earnings before taxes are the sum of the half-years’ net operating profits. Taxes are calculated to be 30 % of the annual earnings before taxation if positive. [GBP] PROFITABILITY PLAN I-VI 20X2 VII-XII 20X2 I-VI 20X3 VII - XII 20X3 Revenue 3,088,555 3,088,555 3,734,360 3,734,360 less Total of costs (2,598,570) (2,598,570) (2,618,740) (2,618,740) Operating profit 489,985 489,985 1,115,620 1,115,620 Earnings before tax 979,970 2,231,240 Income taxes (293,991) (669,372) Earnings after taxes 685,979 1,561,868 -> reserves -> dividend -> carried forward 685,979 1,561,868 Figure 4.12: Profitability plan 26 This makes the case study easier. <?page no="81"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-81 To check the calculations, we prepare a budgeted balance sheet based on the balance sheet of the 1 st Accounting period which is adjusted for the case study. It is simplified about VAT. The amount of 334,379.80 GBP has been deducted from receivables and from cash. This implies the input-VAT and output-VAT have been paid in 20X1. Furthermore, income taxes are calculated based on the manufacturing Accounting data. Due to the application of average costs for aluminium sheets, the profit is 335,225.29 GBP and the income taxes are: 335,225.29 × 30% = 1 100,567.59 GBP. For the next Accounting periods, we assume the pre-tax profit (979,970.00 GBP) equals cash inflows, except of depreciation (to the extent of 30,000.00 GBP). Furthermore, the income taxes of the previous year and the pay-off for the bank loan (20,000.00 GBP) are paid. Hence, the calculation of cash in 20X2 gives: 1,145,899 + 979,970 + 30,000 - 100,567.59 - 20,000 = 2 2,305,301.41 GBP. See the entire budgeted balance sheet below in Figure 4.13. [GBP] BUDGETED BALANCE SHEET 20X1 (actual) 20X2 20X3 P, P, E 120,000 90,000 60,000 Intangibles Financial assets Inventory 639,326 639,326 639,326 Accounts receivables Prepaid expenses Cash/ Bank 1,145,899 2,035,301 3,982,550 Total assets 1,905,225 2,764,628 4,681,877 Share capital 400,000 400,000 400,000 Reserves Retained earnings 234,658 920,637 2,482,505 Interest bear liab 180,000 160,000 140,000 Accounts payables 990,000 990,000 990,000 Provisions Tax liabilities 100,568 293,991 669,372 Total equity and liab. 1,905,225 2,764,628 4,681,877 Figure 4.13: Budgeted balance sheet (annual) The period 20X1 is displayed to show adjustments for the actual period only. The business plan covers the periods 20X2 and 20X3. The entire business plan for the periods 20X2 and 20X3 is displayed in Figure 4.14: <?page no="82"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-82 [GBP] REVENUE PLAN I-VI 20X2 VII-XII 20X2 I-VI 20X3 VII - XII 20X3 amount of windows [#] 2,575 2,575 2,830 2,830 amount of doors [#] 480 480 530 530 revenue windows [GBP] 2,317,500 2,317,500 2,830,000 2,830,000 revenue doors [GBP] 768,000 768,000 901,000 901,000 Total revenue 3,088,555 3,088,555 3,734,360 3,734,360 [GBP] COST PLAN I-VI 20X2 VII-XII 20X2 I-VI 20X3 VII - XII 20X3 COM windows 1,735,550 1,735,550 1,698,000 1,698,000 COM doors 460,320 460,320 518,340 518,340 Administration 400,000 400,000 400,000 400,000 Interest 2,700 2,700 2,400 2,400 Total costs 2,598,570 2,598,570 2,618,740 2,618,740 [GBP] PROFITABILITY PLAN I-VI 20X2 VII-XII 20X2 I-VI 20X3 VII - XII 20X3 Revenue 3,088,555 3,088,555 3,734,360 3,734,360 less Total of costs (2,598,570) (2,598,570) (2,618,740) (2,618,740) Operating profit 489,985 489,985 1,115,620 1,115,620 Earnings before tax 979,970 2,231,240 Income taxes (293,991) (669,372) Earnings after taxes 685,979 1,561,868 -> reserves -> dividend -> carried forward 685,979 1,561,868 [GBP] BUDGETED BALANCE SHEET I-VI 20X2 VII-XII 20X2 I-VI 20X3 VII - XII 20X3 P, P, E n/ a 90,000 n/ a 60,000 Intangibles Financial assets Inventory n/ a 639,326 n/ a 639,326 Accounts receivables Prepaid expenses Cash/ Bank n/ a 2,035,301 n/ a 3,982,550 Total assets n/ a 2,764,628 n/ a 4,681,877 Share capital n/ a 400,000 n/ a 400,000 Reserves Retained earnings n/ a 920,637 n/ a 2,482,505 Interest bear liab n/ a 160,000 n/ a 140,000 Accounts payables n/ a 990,000 n/ a 990,000 Provisions Tax liabilities n/ a 293,991 n/ a 669,372 Total equity and liab. n/ a 2,764,628 n/ a 4,681,877 Figure 4.14: Business plan for PENOR PLC The business plan answers the question 3: How much are future costs? We can read out the costs from the cost plan, and we see further whether PENOR PLC is profitable. To answer question 5 (Are there substantial deviations from the budget? ), it is required to record actual data for the period 20X2 and 20X3 as we did for the 1 st Accounting period. Then, the actual data can be compared to the budgeted figures. To find explanations for deviations, it is very common to analyse the recorded Accounting data more in the details than we do here. For further consideration, we refer to the case study CROXTON Ltd. <?page no="83"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-83 in chapter (15). It covers Monitoring and Variance Analysis. 4.18. Summary This chapter explained the intention and basic features of Managerial Accounting. In contrast to the previous chapter (3), IFRSs are ignored. Data from Financial Accounting are ‘cleared’ from legal requirements as apply for financial statement preparation. After data simplification (cut), product costs are calculated based on Manufacturing Accounting. The WIPand MOHaccounts apply to calculate the cost of manufacturing for the PENOR PLC case study. Costs are recorded for sold products in the Cost of Goods Sold account. Profit is calculated following the cost of sales format. Therefore, allocations are made to cost centres and products. The business plan is prepared based on cost planning. 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, as well as a liquidity plan. Management Accounting does not follow legal requirements. It is designed to be appropriate for the manager support. 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? ’. 4.19. Working Definitions Business Plan: A business plan is the result of the annual planning of all activities of the company. Cost: A cost is a reduction of resources by operations intended by the company. Cost of Goods Sold Account: A cost of Goods Sold account records the unit costs of manufacturing times the number of those goods that are sold during the Accounting period as costs. Cost of Manufacturing: The cost of manufacturing are all costs that are directly or indirectly attributable to the product. Direct Costs: Direct costs are those costs that can be assigned straight to the product, e.g., based on the bill of materials documents or working sheets. Indirect costs occur for different products and require cost allocations. Manufacturing Accounting: The part of Management Accounting that deals with product calculation in an industrial environment called Manufacturing Accounting. Manufacturing Overhead Account: A Manufacturing Overhead account is used in production firms and service rendering companies to allocate all manufacturing overheads to products. Net Operating Profit: A net operating profit NOP is the profit before taxation that results from normal operations which are continued. Overheads: Overhead costs are costs that apply for more than one product. Overhead Application: The application of overheads is the transfer of costs from the Manufacturing Overheads account to the Workin-Process account(s). <?page no="84"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 4-84 Profitability Analysis: A profitability analysis is the income statement for Management Accounting. Work-in-process Account: A WIPaccount is a product or service related account where all direct costs and portions of overheads are allocated to. 4.20. Question Bank: (1) A company holds a bank loan at a principal of 300,000.00 EUR taken on 2.01.20X2 and got paid 298,000.00 EUR due to a bank fee deduction. The annuity is 15,000.00 EUR and the rate of interest 2 %/ a. It discloses the loan for Management Accounting on 31.12.20X5 at: 1. 240,000 EUR . 2. 298,000 EUR . 3. 262,905 EUR . 4. 300,000 EUR . (2) Cost of Manufacturing are: 1. Direct costs and overheads. 2. Batch costs plus interest. 3. Direct and indirect cost of production. 4. Net purchase costs. (3) A company records 120,000.00 EUR in the Work-in-Process account. Half of the goods are finished, and the other half is completed to an extent of 50%. How much costs are added to the Finished Goods Inventory account? 1. nil . 2. 60,000 EUR . 3. 120,000 EUR . 4. 80,000 EUR . (4) In Managerial Accounting, a business plan comprises of: 1. Revenue plan, cost plan, liquidity plan, balance sheet. 2. Balance sheet, cash flow statement, profit plan, register of non-current assets. 3. Revenue plan, plan of cost of manufacturing, profitability plan, budgeted balance sheet. 4. Payment schedule, overhead plan, profitability plan, balance sheet. (5) A production firm got an opening value of raw materials of 100,000.00 EUR. It buys raw material at 400,000.00 EUR and records a closing stock of raw materials of 200,000.00 EUR. Direct labour is amounting to 750,000.00 EUR. Overhead application is 250,000.00 EUR. How much are its prime costs? 1. 950,000.00 EUR . 2. 1,050,000.00 EUR . 3. 1,300,000.00 EUR . 4. 1,450,000.00 EUR . 4.21. Solutions 1-3; 2-3; 3-4; 4-1; 5-2. <?page no="85"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 5-85 5. Management Accounting vs. Financial Accounting 5.1. What is in the Chapter? This chapter explains the Management Accounting concept in general, not based on a case as in the previous chapters. We cover the features and explain the differences to Financial Accounting. 5.2. Learning Objectives After studying this chapter, you know the purpose und major characteristics of Management Accounting and can compare them to Financial Accounting. We know the basics concepts of Management Accounting and are familiarised with technical terms. 5.3. Differences to Financial Accounting The aspects below will be discussed as the main differences between Management Accounting and Financial Accounting. - Management Accounting focusses on planning/ budgeting. - 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 a lot about allocations. - Management Accounting is shortterm: mostly for periods less than one fiscal year. - Management Accounting focusses on deviations. - Management Accounting reports (to managers). 5.4. Management Accounting Focusses on Planning/ Budgeting Financial Accounting is about reporting to owners and the authorities. It informs about what happened in the past. Managers must report on last Accounting period’s activities because they took responsibility for the resources. As a result, Financial Accounting is based on the past. In contrast, Management Accounting’s view is forward. It plans the future of the business. A major portion of Management Accounting work is the preparation of cost plans and the coordination of the Budgeting process. The approved by management cost plan is called the budget. Its preparation and coordination between departments is called the budgeting process. A budget is like a business plan. It contains at least the approved revenue planning, cost planning, profit planning and liquidity planning. Budgets are in the details. In contrast to the business plan, which is related to the whole company, a budget is mostly based on cost centre levels. The detail level of planning determines the quality of cost information but also increases the Accounting workload. Management Accountants calculate profit and cash flows figures based on planned business operations, as derived from production/ service quantities. In a real business, a budget is not planned straight. It is more a kind of loop process that includes negotiations between departments and requires a lot of coordination and compromising. <?page no="86"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 5-86 Do not understand a budget or a business plan as forecast but as the planning of future operations. The quantities of what is planned to produce/ render in the future is a product/ service mix decision which is supported by Marketing Research. The number, resource consumptions and costs of operations depend on the planned output. The budgeting process results in numerous plan versions before the final cost plan is approved. The final and valid version of all plans is the budget. In contains partial plans, such as purchase budget, production budget, cash budget, A/ P budget etc. As the investors of a company want to predict the profits and future development of their company, a business plan is normally presented by the CEO (chief executive officer) or CFO (chief financial officer) on the annual general meeting. The annual general meeting is the assembly of all owners of the business and held annually. The investors want to understand and assess the economic outcome of future activities and their investments. In non-Accounting terms, a budget is often understood as an allowance (you can spend this amount of money). This is not its meaning in Accounting. A budget shows the costs at which a number of goods/ services can be produced to achieve a certain profit goal. Companies strive to plan costs as low as possible in order as they compete with other participants on the market. Hence, a good budget is one which meets the company’s performance goals at lowest costs. Manager should not overspend the budget as it makes the company less profitable. To keep costs at bay, actual costs are always compared toward the budget, which we refer to as Monitoring. Checking cost deviations and analysing their reasons helps a company to achieve its financial goals. We cover Monitoring in chapter (15). 5.5. Management Accounting is not Required by Law In contrast to Financial Accounting, Management Accounting does not follow legal rules. It is a discipline of Business and Management focussing on the internal support of managers with Accounting information. Its aim is to provide managers with useful data required to control the business. No information of Management Accounting should be discussed in public. This means that profit calculations, business plans, budgets, monitoring results and product and service calculations etc. must strictly remain undisclosed. They are not intended for company comparisons (except in case of Benchmarking) but for controlling and decision making. The quality of Management Accounting data depends on the information needs of managers. Therefore, it is possible that a budget is on another aggregation level, e.g., based on entire product groups, than its actual data derived later from Bookkeeping entries. 5.6. Management Accounting is Based on Costs Instead of 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 <?page no="87"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 5-87 business. This means, an expense that is not linked to business operations or to administration, is no cost. E.g., the support of the local soccer team by the grocery dealer is no cost. Management Accounting is based on cost information only. Planning, Monitoring and the Profit and product calculations are all linked to costs. As Management Accounting focusses on operating activities, an expense that is not considered as costs is ignored for controlling. In those cases, the income statement is likely to show a different profit compared to Management Accounting calculations. On the other hand, there can be costs which are no expenses. E.g., a B&B’s owner might not consider her/ his own workload as costs because she/ he does not pay her-/ himself a salary. Maybe, she/ he cuts costs short on the financial statements to increase profit. Although no (labour-)expense applies for the B&B hotel, it is advisable for the calculation of room rates that the equivalent for the manager’s salary is considered. Other examples are interest, if the company borrows from its owners, calculated rent, if the company resides in a building that belongs to its owners and does not pay them rent, calculated labour if the owner works ‘for free’ in her/ his own business etc. In this textbook we assume expenses equal costs by default. 5.7. Management Accounting Works on a Different Details Level The level of precision differs between Financial Accounting and Management Accounting. Financial Accounting reports on legal entity (company) level and is based on Bookkeeping entries. In contrast, Management Accountants plan costs and analyse actual cost information for organisational units (cost centres/ departments) and on a monthly basis. Regarding products, the planning and actual costing is based on single products/ services and groups thereof in Management Accounting. Financial Accounting only supports a product calculation if goods are put on stock and become inventory of finished goods to be disclosed on the balance sheet. 5.8. Management Accounting is About Allocations Decisions in a company are made by managers who are responsible for divisions, departments, cost centres or products. As a result, Management Accounting information must follow the objects managers make decide about. To prepare cost data linked to cost objects single or multiple cost allocations are made. In general, costs are allocated firstly to cost centres, between cost centres and thereafter to products/ services. 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, the data received allow her/ him to calculate profit and we call the department a profit centre. Most of the departments are run as cost centres as the revenue allocation is often difficult and not precise enough if based on rates. As a manager is responsible for the cost in her/ his cost centre, we call her/ him a cost centre responsible. <?page no="88"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 5-88 Managers strive to meet the budgeted costs to not jeopardise the profitability goals of the company. For motivational reasons, it is common to pay managers incentives based on their department performance and for low deviations from budget. 5.9. Management Accounting is for Periods Less than a Fiscal Year Management Accountants provide information for business control. To make decisions about resources and costs, the relevant data must be provided on short notice. For this reason, Management Accountants plan, monitor and report costs for monthly periods. This gives managers the chance to take immediate actions, once monitoring reveals that operations get out of proportions. Knowing cost deviation as soon as possible is critical for damage mitigation. Companies that notice, report and understand reasons for cost deviations gain advantage over companies that don’t notice deviations or cannot analyse them. The problem of cost deviations is merely a mass data problem. Many deviations can be detected but they must be filtered regarding their importance. Monthly cost recording is important to provide appropriate information for cost control. Another aspect for the on-time data availability is calculation. For determination of selling prices, a company must know the cost of manufacturing/ service rendering. A company cannot wait until the Accounting period (year) ends before making price decisions for its products/ services. 5.10. Management Accounting’s Focus is on Deviations A deviation means that, e.g., costs differ from budget. Budgeting strives to plan and decide on business activities that lead to a profit. In general, firms pursue profit, cash flow and return maximisation for its investors. An approved budget is based on the most efficient resource consumption and lowest costs for production or service rendering. Assume all costs in the company equal their budget. Then, the company is as profitable as budgeted. Any deviation causes an underachievement of financial goals and must be addressed. As managers are responsible for cost consumptions, they must compare actual costs to budget on a monthly basis. Management Accounting supports them with appropriate reports and Cost Monitoring. Detected deviations are checked for relevance and in case of significance, the deviations are analysed to detect the reasons and initiate measures to control or compensate costs. Management Accounting must frequently provide managers with deviation reports. Monitoring is followed by variance analysis. Note, that not all managers are Accountants. Therefore, they need support from Management Accounting to run their departments efficiently. 5.11. Management Accounting Reports The main communication in Management Accounting is based on reports. A Management Accounting report is a structured information file sent to managers regularly or triggered by exceptions which should meet <?page no="89"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 5-89 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 actual data derived from the Bookkeeping records. A report can be a standard report or a report that is prepared on demand. Although a lot of detailed knowledge about the business processes is available and accurate cost information is given, Management Accountants aggregate cost information to provide overviews. Managerial Accounting is mostly driven by requirements. Reports are based on a detailed information requirements study. Managers are interviewed to determine what information they need and what the information should look like. In Management Accounting the term cockpit is very common. The Management Accountant provides all relevant information to facilitate the managers piloting the company. The report format depends on the knowledge and understanding of the contents by their recipients. Hence, Management Accounting information is to be made easily accessible and understandable for management support. In some cases, reported information is not sufficient and more detailed data are required. The in-depth analysis in cost data is called drill-down and is add-on to monthly standard reports. This is called an exceptional Reporting. 5.12. How to Become a Management Accountant? Management Accountants support managers. They work as chief financial officer and are responsible for Financial and Management Accounting. 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. If the tax attorney is representing clients in court or at the revenue service, she/ he must hold a degree as Steuerberater (StB) and Wirtschaftsprüfer (WP). In many other countries, postgraduate studies are required for Management Accounting professions. In the US, a degree as CPA Chartered Professional Accountants is common. 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. 5.13. Summary We discussed the characteristics of Management Accounting based on the mini statements: - 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’s focus is on deviations. - Management Accounting reports. - How to become an Accountant. <?page no="90"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 5-90 5.14. Working Definitions Annual General Meeting: The annual general meeting is the assembly of all owners of the business and held annually. Budget/ Business Plan: A budget is the like a business plan. It contains at least the approved revenue planning, cost planning, profit planning and liquidity planning. Cost Centre: A cost centre is an organisational unit where costs are allocated to. The cost centre is controlled by a cost centre manager. Expense: An expense is a consumption of resources which leads to an outflow of economic benefits. Management Accounting Report: A Management Accounting report is a structured information file sent to managers regularly or triggered by exceptions which should meet their information needs to control their unit’s operations and helps to make economic decisions in the interest of the entire business. 5.15. Question Bank (1) In Managerial Accounting … 1. … budgeting is required to compare actual and planned costs. 2. … a cost centre is checked monthly for cost deviations. 3. … a cost centre manager must prepare an efficiency report regularly and disclose consumption and volume variance. 4. … no budgeting nor reporting of deviations is mandatory. (2) Management Accounting calculates materials based on … 1. … always net purchase costs. 2. … based on standard costs. 3. … based on budgeted net purchase prices. 4. … based on budgeted gross purchase prices. (3) In Managerial Accounting, the Profit and Loss account is the basis for … 1. … the income statement. 2. … the statement of comprehensive income. 3. … the profitability analysis. 4. … the calculation. (4) Costs are defined as … 1. … consumption of resources for business purpose. 2. … the equivalent to expenses. 3. … the equivalent to expenditures. 4. … the equivalent to payments. (5) A company that buys materials at 100.00 EUR; 110.00 EUR and 120.00 EUR to the amounts of 100 / 200 / 300 units discloses the standard costs per item based on weighted average cost as: 1. 100.00 EUR . 2. 111.00 EUR . 3. 113.33 EUR . 4. 120.00 EUR . 5.16. Solutions 1-4; 2-2; 3-3; 4-1; 5-3. <?page no="91"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 5-91 Section (2): Accounting for General Management <?page no="92"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-92 6. Cost Planning / Business Plan 6.1. What is in the Chapter? This chapter is about the planning of the company’s operations. We prepare various business plans for different industries. The case study KIRSTENBOSCH (Pty) Ltd. is a fastfood business. We demonstrate how to plan business activities and prepare a revenue plan, a cost plan, a profit plan and a liquidity plan over 3 Accounting periods. With the next case study McTOY GmbH, we cover a more complex case of a production firm. McTOY GmbH produces three kinds of goods (toys), and we study the budgeting process for multiple products and prices changes during these periods. A third business plan SCHLUCHMAN is prepared to demonstrate changes of the legal form of a company. SCHLUCHMAN is a case study linked to Hospitality Management; the firm is a caterer. 6.2. Learning Objectives In this chapter, you learn performance and cost planning for various businesses. After studying this chapter, you understand the planning procedure within Managerial Accounting. You can prepare a business plan for an entire company and understand the differences between profitability and liquidity planning: Profitability is based on revenue and costs - liquidity on payments. 6.3. Business Plan To plan the operations of a business, we must anticipate and decide about its operations in the upcoming Accounting periods. In Managerial Accounting, the term budgeting for the preparation of a business plan is very common. A budget is an approved plan. The core element of a business plan is cost and profit planning. It requires knowledge about the performance, given as the output of each cost centre. The performance depends on the production plan, which is the number of goods/ services produced or rendered. A common structure for a business plan is: (1) Revenue plan. (2) Cost plan. (3) Profit plan. (4) Liquidity plan and/ or cash flow statement. (5) Budgeted balance sheet. We follow this structure and study below the company KIRSTENBOSCH (Pty) Ltd. 6.4. C/ S KIRSTENBOSCH (Pty) Ltd. KIRSTENBOSCH (Pty) Ltd. is in the fastfood industry. The company is a franchisee of a worldwide operating fast-food chain. KIRSTENBOSCH (Pty) Ltd. is established on 2.01.20X0 by a share issue of 250,000 ordinary shares at 2.00 EUR/ s (face value). The share issue is par value; this means no capital reserves apply as no premium got paid. For financing, KIRSTENBOSCH (Pty) Ltd. takes a bank loan from its house bank to the extent of 400,000.00 EUR. The bank loan comes with an annual rate of interest to be paid at the yearend of 5 %/ a. <?page no="93"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-93 The pay-off amount equals to 10 %/ a based on the principal, here: 400,000.00 EUR. Hence, the pay-off is: 10% × 400,000 = 4 40,000.00 EUR/ a which is due at the end of every Accounting period. On 2.01.20X0, KIRSTENBOSCH (Pty) Ltd. furnishes the interior of the restaurant adhering the corporate identity requirements dictated by the fast-food chain and spends 600,000.00 EUR per bank transfer thereon. The appearance of the restaurant is planned to remain unchanged for the next 3 years. After that period, the interior must be renewed based on the franchise contract. No salvage value is considered for the furniture. KIRSTENBOSCH (Pty) Ltd. writes-off the interior of the restaurant over three Accounting periods based on straightline method. For restaurant rent, KIRSTENBOSCH (Pty) Ltd. pays 5,000.00 EUR/ m one month in advance except of for the first month which is paid for on 2.01.20X0 already. Later, rent is paid on the 25 th of the preceding month for the next following one’s. KIRSTENBOSCH (Pty) Ltd. buys materials (meat pads, chicken parts, buns, salad, sauces etc.) for 1,000,000.00 EUR per year. The materials are paid to an extent of 90 % per bank transfer during the Accounting period they are for. The remainder is due in the next following year. KIRSTENBOSCH (Pty) Ltd. pays for labour 300,000.00 EUR/ a. All workers are paid on cash. For administration, KIRSTENBOSCH (Pty) Ltd. pays 240,000.00 EUR/ a. KIRSTENBOSCH (Pty) Ltd.’s revenue is 2,200,000.00 EUR/ a every year. Income taxes are paid in the next following Accounting period; we adhere to the conventions in chapter (1). The appropriation of profits is planned to add all earnings to the earnings reserves. We prepare a business plan for KIRSTENBOSCH (Pty) Ltd. which includes a revenue plan, a cost plan, a profit plan, a liquidity plan, a cash flow plan with reconciliation of profit with operating cash flows (all per year) and provide a balance sheet as at 31.12.20X2. Hence, this business plan covers three Accounting periods and will therefore contain three columns: 20X0, 20X1 and 20X2. The budgeted balance sheet only is required at the end of the budgeting period. We ignore VAT for this case study. Date Sheet for KIRSTENBOSCH (Pty) Ltd. Classification: Hospitality Management; Accounting periods: 20X0; 20X1; 20X2; Issued capital: 500,000.00 EUR; Bank loan: 400,000.00 EUR, annuity: 40,000.00 EUR, 5% interest; P, P, E: 600,000.00 EUR, straight-line method over 3 Accounting periods; rent: 5,000.00 EUR/ m; one month in advance; Materials 1,000,000.00 EUR; 90% paid instantly; Labour: 300,000.00 EUR/ a on cash; administration: 240,000.00 EUR/ a per bank transfer; Proceeds: 2,200,000.00 EUR/ a; Income tax: 30%; Appropriation of profits: towards earnings reserves; VAT ignored. <?page no="94"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-94 6.5. Revenue Plan - C/ S Kirstenbosch (Pty) Ltd. The first step for the business plan preparation is to set up a revenue plan for KIRSTENBOSCH (Pty) Ltd. A revenue plan is an aggregated list of planned revenues for a business displayed on revenue group level for an Accounting period. Companies plan the revenue on different aggregation levels. Many companies plan on product group level. E.g., a restaurant can plan revenue and costs based on product groups, like beef burgers, chicken meals, salads, beverage. The burger group then contains hamburgers, cheeseburgers, double beef burgers etc. To determine the annual revenues, we often run an analysis, called Marketing Research. For KIRSTENBOSCH (Pty) Ltd., the revenue is already given to be 2,200,000.00 EUR every year. REVENUE PLAN 20X0 20X1 20X2 Revenue 2,200,000 2,200,000 2,200,000 Figure 6.1: KIRSTENBOSCH (Pty) Ltd.’s revenue plan 6.6. Cost Plan - C/ S Kirstenbosch (Pty) Ltd. All future costs are disclosed in a cost plan. A cost plan is a list of planned and budgeted costs for a business displayed on detailed costs or cost group levels for an Accounting period. KIRSTENBOSCH (Pty) Ltd.’s costs are for materials, rent, labour, depreciation, administration and for interest. The value for the materials is every year 1,000,000.00 EUR/ a (given). It does not matter for the cost planning, whether KIRSTENBOSCH (Pty) Ltd. pays for its materials. Payments become relevant for the Liquidity Planning, as you will see further below. Rent is given in this case study and its payments/ prepayments do not matter for budgeting. Depreciation results from the interior purchased in 20X0 and written-off along straight-line method over 3 years. It equals: 600,000 / 3 = 2 200,000.00 EUR/ a. Labour is amounting every year to 300,000.00 EUR/ a and administration costs at KIRSTENBOSCH (Pty) Ltd. are 240,000.00 EUR/ a every year. For interest calculation, we prepare an interest and pay-off schedule. Therein, the amount for pay-off always is 10 %/ a of the bank loan’s principal - which equals: 400,000 × 10% = 4 40,000.00 EUR/ a. Interest is based on the rate of interest (= 5 %/ a) and the liabilities owed at the beginning of the Accounting period. E.g., in the Accounting period 20X1, KIRSTENBOSCH (Pty) Ltd. owes the bank 360,000.00 EUR after paying-off 40,000.00 EUR in the first Accounting period. Hence, interest is: 360,000 × 5% = 1 18,000.00 EUR. Observe the interest and pay-off schedule as displayed in Figure 6.2. <?page no="95"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6.95 0.05 Y e ar O p e nin g am o u nt Inte re s t P ayoff Re st 20X 0 400,000 20,000 40,000 360,000 20X 1 360,000 18,000 40,000 320,000 20X 2 320,000 16,000 40,000 280,000 Figure 6.2: KIRSTENBOSCH (Pty) Ltd.’s interest and pay-off schedule We marked the interest column for budgeting in Figure 6.2. This is to indicate, that interest is a cost that get paid whereas the pay-off is a payment only. The cost plan contains all costs: COST PLAN 20X0 20X1 20X2 Material 1,000,000 1,000,000 1,000,000 Rent 60,000 60,000 60,000 Depreciation 200,000 200,000 200,000 Labour 300,000 300,000 300,000 Administration 240,000 240,000 240,000 Interest 20,000 18,000 16,000 Total 1,820,000 1,818,000 1,816,000 Figure 6.3: KIRSTENBOSCH (Pty) Ltd.’s cost plan 6.7. Profit Plan - Kirstenbosch (Pty) Ltd. For profit calculation, we deduct total costs from revenues. A profit plan is a schedule where planned and budgeted costs are deducted from the revenues for an Accounting period. The profit plan is referred to as the profitability analysis in Management Accounting. As income taxes depend on the profit for the period, tax expenses are disclosed on the profit plan, too. The appropriation of profits is also subjected to the profit planning and is shown at the bottom line of the profit plan. This is different to the statements following IFRSs. The reason is that a business plan does not contain a statement of changes in equity. For the case study KIRSTENBOSCH (Pty) Ltd., the profit after taxes for 20X0 equals: (2,200,000 - 1,820,000) × (1 - 30%) = 2 266,000.00 EUR. Taxes are due in the next following Accounting period but they count as an expense no matter when payments are made or received. The profit after taxes is added to earnings reserves, which is an item on the balance sheet. Observe the profitability plan depicted by Figure 6.4. <?page no="96"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-96 PROFITABILITY PLAN 20X0 20X1 20X2 Revenue 2,200,000 2,200,000 2,200,000 less costs (1,820,000) (1,818,000) (1,816,000) EBT 380,000 382,000 384,000 Income Tax (30%) (114,000) (114,600) (115,200) EAT 266,000 267,400 268,800 to: Earnings Reserves: 266,000 267,400 268,800 to: Dividend 0 0 0 Retained Earnings 0 0 0 Figure 6.4: KIRSTENBOSCH (Pty) Ltd.’s profitability plan 6.8. Liquidity Plan - Kirstenbosch (Pty) Ltd. So far, we only considered values that determine the profitability. These are revenues and costs/ expenses. Besides of profit maximisation, companies strive to generate cash with their operations. A positive cash flow is an increase of cash/ bank. A cash flow results from payments or money transfers. As higher the cash flow gets, as higher the solvency of a company becomes. Solvency means the potential of a company to fulfil its payment requirements. Profitability figures can differ from payments. E.g., a company that pays for an investment at the end of the year creates a cash outflow in the first Accounting period which is no cost. In the next Accounting periods, the company depreciates the asset, which is a cost, but no payment is made. As profit and liquidity do not equal, a liquidity plan must be prepared in addition to a profitability plan. A liquidity plan is a list that shows the opening value of the Cash/ Bank account and adds cash inflows and deducts cash outflows for a future Accounting period. The bottom line on the liquidity plan discloses the balance of the Cash/ Bank account. This is also referred to as liquidity. We look at KIRSTENBOSCH (Pty) Ltd. The company lists all payments and cash receipts in the liquidity plan. The plan starts-off with the opening cash/ bank balance and adds/ deducts the cash flows. It is widely common to not distinguish cash from bank. However, there is no problem if a company keeps the values separate to each other. At the bottom line, we can see the liquidity at the end of the Accounting periods, on 31.12.20XX. In 20X0, the opening value is zero. Observe Figure 6.5: <?page no="97"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6.97 LIQUIDITY PLAN 20X0 20X1 20X2 Open amount 935,000 1,363,000 Issue of shares 500,000 Bank loan taken 400,000 interest paid (20,000) (18,000) (16,000) Pay-off (40,000) (40,000) (40,000) Restaurant renewing (600,000) Rent (65,000) (60,000) (60,000) Labour (300,000) (300,000) (300,000) Admin (240,000) (240,000) (240,000) Material expenses paid (900,000) (1,000,000) (1,000,000) Proceeds 2,200,000 2,200,000 2,200,000 Tax paid 0 (114,000) (114,600) Closing amount C/ B 935,000 1,363,000 1,792,400 Figure 6.5: KIRSTENBOSCH (Pty) Ltd.’s liquidity plan The opening amount in 20X0 for KIRSTENBOSCH (Pty) Ltd. is zero, because the company is not established at that time. Thus, the first payment is the receipt of: 250,000 × 2 = 5 500,000.00 EUR for the owners’ contribution. The cash flow is positive which indicates a cash inflow (receipt). The next cash inflow results from the bank loan. The payment from the bank into KIRSTENBOSCH (Pty) Ltd.’s bank account is 400,000.00 EUR. The cash inflow is the principal of the loan. Both receipts (share issue and bank loan receipt) are once-off payments. We do not observe them in the other Accounting periods. The interest and pay-off are paid at the yearends and equal in 20X0: 20,000 + 40,000 = 6 60,000.00 EUR. That cash flow is negative as KIRSTENBOSCH (Pty) Ltd. pays it to the bank. It is a cash outflow. The payment for the investment is negative, too. The full costs of acquisition are paid in 20X0 and equal 600,000.00 EUR. No VAT applies. Rent is paid in advance. The monthly payment equals 5,000.00 EUR. The rent for January 20X0 is due in 20X0 and the payment for January 20X1 is made in 20X0, too, hence, the total rent payments are adding up to: 13 × 5,000 = 65,000.00 EUR in 20X0. The amounts paid for labour and administration are the same as costs. Every Accounting period KIRSTENBOSCH (Pty) Ltd. pays 300,000.00 EUR/ a on labour and 240,000.00 EUR/ a on administration costs. In the case of KIRSTENBOSCH (Pty) Ltd., the company pays only 90 % of its material costs during the actual Accounting period. The remainder of: 10% × 1,000,000 = 1 100,000.00 EUR is paid one year later. As this continues, the payments for purchases are 900,000.00 EUR in 20X0 - but: 100,000 + 900,000 = 1,000,000.00 EUR in 20X1 and 20X2. According to deferred purchase payments, KIRSTENBOSCH (Pty) Ltd. must recognise 100,000.00 EUR/ a in payables in all three Accounting periods. We get back <?page no="98"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-98 to this when we discuss the budgeted balance sheet. The revenue of KIRSTENBOSCH (Pty) Ltd. is paid on time. Therefore, the proceeds for all Accounting periods equal 2,200,000.00 EUR/ a. PProceeds are payments received in exchange of selling products or services. If VAT is considered the value for proceeds is always the gross amount. In contrast, revenue is a term linked to the income statement and is the net amount. Tax payments for income taxes are delayed one Accounting period following our conventions in chapter (1) . Hence, the tax payment in 20X0 is zero and in 20X1 it equals: 30% × 382,000 = 114,600.00 EUR. The income taxes are negative as KIRSTENBOSCH (Pty) Ltd. pays them into the local revenue service’s bank account. The total value as at the end of Accounting period 20X0 in the Cash/ Bank account equals: 500,000 + 400,000 - 60,000 - 600,000 - 65,000 - 300,000 - 240,000 - 900,000 + 2,200,000 = 935,000.00 EUR. Compare the result to the closing balancing figure recognised in the liquidity plan in Figure 6.5. Companies strive to guarantee the liquidity to be positive but try to keep it as low as possible. Cash reserves are no investments and therefore do not contribute to a company’s profit. In contrast to liquidity planning, managers strive to maximise profitability. In terms of Operations Research, profitability is the maximisation problem, and the liquidity is a constraint. In case the liquidity comes out negative, Management Accounting reworks plans, for example by taking a higher bank loan or increasing selling prices etc. In no case a business plan with negative liquidity shall be approved by management as no one deliberately plans a bankruptcy. 6.9. Budgeted Balance Sheet - Kirstenbosch (Pty) Ltd. To analyse a business’s future financial position, companies prepare a budgeted balance sheet. A budgeted balance sheet is a pro-forma statement of financial position at a future balance sheet date. The budgeted balance sheet is prepared for the last day of the last period covered by the business plan. The budgeted balance sheet does not follow IFRS requirements. 27 27 We recommend preparing a balance sheet to check the consistency of the business plan. <?page no="99"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6.99 BUDGETED BALANCE SHEET 20X0 20X1 20X2 PPE 400,000 200,000 0 Prepaid expenses 5,000 5,000 5,000 Cash/ Bank 935,000 1,363,000 1,792,400 1,340,000 1,568,000 1,797,400 SCap 500,000 500,000 500,000 Reserves 266,000 533,400 802,200 Interest bear liab 360,000 320,000 280,000 A/ P 100,000 100,000 100,000 Tax liab 114,000 114,600 115,200 1,340,000 1,568,000 1,797,400 Figure 6.6: KIRSTENBOSCH (Pty) Ltd.’s pro-forma balance sheet The value of P, P, E is for the store equipment bought in 20X0 and is planned to be 600,000.00 EUR. The valuation appearing on the balance sheet is reduced for depreciation and equals: 600,000 - 200,000 = 4 400,000.00 EUR in 20X0. The prepaid expenses represent the January’s rent for the next Accounting period. The value displayed in 20X0 is for January 20X1, the value in the 20X1 column is for January 20X2 and the last one is prepaid expenses for 20X3. The value of cash/ bank equals the liquidity calculated on the liquidity plan. SCap is an abbreviation for share capital and equals: 250,000 × 2 = 5 500,000.00 EUR. Its valuation does not change during the planning period as no further shares are issued or bought back. The reserves are earnings reserves and contain the annual surplus of the periods based on the decision about the appropriation of profits (given). The value in 20X0 equals to the earnings after taxes. The value in 20X1 equals: 266,000 + 267,400 = 5 533,400.00 EUR. The last one equals: 266,000 + 267,400 + 268,800 = 802,200.00 EUR. This means the reserves are accumulating profits (here, adhering to the decision made about the appropriation of profits). The value for the bank loan can be directly taken from the interest and payoff schedule in the rest-column. The payables result from the short-term liabilities caused by purchases. Tax liabilities are income tax liabilities and recognised as a liability because they are paid one Accounting period later. 6.10. Cash Flow Statement - Kirstenbosch (Pty) Ltd. Here, we discuss liquidity again, however, this time from a more Financial Accounting point of view. We now prepare a future cash flow statement. A planned cash flow statement is a list of future operating cash flows, investing cash flows and financial cash flows. The figures are on cash flow group level mostly. Many companies calculate the operating cash flow <?page no="100"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6.100 by reconciliation of the net operating profit with the operating cash flow. This means less Accounting work. The cash flow statement contains similar items as the liquidity plan. In contrast, the structure of cash flows is based on its triggers: operations, investing activities and financial activities. Furthermore, a cash flow statements only discloses the payment and receipts but no opening and closing balance. 20X0 20X1 20X2 CASH FLOW PLAN CF operating activities EBT 380,000 382,000 384,000 Adj for depreciation 200,000 200,000 200,000 Adj for interest 20,000 18,000 16,000 Tax paid 0 (114,000) (114,600) Changes in A/ P 100,000 Changes in tax liab. 0 0 0 Changes in A/ R, prepay (5,000) 695,000 486,000 485,400 CF investing activities Adj for acquisition (600,000) (600,000) 0 0 CF financing activities Share issue 500,000 Interest & pay-off (60,000) (58,000) (56,000) Taking bank loan 400,000 840,000 (58,000) (56,000) Total cash flow 935,000 428,000 429,400 Figure 6.7: KIRSTENBOSCH (Pty) Ltd.’s statement of cash flows The business plan allows to compare liquidity planning and future cash flows. The cash flows indicate the difference in the item cash/ bank. On the liquidity plan, the balancing figure of the Cash/ Bank account is calculated by adding cash flows to the opening value. To check the figures for KIRSTENBOSCH (Pty) Ltd., we calculate the total cash flow for 20X1. It equals to the sum of cash flows from operating activities, cash flows from investing activities and cash flows from financing activities: 695,000 - 600,000 + 840,000 = 935,000.00 EUR. As there is no opening value for the Cash/ Bank account, the liquidity equals 935,000.00 EUR in 20X1. Compare the calculation to Figure 6.5. In the next Accounting period 20X2, according to KIRSTENBOSCH (Pty) Ltd.’s cash flow statement in Figure 6.7, the total cash flow equals: 486,000 + 0 - 58,000 = 4 428,000.00 EUR. Based on the cash flow calculation, the liquidity is the sum of the opening value (same as the closing balance of the previous period) and the cash flows: 935,000 + 428,000 = 1,363,000.00 EUR. This is the figure you <?page no="101"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6.101 can read from the table in Figure 6.5 - bottom line. Accordingly, the liquidity in the last Accounting period equals: 1,363,000 + 485,400 + 0 - 56,000 = 11,792,400.00 EUR. The value is disclosed in the liquidity plan in Figure 6.5 and as balancing figure of the Cash/ Bank account on the balance sheet - such as shown as the cash/ bank item in Figure 6.6. How it is Done (Business Plan) (1) Determine the number of goods/ services that are intended to be sold. (2) Determine net selling prices by Marketing Research. (3) Calculate the revenue by multiplying sales numbers with net selling prices. (4) Determine costs to produce goods or render services. (5) Calculate costs that are not linked to production, such as Marketing, Human Resources or Accounting costs. (6) Deduct costs from revenues to calculate earnings before taxes. (7) Assume tax expenses occur in the period they are for (if the case study does not say otherwise). Deduct income tax expenses from earnings before taxes by multiplying the earnings before taxes with the total tax rate (in the textbook always 30 %). (8) Consider the appropriation of earnings after taxes as either (a) profit carried forward, (b) dividend or (c) reserves. Follow the policy of the company about the appropriation of its profits. (9) Prepare a liquidity plan by direct method or reconciliation of profits with operating cash flows. (10) Deduct cash outflows from opening cash/ bank item and from cash inflows to calculate the cash/ bank closing value. (11) Prepare a balance sheet as at the end of the last Accounting period of the business plan. (12) Run a financial statement analysis for future financial statements to access the business. (13) If the result of the business plan is unsatisfying change the business concept or its parameters and rework from step (1) on. After studying a business plan for a service provider, we take our studies a step further. A business plan for a production firm is more complex because it considers materials and inventory movements. We present the case study McTOY GmbH, which is a German toy manufacturer. <?page no="102"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6.102 6.11. C/ S McTOY GmbH McTOY GmbH is a production firm for toys; it manufactures bicycles, tricycles, and go-karts. For the sake of simplicity, the goods only consist of a frame and 2, 3, or 4 wheels. 6.12. Revenue Plan - McTOY GmbH The planned numbers of sold bicycles are 2,400 u/ a, for tricycles 600 u/ a, and for go-karts 960 u/ a. Bicycle sales stay constant but the quantity of tricycles and go-karts increases from 20X1 to 20X4 by 100 units per year. The net selling price per bicycle is 140.00 EUR/ u, per tricycle 320.00 EUR/ u and per go-kart 350.00 EUR/ u. Prices do not change during the periods 20X1 to 20X4. Observe the revenue plan as in Figure 6.8: 20X1 20X2 20X3 20X4 bicycles sold [units] 2400 2400 2400 2400 revenue bicycles [EUR] 336,000 336,000 336,000 336,000 tricycles sold [units] 600 700 800 900 revenue tricycles [EUR] 192,000 224,000 256,000 288,000 go-karts sold [units] 960 1060 1160 1260 revenue go-karts [EUR] 336,000 371,000 406,000 441,000 total revenue 864,000 931,000 998,000 1,065,000 REVENUE PLAN McToy GmbH for 20X1 to 20X4 Figure 6.8: McTOY GmbH’s revenue plan We advise to prepare a master data sheet in MS-Excel. An example for how this could look like is given in Figure 6.9. Figure 6.9: McTOY GmbH’s master data sheet <?page no="103"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-103 Before we cover the business plan, we show the data sheet for McToy GmbH. Data Sheet for McToy GmbH CClassification: Production; Goods quantities: 2,400 / 600 / 960 - increasing during the next periods; Net selling prices: 140.00 EUR / 320.00 EUR / 350.00 EUR; Start-up costs: 205,000.00 EUR; Materials: steel 3.00 EUR/ kg / steel wheel 8.00 EUR/ u / plastic wheel 5.00 EUR/ u; Product factor steel: 9 kg / 14 kg / 26 kg; Labour costs (production): 45.00 EUR/ h; Department cost rates: 50.00 EUR/ h / 42.00 EUR/ h; 8.00 EUR/ h; P, P, E: 676,000.00 EUR - written-off over 8 years completely (straight-line method); Bank loan: 700,000.00 EUR; annuity: 56,000.00 EUR/ a, 6 % interest included; non-manufacturing costs (without interest): 99,396.00 EUR; VAT applicable. Cost Plan - McToy GmbH McToy GmbH‘s costs include start-up costs, material costs and manufacturing costs. The latter ones are labour and overheads. Furthermore, non-manufacturing costs are relevant. The start-up costs equal 205,000.00 EUR. Direct materials are steel and wheels at the prices below: (1) 3.00 EUR/ kg steel. (2) 8.00 EUR/ steel wheel (for the bicycles. (3) 5.00 EUR/ plastic wheel (for the tricycles and go-karts). From the bill of materials (BOM), we know that a bicycle frame is made from 9 kg steel, the frame for tricycles from 14 kg and the go-kart frame from 26 kg. A bill of materials BOM is a document that tells the part structure of a product. To calculate the material costs for the bicycles in 20X1, McToy GmbH multiplies the quantities with the purchase prices: 2,400 × 3 × 9 = 6 64,800.00 EUR. <?page no="104"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-104 20X1 20X2 20X3 20X4 Start-up costs other 205,000 Material expenses Steel bicycle 64,800 64,800 64,800 64,800 tricycle 25,200 29,400 33,600 37,800 go-kart 74,880 82,680 90,480 98,280 Wheels bicycle 38,400 38,400 38,400 38,400 tricycle 9,000 10,500 12,000 13,500 go-kart 19,200 21,200 23,200 25,200 total material 231,480 246,980 262,480 277,980 expenses COST PLAN McToy GmbH for 20X1 to 20X4 Figure 6.10: McTOY GmbH’s cost plan (partial) McTOY GmbH manufactures as many goods as it sells. Therefore, no closing stock of materials or of finished goods is left at the yearends. Manufacturing of all goods requires 3 production steps: welding, coating and wheel assembly. Direct labour (at a cost rate of 45.00 EUR/ h) for the Coating and Assembling department are as depicted in the routings. 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. Obviously, we can prepare routings that are linked to single resources, however, in general, we refer to machine groups. [min] per bicycles per tricycles per goKart Welding - - - Coating 15 15 15 Assembling 20 30 40 Figure 6.11: McTOY GmbH’s routing information (1) McTOY GmbH deploys a welding robot, hence, no labour applies in its Welding department, check Figure 6.12. For the application of manufacturing overheads, predetermined overhead allocation rates are given. All overhead rates are based on workload hours. In the Welding department, the hourly cost rate is 50.00 EUR/ h, in the Coating department it equals 42.00 EUR/ h and in the Assembling department it equals 8.00 EUR/ h. The operating time for the three departments is given by Figure <?page no="105"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6.105 6.12. You can derive them from routings too. [min] per bicycles per tricycles per goKart Welding 18 30 48 Painting 15 15 15 Assembling 20 30 40 Figure 6.12: McTOY GmbH’s routing information (2) As an example, we calculate manufacturing costs for (all) bicycles: 2,400 × (45/ 60) × 15 + 2,400 × (45/ 60) × 20 + 2,400 × (50/ 60) × 18 + 2,400 × (42/ 60) × 15 + 2,400 × (8/ 60) × 20 = 1 130,600.00 EUR. The costs contain direct labour as well as manufacturing overheads. You can read the same amount for bicycles from McTOY GmbH’s cost plan: 36,000 + 25,200 + 6,400 + 27,000 + 36,000 = 130,600.00 EUR. 20X1 20X2 20X3 20X4 MANUFACTURING OVERHEADS Welding bicycle 36,000 36,000 36,000 36,000 tricycle 15,000 17,500 20,000 22,500 go-kart 38,400 42,400 46,400 50,400 Coating department bicycle 25,200 25,200 25,200 25,200 tricycle 6,300 7,350 8,400 9,450 go-kart 10,080 11,130 12,180 13,230 Assembling bicycle 6,400 6,400 6,400 6,400 tricycle 2,400 2,800 3,200 3,600 go-kart 5,120 5,653 6,187 6,720 DIRECT LABOUR Coating bicycle 27,000 27,000 27,000 27,000 tricycle 6,750 7,875 9,000 10,125 go-kart 10,800 11,925 13,050 14,175 Assembling bicycle 36,000 36,000 36,000 36,000 tricycle 13,500 15,750 18,000 20,250 go-kart 28,800 31,800 34,800 37,800 COST PLAN McToy GmbH for 20X1 to 20X4 Figure 6.13: McTOY GmbH’s cost plan (partial) <?page no="106"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-106 Besides of manufacturing costs, there are labour costs for the supervisor. These count as manufacturing overheads, too, but they are not included in the rates. They equal 75,000.00 EUR/ a plus 12,000.00 EUR/ a for McTOY GmbH‘s contribution to social security. We must include these labour costs for our calculations. Depreciation is included in the rates for production. McTOY GmbH buys machinery at the beginning of 20X1 (2.01.20X2) to cost of acquisition of 676,000.00 EUR (net amount). The useful life of the machinery is 8 years. No residual value applies. Depreciation is based on straightline method. Accordingly, depreciation is amounting to: 676,000 / 8 = 8 84,500.00 EUR/ a. McTOY GmbH takes a bank loan with a principal of 700,000.00 EUR on 2.01.20X1. The bank loan is an annuity that comes with an annual payment of 56,000.00 EUR/ a. The rate of interest is 6%/ a, annually compounded and based on the amount owed. Interest and payoff are paid at yearends. The bank loan is paid-off completely at the end of 20X4. Observe the interest and pay-off schedule for the bank loan in Figure 6.14. 0.06 A m o u n t In t e r e st P a y -o ff A n n u it y Y e a r 7 0 0 ,0 0 0 .0 0 4 2 ,0 0 0 .0 0 1 4 ,0 0 0 .0 0 5 6 ,0 0 0 .0 0 2 0 X 1 6 8 6 ,0 0 0 .0 0 4 1 ,1 6 0 .0 0 1 4 ,8 4 0 .0 0 5 6 ,0 0 0 .0 0 2 0 X 2 6 7 1 ,1 6 0 .0 0 4 0 ,2 6 9 .6 0 1 5 ,7 3 0 .4 0 5 6 ,0 0 0 .0 0 2 0 X 3 6 5 5 ,4 2 9 .6 0 3 9 ,3 2 5 .7 8 6 5 5 ,4 2 9 .6 0 6 9 4 ,7 5 5 .3 8 2 0 X 4 Figure 6.14: McTOY GmbH’s bank loan Interest shows in the cost plan. Non-manufacturing costs apply for: third party costs (cleaning staff): 10,500.00 EUR/ a, membership fees for the engineering body in Germany: Verein Deutscher Ingenieure VDI: 96.00 EUR/ a, costs for administration: 36,000.00 EUR/ a, motor vehicle costs (rent, fuel): 12,000.00 EUR/ a, administration costs (Management and Accounting): 36,000.00 EUR/ a and annual insurance fees to an extent of 4,800.00 EUR. The aggregated cost plan is provided in Figure 6.15. <?page no="107"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6.107 20X1 20X2 20X3 20X4 Start-up costs other 205,000 Material expenses total 231,480 246,980 262,480 277,980 Production facillity costs total 144,900 154,433 163,967 173,500 Labour in production departments including supervisor 209,850 217,350 224,850 232,350 Other expenses 3rd party costs 10,500 10,500 10,500 10,500 Fees 96 96 96 96 Building costs 36,000 36,000 36,000 36,000 MV expenses 12,000 12,000 12,000 12,000 Administration 36,000 36,000 36,000 36,000 Insurance 4,800 4,800 4,800 4,800 Interest 42,000 41,160 40,270 39,326 141,396 140,556 139,666 138,722 Total costs 932,626 759,319 790,962 822,552 COST PLAN McToy GmbH for 20X1 to 20X4 Figure 6.15: McTOY GmbH’s aggregated cost plan 6.13. Profit Plan - McTOY GmbH The calculation of profit for 20X1 is as below: 864,000 - 932,626 = - -68,626.00 EUR. The result indicates a loss. Hence, no income taxes must be paid for 20X1. McTOY GmbH carries forward the loss to 20X2. The loss carried forward to the next Accounting period 20X2 reduces the distributable amount for that period. In 20X2, the profit after taxes equals: 171,680 × (1 - 30%) = 1 120,176.47 EUR. The distributable value for the appropriation of profits is reduced for the loss carried forward and equals: 120,176.47 - 68,626 = 5 51,550.47 EUR. To keep the case study simple, we do not calculate net dividends and do not disclose payable dividend taxes on behalf of the investors. As the net dividend is paid to investors and taxes on capital returns (dividend tax) to the revenue service, a business plan discloses the total payment, no matter who is the recipient. Hence, we only disclose gross dividends on the business plan. At McTOY GmbH, the appropriation of profits is 50: 50 - meaning: 50 % is the gross dividend and 50 % are added to earnings reserves. <?page no="108"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-108 20X1 20X2 20X3 20X4 Revenue 864,000 931,000 998,000 1,065,000 Cost (932,626) (759,319) (790,962) (822,552) Earnings before Tax (68,626) 171,681 207,038 242,448 less income tax (30%) 0 51,504 62,111 72,734 Earnings after Taxes (68,626) 120,176 144,926 169,714 Earnings after Taxes (68,626) 120,176 144,926 169,714 add P/ L carried forward 0 (68,626) 0 0 Distributable Amount (68,626) 51,550 144,926 169,714 (1) Gross Dividend 0 25,775 72,463 84,857 (2) Earnings Reserves 0 25,775 72,463 84,857 McTOY GmbH PROFITABILITY ANALYSIS for 20X1 - 20X4 Figure 6.16: McTOY GmbH’s profit plan You might ask yourself whether the loss for 20X1 is acceptable when we prepare a business plan. Should we change the business model to avoid the loss? Surprisingly, the answer is No. As the company got just established based on its issued capital of 170,000 EUR, the first year’s loss is covered. This means, the loss is that low that the company does not become indebted. In case the loss exceeds a value of 170,000.00 EUR, the company would be obliged to file for bankruptcy - that is a scenario we do not tolerate for planning! 6.14. Liquidity Plan - McTOY GmbH Next, we study the liquidity plan. For the payments it is important to consider that at McTOY GmbH value added tax at a rate of 20 % applies. Like the profitability, the liquidity is essential for the survival of the business. A company that becomes insolvent must file for bankruptcy. Insolvency does not mean the company is not allowed to take loans. It means a company must be able to fulfil its payment obligations, like for labour or taxes. The liquidity plan contains the opening value in the Cash/ Bank account of 170,000.00 EUR and all cash inflows and cash outflows. Regarding payment terms, the conventions in chapter (1) apply: Income tax, VAT and dividends are paid/ received one Accounting period delayed. <?page no="109"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-109 Position 20X1 20X2 20X3 20X4 Opening value Equity 170,000 Opening value 0 146,178 574,019 782,847 170,000 146,178 574,019 782,847 Cash in Bank loan 700,000 0 0 0 Proceeds 864,000 931,000 998,000 1,065,000 Output-VAT 172,800 186,200 199,600 213,000 VAT refund 0 222,496 49,396 52,496 1,736,800 1,339,696 1,246,996 1,330,496 Cash out Annuity (56,000) (56,000) (56,000) (694,755) Acquisition (676,000) 0 0 0 Input-VAT (acquisition) (135,200) 0 0 0 start-up costs (205,000) 0 0 0 Input-VAT (start-up) (41,000) 0 0 0 Material expenses (231,480) (246,980) (262,480) (277,980) VAT from materials (46,296) (49,396) (52,496) (55,596) Production facilities (144,900) (154,433) (163,967) (173,500) Labour in production (209,850) (217,350) (224,850) (232,350) Other expenses (141,396) (140,566) (139,666) (138,722) Adj: depr + interest 126,500 125,660 124,770 123,826 VAT payment 0 (172,800) (186,200) (199,600) Tax payment 0 0 (51,504) (62,111) Dividend paid 0 0 (25,775) (72,463) (1,760,622) (911,865) (1,038,168) (1,783,252) Liquidity 146,178 574,009 782,847 330,091 McToy GmbH LIQUIDITY PLAN for 20X1 to 20X4 Figure 6.17: McTOY GmbH’s liquidity plan In contrast to the previous case study Kirstenbosch (Pty) Ltd., the share issue takes place before business commences. Therefore, we disclose an opening value in cash/ bank. The timing of the owners’ contribution is the default case in business. In general, the opening balance sheet contains the funds at the time of incorporation. The establishment is then completed when operations begin. In 20X1, the liquidity plan for McTOY GmbH shows cash inflows from the bank loan of 700,000.00 EUR and from the proceeds to the extent of: 864,000 × (1 + 20%) = 1 1,036,800.00 EUR. Together, the cash inflows add up to: 700,000 + 1,036,800 = 1 1,736,800.00 EUR. The output-VAT collected from customers on behalf of the revenue service is paid in the next Accounting period 20X2. It then results in a cash outflow of 172,800.00 EUR. In the next following Accounting periods, McTOY GmbH must consider a cash <?page no="110"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-110 inflow resulting from input-VAT refunding. Input-VAT is paid by McTOY GmbH on the start-up costs, on the investment and on the materials. The refund for the input-VAT paid in 20X1 and refunded in 20X2 is amounting to: 135,200 + 41,000 + 46,296 = 2 222,496.00 EUR. In 20X1, cash outflows result from the bank loan’s annuity of 56,000.00 EUR, from the investment of: 676,000 × (1 + 20%) = 8 811,200.00 EUR, from the startup costs of: 205,000 × (1 + 20%) = 246,000.00 EUR, from the purchase of the materials to an extent of: 231,480 × (1 + 20%) = 2 277,776.00 EUR, from the overheads in the factory of 144,900.00 EUR, from labour costs in the factory of 209,850.00 EUR and from miscellaneous costs, which add up to 141,396.00 EUR as disclosed in the cost plan in detail. McTOY GmbH records an adjustment of: 84,500 + 42,000 = 1 126,500.00 EUR for depreciation and interest in the liquidity plan. Depreciation is deducted from cash outflows as it is included in the rates but is not paid. The interest is included in the miscellaneous costs and is considered in the annuity as well. This results in a double consideration and requires adjustment. Therefore, we add depreciation and interest to cash outflows. The total cash outflow for 20X1 equals: 56,000 + 811,200 + 246,000 + 277,776 + 144,900 + 209,850 + 141,396 - 126,500 = 1 1,760,622.00 EUR. The liquidity is the balance of the Cash/ Bank account as per the end of the Accounting period. In 20X1, the value equals: 170,000 + 1,736,800 - 1,760,622 = 1 146,178.00 EUR. 6.15. Budgeted Balance Sheet - McTOY GmbH To assess the financial position of the company, we prepare a budgeted balance sheet. It can be observed in Figure 6.18. A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 338,000 Share capital 170,000 Intangibles Reserves 183,095 Financial assets R/ E Current assets Liabilities Inventory Interest bear liab 0 A/ R 55,596 A/ P 213,000 Prepaid expenses SH4D 84,857 Cash/ Bank 330,091 Tax liabilities 72,734 723,687 723,687 McTOY GmbH STATEMENT of FINANCIAL POSITION as at 31.12.20X4 Figure 6.18: McTOY GmbH’s budgeted balance sheet <?page no="111"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-111 The balance sheet is prepared as at 31.12.20X4. This is the last day of the period the business plan is for. The value of property, plant and equipment equals to the cost of acquisition less four times depreciation: 676,000 - 4 × 84,500 = 3338,000.00 EUR. The receivables result from input-VAT paid on material purchases in 20X4. They will be claimed from the revenue service in 20X5. The value for cash/ bank can be taken from the liquidity plan. The issued capital equals 170,000.00 EUR as given. The value for the reserves is the total of additions to earnings reserves during 20X2 - 20X4: 25,775.23 + 72,463.21 + 84,856.88 = 1 183,095.32 EUR. The payables result from the output-VAT collected from the customers and payable to the revenue service in 20X5. SH4D stands for shareholders for dividend and contains the gross dividends. The tax liabilities displayed are income tax liabilities from 20X4 due in 20X5. 6.16. C/ S Schluchman Our third business plan is about a company that changes its legal form. Therefore, it becomes more complex and relevant for study legal aspects, too. It is recommended to work on this case study by preparing your own business plan on MS-Excel. The case study SCHLUCHMAN is linked to Hospitality Management. The company is a caterer. Its owner Mr Schluchman starts the business as a privately-owned company and after 2 years he transfers it into a privatelyowned limited company in the legal form of a German GmbH. The legal change is planned and therefore we prepare a business plan for 4 years that includes the change. Find below the data sheet for SCHLUCHMAN: Date Sheet for SCHLUCHMAN Classification: Hospitality Management; Inception: 1.01.20X3; P, P, E: stove: 3,000.00 EUR; fridge: 360.00 EUR; car: 21,200.00 EUR; Materials: dough 1.20 EUR/ kg; toppings; BOM: 100 g dough/ pizza; 1.25 EUR toppings/ pizza; Net selling price: 3.60 EUR/ pizza; per event: 100 French pizza sold, 250.00 EUR set-up costs, 80.00 EUR for the waiter; Advertising: 2,400.00 EUR; VAT not applicable. For the first 2 periods, SCHLUCHMAN is a caterer in private ownership. It sells French pizza baked freshly in a mobile pizza stove. Customers can rent the stove and the chef coming out to their house or event location and serving their guests French pizza. On 1.01.20X3, the company is established by the chef Mr Schluchman. He deposits 10,000.00 EUR in a bank account dedicated to the business “SCHLUCHMAN”. Note, the bank account is in the name of its owner, Mr Schluchman. The company is not registered for VAT reduction. On 2.01.20X3, Mr Schluchman buys a pizza stove and pays the price of 3,000.00 EUR to an extent of 50 %. The remainder is due in arrears of 500.00 EUR every yearend. The supplier charges interest at a rate of 4 %/ a. The interest is paid together with the 500.00 EUR for pay-off. The mobile pizza stove has a useful life of 4 years. No residual value is considered. <?page no="112"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-112 On 2.01.20X3, Mr Schluchman buys a mobile fridge with car electrical socket access (cigarette lighter plug) for the delivery van to keep pizza dough and toppings fresh during transport. The mobile fridge costs 360.00 EUR. It will be deployed for 3 years. Mr Schluchman pays the fridge per bank transfer. The business car is a Mercedes Benz Vaneo. Mr Schluchman owns it already, and it is 2 years old. The car was acquired on 2.01.20X1 at a price of 31,200.00 EUR. At that time, Mr Schluchman paid the gross amount of 31,200.00 EUR - he is not registered for VAT reduction; hence, the costs of acquisition are the car’s gross value. Mr Schluchman estimates to use the car 6 years and to sell it thereafter for 1,200.00 EUR. On 1.01.20X3, the car’s carrying value is: 31,200 - (31,200 - 1,200)/ 3 = 2 21,200.00 EUR. Mr Schluchman buys dough from a nearby pizza restaurant which costs 1.20 EUR/ kg. Mr Schluchman always keeps a safety stock of 25 kg dough. There is also a 25 kg dough stock left at the yearends. We assume, dough does not expire, it is used on a first-in-first-out basis, and therefore, no spoilage applies. The toppings for the French pizza are: onions, olives, bacon, sour cream, rocket salad etc. Mr Schluchman stores the toppings in the mobile fridge, too. The safety stock of toppings is worth 60.00 EUR. As not all toppings can be stored for a week, we consider toppings waste to an extent of 50 % of the safety stock on average every week. The toppings at the end of the week equal 60.00 EUR. Half thereof is disposed. As a result, there is toppings stock at the yearend to the extent of 30.00 EUR. During the Accounting periods 20X5 and 20X6, the stock level is the same, but the VAT reduction declines the cost of purchase to: 60/ 120% = 5 50.00 EUR. Waste and spoilage according to this, are: 50/ 2 = 2 25.00 EUR. Mr Schluchman pays the toppings supplier 80 % to the supplier instantly, the remainder is due in the next Accounting period. Per French pizza, 100 g/ u of dough are used, and toppings worth 1.25 EUR/ u (purchase costs) are added to the dough. Every French pizza is sold at 3.60 EUR/ u, which is the paid price by the clients. Mr Schluchman’s business model is to charge the client who hosts the party for all French pizza sold. Per event, he sells 100 French pizza. For each event, Mr Schluchman charges extra 250.00 EUR as set-up costs. During the years 20X3 and 20X4, Mr. Schluchman caterers 180 events. Mr Schluchman bakes the French pizza himself but does not pay himself a salary. His daughter, who is an Accounting student works as waiter/ assistant cook. She gets paid 80.00 EUR/ event on a freelancer basis. Mr Schluchman askes an Advertising agency to design a website. He assumes that after 2 years of business, the company will grow and can be taken to the next level. The agency charges him 2,400.00 EUR on 30.06.20X3 as once-off payment. Mr SCHLUCHMAN pays personnel income taxes based on a (simplified) tax progression system at the income tax rates below: from: 0 … 20,000 EUR: 0% from: 20,001 … 30,000 EUR: 20 % from: 30,001 … 40,000 EUR: 25 % from: 40,001 … 50,000 EUR: 30 % from: 50,001 … 60,000 EUR: 35 % <?page no="113"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-113 from: 60,001 EUR: 40% Mr SCHLUCHMAN has no other occupation meaning he does not earn another income. He makes a drawing to the extent of his personal income tax liability resulting from the business plus a 35,000.00 EUR/ a amount. After two years, Mr Schluchman transfers his business into a limited company in the legal form of a GmbH. He launches MOBILE TARTE FLAMBEE GmbH. See below the data sheet for MOBILE TARTE FLAMBEE GmbH: Data Sheet for MOBILE TARTE FLAMBEE GmbH CClassification: Hospitality Management; Established: 1.01.20X5: 40,000.00 EUR; registered for VAT reduction; P, P, E: 5 stoves (4 new, one preowned: 2 years); 4 mobile friges (3 new, one preowned: 2 years); car: 11,200.00 EUR; Labour: waiter: 80.00 EUR/ event; cook: 100.00 EUR/ event; Mr Schluchman: 40,000.00 EUR/ a / 45,000.00 EUR/ a; Business plan for 20X3, 20X4; 20X5; 20X6. VAT applicable at a VAT rate of 20 %. The company is established by 40,000.00 EUR of equity - fully paid into the company’s bank account. Mr Schluchman hires an attorney to establish MOBILE TARTE FLAMBEE GmbH and to register the company at the local court. It is registered for VAT reduction at the revenue service on 2.01.20X5, too. MOBILE TARTE FLAMBEE GmbH buys 4 stoves at 3,000.00 EUR gross purchase price. The prior terms and conditions apply: the price is only paid half, and the remainder is charged 4 %/ a of interest. The 5 th stove is the one, Mr Schluchman privately sells his company at 1,500.00 EUR. For the latter payment no VAT can be claimed as Mr Schluchman (seller) is a private person. The remaining useful life is 2 years. The purchase contract and the amount Mr Schluchman owes the stove supplier for the old stove, does not matter for the business plan, as Mr Schluchman is the supplier’s debtor - not his firm. He pays the remaining debts of 500.00 EUR and interest of: 500 × 4% = 220.00 EUR at the end of 20X5 privately. The company buys the stove from Mr Schluchman at 1,500.00 EUR which is at carrying value. MOBILE TARTE FLAMBEE GmbH buys 4 mobile fridges at the same price (360.00 EUR gross selling price) and same useful life (3 years). No residual value is to be considered. The old fridge is sold to the company at 120.00 EUR by Mr Schluchman. It gets replaced by a new fridge (gross amount of 360.00 EUR) on 2.01.20X6. Its useful life is 3 years then, too. With the new equipment, MOBILE TARTE FLAMBEE GmbH can serve 5 events at a time. We refer to the equipment required to serve 1 party as a ‘party-unit’. MOBILE TARTE FLAMBEE GmbH buys the delivery van from Mr Schluchman at 11,200.00 EUR. No VAT applies for the purchase from the private seller (Mr Schluchman). However, when selling the car at the end of 20X6, its net selling price will be 1,000.00 EUR and the gross amount: 120% × 1,000 = 1,200.00 EUR - as scheduled before. The inventory levels are now relevant per party-unit, which requires to be multiplied with 5. All other business conditions apply for now 5 party-units. E.g., the waste on toppings is: 5 × 25 = 1 125 EUR/ w. <?page no="114"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-114 The van serves all party-units during a night. No inventories, like dough or toppings, are transferred from the old private business to the new company. For the cooking and service, MOBILE TARTE FLAMBEE GmbH employs freelancers. The waiters are students who charge 80.00 EUR/ event. 1 student is needed per event. A freelancer-cook charges 100.00 EUR/ event. One is deployed per party. Mr Schluchman is now the manager and does not work as chef anymore as he did before. MOBILE TARTE FLAMBEE GmbH is busy at 800 events in 20X5 and at 950 events in 20X6. Mr Schluchman is the chief executive officer (CFO) at MOBILE TARTE FLAMBEE GmbH and earns 40,000.00 EUR in 20X5 and 45,000.00 EUR in 20X6. We prepare a business plan for the Accounting periods 20X3 - 20X6. In the first years, the business is privatelyowned and in the 2 following years the company is a limited company. The appropriation of profits for the company is at a 50 : 50 ratio, which means 50 % of the distributable amount goes to reserves and 50 % are paid to the owners. No profit is carried forward. Revenue Plan - MTF GmbH We look at Mr Schluchman’s and MOBILE TARTE FLAMBEE GmbH’s (MTF GmbH) revenue plan. It is depicted in Figure 6.19. Revenue plan 20X3 20X4 20X5 20X6 Parties, set up costs 45,000 45,000 200,000 237,500 French pizza 64,800 64,800 240,000 285,000 Total revenue 109,800 109,800 440,000 522,500 Figure 6.19: Mr Schluchman’s/ MOBILE TARTE FLAMBEE GmbH’s revenue plan The revenue is divided into 2 items, the first one is the set-up fees (fixed) and the second one is for the French pizza sale (prop.). The set-up fees depend on the event numbers. In 20X3, the revenue equals: 180 × 250 = 4 45,000.00 EUR. In 20X5, the set-up fees are the same per customer, however the value is ex VAT. This means by registration for VAT reduction, the set-up fees net value stays but the money received from clients increases due to output-VAT collection. Thus, the registration of VAT reduction causes the prices to increase for a non- VAT-registered client. As a lot of events are house parties this applies for most of the events. In 20X5, the revenue from set-up fees is: 800 × 250 = 2 200,000.00 EUR. In the next year, the value will increase to: 950 × 250 = 2 237,500.00 EUR. The VAT included in the values from 20X5 onwards becomes relevant for the liquidity planning as well. The sales price of French pizza is different. The selling price is always 3.60 EUR. Hence, the revenue per French pizza declines in 20X5 and 20X6 due to VAT registration. MOBILE TARTE FLAMBEE GmbH does not intend to change the selling prices for its (private) customers. <?page no="115"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-115 The revenue in the first years equals: 180 × 100 × 3.6 = 6 64,800.00 EUR. The net selling price per pizza is 3.60 EUR/ u. After MOBILE TARTE FLAMBEE GmbH’s incorporation, the net selling price per French pizza equals: 3.60/ 120% = 3 3.00 EUR/ u. As a result, the revenue in 20X5 equals: 800 × 100 × 3 = 2 240,000.00 EUR. In the next year, the revenue equals: 950 × 100 × 3 = 2 285,000.00 EUR. Cost Plan - MTF GmbH The cost plan for Mr Schluchman/ MOBILE TARTE FLAMBEE GmbH is shown in Figure 6.20. We explain every figure disclosed therein below. Cost plan 20X3 20X4 20X5 20X6 Stove Depreciation stove 750 750 2,500 2,500 Depreciation old stove 750 750 Interest on stove 60 40 240 160 Fridge Depreciation on fridge 120 120 120 Depreciation on new fridge 400 500 Car Depreciation on car 5,000 5,000 5,100 5,100 Materials Material dough 2,160 2,160 8,000 9,500 Material toppings 24,060 24,060 91,133 106,758 Labour Labour waiters/ assistants 14,400 14,400 144,000 171,000 Web agency costs 2,400 Manager costs 40,000 45,000 Total costs 48,950 46,530 292,243 341,268 Figure 6.20: Mr Schluchman’s / MOBILE TARTE FLAMBEE GmbH’s cost plan The cost plan goes by items: stove, refrigerator, car, material costs and labour. The stoves are depreciated. Depreciation is in the first years (1 stove) amounting to: 3,000 / 4 = 7 750.00 EUR/ a. The stove is transferred to MOBILE TARTE FLAMBEE GmbH and written-off in 20X5 and 20X6. The cost of acquisition for the new stoves is: 3,000 / 120% = 2 2,500.00 EUR/ u. The amount is written-off over 4 years, which gives an annual depreciation of: 2,500 / 4 = 6 625.00 EUR/ (u × a). MOBILE TARTE FLAMBEE GmbH operates 4 stoves. Thus, depreciation equals: 4 × 625 = 2 2,500.00 EUR/ a. The stoves are paid only half. Mr Schluchman owes the supplier 1,500.00 EUR in 20X4 and pays 4 %/ a on interest. The interest is: 1,500 × 4% = 660.00 EUR. At the end of the Accounting period, Mr Schluchman paysoff 500.00 EUR. The interest for 20X4 equals: (1,500 - 500) × 4% = 4 40.00 EUR. When buying the new stoves MOBILE TARTE FLAMBEE GmbH owes the supplier 6,000.00 EUR in 20X5 and pays interest to an extent of: 6,000 × 4% = <?page no="116"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-116 2240.00 EUR/ a. In the next year, interest costs: 4,000 × 4% = 1 160.00 EUR/ a. The mobile fridge is bought at 360.00 EUR. Depreciation equals: 360 / 3 = 120.00 EUR/ a. As the mobile fridge is sold to MOBILE TARTE FLAMBEE GmbH at the beginning of 20X5 for 120.00 EUR and still got a year of useful life depreciation on that fridge is 120.00 EUR in 20X5, too. In 20X5, MOBILE TARTE FLAMBEE GmbH buys 4 fridges at 360.00 EUR/ u which gives cost of acquisition of: 360 / 120% = 3 300.00 EUR/ u. Depreciation on 4 fridges equals: 4 × 300 / 3 = 4400.00 EUR. In 20X6, MOBILE TARTE FLAMBEE GmbH replaces the old fridge and according to the acquisition, it now depreciates 5 fridges at 100.00 EUR/ a. Hence, depreciation equals: 5 × 100 = 5 500.00 EUR/ a. The car is valued at 21,200.00 EUR when Mr Schluchman starts his private business. He depreciates it following straight-line method and estimates to sell the car for 1,200.00 EUR 4 years later. As a result, depreciation in the first two years is: (21,200 - 1,200) / 4 = 5,000.00 EUR/ a. After MOBILE TARTE FLAMBEE GmbH bought the car for 11,200.00 EUR, depreciation is based on the cost of acquisition and the estimated net selling price. It equals: (11,200 - 1,000) / 2 = 5 5,100.00 EUR/ a. The net selling price changes due to output-VAT. The costs of acquisition are 11,200.00 EUR as the firm buys from a private seller. No VAT reduction applies. For the residual value, VAT is considered as the company is registered for VAT reduction and must collect the output VAT for the car sale. 28 As the material expenses drop due to input-VAT reduction and the waste remains unchanged, a higher waste rate applies. The “materials” for dough and toppings are linked to the amount that is used or wasted. The dough per pizza is 100 g. In the first 2 Accounting periods, the dough which is bought at 1.20 EUR/ kg equals: 180 × 100 × 0.1 × 1.20 = 2 2,160.00 EUR. No waste of dough applies. In the next periods, MOBILE TARTE FLAMBEE GmbH can claim input-VAT. Thus, the dough costs drop to: 1.20 / 120% = 1 1.00 EUR/ kg. In 20X5, the total dough costs are: 800 × 100 × 0.1 × 1 = 8 8,000.00 EUR. In 20X6, the costs are: 950 × 100 × 0.1 × 1 = 9 9,500.00 EUR. The toppings consumed in the first Accounting periods cost 1.25 EUR/ u per French pizza. Furthermore, waste of 30.00 EUR per week is considered. The toppings cost: 180 × 100 × 1.25 + 30 × 52 = 2 24,060.00 EUR. In the next Accounting periods 20X5 and 20X6, MOBILE TARTE FLAMBEE GmbH reduces the cost of purchase due to input-VAT deduction. The amount is: 800 × 100 × 1.25/ 120% + 5 × 25 × 52 = 89,833.33 EUR. In 20X6, the costs are: 950 × 100 × 1.25/ 120% + 5 × 25 × 52 = 105,458.33 EUR. 28 Labour costs in the first Accounting period are only for the waiter/ assistant chef. Mr Schluchman does not pay himself a salary as he earns the profit from the business. Labour costs are 80.00 EUR per party. The total labour costs are: 180 × 80 = 1 14,400.00 EUR. In the next Accounting periods 20X5 and 20X6, the labour costs are: 100 + 80 = 1 180.00 EUR/ party. This gives: 800 × 180 = 144,000.00 EUR in 20X5 and: 950 × 180 = 1 171,000.00 EUR in 20X6 for the waiter and chef. The management salary is 40,000.00 EUR in 20X5 and 45,000.00 <?page no="117"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-117 EUR in 20X6. No calculated salary applies for the 1 st years as the business plan is not used for pricing the French pizza. The web agency charges 2,400.00 EUR in 20X3. Profit Plan - MTF GmbH The profit calculation can be derived from the table in Figure 6.21. Profitability plan 20X3 20X4 20X5 20X6 Revenue 109,800 109,800 440,000 522,500 less Total of costs (48,950) (46,530) (290,943) (339,968) Earnings before taxes EBT 60,850 63,270 149,057 182,532 Income taxes 0 0 (44,717) (54,760) Earnings after taxes 60,850 63,270 104,340 127,772 -> reserves 52,170 63,886 -> dividend 52,170 63,886 Profit along 4.3: 65,668 63,264 Schluchman's tax 13,267 12,305 Figure 6.21: Mr Schluchman’s / MOBILE TARTE FLAMBEE GmbH’s profitability plan The profitability analysis based on the commercial law is less complicated than for the tax law. For the commercial profit calculation, all costs are deducted from the revenue as it can be seen in the profitability plan. However, the tax calculation in the first 2 Accounting periods follows the 4.3- profit-calculation method. In accordance with the 4.3-method the accrual principle only applies for investment/ depreciation situations. Otherwise, payments count. The difference becomes relevant for the purchase of the toppings as they are paid in the next Accounting period to an extent of 20 %. As a result, the profit increases by: 20 % × 24,090 = 4,818.00 EUR. The income tax relevant profit based on the 4.3-method then 29 Mr Schluchman can deduct the payments for toppings as expense in 20X5 from his personal income taxes. This gives him an individual taxable income of: 40,000 - 4,812.00 + 51,714.83 = 86,902.83 EUR. The income tax resulting from working in the company plus the loss from the application of 4.3-method are levied along the equals: 60,850 + 4,818 = 6 65,668.00 EUR. The income taxes following the given tax scheme, equal: 20,000 × 0 + 10,000 × 20% + 10,000 × 25% + 10,000 × 30% + 10,000 × 35% + (65,668 - 60,001) × 40% = 1 13,266.80 EUR. In the next Accounting period, the deferred payments for the toppings cancel out themselves, except of the safety stock to the extent of: 20% × 30 = 6 6.00 EUR. As a result, the taxable income is amounting to: 63,270 - 6 = 63,264.00 EUR. As the assets, such as stove, fridge and car, are sold at their carrying amounts to the new company, no taxable profit results from liquidations. The income taxes paid are: 20,000 × 0 + 10,000 × 20% + 10,000 × 25% + 10,000 × 30% + 10,000 × 35% + (63,264 - 60,001) × 40% = 1 12,305.20 EUR. 29 given income tax scheme. The same applies for the income from the company shares which is subject to the withdrawal tax for capital gains. We assume, Mr Schluchman is the only shareholder. For our simplified tax calculation, we ignore tax-free income and any per- <?page no="118"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-118 The tax payments for 20X3 and 20X4 are Mr Schluchman’s personnel business. We determine taxes only to calculate the drawings as disclosed on the liquidity plan. The appropriation of profits in 20X5 and 20X6 follows a half : half approach. Thus, half of the earnings after taxes are paid to the shareholders (Mr Schluchman only) and the other half is added to reserves. 6.17. Liquidity Plan - MTF GmbH The liquidity plan is displayed in Figure 6.22. Liquidity plan 20X3 20X4 20X5 20X6 Opening value 10,000 9,651 40,000 243,800 Proceeds Revenue 109,800 109,800 440,000 522,500 Output-VAT 88,000 104,500 Output-VAT paid (88,000) Car Acquisition of the car (21,200) 0 (11,200) Stove Acquisition of the stove (1,500) 0 (1,500) Downpayment for stoves (6,000) Input-VAT on stove refunded 2,000 Interest on stove (60) (40) (240) (160) Pay-off of stove (500) (500) (2,000) (2,000) Acquisition of the old fridge (120) Refrigerator Acquisition of the fridges (360) 0 (1,440) (360) Input-VAT on fridge refunded 240 Materials Payment for dough (2,190) (2,160) (9,750) (11,400) Input-VAT refunded 1,625 Payment for toppings (19,272) (24,066) (107,950) (126,550) Input-VAT refunded 17,992 Labour waiter/ assistant (14,400) (14,400) (144,000) (171,000) Payment for web agency (2,400) 0 0 0 Payment for manager (40,000) (45,000) Payment for dividend (52,170) Drawing for tax/ later: ITL (48,267) (47,305) (44,717) Liquidity 9,651 30,980 243,800 351,300 Figure 6.22: Mr Schluchman’s / MOBILE TARTE FLAMBEE GmbH’s liquidity plan The liquidity plan only shows payments and opening/ closing balances. The sonal characteristics of taxpayers as well as the German reunion tax. We further assume the income tax on capital gains equals 25 %. The tax liabilities of Mr Schluchman in 20X5 equal: 20,000 × 0 + 10,000 × 20% + (40,000 - 4,812 - 30,001 × 25% + 25% × 51,714.83 = 3,296.75 + 12,928.71 = 16,225.46 EUR. The tax liabilities contain income tax opening value is the owner’s contribution and the value in cash/ bank resulting and the tax on capital gains. The tax liabilities of Mr Schluchman are not relevant for the business plan of the company and, thus, do not appear thereon in 20X5 and 20X6. <?page no="119"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-119 from prior Accounting periods. Next, we explain all figures shown in Figure 6.23. The revenue is the basis for the calculation of proceeds. After the company registered for VAT, it starts to collect output-VAT from its customers and pays it accordingly to the conventions in chapter (1) during the next Accounting period to the German revenue service. The acquisition of the car takes place in 20X3 when the business opens. The car is bought in 20X5 by MOBILE TARTE FLAMBEE GmbH from Mr Schluchman. The cash input for the car sale in Mr Schluchman’s private account is not relevant for the company’s business plan. It is his own business. The business plan only contains the payments made by him in 20X3/ 20X4 and MOBILE TARTE FLAMBEE GmbH’s payments in 20X5/ 20X6. The latter one is with VAT consideration. The payment for the stove is only half of the price following the payment terms above. Mr Schluchman pays the remaining price later. The instalments are shown as pay-off of the stove. The acquisition of 4 pizza-stoves during 20X5 leads to a payment of: 4 × 3,000 / 2 = 66,000.00 EUR. The company pays only half of the price. The stove prices contain input-VAT to an extent of: 20% × 12,000/ 120% = 2 2,000.00 EUR. 30 MOBILE TARTE FLAMBEE GmbH receives a refund for input-VAT in 20X6 from the German revenue service. The instalments for the stoves are 500.00 EUR per stove and Accounting period. Mr Schluchman and MOBILE TARTE FLAMBEE GmbH pay interest on the owing amount. Interest is calculated in the cost plan already and is disclosed to the same value on the liquidity plan. 30 The timing of payments is irrelevant for VAT calculation. The first fridge is bought at 360.00 EUR. No VAT is relevant. It is later sold at carrying value of 120.00 EUR to MOBILE TARTE FLAMBEE GmbH by Mr Schluchman. The acquisition of the new fridges leads to a payment of: 4 × 360 = 1,440.00 EUR. The payment contains: 20% × 1,440/ 120% = 2 240.00 EUR input- VAT as refunded in 20X6. The replacement fridge is bought in 20X6 at a price of 360.00 EUR. The input-VAT therein is a receivable on the balance sheet and expected for 20X7. The material payments are for the dough and the toppings. The dough payment in 20X3 is higher to the extent of 30.00 EUR because Mr Schluchman must buy the safety stock. In 20X5 the payment for the dough contains the dough plus safety stock - both including input-VAT. The price equals: (8,000 + 125) × 120% = 9 9,750.00 EUR. The input- VAT therein to the extent of: 20% × 8,125 = 1 1,625.00 EUR is refunded in 20X6. In the next Accounting period 20X6, the dough purchase is based on material costs only, as the safety stock is still in the fridge (consider FIFO). The gross amount is: 9,500 × 120% = 11,400.00 EUR. The input-VAT therein which is 1,900.00 EUR is a receivable on the balance sheet as at 31.12.20X6. For the toppings, a 2-Accounting-Periodpayment applies. The toppings cost (including waste and spoilage) plus the initial stock level are paid to an extent of 80 %. In the first Accounting period, the payment equals: (24,060 + 30) × 80% = 19,272.00 EUR. In 20X4, the remaining 20 % of the 20X3 delivery are paid. No toppings must be stocked as the safety stock of toppings still exists. The price paid is: (24,060 + 30) × 20% + 24,060 × <?page no="120"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-120 80% = 2 24,066.00 EUR. At the time of MOBILE TARTE FLAMBEE GmbH commences its operations, no safety stock of topping gets transferred. The price for the toppings contains the topping materials including waste plus the safety stock of 125.00 EUR. The price also contains input-VAT and adds up to: (89,833.33 + 125) × 120% = 1 107,950.00 EUR. The payment includes an amount of 17,991.67 EUR input-VAT to be refunded in 20X6. In 20X6, no safety stock for toppings is paid for and the toppings payment equals: 105,458.33 × 120% = 126,550.00 EUR. The input-VAT portion therein equals: 20% × 126,550 / 120% = 21,091.67 EUR and is recorded as receivables on the balance sheet for 20X6. The payment for labour equals to the labour costs. Dividends and taxes are paid one Accounting period delayed following our conventions in chapter (1). The owner, Mr Schluchman, takes a cash drawing to the extent of his personal income taxes in 20X3 and 20X4 plus 35,000.00 EUR/ a. In 20X3, the drawing equals: 13,266.80 + 35,000 = 4 48,266.80 EUR. One year later the drawing is amounting to: 12,305.20 + 35,000 = 47,305.20 EUR. Budgeted Balance Sheet - MTF GmbH The budgeted balance sheet is depicted in Figure 6.23. Budgeted balance sheet 20X3 20X4 20X5 20X6 P, P, E Stove (4) 2,250 1,500 7,500 5,000 old stove 750 0 Fridges 240 120 800 600 old fridge 0 car 16,200 11,200 6,100 1,000 Inventory Dough 30 30 125 125 Toppings 30 30 125 125 Accounts receivables VAT receivables 21,857 23,052 Cash/ Bank 9,651 30,980 243,800 351,300 Total assets 28,401 43,860 281,057 381,202 Share capital 10,000 10,000 40,000 40,000 Reserves 52,170 116,056 Retained earnings 12,583 28,548 0 0 Accounts payables output VAT 88,000 104,500 stove 1,000 500 4,000 2,000 dividend 52,170 63,886 A/ P toppings 4,818 4,812 Tax liabilities 44,717 54,760 Total equity and liabilities 28,401 43,860 281,057 381,202 Figure 6.23: Mr Schluchman’s / MOBILE TARTE FLAMBEE GmbH’s balance sheet <?page no="121"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-121 The balance sheet shows the carrying values of the assets. The values are the cost of acquisition less accumulated depreciation. E.g., the carrying value for the car in the 20X3 equals: 21,200 - 5,000 = 1 16,200.00 EUR. Additionally, the inventory values are provided which include the safety stocks. The value for VAT receivables in 20X5 contains the input-VAT for the stoves, the fridges, the dough and the toppings: 2,000 + 240 + 1,625 + 17,991.67 = 2 21,856.67 EUR. The value for cash/ bank can be taken from the liquidity plan. On the credit side, the balance sheet shows an issued capital of 10,000.00 EUR for the privately-owned business and of 40,000.00 EUR share capital. The line retained earnings contains the profit less drawings in the first periods and a zero for the Accounting periods 20X5 and 20X6 - due to the full appropriation of profits. The reserves contain the portions of the profits that are not distributed to the shareholders. In 20X6, the reserves equal: 52,169.83 + 63,886.08 = 116,055.91 EUR. The liabilities are displayed separately and are easily understandable. The short-term liabilities are linked to output-VAT, liabilities to suppliers and shareholders and for toppings payments scheduled for the next Accounting period and resulting from the previous one. The tax liabilities only appear at MOBILE TARTE FLAMBEE GmbH, as Mr Schluchman is privately obliged to pay taxes. 6.18. Summary Companies plan their operations for the next upcoming Accounting periods and prepare 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. In this chapter we explained detailed business plans for 3 different case studies. 6.19. Working Definitions Budgeted Balance Sheet: A budgeted balance sheet is a pro-forma statement of financial position at a future balance sheet date. Budgeted Cash Flow Statement: A planned cash flow statement is a list of future operating cash flows, investing cash flows and financial cash flows. Cost Plan: A cost plan is a list of planned and budgeted costs for a business displayed on detailed costs or cost group level for an Accounting period. Liquidity Plan: A liquidity plan is a list that shows the opening value of the Cash/ Bank account, adds cash inflows and deducts cash outflows for a future Accounting period. Proceeds: Proceeds are payments received in exchange of selling products or services. Profit Plan: A profit plan is a schedule where planned and budgeted costs are deducted from the revenues for an Accounting period. Revenue Plan: A revenue plan is a list of planned revenues for a business displayed on revenue group level for an Accounting period. Routing: A routing is a document in a production firm that shows how much time a production step on which machine group takes to get processed. <?page no="122"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 6-122 6.20. Question Bank (1) A company (registered for VAT reduction) buys goods at purchase costs of 10,000.00 EUR every year and pays 80 % thereof and the remainder in the next year. You are to prepare the liquidity plan. How much are payments in the first 3 years? 1. 8,000.00 EUR / 8,000.00 EUR / 8,000.00 EUR . 2. 9,600.00 EUR / 10,000.00 EUR/ 10,000.00 EUR . 3. 9,600.00 EUR / 12,000.00 EUR / 12,000.00 EUR . 4. 9,600.00 EUR / 10,400.00 EUR / 10,000.00 EUR . (2) A company pays 250.00 EUR/ m rent. Rent is not subjected to VAT. The payment is 2 months in advance. On a 3 years business plan the rent shows in the cost plan as: 1. 3,500.00 EUR / 3,000.00 EUR / 3,000.00 EUR . 2. 3,500.00 EUR / 3,500.00 EUR / 3,500.00 EUR . 3. 3,500.00 EUR / 2,500.00 EUR / 3,000.00 EUR . 4. 3,000.00 EUR / 3,000.00 EUR / 3,000.00 EUR . (3) A business plan contains … 1. … a revenue plan, a cost plan, a profit plan and a cash flow statement. 2. … a revenue plan, a cost plan, a budgeted balance sheet and a liquidity plan. 3. … a profit plan, a product calculation and a liquidity plan. 4. … a cost plan, a profit plan, an asset plan and a budgeted balance sheet. (4) A company prepares a profit plan and discloses the appropriation of profits therein. The appropriation of profits is at an 80 : 20 ratio as dividends : R/ E. How much are dividends if the pre-tax profit is in every year 100,000.00 EUR? 1. 80,000.00 EUR / 96,000.00 EUR / 99,200.00 EUR . 2. 80,000.00 EUR / 80,000.00 EUR / 80,000.00 EUR . 3. 56,000.00 EUR / 67,200.00 EUR / 69,440.00 EUR . 4. 56,000.00 EUR / 56,000.00 EUR / 56,000.00 EUR . (5) A company buys a non-current asset at 150,000.00 EUR cost of acquisition. The dealer offers a discount of 5 %. VAT is to be considered at a rate of 20 %. Depreciation is along straight-line method over 10 years. How does the asset show on the budgeted balance sheet? 1. 128,250.00 EUR / 114,000.00 EUR / 99,750.00 EUR . 2. 142,000.00 EUR / 128,000.00 EUR / 114,000.00 EUR . 3. 153,000.00 EUR / 136,900.00 EUR / 119,700.00 EUR . 4. 171,000.00 EUR / 153,900.00 EUR / 136,900.00 EUR . 6.21. Solutions 1-2; 2-4; 3-2; 4-3; 5-1. <?page no="123"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 7-123 7. Cost Concepts, Cost Behaviour and Cost Separation 7.1. What is in the Chapter? In this chapter, we study behaviour of costs. This means we try to understand whether costs change with the performance or whether they stay constant. We strive to determine what drives costs in order to predict them for different output scenarios. The output of a company is the quantity of goods it produces or services it renders. The performance of cost centres depends proportionally on the output of a company. In order to keep Accounting simple, we only study the reaction of costs to the performance. Behavioural Accounting is important for cost planning. The techniques taught in this textbook are the high-low method, the scatter graph and the simple regression method. All methods are studied and compared for the same case study DANNING (Pty) Ltd. which is a law firm in Australia. 7.2. Learning Objectives In this chapter, you learn the basic concepts of how to plan costs on output/ performance amounts. After studying this chapter, you can distinguish proportional and fixed costs. Proportional costs change with the performance. For budgeting, we need to know if and how costs change with the performance. From studying cost behaviour, Management Accountants know what drives proportional costs and which costs are fixed. Knowing the cost functions ‘cost over performance’ you can say which costs are to be expected if a certain number of goods or services is produced/ rendered. You learn to understand different cost behaviour patterns and know how to determine costs if the output is known. You also understand how to derive a cost centre’s performance from outputs. You learn the most common methods for cost function determination. You will be able to apply these methods and know their strong and weak points and can estimate the effort for their application. 7.3. Cost Concepts We distinguish 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. Note, that proportional cost is a special instance of variable costs. Variable refers to any dependency whereas a proportional dependency shows a straight line when drawn in a cost-volume-diagram. For management purposes, the concepts of incremental costs, sunk costs and opportunity costs are relevant, as we will discuss below. Costs represent a consumption of resources and are linked to business operations. E.g., materials only become as a cost, if used in production. Check the previous chapter (6) where the material costs for dough in 20X5 were estimated to be (check Figure 6.20): 180 × 100 × 0.1 × 1.20 = 2,160.00 EUR. The purchases were: 2,160 + 30 = <?page no="124"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 7-124 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 added to safety stock. You can see the dough on stock in Figure 6.23 as inventory on the balance sheet. 31 For the sake of correct terminology, we introduce common cost concepts in Management Accounting and illustrate them by small cases. The cost concepts we cover are: (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. 7.4. Direct vs. Indirect Costs Direct costs are direct materials and direct labour. The term direct indicates that the costs can be assigned straight to the product based on a 1 : 1 relationship. Materials are firstly recorded in the Raw Materials Inventory account and contain all materials bought from suppliers. Raw materials can be dough in a pizza restaurant or a full headlight component for a car manufacturer. Once materials are assigned to products, the Accountant makes a debit entry in the WIP-account and a credit entry in the Inventory account. In contrast to direct materials, indirect costs cannot be traced to single goods/ services without allocations. They are added to the cost of a cost centre in the Manufacturing Overheads account 31 We acknowledge that the expression ‘cost of purchase’ from Financial Accounting is misleading. Purchases are no costs, only material consumption results in costs. (MOH-account) if linked to production. Direct labour are those labour costs that are assigned straight to the product/ service. Some manufacturers call direct labour ‘touch labour’ to indicate that workers touch the product. In contrast, indirect labour serves more/ all products and is, e.g., supervisors’ salary, janitor costs, security service fees or warehouse management costs. Those costs are not attached to the products. 7.5. Manufacturing vs. non-Manufacturing Costs Even as the term manufacturing-related indicates the costs occur in a factory, the cost concept applies in other industries, too. Manufacturing costs are costs linked to the output or performance. They contain direct materials, direct labour and manufacturing overheads. In contrast, non-manufacturing costs are not linked to the goods production or service rendering but, e.g., to selling and administration (SG&A). In Accounting, non-manufacturing costs are not added to the Manufacturing Overhead account but recorded in separate accounts, such as Marketing account, Administration account etc. Along IAS 2, non-manufacturing costs cannot be considered for inventory valuation of finished goods as they don’t contribute to production. Later, we classify the non-manufacturing costs as period costs. In Management Accounting, two further technical terms are frequently in <?page no="125"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 7-125 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 ones represent the costs necessary to convert the materials to the finished product, but they do not contain materials. The total of prime costs and manufacturing overheads, which equals to the sum of direct materials and cost of conversion, is referred to as the cost of manufacturing. 7.6. Product vs. Period Costs The classification in product and period costs is based on the disclosure of costs on financial statements. Product costs are assigned to products which can be put on stock. They are the cost of manufacturing of the goods on stock. When goods are added to stock, their product costs are deferred to later Accounting periods when the goods are sold. This means, the cost consideration on the income statement is delayed until the sale of the goods. One could say product costs are ‘parked’ in inventory until sales takes place. This is the reason, why nonmanufacturing costs are not accepted to be assigned to product costs. The inventory valuation is used for the disclosure of inventories of finished goods. Once a company breaks the rules of Financial Accounting, the inventory valuation is not permitted for disclosure on the balance sheet. If, e.g., PENOR (Pty) Ltd. calculates doors based on average purchase costs, the resulting inventory valuation does not qualify for Financial Accounting. Period costs are linked to the Accounting period they occur in. Period costs cannot be assigned to inventories as they elapse after the Accounting period. All accounts for period costs are closed-off to the Profit and Loss account at the end of the Accounting period. Typical period costs are non-manufacturing costs, like for administration, sales, Accounting etc. 7.7. C/ S STAFFORD (Pty) Ltd. We explain the distinction between product and period costs with a small case study STAFFORD (Pty) Ltd. which we also prepare financial statements for. STAFFORD (Pty) Ltd. is in the textile industry and produces polo shirts in Cape Town. We ignore VAT. Find below the data sheet for STAFFORD (Pty) Ltd.: Data Sheet for STAFFORD (Pty) Ltd. CClassification: Production; Issued capital as per 1.01.20X1: 1,000,000.00 ZAR; P, P, E: sewing machinery: 4,000,000.00 ZAR; Materials: 800,000.00 ZAR/ a; consumed: 640,000.00 ZAR Labour: 1,900,000.00 ZAR/ a; direct labour: 1,600,000.00 ZAR; indirect labour: 300,000.00 ZAR (SG&A: 220,000.00 ZAR thereof); Depreciation on sewing machines: 500,000.00 ZAR/ a; Output: 320,000 u/ a; Sales: 250,000 u/ a at 34.00 ZAR/ u; VAT ignored. On 1.01.20X1, STAFFORD (Pty) Ltd. is established by a share issue of 100,000 ordinary shares at 10.00 ZAR/ s. STAFFORD (Pty) Ltd. buys sewing machines at 4,000,000.00 ZAR and pays <?page no="126"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 7-126 them by bank transfer. The company purchases fabric and yarn from its supplier at 800,000.00 ZAR (together). The purchases are recorded in the Raw Materials Inventory account. STAFFORD (Pty) Ltd. employs sewers and supervisors in the production department to an extent of 1,900,000.00 ZAR/ a. Depreciation on the sewing machines equals 500,000.00 ZAR/ a. We observe the accounts to produce 320,000 polo shirts. All activities are recorded in 20X1. During the first Accounting period, STAFFORD (Pty) Ltd. sells 250,000 polo-shirts at 34.00 ZAR/ u. The revenue equals: 250,000 × 34 = 8 8,500,000.00 ZAR. We study the Bookkeeping entries below: (1) Establishment of STAFFORD (Pty) Ltd.: DR Cash/ Bank.................... 1,000,000.00 ZAR CR Issued Capital............... 1,000,000.00 ZAR (2) Purchase of materials: DR Raw Materials Inventory...... 800,000.00 ZAR CR Cash/ Bank.................... 800,000.00 ZAR (3) Recording labour: DR Labour....................... 1,900,000.00 ZAR CR Cash/ Bank.................... 1,900,000.00 ZAR (4) Acquisition of machinery: DR P, P, E Account.............. 4,000,000.00 ZAR CR Cash/ Bank.................... 4,000,000.00 ZAR (5) Depreciation: DR Depreciation................. 500,000.00 ZAR CR Acc. Depr.................... 500,000.00 ZAR (6) Revenue recognition: DR Cash/ Bank.................... 8,500,000.00 ZAR CR Revenue...................... 8,500,000.00 ZAR Observe the recording of the polo shirt production in Figure 7.1: <?page no="127"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 7-127 D C D C (1) 1,000,000.00 (2) 800,000.00 (1) 1,000,000.00 (6) 8,500,000.00 (3) 1,900,000.00 (4) 4,000,000.00 Cash/ Bank C/ B Issued capital ISS D C D C (2) 800,000.00 (3) 1,900,000.00 Raw Materials Inventory RMI Labour-20X1 LAB D C D C (4) 4,000,000.00 (6) 8,500,000.00 Property, plant, equipment PPE Revenue-20X1 REV D C D C (5) 500,000.00 (5) 500,000.00 Depreciation-20X1 DPR Acc depr ACC Figure 7.1: STAFFORD (Pty) Ltd.’s accounts The materials consumed in production are 640,000.00 ZAR. The labour is to an extent of 1,600,000.00 ZAR direct labour and 300,000.00 ZAR is indirect labour. Consider 220,000.00 ZAR of the indirect labour for selling and administrative costs (SG&A). The application of overheads is to its full extent meaning all overheads are applied. We record production as below in Figure 7.2. 32 D C D C (1) 1,000,000.00 (2) 800,000.00 c/ d 1,000,000.00 (1) 1,000,000.00 (6) 8,500,000.00 (3) 1,900,000.00 b/ d 1,000,000.00 (4) 4,000,000.00 c/ d 2,800,000.00 9,500,000.00 9,500,000.00 b/ d 2,800,000.00 Cash/ Bank C/ B Issued capital ISS Figure 7.2: STAFFORD (Pty) Ltd.’s accounts 32 Study our textbook Basics of Accounting, chapter (25). <?page no="128"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 7-128 D C D C (2) 800,000.00 WIP 640,000.00 (3) 1,900,000.00 WIP 1,600,000.00 c/ d 160,000.00 MOH 220,000.00 800,000.00 800,000.00 M/ A 80,000.00 b/ d 160,000.00 1,900,000.00 1,900,000.00 Raw Materials Inventory RMI Labour-20X1 LAB D C D C (4) 4,000,000.00 c/ d 4,000,000.00 P&L 8,500,000.00 (6) 8,500,000.00 b/ d 4,000,000.00 D C D C (5) 500,000.00 MOH 500,000.00 c/ d 500,000.00 (6) 500,000.00 b/ d 500,000.00 Depreciation-20X1 DPR Acc depr ACC Property, plant, equipment PPE Revenue-20X1 REV D C D C RMI 640,000.00 IFG 2,960,000.00 LAB 220,000.00 WIP 720,000.00 LAB 1,600,000.00 DPR 500,000.00 MOH 720,000.00 720,000.00 720,000.00 2,960,000.00 2,960,000.00 D C D C WIP 2,960,000.00 COS 2,312,500.00 FGI 2,312,500.00 P&L 2,312,500.00 c/ d 647,500.00 2,960,000.00 2,960,000.00 b/ d 647,500.00 D C D C COS 2,312,500.00 Rev 8,500,000.00 LAB 80,000.00 P&L 80,000.00 M/ A 80,000.00 EBT 6,107,500.00 8,500,000.00 8,500,000.00 ITL 1,832,250.00 b/ d 6,107,500.00 R/ E 4,275,250.00 6,107,500.00 6,107,500.00 Profit and Loss P&L Marketing and administration M/ A Work in Process WIP Manufacturing overheads MOH Finished goods inventory FGI Cost of goods sold COS Figure 7.2: STAFFORD (Pty) Ltd.’s accounts (continued) <?page no="129"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 7-129 D C D C c/ d 1,832,250.00 P&L 1,832,250.00 c/ d 4,275,250.00 P&L 4,275,250.00 b/ d 1,832,250.00 b/ d 4,275,250.00 Income tax liabilities ITL Retained earnings R/ E Figure 7.2: STAFFORD (Pty) Ltd.’s accounts (continued) Regarding the goods, the correct values are shown in the Inventory accounts at all times. During the Accounting period 20X1, the polo shirts are under production and considered work-in-process. The Work-in-Process account falls under inventory accounts, too. Consider the factory’s shop floor as storage for goods under production. After production is completed, the polo shirts are added to the Finished Goods Inventory account. All costs which are linked to the product, like materials, direct labour, indirect labour, manufacturing overheads are product costs. These costs can be deferred to another Accounting period, such as the 70,000 polo shirts, which caused unit costs of manufacturing of 9.25 ZAR/ u. Hence, 70,000 × 9.25 = 647,500.00 ZAR in the Finished Goods Inventory account are transferred to the next Accounting period 20X2 although the costs of manufacturing occurred in 20X1. If we defer costs, they cannot be considered for profit or loss in 20X1. They are added to costs when they get sold. Even when we dispose goods because no sale is possible they become expenses, recorded as disposal or waste costs. In contrast, costs that are expensed during the Accounting period when they occur are called period costs. This applies here for non-manufacturing costs and the cost of sold polo shirts. Releasing goods from stock leads to a cost, as well. As former product costs (polo shirts) are then classified to period costs (cost of goods sold), Accountants call this transition ‘expensing inventories’. All period costs show on the income statement. This applies for cost of goods sold and non-manufacturing costs. Observe the financial statements for STAFFORD (Pty) Ltd. below in Figure 7.3 and Figure 7.4. <?page no="130"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 7-130 [ZAR] Revenue 8,500,000 Other income 8,500,000 COS (2,312,500) Other expenses (80,000) Earnings before int and taxes (EBIT) 6,107,500 Interest 0 Earnings before taxes (EBT) 6,107,500 Income tax expenses (1,832,250) Deferred taxes Earnings after taxes (EAT) 4,275,250 Stafford (Pty) Ltd. STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X1 Figure 7.3: STAFFORD (Pty) Ltd.’s income statement A C, L Non-current assets [ZAR] Owners' capital [ZAR] P, P, E 3,500,000 Share capital 1,000,000 Intangibles Reserves Financial assets R/ E 4,275,250 Current assets Liabilities Inventory 807,500 Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 2,800,000 Tax liabilities 1,832,250 7,107,500 7,107,500 Stafford (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X1 Figure 7.4: STAFFORD (Pty) Ltd.’s balance sheet 7.8. Variable vs. Fixed Costs In Management Accounting, costs are classified based on their behaviour regarding the output of the business. The output of a company is the quantity of goods produced or services rendered. The behaviour of costs refers to how costs change as response to different <?page no="131"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 7-131 outputs. Variable cost change with the output of the company. We acknowledge: Proportional costs depend directly on the output. To understand the dependencies better, we study an example: A car manufacturer records assembling costs for dash boards build in into cars. The factor, conversion costs depend on, is the assembling time. The assembling time for two dash boards is double of the time for assembling one dashboard. The time for three dash boards will be triple of the assembling time for one dashboard, and so on. Hence, the time for assembling dash boards depends proportionally on the number of dash boards installed. Also, assembling costs depend proportionally on the assembling time. Hence, we classify assembling costs to proportional costs. Management Accountants identify and plan performance factors like the assembling time for budgeting. 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 department. For now, we only divide costs in 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 manufactured on a machine, its time-related depreciation remains the same. Even if the machine is not deployed at all, depreciation remains constant. Further cost behavioural patterns are step-fixed costs. Those are costs that increase if threshold quantities are exceeded. Think about a university, that runs an examination service department. There is one 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, 3 admin officers are needed etc. If you draw the cost-over-student function your diagram will look like a flair of stairs. For this reason, Management Accountants call this cost behaviour pattern stepfixed costs. Most of the situations in Management Accounting are linked 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 budgeting, you must know how costs change in response to different outputs. For that reason, we must isolate the portion that is fixed from the proportional costs. This procedure is called Cost separation. In other words, you get to know the total (mixed) costs and must determine, how much thereof are fixed and how much is proportional. Often this problem is solved based on past data samples. 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 every cost category separately. However, very often, hundreds of different cost categories apply. Hence, your effort for separating costs can become quite intense. There are more efficient ways for cost separation. All methods start from the total <?page no="132"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 7-132 costs, which frequently include different cost categories, like labour, depreciation etc. Methods for cost separation are: (a) High-low method. (b) Scatter graph. (c) Regression method. All methods result in a linear cost function with the format: 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 aim is to determine the proportional costs PC and the fixed costs FC. 7.9. C/ S DANNING (Pty) Ltd. To compare the three mentioned methods, we study DANNING (Pty) Ltd., a tax law firm. At DANNING (Pty) Ltd., the tax attorneys prepare financial statements for their clients. For budgeting purposes, the firm wants to know how costs depend on the performance. DANNING (Pty) Ltd. measures performance by the number of tax statements. DANNING (Pty) Ltd. recorded during the last four months its quantities of tax statements and the costs that occurred. The total costs include the salary of administration clerks for customer care as well as the tax attorneys’ remunerations. We acknowledge, the total costs contain different labour cost categories. The administration expenses are fixed costs and the costs for the attorneys are proportional costs. We pretend not knowing the single values. DANNING (Pty) Ltd. recorded the total costs only. As fixed as well as proportional costs apply, the cost function is classified as mixed costs. For budgeting based on the quantity of tax statements, DANNING (Pty) Ltd. wants to understand the cost behaviour. It must determine its cost function C(TS) which depends on the reference unit tax statements (TS). We run a cost separation based on the three methods mentioned above. Observe the recorded costs from the past four months, depicted in Figure 7.5: Month Costs [AUD] Tax statements January 27,500 30 February 32,500 40 March 37,500 50 April 30,000 35 Figure 7.5: DANNING (Pty) Ltd.’s cost volume records 7.10. High-low Method - DANNING (Pty) Ltd. The high-low method considers the highest and lowest observations with cost and factor amount and calculates a straight line that goes through these two points of the cost function. Applying the high-low method, DANNING (Pty) Ltd. only considers the observations in the months of January and March, when the recording shows <?page no="133"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 7-133 the highest and lowest values in terms of TS quantity. The number of 30 TS is the lowest observation, the number of 50 TS in March the highest one. DANNING (Pty) Ltd. knows the costs for the low quantity of tax statements which equals: C(TS = 30) = 27,500.00 AUD and the peak month’s costs as: C(TS = 50) = 37,500.00 AUD. You can take the costs from the observation records. The slope of the cost line represents the proportional costs PC and equals: (37,500 - 27,500) / (50 - 30) = 10,000 / 20 = 5500.00 AUD/ TS. The fixed costs FC can be calculated based on the information provided for one observation, such as January. In January, the cost function applies: C (TS = 30) = 27,500 = 500 × 30 + FC. We dissolve the equation by isolating the fixed costs: FC = 27,500 - 15,000 = 1 12,500.00 AUD. Based on the calculation of the proportional and fixed costs, DANNING (Pty) Ltd.’s cost function is: C (TS) = 500 × TS + 12,500. The application of the high-low method is very simple. The downside of this method lies in the consideration of only 2 observations. Choosing exceptional cost observations can make the highlow method fail. We consider the high-low-method as not reliable for budgeting. 7.11. Scatter Graph - DANNING (Pty) Ltd. The scatter graph method is based on a graphic diagram of the cost over factor (here: TS) observations and requires us to manually draw a line in the diagram that way that most observation marks are on or close to the line. The scatter graph method requires drawing the monthly observations to scale which at DANNING (Pty) Ltd.’s results in 4 marks in the cost - tax statement diagram. In the next step, we draw a line through the marks that way that all marks are on or at least very close to the cost line. Observe Figure 7.6. to study a self-drawn cost function for DANNING (Pty) Ltd. <?page no="134"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 7-134 Figure 7.6: DANNING (Pty) Ltd.’s Cost separation by scatter graph method Obviously, the scatter graph method is no option for Accounting as it is not accurate enough. On the other hand, the scatter graph method is nice to explain cost separation in academia or management meetings. 7.12. Regression Method - DANNING (Pty) Ltd. The regression method is the most common approach for Cost separation in Management Accounting. The regression method calculates the function’s parameters based on all 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. At DANNING (Pty) Ltd., we strive to calculate a cost function. The simple regression method is based on 2 independent equations linked to the cost-tax statement diagram. We need 2 equations to determine 2 variables, PC = proportional costs and FC = fixed costs. The equations refer to all observations available, which will be counted by the index i at DANNING (Pty) Ltd.: i = 1 … 4. We made 4 observations. 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, <?page no="135"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 7-135 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. 4 1 2 4 1 4 1 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 values only. There are 4 cost-values C i . We want to divide costs in a proportional and a fixed portion. 4 1 4 1 4 i i i i TS PC FC C For a convenient calculation, we determine a few sums used in the equations. This makes dissolving the equations simpler. We therefor prepare a MS- Excel sheet as it goes quick and tells us where the data come from. Consider the calculations in Figure 7.7 as workings in preparation of the simple regression method’s application. i C TS C x TS TS 2 1 27 500.00 30 825 000.00 900 2 32 500.00 40 1 300 000.00 1600 3 37 500.00 50 1 875 000.00 2500 4 30 000.00 35 1 050 000.00 1225 sum 127 500.00 155 5 050 000.00 6225 Figure 7.7: Workings for regression analysis We prepare the cost function for DANNING (Pty) Ltd.’s costs depending on tax statement amounts: From the 1 st equation, we derive: 5,050,000 = FC × 155 + PC × 6,225. From the 2 nd equation, we derive: 127,500 = FC × 4 + PC × 155. => FC = (127,500 - PC × 155) / 4 We insert the 2 nd equation into the 1 st one: <?page no="136"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 7-136 => 5,050,000 = 155 × (127,500 - PC × 155) / 4 + PC × 6,225 = 4,940,625 - PC × 6,006.25 + PC × 6,225 => PC = (5,050,000 - 4,940,625) / (6,225 - 6,006.25) = 5 500.00 AUD/ TS Next, we insert the proportional costs PC into the 2 nd equation and calculate the fixed costs FC: => FC = (127,500 - 500 × 155) / 4 = 12,500.00 AUD. As based on the high-low-method, the cost function for DANNING (Pty) Ltd. equals: C (TS) = 5 500 × TS + 12,500. In case DANNING (Pty) Ltd. expects 48 tax statements in May, the planned costs will equal: C (48) = 500 × 48 + 12,500 = 3 36,500.00 AUD. It is no coincidence that we determine the same function as by the high-lowmethod. The reason is that in DANNING (Pty) Ltd.’s case all observations are directly on the cost line. 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 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 7.13. Common Format for the Simple Regression Method After we applied the simple regression method, we want to explain it further. (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 property 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 to determine 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 can calculate its selling price based on the observations from in the past. Computer programs that provide you with used-car valuations like the German Schwacke- Liste, are based on regression methods and data input from recent sales. <?page no="137"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 7-137 In contrast, in Accounting we only discuss a cost function depending on a single variable: the output, such as the tax statements at DANNING (Pty) Ltd. Because the simple regression method determines one dependency only, we classify it to ‘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 calculation 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 costs. The equations are explained below based on only 2 observations. Accordingly, the parameter for the sum have been adjusted. n is now replaced by 2. (1) 2 1 2 2 1 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: X 1 × Y 1 + X 2 × Y 2 . Figure 7.8: Marked areas in the linear function Y(X) <?page no="138"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 7-138 In Figure 7.8 the area X 1 × Y 1 is marked as a dotted line with a dark filling and the area X 2 × Y 2 by a light filling. The areas are overlapping. In the diagram the function is drawn as a line and indicated by Y(X) = a × X + b. 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 α which is the opposite leg of the angle α divided by its adjacent leg. Figure 7.9: calculation of the slope of Y(X) By the next step we study the righthand 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: <?page no="139"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 7-139 Figure 7.10: Areas A and C for the function Y(X) The area A got the size: b × X 1 . Regarding the formula, the area C has the size: a × X 12 multiplied by a factor, see below. The area A forms a square if a = tan α equals 1. This will be the case if: α = 45° because tan 45° = 1. This means graphically that the length of (Y 1 - b) equals to the one of (X 1 - 0). In cases the angle α is less than 45° the tangent “squeezes” the area. E.g., if α = 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 α exceeds 45°, e.g., if α = 60°, the slope is steep and the factor a will expand area C in a way of stretching it upwards. At 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. <?page no="140"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 7-140 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 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 α × (X 12 + X 22 ) We now study the equation (2) for 2 observations as well: (2) 2 1 2 1 2 i i i i X a b Y 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 Yvalues 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-values that does not depend on Y. Therefore, the first summand got the height of: 2 × b. The second summand is the value of (Y 1 - b) and (Y 2 - b) that depends proportionally on X i . <?page no="141"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 7-141 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 α = (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 α = (Y 2 - b) / X 2 . If the slope of the function is positive the contribution for the second observation to the Y-value will be higher than for the first one because Y i - b = a × X i = tan α × X i . The equation below is valid: Y 1 + Y 2 = 2 × b + tan α × (X 1 + X 2 ) The simple regression method is an instrument widely applied in Management Accounting to separate costs for cost functions that depend linear from a reference unit. 7.14. Differential/ Sunk/ Opportunity Costs Most of the management problems are linked to decisions which is why costs should be calculated for alternatives to support decision making. 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 already deployed. If positive, we also refer to incremental 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 from the considerations. If DANNING (Pty) Ltd. must hire an additional attorney for the next tax statement TS to be prepared, step fixed costs would apply. <?page no="142"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 7-142 Differential costs are based on 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. If production declines, the consumption of meat patties will follow the decrease. The cost per one meat patty are incremental costs caused by one additional burger. As differential costs depend directly on the output, the knowledge about incremental costs is important for product mix decision making and budgeting. Low budget airlines make use of their low differential costs. E.g., EasyJet keeps them extremely low by not serving food on board, not printing boarding passes and not transporting luggage for free. If seats are not sold, they advertise them at low prices like 29.00 EUR per flight - and make a profit therewith, because the only incremental costs are airport landing fees. 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 makes a commitment, like towards rent or interest by signing a contract. Sunk costs are costs that cannot be changed any more. They do not depend on future decisions but are fixed within the nearby future. Assume the video rental store WOTSCH GmbH takes a bank loan of 100,000.00 EUR and agrees on an interest payment of 4,000.00 EUR/ a for the next 20 years, the interest costs will fall under sunk costs. No matter, how many DVDs WOTSCH GmbH rents out, the costs for interest will stay the same. Opportunity costs are costs for an alternative given up in order to perform an activity. They seldom appear in Managerial Accounting records, but they are important for decision making. Check the case of the attorney Dr MEPPEN. Dr. Meppen decides to attend a seminar in family law on 4 Fridays in June. During this time, he gives up the opportunity to advice or to represent his clients in court and to charge 8,000.00 EUR during the time he now spends in the seminar venue. Hence, the opportunity costs for the seminar attendance equal 8,000.00 EUR (opportunity costs). 7.15. Summary Management Accounting applies different cost terms. There is a distinction between direct and indirect costs. Direct costs can be assigned straight to the product/ service. There is a distinction between manufacturing and nonmanufacturing 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 performance measured in reference units. Fixed costs do not depend on the output. Cost separation is a method to determine the amount of proportional costs and fixed costs in a business, <?page no="143"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 7-143 where mixed costs apply. The Cost separation supports budgeting, as proportional costs are calculated based on the output. In contrast, fixed costs only change by management decisions. Differential costs are the increase/ decrease of costs caused by one further/ lesser unit produced ignoring jump costs. Sunk costs are costs that do not depend on decisions any further. Opportunity costs are costs to the extent of the benefit of a forfeited alternative option. 7.16. Working Definitions Cost of Conversion: The costs of conversion contain direct labour and manufacturing overheads. Cost Separation: Cost separation is the determination the proportional cost portions and fixed costs within mixed costs. 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 already deployed. Fixed Costs: Fixed costs do not change with the output. High-Low Method: The high-low method considers the highest and lowest observations with cost and factor value and calculates a straight line that goes through these two points of the cost function. Mixed Costs: Mixed costs contain a portion that is proportionally depending on the output and another portion that is fixed. Opportunity Costs: Opportunity costs are costs for an alternative given up in order to perform an activity. Output: The output of a company is the quantity of goods produced or services rendered. Period Costs: Period costs are linked to the Accounting period they occur in. Prime Costs: Prime costs are direct materials and direct labour. Product Costs: Product costs are assigned to products which can be put on stock. 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. Regression Method: The regression method calculates the function’s parameters 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. Scatter Graph: The scatter graph method 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 marks are on or close to the line. Sunk Costs: Sunk costs are costs that cannot be changed any more. Variable Costs: Variable costs depend on the output of the business whereas fixed costs remain unchanged no matter how much the output is. 7.17. Question Bank (1) A cost separation along the high-low method records the below cost - volume data: 2,100.00 EUR - 50 units / 1,700.00 EUR - 40 units <?page no="144"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 7-144 / 2,300.00 EUR - 60 units. What does the cost function look like? 1. C(X) = 40 × X + 100. 2. C(X) = 20 × X + 1,100. 3. C(X) = 30 × X + 500. 4. C(X) = 20 × X + 1,300. (2) Mixed costs are … 1. …costs that increase incremental. 2. …costs that result from different cost categories. 3. … cost that contain a proportional and a fixed portion. 4. … costs that contain a proportional and a variable portion. (3) Methods for Cost separation are … 1. Scatter graph method, high-low method, multiple regression method. 2. Scatter graph method, high-lowmethod, simple regression method. 3. Scatter graph, high-low-average method, regression method. 4. Equation method, high-low method, regression method. (4) What are opportunity costs? 1. Costs for an opportunity you give up. 2. Costs that might or might not occur. 3. Costs for taking chances. 4. Costs for offers to be expected by a probability that exceeds 50 %. (5) Which of the below alternatives are period costs in a factory that applies the COS format for profit calculation? 1. Administration, depreciation on production facilities, labour in the factory. 2. Accounting department costs, costs of stock releases, administration. 3. Direct materials, HR department costs, cafeteria deficit contribution. 4. Marketing expenses, depreciation on production facilities, product cost. 7.18. Solutions 1-3; 2-3; 3-2; 4-1; 5-2. <?page no="145"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 8-145 8. Cost Volume Profit Analysis (CVP-Analysis) 8.1. What is in the Chapter? This chapter discusses how many products a business must produce and sell to break-even. To break-even indicates a situation where revenue meets costs. E.g., a passenger flight’s certain load factor that tells the airline how many revenue tickets must be sold to earn a zero profit. We only consider costs, like labour, depreciation, fuel etc. Airlines strive to exceed that threshold load factor to make their flights profitably. We demonstrate that the CVP-analysis is a more powerful tool than only to determine the critical number of products to break-even. It is widely used to make decisions about the launch of new products or changes in the service/ product mix. In this chapter, we study the case of DEERFIELD TOURS (Pty) Ltd. a tour company that offers trips to South Africa and to Kuala Lumpur from Frankfurt/ Main. We also discuss the calculation of the probability for profits if various factors are unknown but can be assumed to be normally distributed around the best estimated value. 8.2. Learning Objectives After studying this chapter, you understand that cost volume profit analysis requires a cost separation as discussed in the previous chapter (7). You further understand how a CVP-Analysis helps managers to find the right level of activities to earn and maximise profits. Based on selling prices and costs, you can calculate from which activity level on the company earns profit. You will be able to apply and discuss the outcome of a CVP-analysis and are able to find the product amount and/ or product mix from where profitability starts. You also can apply the CVP-Analysis to determine what happens if changes in the business model are made by running a what-if analysis. Another outcome of this chapter is that you learn about the calculation of probabilities for profit. 8.3. Basics of Cost-Volume-Profit Analysis The CVP-Analysis is also known as break-even analysis. When a company starts with its operations, at first fixed costs apply, e.g. depreciation on the investments. A business that does not require investments is very seldom. Think about a taxi company. It must first buy a car. Without investing, the company leases/ rents the car which means, someone else (the lessor) covers fixed costs but charges the taxi company for rent. Acquisitions in machinery at first lead to fixed costs for depreciation. Note, a break-even analysis differs from the amortisation method in Investment Appraisal. We do not determine which production output pays the investments but assure that depreciation expenses are covered, which is only a fraction of the entire investment, e.g., 25 % if useful life is 4 years. In CVP- Analysis, the first unit of production must cover the fixed costs. Only after the business produces/ sells a quantity of goods or services that cover its fixed costs, revenue exceeds costs, and the <?page no="146"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 8-146 company begins to earn profits. We say the company breaks-even to indicate the point from where revenue exceeds costs. 8.4. C/ S Ameer - GRAB Driver We observe Ameer, an Accounting student in Malaysia. He runs a GRAB taxi service and plans to study his textbooks during waiting periods. He applies for a GRAB license and buys a car, which is a 5 year old E-class Mercedes-Benz. The car costs 80,000.00 MYR without VAT 33 . The car has still a useful life of 5 years, but he intends to sell it after 2 years at 50,000.00 MYR (net amount). The depreciable value for Management Accounting equals: 80,000 - 50,000 = 3 30,000.00 MYR. Annual depreciation is: (80,000 - 50,000) / 2 = 1 15,000.00 MYR/ a. For financing his business, Ameer takes a bank loan of 50,000.00 MYR at a rate of interest of 3.5 %/ a and borrows the rest from his family free of interest. Hence, interest expenses are: 50,000 × 3.5% = 1 1,750.00 MYR/ a. Per taxi ride Ameer earns 20.00 MYR/ ride in revenue. The revenue includes a commission of 20 % to GRAB. He calculates petrol costs per ride to be 5.00 MYR/ ride. He ‘earns’ a margin of: 20 × (1 - 20%) - 5 = 111.00 MYR/ ride before interest, depreciation and taxation. The CVP-Analysis answers the question “How many rides must Ameer make per working day (Monday to Friday) to break-even? ” The answer is: (15,000 + 1,750) / (5 × 52 × 11) = 5 5.86 rides. With this number of rides, Ameer does not pay income taxes, as taxation only applies if a profit is earned. We acknowledge, he breaks-even with 6 33 Consider an exchange rate of 5.00 MYR = 1.00 EUR. rides per working day, as we round the rides number to the nearest integer. 8.5. Benefit from CVP-Analysis Management Accountants strive to find the right product/ service quantities to make their companies profitable. No one plans operations below break-even point. Another important question is: How save is breaking-even, in other words: how high is the probability to exceed break-even? We answer that question at the end of this chapter. At first, we study the profit after breaking-even to understand what happens once the company exceeds the break-even quantity. We assume, there is a company selling goods at 115.00 EUR/ u with variable unit cost of manufacturing of 65.00 EUR/ u. If the fixed costs are amounting to 1,000.00 EUR, the 50.00 EUR difference between revenue und variable unit costs: 115 - 65 = 5 50.00 EUR/ u (= contribution margin) must cover all fixed costs. Hence, after 20 products have been sold, the contribution margin covers all fixed costs: 20 × 50 = 1 1,000.00 EUR. Further coverage is not required. At this stage, the company earns zero profit: 20 × (115 - 65) - 1,000 = 0 0.00 EUR. From the 21 st product sold onwards the business is profitable. If the company sells 21 products the profit will be: 21 × (115 - 65) - 1,000 = 5 50.00 EUR. We say: the company must produce and sell more than 20 goods in order to break-even. Beyond breaking-even, the profit equals to the contribution margin per unit, here: 50 EUR/ u. <?page no="147"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 8-147 The below assumptions apply to study a CVP-Analysis: (1) The selling prices per unit are constant. No discounts apply. (2) The unit cost function is constant. This means variable costs do not change because of the number of goods/ services. A cost separation must be possible. Furthermore, no jump costs exist, which implies there are no step-fixed costs as the existing resources allow the production of all goods/ services. (3) Companies that are selling different products must sell a constant mix. This requires that the goods ratio is constant, like ‘for 3 oranges we sell 2 bananas’. 34 (4) There are no changes in inventories of finished goods. Hence, production number equals sales quantities. No goods are added to inventories or released from stock. How it is Done (CVP calculation) (1) Check the requirements for a CVP analysis as above. (2) Determine standard costs for the planned output (planned costs). (3) Calculate/ plan the portion of fixed costs. If only total costs are available run a Cost separation. (4) Determine the cost function that depends on the quantity of products. (5) Plan the budgeted revenue per unit(s) or consider actual revenues derived from Financial Accounting. (6) In case the company produces/ renders more than one type of goods/ services determine the ratio of product/ service for sales. (7) Prepare the revenue function that depends on the quantity of products (to be) sold. (8) Determine the product number where the revenue curve intersects the cost curve. 8.6. C/ S DEERFIELD TOURS (Pty) Ltd. Next, we study the CVP-Analysis for DEERFIELD TOURS (Pty) Ltd., which is a tourist company. Data Sheet for DEERFIELD TOURS (Pty) Ltd. (Base Case) CClassification: Tourism; 34 Without a fixed mix you can calculate where to breakeven, but you must know one quantity in order to calculate the corresponding one. SA-tour: 10 … 25 t/ tour; base case: 19 trips; flight: 1,500.00 EUR/ t; hotel: 700.00 EUR/ t; meals: 400.00 EUR/ t; Fixed costs: administration: 3,400.00 EUR/ tour; bus: 7,000.00 EUR/ tour; Net selling price: 3,900.00 EUR/ t; VAT ignored. DEERFIELD TOURS (Pty) Ltd. is a tour provider that offers 1-week trips to the Garden Route in South Africa. The tours <?page no="148"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 8-148 start and end in Frankfurt (Main) airport. Variable costs per traveller-trip (/ t) are the flight fare at 1,500.00 EUR/ t, the hotel stay-over-costs: 7 × 100 = 7 700.00 EUR/ t and costs for meals at: 8 × 50 = 400.00 EUR/ t. In total, the variable costs add up to: 1,500 + 700 + 400 = 2 2,600.00 EUR/ t. The fixed costs must cover the tour planning and administration costs of 3,400.00 EUR/ tour and transportation in South Africa in a rented 25-seater bus at 7,000.00 EUR/ tour, in total: 3,400 + 7,000 = 1 10,400.00 EUR/ tour. DEERFIELD TOURS (Pty) Ltd. sells a trip at 3,900.00 EUR/ t. The maximum traveller quantity is limited by the bus capacity to 25 passengers. DEERFIELD TOURS (Pty) Ltd. reserves the right to cancel a tour if less than 10 travellers make reservations. Cancellations from travellers are considered as no-show and are not refunded. This option puts DEERFIELD TOURS (Pty) Ltd. in an almost risk-free position! To calculate costs at break-even, DEERFIELD TOURS (Pty) Ltd. prepares a MS-Excel sheet we call contribution income statement. It tells us how much profit is earned based on the number of trips. We enter the number of trips in the grey field to calculate profit. We call the MS-Excel sheet contribution income statement, as a contribution margin is calculated by deducting variable costs from revenues. The calculation is presented in Figure 8.1. In the MS-Excel sheet we must enter the number of travellers to determine the net profit. (It is recommended to prepare an MS-Excel sheet like in Figure 8.1 for your personnel study support.) We define two variables for DEERFIELD TOURS (Pty) Ltd.: tours and trips. The latter one is the number of travellers for one tour, which we refer to as trip (t). A trip is one person who books a tour. In contrast, a tour is a service for 10 … 25 travellers (no abbreviation in use). For our break-even analysis, the trip is the primary parameter. Sales of 1 trips Item Total Per unit Sales 3,900.00 3,900.00 Variable expenses (2,600.00) (2,600.00) Contribution margin 1,300.00 1,300.00 less: Fixed expenses (10,400.00) Net profit (9,100.00) CONTRIBUTION INCOME STATEMENT Figure 8.1: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (1) If DEERFIELD TOURS (Pty) Ltd. sells 10 trips the contribution income statement looks as in Figure 8.2. <?page no="149"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 8-149 Sales of 10 trips Item Total Per unit Sales 39,000.00 3,900.00 Variable expenses (26,000.00) (2,600.00) Contribution margin 13,000.00 1,300.00 less: Fixed expenses (10,400.00) Net profit 2,600.00 CONTRIBUTION INCOME STATEMENT Figure 8.2: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (2) To find the number of trips to breakeven, we prepare a profit equation. The revenue is the number of trips multiplied with the selling price per trip. We call X the number of trips. X × 3,900 = 10,400 + X × 2,600. We isolate X and dissolve the equation to get the number of trips: X = 10,400 / (3,900 - 2,600) = 10,400 / 1,300 = 8 8 trips. For checking, we calculate the profit for 8 trips: 8 × (3,900 - 2,600) - 10,400 = 0.00 EUR/ tour. The break-even point in a CVP analysis is the quantity of goods or the activity level where the company earns a zero profit. In case DEERFIELD TOURS (Pty) Ltd. runs the tour at 10 trips, the tour profit becomes: 10 × (3,900 - 2,600) - 10,400 = 2,600.00 EUR/ tour. Compare the result to Figure 8.2. After breaking-even with 8 travellers, DEERFIELD TOURS (Pty) Ltd. earns the contribution margin for every trip exceeding the break-even quantity as a profit. T The contribution margin is the sales minus variable costs. We check the profit for 20 trips in Figure 8.3. Sales of 20 trips Item Total Per unit Sales 78,000.00 3,900.00 Variable expenses (52,000.00) (2,600.00) Contribution margin 26,000.00 1,300.00 less: Fixed expenses (10,400.00) Net profit 15,600.00 CONTRIBUTION INCOME STATEMENT Figure 8.3: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (3) DEERFIELD TOURS (Pty) Ltd.’s profit is 15,600.00 EUR/ tour. We analyse the result: 20 trips mean: 12 trips beyond breaking-even. The profit is 12 times the contribution margin. 12 × 1,300 = 15,600.00 EUR/ tour. What is the use of a CVP analysis for managers? Obviously, it is to know the <?page no="150"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 8-150 break-even quantity. However, most companies operate beyond that point. Even if a company cannot predict the quantity of its products, in most cases it cannot deny the service if it falls below break-even. E.g., a restaurant cannot close due to low reservations and send the chef and waiters home to cut costs. Or a university cannot cancel an exam if not enough students enrol. However, in the case of DEERFIELD TOURS (Pty) Ltd. such an escape route is guaranteed by the cancellation clause in the contract. 8.7. CVP-Analysis for Changing Business Model A CVP-Analysis also supports managers making decisions about adjustments of the business concept and to predict whether changes result in profit improvements. We continue studying DEERFIELD TOURS (Pty) Ltd. Now, we analyse a few possible changes regarding its business model: 8.8. Online-Shop for DEERFIELD TOURS (Pty) Ltd. DEERFIELD TOURS (Pty) Ltd. sells on average 19 trips per tour. The business now plans to sell trips online to increase profit. The website costs increase the fixed costs by 1,500.00 EUR/ tour. DEERFIELD TOURS (Pty) Ltd. expects to increase the average number of trips by 2 trips due to the online shop. We want to analyse, whether the online shop increases the tour profit with: 19 + 2 = 2 21 trips. For checking, we amend DEERFIELD TOURS (Pty) Ltd.’s contribution income statement on MS-Excel. We add 1,500.00 EUR/ tour to the fixed costs and add 2 trips. Compare the base case in Figure 8.4 to the adjusted online-shopversion in Figure 8.5. Sales of 19 trips Item Total Per unit Sales 74,100.00 3,900.00 Variable expenses (49,400.00) (2,600.00) Contribution margin 24,700.00 1,300.00 less: Fixed expenses (10,400.00) Net profit 14,300.00 CONTRIBUTION INCOME STATEMENT Figure 8.4: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (base case) The fixed cost for the alternative (onlineshop-version) tour concept are: 10,400 + 1,500 = 1 11,900.00 EUR/ tour. The number of trips has been increased based on the estimated quantity. <?page no="151"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 8-151 Sales of 21 trips Item Total Per unit Sales 81,900.00 3,900.00 Variable expenses (54,600.00) (2,600.00) Contribution margin 27,300.00 1,300.00 less: Fixed expenses (11,900.00) Net profit 15,400.00 CONTRIBUTION INCOME STATEMENT Figure 8.5: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (online-shop) The internet shop increases the tour profit by: 15,400 - 14,300 = 1 1,100.00 EUR/ tour. The advice should be: Go for the online-shop! 35 We return to the base case with 19 passengers without online-shop to take further changes from there: 8.9. Bungee Jumping - DEERFIELD TOURS (Pty) Ltd. As another alternative, we discuss increasing the customer’s value of a trip by adding a bungee jumping option. The bungee jump costs per traveller, who takes the offer 100.00 EUR. DEERFIELD TOURS (Pty) Ltd. estimates that every second traveller goes for the bungee jump. DEERFIELD TOURS (Pty) Ltd. adds 50.00 EUR/ t to the sales price and to the variable costs for each trip. This keeps the bungee jump option neutral to travellers. Due to the more attractive trip, the number of trips per tour is estimated to increase by 1 trip per tour. The administration costs per tour increase by 500.00 EUR compared to the base case scenario. Hence, the fixed costs are now: 10,400 + 500 = 1 10,900.00 EUR/ tour. Sales of 20 trips Item Total Per unit Sales 79,000.00 3,950.00 Variable expenses (53,000.00) (2,650.00) Contribution margin 26,000.00 1,300.00 less: Fixed expenses (10,900.00) Net profit 15,100.00 CONTRIBUTION INCOME STATEMENT Figure 8.6: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (bungee jumping) With the bungee jumping option, the profit increases by: 15,100 - 14,300 = 35 DEERFIELD TOURS (Pty) Ltd. pays for the internet shop per tour. 800.00 EUR/ tour. The advice is: Go for bungee jumping! The assumption of <?page no="152"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 8-152 every 2 nd traveller jumping off the bridge must be fulfilled for increasing the profit as estimated. 8.10. Revenue Calculation - DEERFIELD TOUR (Pty) Ltd. Another analysis aims to revenue calculations for given tour profits. We refer to the base case again and make amendments. DEERFIELD TOURS (Pty) Ltd. plans to run the tour in a more luxury bus. The costs for the fancy bus are 11,000.00 EUR/ tour. The bus is a 35-seater which allows an increase of trips per tour. The Marketing department claims that the fancy bus will attract 6 more travellers. The question for DEERFIELD TOURS (Pty) Ltd. is: How do we change the net selling price per trip to earn the same profit as in the base case? For revenue calculation, there are 2 options. (1) The first one is academically elegant: We set up the equation for the profit of the base case (= 14,300.00 EUR/ tour) and isolate the net selling price NSP: (19 + 6) × NSP - (19 + 6) × 2,600 - (10,400 + 4,000) = 14,300 EUR/ tour. The NSP equals: NSP = (14,300 + 25 × 2,600 + 14,400) / 25 = 3 3,748.00 EUR/ trip. (2) The second one is more Accountantlike: We use the goal seek function in MS-Excel: Figure 8.7: DEERFIELD TOURS (Pty) Ltd.’s calculation of the adjusted net selling price The net selling price drops with the newbus-option because of the assumption of 6 additional trips. The advice is to go for the new bus if sure about the traveller increase! 8.11. What-if-Analysis As shown, a CVP analysis can be used as what if-analysis. A what-if analysis is no simulation. However, it is a calculation of the outcome by alternating certain variables. Being no simulation means that no random figures apply. <?page no="153"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 8-153 A what-if analysis is regarded as helpful instrument for budgeting. The CVP-analysis can even help us to combine changes regarding the business plan, such as DEERFIELD TOURS (Pty) Ltd. deploying an alternative bus and including the bungee-jumping option together. One critical question for budgeting stays: How does DEERFIELD TOURS (Pty) Ltd. know, what happens to the number of trips per tour in response of product parameter changes? The answer is: They don’t know. However, the experience will proof what Marketing research estimates. We next study probabilities and distributions to predict customers’ decisions based on experiences in the past. 8.12. Statistics - DEERFIELD TOURS (Pty) Ltd. We refer to the DEERFIELD TOURS (Pty) Ltd. case again: We assume, that the Marketing department estimates the number of trips per tour based on the online-shop-option. The Marketing department claims the number of the travellers is 21 on average (as above). An average number is not sufficient for budgeting as we do not know how far values deviate. We pretend, the experts from the Marketing claim the number of trips is normally distributed and the standard deviation is 4.37 t (= trips). See Figure 8.8: A normal distribution depends on two variables only: on its mean and its standard deviation. All other parameters are constant values. In other words: once we know the mean and the standard deviation of a normal distribution, we can determine the probability values exceeding a threshold value, here the probability for a certain number of trips. This supports us in answering the following question: ‘How likely are 20+ trips per tour? ’, ‘How likely is a low number of travellers at which DEERFIELD TOURS (Pty) Ltd. only breaks-even? ’ or ‘How likely is a loss? ’ To give the answers, we transform the normal distribution towards a standard normal distribution. Then we can read out the probabilities from tables in textbooks of Mathematics or from the internet. In case of DEERFIELD TOURS (Pty) Ltd. we know the estimate (= 21 t/ tour) as well as the standard deviation (= 4.37 t/ tour). We demonstrate how to calculate the probability to break-even. The contra-probability gives us the likelihood for a loss. From 20 similar observations, Marketing experts derive that on average 21 trips per tour are booked through the online shop. Despite the low observation quantity, experts assume the values are normally distributed. N Normal distributed figures result in a bell-shaped curve in case you draw a frequency-over-valuediagram. The technical term is probability density function. The peak of the curve is where the mean is. Hence, the mean is the most likely value. We refer thereto as best estimate. Trip per tour numbers next to the mean are less likely and the probability for values far away from the mean approximate zero. The probability for all values together is 100 %. It is also the area underneath of the probability density curve. <?page no="154"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 8-154 Observation Amount (t) Diff to mean (Diff) 2 1 20 -1 1 2 17 -4 16 3 21 0 0 4 18 -3 9 5 16 -5 25 6 24 3 9 7 20 -1 1 8 26 5 25 9 23 2 4 10 30 9 81 11 30 9 81 12 21 0 0 13 21 0 0 14 11 -10 100 15 21 0 0 16 19 -2 4 17 24 3 9 18 17 -4 16 19 21 0 0 20 20 -1 1 average: 21 standard dev.: 4.37 Figure 8.8: Observations To determine the distribution of trip numbers, we refer to mean and standard deviation. We could take the values for standard deviations straight from the MS-Excel function but for the sake of teaching we calculate them “manually”. A standard deviation is defined as the average difference of observed values to the mean. As the differences can be positive as well as negative, we square them and calculate the standard deviation as: ((1/ 20) × Sum of (diff) 2 ) 0.5 = 44.37 trips/ tour (rounded off). By ‘diff’ we mean the difference of a single observation to the mean. In the first observation line, diff is amounting to: 20 - 21 = - -1 t. In case we omitted squaring the differences, the standard deviation would always give a mean of zero because the normal distribution is symmetrical. The distribution of observations in Figure 8.8 can be transformed to a standard normal distribution. A standard normal distribution is normally distributed and the mean equals 0 and the standard deviation is 1. Tables for standard normal distributions provide us with the probabilities for each value. You find a table for the normal standard distribution in Figure 8.10. DEERFIELD TOURS (Pty) Ltd. follows the Marketing campaign (online-shop) idea as discussed above. The mean of 21 trips per tour promises an increase in profit to the extent of 1,100.00 EUR/ tour. However, DEERFIELD TOURS (Pty) Ltd. needs to calculate, how risky the tour becomes <?page no="155"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 8-155 in terms of making a loss. This is the contra probability for breaking-even. By the next step, we calculate the breakeven point. We determine the number of trips to break-even based on the onlineshop option. We use MS-Excel’s goal seek function. Find the result in Figure 8.9. Sales of 9.154 trips Item Total Per unit Sales 35,700.00 3,900.00 Variable expenses (23,800.00) (2,600.00) Contribution margin 11,900.00 1,300.00 less: Fixed expenses (11,900.00) Net profit 0.00 CONTRIBUTION INCOME STATEMENT Figure 8.9: DEERFIELD TOURS (Pty) Ltd.’s break-even point (internet campaign) The number of trips must be integer. Based on the result of 9.15 travellers per tour to break-even, we consider 0 to 9 travellers as the loss case. If DEERFIELD TOURS (Pty) Ltd. sells 10+ trips per tour, it earns a profit. In order to determine the probability for the worst case(s) of making a loss - no matter how big the loss is - we want to know how likely less than 10 travellers/ tour are. We transform the normal distribution to a standard normal distribution and call the values for the standard normal distribution z-amounts. The values of the normal distribution are the trips per tour. We call them ‘t’ as in trips. We apply the transformation formula, which transforms t-values to z-values: z(t) = (t - mean)/ standard deviation = (9 - 21) / 4.37 = - -2.746. We write in a shorter way: z(t = 9) = - -2.746. The zvalue is negative because it is below the mean. By the next step, we read the probability for z < -2.746 from the tables for a standard normal distribution. The table in Figure 8.10 lists the probabilities for an event based on the interval 0 … z. However, we need the probability for an event below the z amount of - 2.746. As a standard normal distribution is symmetrical, we calculate the probability in question via its contra probability. At first, we read the probability for +2.746 from the table: The probability for +2.74 to be exceeded equals 49.69 % and the probability for 2.75 equals 49.70 %. The value we want to know is in between. By interpolation, we determine a z-value for 2.746 being 49.696 % which gives 49.70 % after rounding. Next, we determine the probability in question via its contra probability, which equals: 50% - 49.70% = 0 0.30 %. With the given Marketing data in Figure 8.8, the probability for DEERFIELD TOURS (Pty) Ltd. of making a loss, equals 0.30 %. This green-lights the online-shop as DEERFIELD TOURS (Pty) Ltd. tolerates that low risk. Anyway, DEERFIELD TOURS (Pty) Ltd. is risk-free thanks to its cancellation policy. <?page no="156"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 8-156 z 0 1 2 3 4 5 6 7 8 9 0 0.0000 0.0040 0.0080 0.0120 0.0160 0.0199 0.0239 0.0279 0.0319 0.0359 0.1 0.0398 0.0438 0.0478 0.0517 0.0557 0.0596 0.0636 0.0675 0.0714 0.0753 0.2 0.0793 0.8320 0.0871 0.0910 0.0948 0.0987 0.1626 0.1064 0.1103 0.1141 0.3 0.1179 0.1217 0.1255 0.1293 0.1331 0.1334 0.1406 0.1443 0.1480 0.1517 0.4 0.1554 0.1591 0.1628 0.1664 0.1700 0.1736 0.1772 0.1808 0.1844 0.1879 0.5 0.1913 0.1950 0.1985 0.2019 0.2054 0.2088 0.2123 0.2157 0.2190 0.2224 0.6 0.2257 0.2291 0.2324 0.2357 0.2389 0.2422 0.2454 0.2486 0.2517 0.2549 0.7 0.2580 0.2611 0.2642 0.2673 0.2704 0.2734 0.2764 0.2794 0.2823 0.2852 0.8 0.2881 0.2910 0.2929 0.2967 0.2995 0.3023 0.3051 0.3078 0.3106 0.3133 0.9 0.3159 0.3186 0.3212 0.3238 0.3264 0.3289 0.3315 0.3340 0.3365 0.3389 1 0.3413 0.3438 0.3461 0.3485 0.3508 0.3531 0.3554 0.3577 0.3599 0.3621 1.1 0.3643 0.3665 0.3686 0.3708 0.3729 0.3749 0.3770 0.3790 0.3810 0.3830 1.2 0.3849 0.3869 0.3888 0.3907 0.3925 0.3944 0.3962 0.3980 0.3997 0.4015 1.3 0.4032 0.4049 0.4066 0.4082 0.4099 0.4115 0.4131 0.4147 0.4162 0.4177 1.4 0.4192 0.4207 0.4222 0.4236 0.4251 0.4265 0.4279 0.4292 0.4306 0.4319 1.5 0.4332 0.4345 0.4357 0.4370 0.4382 0.4394 0.4406 0.4418 0.4429 0.4441 1.6 0.4452 0.4463 0.4474 0.4484 0.4495 0.4505 0.4515 0.4525 0.4535 0.4545 1.7 0.4554 0.4564 0.4573 0.4582 0.4591 0.4599 0.4608 0.4618 0.4625 0.4633 1.8 0.4641 0.4649 0.4656 0.4664 0.4671 0.4678 0.4686 0.4693 0.4699 0.4706 1.9 0.4713 0.4719 0.4726 0.4732 0.4738 0.4744 0.4750 0.4756 0.4761 0.4767 2 0.4772 0.4778 0.4783 0.4788 0.4793 0.4798 0.4803 0.4808 0.4812 0.4817 2.1 0.4821 0.4826 0.4830 0.4834 0.4838 0.4844 0.4846 0.4850 0.4854 0.4857 2.2 0.4861 0.4864 0.4868 0.4871 0.4875 0.4878 0.4881 0.4884 0.4887 0.4890 2.3 0.4893 0.4896 0.4898 0.4901 0.4904 0.4906 0.4909 0.4911 0.4913 0.4916 2.4 0.4918 0.4920 0.0492 0.4925 0.4927 0.4929 0.4931 0.4932 0.4934 0.4936 2.5 0.4938 0.4940 0.4941 0.4943 0.4945 0.4946 0.4948 0.4949 0.4951 0.4952 2.6 0.4953 0.4955 0.4956 0.4957 0.4959 0.4960 0.4961 0.4962 0.4963 0.4964 2.7 0.4965 0.4966 0.4967 0.4968 0.4969 0.4970 0.4971 0.4972 0.4973 0.4974 2.8 0.4974 0.4975 0.4976 0.4977 0.4977 0.4978 0.4979 0.4979 0.4980 0.4981 2.9 0.4981 0.4982 0.4982 0.4983 0.4984 0.4984 0.4985 0.4985 0.4986 0.4986 3 0.4987 0.4987 0.4987 0.4988 0.4988 0.4989 0.4989 0.4989 0.4990 0.4990 Figure 8.10: Standard normal distribution table 8.13. Multiple Product CVP-Analysis CVP-Analysis also applies when a company produces and sells more than one product. In case of 2 products the break-even point turns out to be a break-even line. For 3 products we get an area in the meaning of Mathematics - etc. To determine a break-even ‘point’ with a certain combination of products (product mix), Accountants assume a fixed ratio for the product numbers. This narrows the number of solutions down to only one. A ratio of product numbers gives for a certain number of one product the quantity for the other one. We apply the method for DEERFIELD TOURS (Pty) Ltd. and enhance its business model. The company now offers 2 tours. The trips are linked to each other by a trip ratio, see below. 8.14. 2-Tour-Case - DEERFIELD TOURS (Pty) Ltd. DEERFIELD TOURS (Pty) Ltd. offers besides of the tours to South Africa, city trips to visit Kuala Lumpur. Find below the data sheet for the Kuala Lumpur trips at DEERFIELD TOURS (Pty) Ltd.: <?page no="157"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 8-157 Data Sheet for KL-Tour CClassification: Tourism; KL-tour: 10 … 30 trips/ tour; base case: 1/ 5 of the Strips; flight: 1,400.00 EUR/ t; hotel: 560.00 EUR/ t; meals: 320.00 EUR/ t; Fixed costs: administration: 3,400.00 EUR/ tour; bus: 5,000.00 EUR/ tour. Selling price: 3,500.00 EUR/ t; VAT ignored. The tours to Malaysia start and end in Frankfurt (Main), too. The variable costs per trip are: the flight expenses at 1,400.00 EUR/ t, the hotel costs of: 7 × 80 = 5560.00 EUR/ t and meals at: 8 × 40 = 320.00 EUR/ t. In total, the variable costs equal: 1,400 + 560 + 320 = 2 2,280.00 EUR/ t. The fixed costs for tour planning and administration are 3,400.00 EUR/ tour and for the transport in a rented 30-seater bus 5,000.00 EUR/ tour. DEERFIELD TOURS (Pty) Ltd. sells a trip at 3,500.00 EUR/ t. The maximum number of travellers is 30 t per tour. DEERFIELD TOURS (Pty) Ltd. reserves the right to cancel a trip if less than 10 travellers book the tour. Based on its business plan, for 5 tours to the Garden Route there is 1 tour to Kuala Lumpur. As the traveller numbers spread, we calculate a traveller ratio of: (5 × 25) : 30, as: 1 125 : 30. Observe the adjusted contribution income statement depicted in Figure 8.11. 125 30 trips Item Garden Route Kuala Lumpur Sum Per unit Sales 487,500.00 105,000.00 592,500.00 100.0% Variable expenses (325,000.00) (68,400.00) (393,400.00) -66.4% Contribution margin 162,500.00 36,600.00 199,100.00 33.6% less: Fixed expenses (60,400.00) Net profit 138,700.00 CONTRIBUTION INCOME STATEMENT Figure 8.11: DEERFIELD TOURS (Pty) Ltd. 2-product statement The calculation in the 2-product contribution income statement contains the items below: (1) The amount of Kuala Lumpur trips is calculated as: t KL = 30 × t GR / 125. (2) The sales for the Garden Route tour are: S GR = t GR × 3,900. (3) The sales for the Kuala Lumpur tour are: S KL = t KL × 3,500. (4) The variable costs for the Garden Route tour are: VC GR = t GR × 2,600. (5) The variable costs for the Kuala Lumpur tour are: VC KL = t KL × 2,280. (6) The contribution margin ratio is calculated as: (S GR + S KL ) - (VC GR + VC KL ) / (S GR + S KL ). The contribution margin ratio does not depend on the number of trips as long equation (1) is valid: t KL = 30 × t GR / 125. (7) The fixed costs are: 5 × (3,400 + 7,000) + (3,400 + 5,000) = 6 60,400.00 EUR. For t GR = 100 and t KL = 24, the contribution margin ratio equals: (100 × 3,900 + 24 × 3,500 - (100 × 2,600 + 24 × 2,280)) / (100 × 3,900 + 24 × 3,500) = 0.34 = 33.60 %. Compare the result to the MS- Excel calculation as demonstrated in Figure 8.12. <?page no="158"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 8-158 100 24 trips Item Garden Route Kuala Lumpur Sum Per cent Sales 390,000.00 84,000.00 474,000.00 100.0% Variable expenses (260,000.00) (54,720.00) (314,720.00) -66.4% Contribution margin 130,000.00 29,280.00 159,280.00 33.6% less: Fixed expenses (60,400.00) Net profit 98,880.00 CONTRIBUTION INCOME STATEMENT Figure 8.12: DEERFIELD TOURS (Pty) Ltd.’s 2-product statement (2) Once we study the enhanced contribution income statement, we see that the contribution margin for both tours must cover all fixed costs for breaking-even. Cross product support is possible (fixed costs are added). To calculate the trip numbers for breaking-even, we look for trip numbers based on the given ratio that are that high that all trips together result in a contribution margin of 60,400.00 EUR. Accordingly, we can calculate sales of: 60,400 / 33.6% = 179,761.90 EUR. The formula for the total sales depending on t GR is: 179,761.90 = t GR × 3,900 + 30 × (t GR / 125) × 3,500. t GR = 179,761.90 / (3,900 + (30 × 3,500) / 125) = 337.92. This means the travellers to Kuala Lumpur are: t KL = 30 × 39.92 / 125 = 9 9.1. If the MS-Excel spreadsheet for the contribution income statement is wellstructured, we can apply the goal seek function. Figure 8.13: Goal seek function break-even point calculation Rounding to the next integer for the trip numbers, gives a loss of 20.00 EUR if DEERFIELD TOURS (Pty) Ltd. sells 38 trips for the Garden Route and 9 trips for Kuala Lumpur tour. This value only is obtained by 5 tours to South Africa and one <?page no="159"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 8-159 to Malaysia. If 38 trips result only in 4 tours to the Garden Route, fixed costs would change. 38 9 trips Item Garden Route Kuala Lumpur Sum Per cent Sales 148,200.00 31,500.00 179,700.00 100.0% Variable expenses (98,800.00) (20,520.00) (119,320.00) -66.4% Contribution margin 49,400.00 10,980.00 60,380.00 33.6% less: Fixed expenses (60,400.00) Net profit (20.00) CONTRIBUTION INCOME STATEMENT Figure 8.14: DEERFIELD TOURS 2-product statement (3) 8.15. Summary The CVP-Analysis calculates profits for different product/ service/ activity levels. Frequently, the CVP analysis is applied to determine the break-even point. This is the output quantity where the company does not earn a profit (zero-profit). A good use of the CVP-Analysis is to study alterations of the business concept and test for the most profitable alternative. We recommend running CVP-Analysis on a spreadsheet program. In this chapter, we studied the application of the CVP- Analysis for various scenarios for the case study DEERFIELD TOURS (Pty) Ltd. 8.16. Working Definitions Break-Even Point: The break-even point in a CVP analysis is the number of goods or the activity level, where the profit equals zero. Contribution Margin: The contribution margin is the sales deducted by variable costs. Normal Distribution: Normal distributed figures result in a bell-shaped curve in case you draw a frequencyover-value-diagram. Standard Normal Distribution: A standard normal distribution is normally distributed and the mean equals to 0 and the standard deviation equals to 1. What-if Analysis: A what-if analysis is a calculation of the outcome by alternating certain variables. 8.17. Question Bank (1) A standard normal distribution is … 1. … a probability density function with the mean 1 and the standard deviation 0. 2. … a probability density function with the mean 0 and the standard deviation 1. 3. … a probability for the mean to be 1 and the standard deviation 0. 4. … a probability for the mean to be 0 and the standard deviation 0. <?page no="160"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 8-160 (2) A company produces goods at proportional costs of 125.00 EUR/ u. The non-manufacturing costs per good produced are 20.00 EUR/ u. There are fixed costs of 11,600.00 EUR. How many products must be manufactured to earn a positive profit? 1. 92 units . 2. 93 units . 3. 80 units . 4. 81 units . (3) The equation to calculate the break-even point, that is based on the revenue per unit ‘rev’, the unit costs ‘pc’, the fixed costs ‘FC’ and the product quantity ‘X’ is: 1. X = FC/ (rev +pc). 2. rev +x = pc × X + FC. 3. 0 = rev × X - (FC + pc × X). 4. 0 = rev × X - (FC pc × X). (4) The requirements for the application of the CVP-analysis are: 1. Constant product prices, cost separation possible, no discounts. 2. Degressive cost function, cost separation possible, no changes in inventory. 3. Constant product prices, only integer figures applicable for quantities, no discounts. 4. Cost separation positive, no discounts, no inventory increases. (5) A company produces goods with the following costs: materials 80.00 EUR/ u, direct labour 35.00 EUR/ u and depreciation on production facilities 20,000.00 EUR. Administration is amounting to 10,000.00 EUR. How much must be the revenue to break-even with 500 products? 1. 175.00 EUR/ u . 2. 155.00 EUR/ u . 3. 135.00 EUR/ u . 4. 115.00 EUR/ u . 8.18. Solutions 1-2; 2-4; 3-3; 4-1; 5-1. <?page no="161"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 9-161 9. Degree of Operating Leverage (DOL) 9.1. What is in the Chapter? This chapter discusses a concept for decision making about fixed assets. In general, investments reduce the flexibility of a business due to poor liquidation options. They move the breakeven point towards higher output numbers (more depreciation) and in over-capacity situations, there are less products available to cover fixed costs. The degree of operating leverage DOL is a factor that indicates how much profit or cash flow changes in response of changes in revenues (outputs). Investments work as a leverage: As more a company invests as more profit increases due to higher sale quantities. But caution! The leverage works both ways, lower quantities of goods/ services cause profits to decline. We study the DOL with the case study of DEERFIELD TOURS (Pty) Ltd. Later we introduce the new case study of a production firm. EMS KAYAK GmbH produces kayaks. 9.2. Learning Objectives A company operating beyond breakeven point, earns with every product added a profit to the extent of the contribution margin. The reason is, that with fixed costs covered already, profit increases with 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. After studying this chapter, you will be able to understand the DOL concept and can analyse the DOL for alternative business scenarios. You also can understand the limitation of the DOL concept and can explain why Accountants refer to a leverage regarding investments. 9.3. Profit and Output Relationship Managers strive to understand, how a business responds to changes in demand. E.g., they need to know how profit changes as result of one additional unit of output. For making economic decisions, managers must consider that investments amplify the effect changes in output have on profits - in both directions. If a business is uncertain about sales quantities, the DOL effect can lead to decisions to reduce fixed costs, e.g., by outsourcing or selling and leasing back assets. For this chapter, we assume that net selling prices per unit are constant. How it is Done (Calculation of DOL) (1) Determine the revenue for a particular output that is the reference case. Call the scenario A or base case. (2) Determine the revenue for an alternative output. Call the scenario B. (3) Determine the percentage of changes in output. The percentage increase/ decrease is: Δ Output A,B = Output B / Output A - 1. <?page no="162"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 9-162 (4) Determine the percentage of changes in profit. The percentage increase/ decrease is: Δ EBIT A,B = EBIT B / EBIT A - 1. (5) Calculate the Degree of Operating Leverage. It equals to: DOL A,B = Δ EBIT A,B / Δ Output A,B 9.4. C/ S DEERFIELD TOURS (Pty) Ltd. We start with the example from the previous chapter, DEERFIELD TOURS (Pty) Ltd. The company DEERFIELD TOURS (Pty) Ltd. offers holiday trips to the South African Garden Route and identifies variable and fixed costs thereof. It breakseven with 8 travellers. Observe Figure 9.1: Sales of 8 trips Item Total Per unit Sales 31,200.00 3,900.00 Variable expenses (20,800.00) (2,600.00) Contribution margin 10,400.00 1,300.00 less: Fixed expenses (10,400.00) Net profit 0.00 CONTRIBUTION INCOME STATEMENT Figure 9.1: DEERFIELD TOURS (Pty) Ltd. break-even point We repeat the data sheet for DEERFIELD TOURS (Pty) Ltd. below: Data Sheet for DEERFIELD TOURS (Pty) Ltd. Classification: Tourism; SA-tour: 10 … 25 t/ tour; base case: 19 trips (t); flight: 1,500.00 EUR/ t; hotel: 700.00 EUR/ t; meals: 400.00 EUR/ t; Fixed costs: administration: 3,400.00 EUR/ tour; bus: 7,000.00 EUR/ tour; Net selling price: 3,900.00 EUR/ t; VAT ignored. If DEERFIELD TOURS (Pty) Ltd. sells 8 trips for a tour, all its fixed costs are covered. The company earns zero profit then. Any additional traveller will contribute to the profit by the margin of revenue minus proportional costs. We call that margin the net operating income. The net operating income is the profit that remains after all operational costs are paid. We explain the term net operating income by a case where a landlord rents out property. The net operating income is amounting to rental income minus all costs to be paid as stated per the rental contract, like maintenance, municipality rates or gardening service. In contrast, no overheads like administration or depreciation, are deducted. The net operating income is close to a contribution margin however contribution margin is an expression derived from product calculations and is linked to Cost separation. <?page no="163"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 9-163 For DEERFIELD TOURS (Pty) Ltd., this means once all fixed costs are covered every additional trip increases the profit by its operating income of: 3,900 - 2,600 = 11,300.00 EUR/ t. Next, we study the profit for additional travellers after DEERFIELD TOURS Ltd. exceeded the breaks-even point. If DEERFIELD TOURS (Pty) Ltd. sells 9 trips per tour, its profit equals 1,300.00 EUR/ tour. Observe the calculation in Figure 9.2: Sales of 9 trips Item Total Per unit Sales 35,100.00 3,900.00 Variable expenses (23,400.00) (2,600.00) Contribution margin 11,700.00 1,300.00 less: Fixed expenses (10,400.00) Net profit 1,300.00 CONTRIBUTION INCOME STATEMENT Figure 9.2: DEERFIELD TOURS (Pty) Ltd.’s/ profit calculation (1 additional traveller) The next additional trip makes DEERFIELD TOURS (Pty) Ltd. earn a profit of 2,600.00 EUR/ tour. We check 11 trips. This will be 3 travellers beyond break-even. All 3 travellers add 1,300.00 EUR/ t to DEERFIELD TOURS (Pty) Ltd.’s profit, as the operating income is no longer used for the coverage of fixed costs. Thus, we expect the profit to be: (11 - 8) × 1,300 = 3 3,900.00 EUR/ tour. Observe Figure 9.3 for confirmation. Sales of 11 trips Item Total Per unit Sales 42,900.00 3,900.00 Variable expenses (28,600.00) (2,600.00) Contribution margin 14,300.00 1,300.00 less: Fixed expenses (10,400.00) Net profit 3,900.00 CONTRIBUTION INCOME STATEMENT Figure 9.3: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (11 travellers) As our intention is to study relative changes in profit caused by increases/ decreases of sales, we compare the calculations in Figure 9.2 to those displayed in Figure 9.3: The sales numbers, measured in trips, increases from 9 to 11. This results in an: 11 / 9 - 1 = 2 22.22 % increase of sales. As result of this change in output, there is an increase of profit to the extent of: (3,900 - 1,300) / 1,300 = 2 200 %. <?page no="164"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 9-164 We acknowledge a 200 % increased profit because of a 22.22 % increase in sales. The amplifier between these percentages is called the Degree or Operating Leverage DOL. The factor between the changes in EBIT and in sales is called the degree of operating leverage DOL. The DOL equals to changes in terms of EBIT over changes in terms of sales. Sales EBIT DOL At DEERFIELD TOURS (Pty) Ltd., the degree of operating leverage is: 200 % / 22.22 % = 9 9.00. The DOL is high as the company’s profit works close to the break-even point. Companies with a high DOL will experience high changes in profit when the sales numbers change. To make the effect more precedent, we write the equation again but now we isolate ∆EBIT: Sales DOL EBIT This notation shows how DOL works as an amplifier of changes in sales. We consider companies with high DOL as risky. E.g., DEERFIELD TOURS (Pty) Ltd. will half its profit if losing 2 customers out of 11! There are two factors that determine the degree of operating leverage. (1) DOL-degression effect. (2) Fixed costs effect. 9.5. DOL-Degression Effect As the profit equals to zero at the break-even point and we measure changes by percentages, profit changes near to the break-even point are high. This effect becomes clearer once we observe an increase of 5 trips on a current situation of 20 trips. It causes an output increase of: 25/ 20 - 1 = 2 20.00 %. The profit will change by: (((25 - 8) × 1,300) - ((20 - 8) × 1,300))) / ((20 - 8) × 1,300)) = (17 - 12) / 12 = 4 41.67 %. The degree of operating leverage now only is: 41.67 % / 20 % = 22.08. We refer to this effect as ‘DOL-degression’. Outputs close to the break-even point show higher DOLs than those more far away. 9.6. Fixed Costs Effect The degree of operating leverage depends on fixed costs. To reduce the portion of fixed costs moves the break-even point to lower numbers of volume. Therefore, it becomes a trade-off between enjoying the leverage to increase profits and suffering from decreasing flexibility and higher risks by investing in machinery. Managers who change cost structures towards fixed costs, must tolerate a loss in flexibility. The situation is like your decision whether you buy a bicycle to ride it to the university or you come with an UBER. The bicycle acquisition results in fixed costs which means the investment only makes sense if you ride your bicycle several times. For a one-time <?page no="165"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 9-165 ride the UBER alternative is better as no fixed costs apply. However, if you go often to the university the bicycle option is the cheaper one. Your investment decision makes the rides cheaper but in terms of the cost structure you are less flexible with the bicycle. To understand the concept better, we study a new case EMS KAYAK GmbH where a company reduces its fixed costs by outsourcing. This way, the company can enjoy the effects of high DOL if certain about selling beyond break-even. Before we can discuss the fixed-costs-effect, we must introduce the case study and some technical terms. Later, we also study the impact of outputs on changes in operating cash flows, the so called DOL(CF). 9.7. C/ S EMS KAYAK GmbH In contrast to DEERFIELD TOURS (Pty) Ltd., the next case study EMS KAYAK GmbH covers a production firm which operates at higher fixed costs. The company invests in production facilities used over a period of 5 years. Hence, it is committed to its cost structure for the upcoming Accounting periods. In preparation for our DOL studies, we prepare an income statement and a cash flow statement in MS-Excel. We determine the company’s Accounting break-even point, the cash break-even point and the financial break-even point. The Accounting break-even point is at zero-profit. The cash breakeven point is where the resulting operating cash flow becomes zero. The financial break-even point is where the investment’s net present value is amounting to zero. We need the breakeven points to study DOLs with regard to profit and cash flow. Below we show the data sheet for EMS KAYAK GmbH: Data Sheet for EMS KAYAK GmbH CClassification: Production; Net selling price: 400.00 EUR/ u; proportional costs per unit: 200.00 EUR/ u; Fixed costs: 5,000.00 EUR; Investment in machinery: 35,000.00 EUR fully depreciable over 5 years; periods: 20X3 … 20X7; Boat quantity: 525 u/ a; Discount rate: 10 %; VAT ignored . EMS KAYAK GmbH is a kayak manufacturer in Vöcklabruck in Austria. EMS KAYAK GmbH sells a kayak at 400.00 EUR/ u. The proportional costs per kayak are 200.00 EUR/ u. The fixed costs for the EMS KAYAK GmbH are amounting to 5,000.00 EUR and are linked to labour in production and to administration. The investment in manufacturing facilities is for the boat hull production and costs 35,000.00 EUR, payable in 20X2. The depreciable value is written-off during the next 5 Accounting periods following straight-line method without residual value. During the Accounting periods 20X3 … 20X7, EMS KAYAK GmbH estimates to manufacture and sell 525 kayaks. The rate of interest is 10 %/ a on the capital market and applies for the calculation of the net present value (NPV) of the investment. No financing of EMS KAYAK GmbH by bank loans applies. The present value calculation is based on the investing cash flow in 20X2 (acquisition) and the operating cash flows (returns) during the following 5 years. <?page no="166"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 9-166 Returns are earned from 20X3 to 20X7. For EMS KAYAK GmbH, an income tax rate of 30 % applies. As EMS KAYAK GmbH wants to determine the net present value of its investment, it must prepare a payment vector for investing and operating cash flows. The investing cash flow equals to the cost of acquisition: -35,000.00 EUR. The operating cash flow contains the proceeds from the revenue of: 525 × 400 = 2210,000.00 EUR. The negative operating cash flows are for proportional costs of: 525 × 200 = 1 105,000.00 EUR/ a and for other fixed costs which are 5,000.00 EUR/ a. The operating cash flows during the Accounting periods 20X3 … 20X7 are: 210,000 - 105,000 - 5,000 = 100,000.00 EUR/ a. When manufacturing different kayak numbers (#ky), the cash flows will adjust. The payment vector is based on 525 kayaks and equals: CF 525 (t) = { {-35,000; 72,100.00; 72,100.00; 72,100.00; 72,100.00; 72,100.00}. To check whether the kayak production is adding value to the company, EMS KAYAK GmbH calculates the net present value of the kayak production project. The net present value equals: -35,000 + 72,100 × ((1 + 10%) 5 - 1) / (10% × (1 + 10%) 5 ) = 2 238,315.73 EUR. Figure 9.4 shows the profit and cash flow calculation and the net present value for an output of 525 kayaks. / u [EUR] [EUR] Sales 400.00 210,000.00 Proceeds 210,000.00 Prop. Costs 200.00 (105,000.00) Prop. Costs (105,000.00) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation (7,000.00) Tax (27,900.00) EBT 93,000.00 OCF 72,100.00 less: tax (27,900.00) EAT 65,100.00 Output = 525 NPV 20X2 = 238,315.73 (35,000.00) + 72,100.00 × 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.4: EMS KAYAK GmbH’s profit and cash flow calculation (1) 9.8. 3 Break-Even Points - EMS KAYAK GmbH Next, we calculate break-even points. ‘How many kayaks (#ky) must EMS KAYAK GmbH sell to break-even? ’ The solution is based on a profit calculation: EBT(#ky) = #ky × 200 + 5,000 + 7,000. It gives: #ky BE = 12,000 / 200 = 6 60 kayaks. Figure 9.5 proves the accounting breakeven point calculation. The Accounting break-even point is based on the output which makes the company earn a profit of zero. For EMS KAYAK GmbH, the number of kayaks #ky for the Accounting breakeven point is 60 kayaks. <?page no="167"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 9-167 / u [EUR] [EUR] Sales 400.00 24,000.00 Proceeds 24,000.00 Prop. Costs 200.00 (12,000.00) Prop. Costs (12,000.00) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation (7,000.00) Tax 0.00 EBT 0.00 OCF 7,000.00 less: tax 0.00 EAT 0.00 Output = 60 NPV 20X2 = (8,464.49) (35,000.00) + 7,000.00 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.5: EMS KAYAK GmbH’s Accounting break-even point (2a) For the cash break-even point, the number of kayaks #ky C-BE must meet the point, where EMS KAYAK GmbH’s operating cash flow is zero. Beyond that kayak quantity #ky C-BE , the project earns cash from its operating activities. The cash break-even point is based on the output that makes the operating cash flow become zero. The cash breakeven point only matters in Accounting periods when EMS KAYAK GmbH manufactures kayaks and receives returns from operations. To calculate the cash break-even point, we consider the taxes-over-profit function. If EMS KAYAK GmbH earns a loss, the taxes are zero. In case of earning a profit, the taxes are 30 % based on the earnings before taxes. Due to the simplicity of the case study, we ignore the possibility of the negative tax expenses and make adjustments where the * * is. The provisional cash flow equation is as below: OCF(#ky C-BE ) = #ky C-BE × 400 - #ky C-BE × 200 - 5,000 - 30% × (#ky C-BE × 400 - #ky C-BE × 200 - 5,000 - 7,000) = #ky C-BE × 140 - 1,400 = 0. After isolating #ky C-BE , we determine the cash break-even point at the number of kayaks: #ky C-BE = 1,400 / 140 = 1 10 kayaks. * Here comes the re-working for our calculation: Due to a loss with only 10 kayaks sold, the tax expenses are zero. Hence, the operating cash flow of 10 kayaks is: -3,000.00 EUR but not zero as calculated. Hence, the cash break-even point is reached at more than 10 kayaks. <?page no="168"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 9-168 / u [EUR] [EUR] Sales 400.00 4,000.00 Proceeds 4,000.00 Prop. Costs 200.00 (2,000.00) Prop. Costs (2,000.00) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation (7,000.00) Tax 0.00 EBT (10,000.00) OCF (3,000.00) less: tax 0.00 EAT (10,000.00) Output = 10 NPV 20X2 = (46,372.36) (35,000.00) + (3,000.00) * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.6: EMS KAYAK GmbH’s profit and cash flow calculation (2b) Once the pre-tax-profit is negative, the tax expenses must become zero. In the MS-Excel sheet the tax cell reads: “if(EBT>0,-0.3×EBT,0)”. Hence, our spreadsheet calculates correctly, but the above presented formula does not. We adjust the equation for sections of negative EBTs by (manually) erasing the summands for taxation 36 and now recalculate: OCF(#ky C-BE ) = #ky C-BE × 400 - #ky C-BE × 200 - 5,000 = #ky C-BE × 200 - 5,000 = 0. Now, the financial break-even point is at: #ky C-BE = 5,000 / 200 = 2 25 kayaks. / u [EUR] [EUR] Sales 400.00 10,000.00 Proceeds 10,000.00 Prop. Costs 200.00 (5,000.00) Prop. Costs (5,000.00) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation (7,000.00) Tax 0.00 EBT (7,000.00) OCF 0.00 less: tax 0.00 EAT (7,000.00) Output = 25 NPV 20X2 = (35,000.00) (35,000.00) + 0.00 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.7: EMS KAYAK GmbH’s cash break-even point (2b) We study the cash break-even point in cases, where a company needs to 36 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 know, whether a project contributes to cash flows. zero taxation for loss and zero profit cases automatically and we do not have to erase tax-relevant summands manually in loss cases. <?page no="169"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 9-169 We check the financial break-even point. It is relevant for investment decisions. The question is: ‘How many goods/ services must be produced/ rendered, to take 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 together and considers the time value of money for the useful life of the investment. The financial breakeven point is at that output where the net present value is zero. The formula for the calculation of the financial break-even point requires to deal with 5th degree polynomial. We do not bother ourselves therewith and apply the goal seek function in MS-Excel. Observe the result in Figure 9.8. / u [EUR] [EUR] Sales 400.00 30,379.75 Proceeds 30,379.75 Prop. Costs 200.00 (15,189.87) Prop. Costs (15,189.87) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation (7,000.00) Tax (956.96) EBT 3,189.87 OCF 9,232.91 less: tax (956.96) EAT 2,232.91 Output = 75.9493702 NPV 20X2 = 0.00 (35,000.00) + 9,232.91 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.8: EMS KAYAK GmbH’s financial break-even point (2c) We round the kayak number #ky F-BE to the next integer and arrive at 76 kayaks, which guarantees a positive net present value of the kayak production project. Observe Figure 9.9. <?page no="170"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 9-170 / u [EUR] [EUR] Sales 400.00 30,400.00 Proceeds 30,400.00 Prop. Costs 200.00 (15,200.00) Prop. Costs (15,200.00) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation (7,000.00) Tax (960.00) EBT 3,200.00 OCF 9,240.00 less: tax (960.00) EAT 2,240.00 Output = 76 NPV 20X2 = 26.87 (35,000.00) + 9,240.00 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.9: EMS KAYAK GmbH’s financial break-even point (2c) 9.9. DOL-Studies - EMS KAYAK GmbH After we checked the break-even points, we can study the degree of operating leverage DOL for alternative outputs. The base case (1) is about 525 kayaks. Coming from 525 kayaks, EMS KAYAK GmbH increases production and sales by 200 kayaks 37 . (The profit and cash flows for 525 kayaks can be read from Figure 9.4.) The distance to the break-even point is high enough to ignore the DOLdegression effect. The scenario of EMS KAYAK GmbH producing and selling 725 kayaks is indicated in Figure 9.10: / u [EUR] [EUR] Sales 400.00 290,000.00 Proceeds 290,000.00 Prop. Costs 200.00 (145,000.00) Prop. Costs (145,000.00) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation (7,000.00) Tax (39,900.00) EBT 133,000.00 OCF 100,100.00 less: tax (39,900.00) EAT 93,100.00 Output = 725 NPV 20X2 = 344,457.76 (35,000.00) + 100,100.00 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.10: EMS KAYAK GmbH’s profit and cash flow calculation (3) 37 We mark that case by (3). <?page no="171"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 9-171 We calculate the degree of operating leverage for EMS KAYAK GmbH increasing production and sales from 525 to 725 kayaks: With constant selling prices for kayaks, we can express the changes in sales by the number of kayaks. The degree of operating leverage for an increase of 200 kayaks based on the 525 kayak-situation gives: DOL (1)-(3) = ((133,000/ 93,000) -1) / ((725/ 525) - 1) = 11.13. We say: a 1%-change in sales results in a 1.13% change of profit (here: EBIT). EBIT increase by 13 % more than sales. For checking the DOL-degression effect, we study another output. We want to determine, what happens once EMS KAYAK GmbH increases production and sales by 100 further kayaks, from 725 to 825. The situation of EMS KAYAK GmbH producing and selling 825 kayaks is shown by Figure 9.11 and is indicated by scenario (4). / u [EUR] [EUR] Sales 400.00 330,000.00 Proceeds 330,000.00 Prop. Costs 200.00 (165,000.00) Prop. Costs (165,000.00) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation (7,000.00) Tax (45,900.00) EBT 153,000.00 OCF 114,100.00 less: tax (45,900.00) EAT 107,100.00 Output = 825 NPV 20X2 = 397,528.77 (35,000.00) + 114,100.00 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.11: EMS KAYAK GmbH’s profit and cash flow calculation (4) The DOL now changes slightly, only based on the DOL-degression effect: DOL (3)-(4) = ((153,000/ 133,000) - 1)/ ((825/ 725) - 1) = 11.09. Now, a 1 % change in sales causes a 1.09% change in profit. As we learned from the DOL-degression effect, it is normal, that as more distant figures are from the break-even point, as lower the DOL gets. We can neglect the difference as EMS KAYAK GmbH operates far beyond its break-even point of 60 kayaks. Furthermore, only limited changes in output are possible for EMS KAYAK GmbH as it cannot increase production significantly without further investments. 9.10. Fixed Cost Effect - EMS KAYAK GmbH We study what happens if EMS KAYAK GmbH changes the cost structure in favour of variable costs. We know already, this will reduce the DOL and increases flexibility. ‘How can EMS KAYAK GmbH <?page no="172"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 9-172 reduce fixed costs in comparison to variable cost portions? ’ It must outsource production steps and sell/ not buy machinery. We assume, that EMS KAYAK GmbH farms out the hull production to a supplier. EMS KAYAK GmbH pays for every kayak 15.00 EUR/ ky proportional costs but the investment in the hull production machinery becomes obsolete. EMS KAYAK GmbH sells machinery to cut short depreciation. In comparison to the previous situation, the unit costs increase slightly, as depreciation per kayak was: 7,000 / 525 = 1 13.33 EUR/ ky. Figure 9.12 discloses the financial situation of EMS KAYAK GmbH producing 525 kayaks based on the outsource situation. No depreciation applies but the proportional costs increase by 15.00 EUR/ ky and now are: 200 + 15 = 2 215.00 EUR/ ky. The fixed costs for labour and administration equal 5,000.00 EUR still. / u [EUR] [EUR] Sales 400.00 210,000.00 Proceeds 210,000.00 Prop. Costs 215.00 (112,875.00) Prop. Costs (112,875.00) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation 0.00 Tax (27,637.50) EBT 92,125.00 OCF 64,487.50 less: tax (27,637.50) EAT 64,487.50 Output = 525 NPV 20X2 = 209,458.36 (35,000.00) + 64,487.50 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.12: EMS KAYAK GmbH’s profit and cash flow calculation (5) With the hull production outsourced, EMS KAYAK GmbH earns a pre-tax profit of 92,135.00 EUR. We indicate this scenario by (5). The profit decreases in contrast to scenario (1) by: 93,000 - 92,125 = 8 875.00 EUR. This is for the increase in unit costs due to outsourcing the hull production. However, EMS KAYAK GmbH is better off as its DOL now decreased. We check the increase by 200 kayaks in Figure 9.13, which shows as scenario (6). <?page no="173"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 9-173 / u [EUR] [EUR] Sales 400.00 290,000.00 Proceeds 290,000.00 Prop. Costs 215.00 (155,875.00) Prop. Costs (155,875.00) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation 0.00 Tax (38,737.50) EBT 129,125.00 OCF 90,387.50 less: tax (38,737.50) EAT 90,387.50 Output = 725 NPV 20X2 = 307,639.74 (35,000.00) + 90,387.50 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.13: EMS KAYAK GmbH’s profit and cash flow calculation (6) The DOL for an increase of 200 kayaks based on the 525-kayak situation gives: DOL (5)-(6) = ((129,125/ 92,125) - 1) / ((725/ 525) - 1) = 11.05. For an increase of 1 % of the kayaks the profit will increase by 1.05 %. For the next increase by 100 kayaks, from 725 to 825, we study Figure 9.14, which shows the profit and cash flows for 825 kayaks with regard to the outsourcing situation. We indicate this scenario by (7). / u [EUR] [EUR] Sales 400.00 330,000.00 Proceeds 330,000.00 Prop. Costs 215.00 (177,375.00) Prop. Costs (177,375.00) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation 0.00 Tax (44,287.50) EBT 147,625.00 OCF 103,337.50 less: tax (44,287.50) EAT 103,337.50 Output = 825 NPV 20X2 = 356,730.43 (35,000.00) + 103,337.50 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.14: EMS KAYAK GmbH’s profit and cash flow calculation (7) The calculation of a DOL at higher outputs makes the DOL decrease: Observe the DOL-degression effect for the additional increase in output at EMS KAYAK GmbH: DOL (6)-(7) = ((147,625/ 129,125) - 1) / ((825/ 725) - 1) = 11.04. <?page no="174"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 9-174 Below, we show the situation in a costvolume-diagram which is not to scale. Figure 9.15: Graphical implication of the outsourcing effect The outsourcing of the hull production is shown in Figure 9.15. In the diagram, the sales are represented by a bold line. The initial cost line is a straight line starting with the fixed costs. The intersection of the cost line and the sales line marks the break-even point A. Arrow 1 indicates the reduction of fixed costs by disposal of the machinery when farming out production steps, as in the case of EMS KAYAK GmbH with the hull production. As a further outsourcing effect variable costs increase which 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 lower quantities. This means the company breaks-even at less product numbers. This improves the risk situation. As the fixed 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 must compare these effects properly. To determine the variable costs that can be added to an existing production scenario we study EMS KAYAK GmbH again at the break-even point as depicted by Figure 9.5. EMS KAYAK GmbH breaks-even with #ky = 60 kayaks. The equation indicates that the profit is zero because sales equal costs. P(60) = 0 = 400 × 60 - 200 × 60 - 5,000 - 7,000. (with: P = profit). We now want to increase the variable costs by ΔPC and dispose machinery. No depreciation applies thereafter. The break-even point is to stay at #ky = 60 to keep the risk at the same level. Hence, P out (60) = <?page no="175"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 9-175 0 = 400 x 60 - (200 + ΔPC) x 60 - 5,000. As a result, ΔPC = ((400 - 200) x 60 - 5,000) / 60 = 1 116.67 EUR. (with: P out = profit based on outsourcing, ΔPC = increase of proportional costs). To demonstrate the effect, we add the proportional cost increase to EMS KAYAK GmbH’s profit and cash flow calculation as shown in Figure 9.16. / u [EUR] [EUR] Sales 400.00 24,000.00 Proceeds 24,000.00 Prop. Costs 316.67 (19,000.00) Prop. Costs (19,000.00) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation 0.00 Tax 0.00 EBT (0.00) OCF (0.00) less: tax 0.00 EAT (0.00) Output = 60 NPV 20X2 = (35,000.00) (35,000.00) + (0.00) * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.16: EMS KAYAK GmbH’s profit and cash flow plan for the farming out case EMS KAYAK GmbH’s can increase the proportional costs by 116.67 EUR and keeps the break-even point unchanged. However, this high amount of variable costs decreases profit at the operating point of 525 kayaks a lot. The profit was: P(525) = 400 × 525 - 200 × 525 - 5,000 - 7,000 = 9 93,000.00 EUR and now is: P out (525) = 400 × 525 - (200 + 116.67) × 525 - 5,000 = 3 38,748.25 EUR. This is a profit decrease of: (93,000 - 38,748.25) / 93,000 = 5 58.34% which is a high sacrifice for risk reduction. For higher volumes the reduction in profits becomes worse. It is recommended calculating the ‘neutral increase’ of proportional costs at an operating point beyond breaking-even. We discussed break-even point shifting to show that risks for a business depend on its flexibility to changes output. Investments cannot be made undone easily. If the company needs to cut costs, machines must be disposed. In contrast to reductions of fixed cost, cost for current assets, such as supplies and materials, can easily adjusted to demand. Thus, a company that contractors out production steps shifts the risk (as well as profits) to its suppliers. For the situation of EMS KAYAK GmbH, farming out hull production, the breakeven point moves down on the volume scale, which indicates lower risks because less kayaks are required for breaking-even. As in this example depreciation becomes zero, the profit and cash flow are the same for the break-even points. Furthermore, the investing cash flow becomes zero. This results for the EMS KAYAK GmbH case study in the situation of all break-even points being at the same kayak number #ky. Observe the situation of EMS KAYAK GmbH or- <?page no="176"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 9-176 dering hulls from a supplier for additional 15.00 EUR/ ky in Figure 9.17 that has been determined by goal seek function on the profit and cash flow plan. / u [EUR] [EUR] Sales 400.00 10,810.81 Proceeds 10,810.81 Prop. Costs 215.00 (5,810.81) Prop. Costs (5,810.81) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation 0.00 Tax (0.00) EBT 0.00 OCF 0.00 less: tax (0.00) EAT 0.00 Output = 27.02702703 NPV 20X2 = 0.00 0.00 + 0.00 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 9.17: EMS KAYAK GmbH’s break-even point As result of the break-even point calculation, #ky BE = #ky C-BE = #ky F-BE = 227.03 kayaks. This is a significant risk reduction as now the number of kayaks to make the kayak production work decreases by: 27.03 / 75.95 - 1 = 6 64.41 %. 9.11. DOL for Cash Flows Next, we focus on cash flows and study what happens to cash flows if revenue changes. The DOL(CF) is the degree of operating cash flow leverage. It measures the sensitivity of a firm’s operating cash flows to the sales. The DOL(CF) is: Sales OCF CF DOL ) ( We determine EMS KAYAK GmbH’s DOL(CF) for an increase of 200 kayaks. The base case (1) applies. DOL(CF) (1)-(3) = ((100,100/ 72,100) - 1) / ((725/ 525) - 1) = 1 1.01. The result means that an increase of 1 % sales will make the operating cash flow increase by 101 %. 9.12. Summary The degree of operating leverage DOL measures the sensitivity of the profit (EBIT, or in some cases only NOI) to changes in sales. The DOL depends on the cost structure. High DOLs are regarded as risky as a company’s profits and cash flows react to sales reductions by DOL × profit decreases. 9.13. Working Definitions Accounting Break-Even Point: The Accounting break-even point is based <?page no="177"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 9-177 on the output which makes the company earn a profit of zero. Cash Break-even Point: The financial break-even point is based on the output that makes the operating cash flow become zero. Degree of Operating Cash Flow Leverage: The DOL(CF) is the degree of operating cash flow leverage. It measures the sensitivity of a firm’s operating cash flows to the sales. Degree of Operating Leverage: The factor between the changes in EBIT and in sales is called the degree of operating leverage DOL. The DOL equals to changes in terms of EBIT over changes in terms of sales. Degree of Operating Leverage Concept: The Degree of Operating Leverage (DOL) is a concept that will tell managers how profit will change based on variations in revenue. Financial Break-even Point: The financial break-even point is at the output where the net present value is zero. Net Operating Income (NOI): The net operating income is the profit that remains after all operating costs are paid. 9.14. Question Bank: (1) What is a financial break-even point? 1. The output where the borrowing interest is covered by the revenue. 2. The output where the present value of free cash flows over the periods of a project equals zero. 3. The output where the financial cash flows’ present value is zero. 4. The output where operating cash flows intercept with financing and investing cash flows. (2) A company calculates a DOL to be 5. Sales are 120,000.00 EUR (net amount). Actual profit is 75,000.00 EUR. How much is the profit at sales of 150,000.00 EUR? 1. 78,750.00 EUR . 2. 150,000.00 EUR . 3. 90,000.00 EUR . 4. 168,750.00 EUR . (3) What is a DOL-cash flow? 1. Δ CF / Δ EBIT. 2. Δ CF / Δ Sales. 3. Δ CF / Δ Proceeds. 4. Δ Sales / Δ CF. (4) What is a net operating income in rental business? 1. Profit after deduction of operational costs. 2. Proceeds less depreciation. 3. Fees paid by the tenant of the property agent. 4. Proceeds less maintenance. (5) What does a high DOL tell? 1. The variable costs are high in comparison of fixed costs. 2. The company is flexible. 3. The company has free capacity. 4. Profits increase more than sales due to high investments. 9.15. Solutions 1-2; 2-4; 3-2; 4-1; 5-4. <?page no="178"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 10-178 10. Performance Measurement 10.1. What is in the Chapter? This chapter covers the measurement of output based on the case study VANHUIZEN BV which is a tinting service for car windows. Performance is the major success factor for a business. It determines how a company achieves its profit, return, cash flow and value objectives. We study return figures and the concept of the Economic Value Added EVA TM for two branches of VANHUIZEN BV and compare their performance. 10.2. Learning Objectives In this chapter, you learn different concepts of performance valuation. We teach you technical terms and performance ratios and you get to know how to apply them. We analyse the impacts of different concepts for performance figures to support managers’ decisions. Due to efficiency, it is required to monitor performance ratios regularly and to allocate resources to where the best performance is expected. After studying this chapter, you know performance ratios and develop an awareness of how to monitor performance in divisions. 10.3. What is Performance? Performance measurement refers to the achievements of an organisational unit, e.g., of a cost centre. In the first place, we could measure the output of a division, e.g., the number of products 38 BV = Besloten vennootschap met beperkte aansprakelijkheit. finished during a period. Sometimes the performance is only supporting the output of a company (finished goods); then we measure the performance by reference units, e.g., machine hours, m 3 , kWh etc. In those cases, the technical term for the performance is volume. Another and wider interpretation of performance is profit. Therefore, performance of a division also is its profit, e.g., the pre-tax profit. Next, we study performance measurement for different divisions of the case study VANHUIZEN BV 38 . 10.4. C/ S VANHUIZEN BV VANHUIZEN BV is a Dutch automobile accessories company with branches in Geldern and Pieterburen. These 2 branches are considered being divisions. The company is specialised in tinting car windows. Its headquarters is based in Kampen where no manufacturing facilities are located. Window tinting is a manual process. Foils are purchased in different colours and with different shade characteristics from its supplier OCTUPUS PLC. The foils are cut manually (with a scalpel) to fit the windows of the customers’ motor vehicle. The degree of automation for the window tinting process is low, as most all work is craftsmanship. Regarding the cost structure, the cost categories below apply: - Materials, foils. - Miscellaneous: like gloves, knives, soap. <?page no="179"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 10-179 - Labour. - Store rent. - Depreciation on the cutter-table. The main activity of VANHUIZEN BV is the deployment of workers and selling their services to customers. The foils are materials for business operations. Most costs are linked to direct materials and direct labour, which we refer to as prime costs. The company’s return on investment is quite high as its total assets’ value is low if compared to other costs. No precious machinery is required for window tinting. The cost-investment relation would change, if VANHUIZEN BV stores inventories high in value, e.g., to buy higher quantities of foils to receive discounts from its suppliers, or for offering a higher variety of colours and shade levels. A situation of high performance based on low assets applies for many service companies, such as consultancies, clinics or law firms. To provide an overview of VANHUIZEN BV, we show below its data sheet: Data Sheet for VANHUIZEN BV: CClassification: Manufacturing; Revenue per car: 400.00 EUR/ u; Sales quantity: 2,080 cars / 3,640 cars; Materials: 150.00 EUR/ car; Labour: 75.00 EUR/ car; Miscellaneous: 5,000.00 EUR / 8,000.00 EUR Order management: 40,000.00 EUR / 40,000.00 EUR; Depreciation: 100,000.00 EUR / 200,000.00 EUR; Other expenses: 40,000.00 EUR / 60,000.00 EUR; Headquarters costs: 500,000.00 EUR; Assets: 1,000,000.00 EUR / 2,000,000.00 EUR as costs of acquisition VAT ignored. At VANHUIZEN BV, the price for a car window tinting is 400.00 EUR/ car. During the last years, the below disclosed revenues and costs were recorded in the two divisions of VANHUIZEN BV. In the GELDERN store, 2,080 cars were ‘tinted’; in PIETERBUREN the number was 3,640 cars. Both departments’ profitability reports are displayed in Figure 10.1 and Figure 10.2. The number of tinted cars is called output or volume. <?page no="180"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 10-180 [EUR] Revenue 832,000 Other income 832,000 Materials (312,000) Miscellaneous (5,000) Labour, var (156,000) Labour, fixed (40,000) Depreciation (100,000) Other expenses (40,000) Earnings before int. & taxes (EBIT) 179,000 Vanhuizen BV - GELDERN PROFITABILITY ANALYSIS for the year ended 31.12.20X1 Figure 10.1: Profitability analysis for the GELDERN branch [EUR] Revenue 1,456,000 Other income 1,456,000 Materials (546,000) Miscellaneous (8,000) Labour, var (273,000) Labour, fixed (40,000) Depreciation (200,000) Other expenses (60,000) Earnings before int. & taxes (EBIT) 329,000 Vanhuizen BV - PIETERBUREN PROFITABILITY ANALYSIS for the year ended 31.12.20X1 Figure 10.2: Profitability analysis for the PIETERBUREN branch VANHUIZEN BV wants to know which division performs highest. Firstly, it compares the divisions’ profits before taxes. We acknowledge that profit in the PIETERBUREN division is higher than in GELDERN. However, figures for depreciation and other costs indicate that the branch is just bigger which means it has more capacity. We acknowledge higher revenue, higher labour costs and more depreciation. Following Drury, we divide profit in controllable and non-controllable portions, and in portions necessary and unnecessary for operations. We further consider costs allocated towards divisions, like <?page no="181"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 10-181 lawyer service, HR department and Accounting. In the case of VANHUIZEN BV, these costs fall under headquarters costs and are not caused by activities or decisions made in its division. Division revenues are based on the net selling price of the tinting service which is 400.00 EUR/ car. In the GELDERN division, total sales are: 2,080 × 400 = 8832,000.00 EUR. In PIETERBUREN, we calculate: 3,640 × 400 = 1 1,456,000.00 EUR. For profit calculation, we deduct costs from revenues. However, as we want to measure the performance of the divisions, costs are studied regarding their dependency on managers’ decision, their necessity for the existence of the division and where they are coming from. Some costs are allocations from headquarters. From studies in Organisation, we know that we only can hold managers responsible for what they can decide. As a result, it would be wrong to include headquarters cost in performance reports for divisions if we intend to use the reports later for the evaluation of the managers’ performance. We calculate different profits by stepwise deducting cost 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 to Figure 10.3! 10.5. 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 for tinting car windows. Hence, labour is a direct cost. After deduction of variable costs from the revenues, we arrive at 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 number of “window tinted” cars, we call it a variable contribution margin. The variable contribution margin in GELDERN is: 832,000 - 2,080 × (150 + 75) = 3 364,000.00 EUR. In PIETERBUREN, the variable contribution margin equals: 1,456,000 - 3,640 × (150 + 75) = 6637,000.00 EUR. 10.6. Controllable Contribution Margin Next, we deduct all controllable fixed costs from the short-run contribution margin. Fixed and controllable costs are for miscellaneous materials, such as gloves, knives and soap, as well as for fixed labour. The latter one is for the order management in the stores. Controllable costs are needed for running the divisions, but they are no variable costs because they are not related to the output which is the number of window tinted cars. Therefore, they are classified as fixed costs and depend on local management 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: 364,000 - 40,000 - 5,000 = 3 319,000.00 EUR. In <?page no="182"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 10-182 PIETERBUREN the controllable contribution margin is: 637,000 - 40,000 - 8,000 = 5589,000.00 EUR. 10.7. Divisional Contribution Margin By the next step, further fixed costs are deducted from the controllable contribution margins. The deductions are linked to those costs which become obsolete once the division is closed-down. These costs cannot be decided by local managers (in the divisions). They are necessary to maintain the division and are determined by general management. At VANHUIZEN BV, these costs are depreciation on the cutter tables and rental costs for the shop. After deduction of these costs for continued operations from the controllable contribution margin, we arrive at the divisional contribution margin. The divisional contribution margin in GELDERN equals: 319,000 - 100,000 - 40,000 = 179,000.00 EUR. The divisional contribution margin in PIETERBUREN is: 589,000 - 200,000 - 60,000 = 3 329,000.00 EUR. 10.8. 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. The Headquarters is only for administration purpose, as no car window tinting takes place there. We do not consider the application of headquarters costs to divisions helpful for performance measurement. However, we calculate a total net profit to compare the divisions to other firms from a shareholder’s perspective. Headquarters costs are 500,000.00 EUR/ a and are allocated equally, at a 50 : 50 ratio, to divisions. We derive the divisional profit before taxation by deduction of 250,000.00 EUR from the divisional contribution margins in GELDERN and PIETERBUREN. GELDERN branch’s net profit is negative. It equals: 179,000 - 200,000 = - -21,000.00 EUR. The divisional net profit in PIETERBUREN is amounting to: 329,000 - 200,000 = 129,000.00 EUR. Observe the entire calculation of performance ratios in Figure 10.3: <?page no="183"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 10-183 Geldern Pieterburen Total sales 832,000 1,456,000 less variable costs (468,000) (819,000) Variable short-run Contribution Margin 364,000 637,000 less controllable fixed costs (45,000) (48,000) Controllable Contribution Margin 319,000 589,000 less non-avoidable costs (140,000) (260,000) Divisional Contribution Margin 179,000 329,000 less HQ contribution (200,000) (200,000) Divisional NP before taxes (21,000) 129,000 Vanhuizen BV PERFORMANCE REPORT for 20X1 Figure 10.3: Performance figures for VANHUIZEN BV The controllable contribution margin is the most appropriate measurement for departmental performance. The controllable contribution margin considers all costs in the power of division management. No depreciation on divisional assets nor costs for the shop rent are included as local managers do not decide thereon. They only change once the branch is closed-down meaning if VANHUIZEN BV stops rental payments and liquidates all assets in the division. In preparation for ratio calculations, we look at the whole company and determine the net operating profit after taxes. The profit earned by all divisions together is the taxable income for VANHUIZEN BV. We assume an income tax rate of 30 %/ a based on the conventions in chapter (1). Hence, the income taxes equal: 108,000 × 30% = 3 32,400.00 EUR. The net profit after taxation is amounting to: 108,000 - 32,400 = 75,600.00 EUR. <?page no="184"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 10-184 Geldern Pieterburen Total sales 832,000 1,456,000 less variable costs (468,000) (819,000) Variable short-run Contribution Margin 364,000 637,000 less controllable fixed costs (45,000) (48,000) Controllable Contribution Margin 319,000 589,000 less non-avoidable costs (140,000) (260,000) Divisional Contribution Margin 179,000 329,000 less HQ contribution (200,000) (200,000) Divisional NP before taxes (21,000) 129,000 Entire NP before taxes less income taxes Net operating profit after taxes NOPAT 108,000 (32,400) 75,600 Vanhuizen BV PERFORMANCE REPORT for 20X1 Figure 10.4: Profit calculation VANHUIZEN BV By studying different performance measures for VANHUIZEN BV, we noticed that branches differ in size. This requires a more sophisticated monitoring as we discussed so far. Therefore, we introduce more meaningful performance ratios. We discuss below: - Return on investment. - Return on equity. - Residual income. - Economic value added EVA TM . 10.9. Return on Investment The return on investment shows the profit as percentage of the invested funds. The consideration of assets supports comparisons of companies or divisions of different sizes. In the case of VANHUIZEN BV we consider the investments at cost of acquisition 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 performance of managers, 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 = 29.45 %/ a. If we intend to compare investments of the company to other investment opportunities, we should consider the divisional contribution margin for the nominator of the return on investment ratio, which gives: ROI div,GELDERN = 179,000 / 1,000,000 = 1 17.90 %/ a and: <?page no="185"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 10-185 ROI Div,PIETERBUREN = 329,000 / 2,000,000 = 1 16.45 %/ a. The return on investment comes with a systematic disadvantage for decision making: Consider that division managers are only keen to invest if the return on investment for her/ his division will increase. In case the return on similar investments is 17.0 %/ a and the manager in GELDERN is offered an investment opportunity (store extension) that comes with an estimated return of 17.5 %/ a, she/ he would forfeit the good (better than alternatives) opportunity because it will drag down the average return of her/ his division. Remember, the return rate is 17.9 %/ a in GELDERN. On the other side, the manager in PIETERBUREN would be happy to invest in an extension of her/ his shop which gives her/ him a 16.80 %/ a return because it helps him/ her to increase her/ his average return on investment which was before 16.45%. However, both investment decisions are wrong! Because a return on investment of 17 %/ a is available for investments, the manager in GELDERN should take the opportunity to extend her/ his business at 17.5 %/ a of return and the manager in PIETERBUREN should deny the offer of a 16.8 %/ a investment as there are better alternatives. This example shows that managers who are guided by the return on investment only are prone to make wrong decisions. Another disadvantage results from the denominator of the return on investment. The denominator either is the initial investment (cost of acquisition) or its carrying value (after depreciation). In case the initial investment value applies, managers are motivated to reinvest continuously, as new investments do not have an impact on their performance. Let’s say, a taxi driver sells his taxi every year. There is no reason to keep it as the performance ratio is based on the costs of acquisition. She/ he then enjoys riding a brand-new taxi car with low maintenance costs. In the alternative case if the carrying amount applies for the denominator of the return of investment figure, the taxi driver keeps her/ his car and can even reduce the rides after a few years, because performance increases due to depreciation automatically (the denominator is the carrying value which declines by depreciation). 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. To maintain her/ his return on investment at a constant level, the taxi driver can reduce her/ his 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 still gives her/ him a ROI 3,half = 10,000 / (50,000 - 30,000) = 50.00 %/ a, same as in the first year. Not a good idea! We study this ROI effect for VANHUIZEN BV: We apply a return of investment calculation based on the controllable contribution margin in the nominator and the carrying value of the cutter tables in the <?page no="186"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 10-186 denominator. The carrying value of the investments is regarded as the fair value for asset valuation. Hence, it gives us the correct input for the return ratio. We consider the cutter tables are written-off over a period of 10 years and the ones in GELDERN are more than 5 years old and the ones in PIETERBUREN are more than 2 years old. Hence, the carrying value of the tables in GELDERN is: CA cutter = 1,000,000 - 5 × 100,000 = 5 500,000.00 EUR. The return on investment for the division in GELDERN is: 179,000 / 500,000 = 3 35.80 %/ a. In PIETERBUREN the return on investment for the division is lower: 329,000 / (2,000,000 - 2 × 200,000) = 2 20.56 %/ a. In both cases, the return on investment increases only due to time. In the next year, the return in PIETERBUREN will ceteris paribus become: 329,000 / (2,000,000 - 3 × 200,000) = 2 23.5 %/ a. The return increases progressively. However, aging of machinery should not drive performance ratios. As a result, we suggest avoiding the return on investments for performance comparisons if machinery of different ages is in use. 10.10. Return on Equity The problems regarding the denominator of the return on investment figure can be remedied by a comparison of returns on equity. However, it is difficult to allocate portions of equity to divisions. The return on equity shows the profit after taxation as percentage of the book value of the company. The return on equity provides the owners of a company with a performance ratio which is based on their investment. The owners hold equity which includes reserves and retained earnings as well as the share capital. Hence, their input (denominator) is the book value of the company. The outcome of the company (nominator) is the profit after taxes. These are the earnings which can be declared as dividends to the shareholders. We consider the whole company VANHUIZEN BV and calculate its performance “available” for distribution to the owners. The net operating profit after taxes equals 75,600.00 EUR. This value is divided by the book value of the company which we pretend to be 900,000.00 EUR. The return on equity equals: 75,600 / 900,000 = 8 8.4 %/ a. Note, we still did not solve the problem, how we can split equity amongst divisions but the return on equity comes with a further disadvantage: The application of the return on equity can become misleading due to 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 capital costs, high levels of debts cause increases of the return on equity. This means if we follow the return on equity, we notice performance increases due to borrowing - not a good concept either! We 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 interest of 5.5 %/ a and 900,000.00 EUR bonds at a coupon rate of 4.5 %/ a. <?page no="187"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 10-187 The interest of: 1,200,000 × 5.5% + 900,000 × 4.5% = 1 106,500.00 EUR is included in the headquarters costs. We now change the capital structure for VANHUIZEN BV: equity is 500,000.00 EUR and the bank loan is 1,600,000.00 EUR (same total). This increases the interest (before taxation) to the extent of: 1,600,000 × 5.5% + 900,000 × 4.5% - 106,500 = 2 22,000.00 EUR. We apply these changes for the division comparison as disclosed in Figure 10.5 (headquarters contribution increased by 11,000.00 EUR in both divisions): Geldern Pieterburen Total sales 832,000 1,456,000 less variable costs (468,000) (819,000) Variable short-run Contribution Margin 364,000 637,000 less controllable fixed costs (45,000) (48,000) Controllable Contribution Margin 319,000 589,000 less non-avoidable costs (140,000) (260,000) Divisional Contribution Margin 179,000 329,000 less HQ contribution (adjusted) (211,000) (211,000) Divisional NP before taxes (32,000) 118,000 Entire NP before taxes less income taxes Net operating profit after taxes NOPAT 86,000 (25,800) 60,200 Vanhuizen BV PERFORMANCE REPORT for 20X1 Figure 10.5: VANHUIZEN BV’s performance report (alternative 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: 60,200 / 500,000 = 1 12.04 %/ a. We acknowledge an increase of 3.64 % in return on equity only due to a change of the company’s capital structure. However, the company does not perform higher. There are now 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 caused by the capital structure and makes the return on equity a weak performance ratio if companies are compared with different capital structures. For division comparisons, the return on equity requires an allocation of equity to divisions which only can be done by value- <?page no="188"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 10-188 based allocations, e.g., based asset values of the divisions. This is no satisfying equity allocation as it is arbitrary. An alternative ratio to the return on equity is the Earnings per share ratio. It is based on IAS 33 and divides the earnings available for distribution to ordinary shareholders by the number of ordinary shares outstanding. For the calculation of earnings, the profit after taxation is adjusted for required allocations, e.g., preference dividends, and to additions to legal reserves (in Germany for companies in the legal form of an AG), and hence reduce distributions to shareholders. The earnings are divided by the number of outstanding ordinary shares. The earnings per share ratio gives the highest possible dividend that can be declared to the ordinary shareholders (100 %) if no profit carried forward is considered. By multiplying the EPS figure with the number of shares, the annual and distributable earnings (linked to the book value) are calculated. This is very close to a return on equity ratio except of the fact that it is related to only ordinary shareholders. Even as the EPS ratio is widely in use, it suffers from the capital structure impact like the return on equity. The only difference to a return on equity ratio are the adjustments. Again, the allocation of company values to divisions is arbitrary as based on value based allocations. 10.11. Residual Income The residual income is the profit or profit contribution after deduction of allocated capital costs. The residual income is calculated here as the controllable contribution margin minus capital costs. It gives an absolute figure in EUR (here). In the case of VANHUIZEN BV, the residual income is calculated for the two branches based on capital costs of 17 %/ a. For the GELDERN branch, the residual income is: 319,000 - 17% × 1,000,000 = 1149,000.00 EUR. For the PIETERBUREN branch, the residual income is: 589,000 - 17% × 2,000,000 = 2 249,000.00 EUR. The residual income indicates that both branches achieve an excess of the controllable contribution margin over their capital costs. 10.12. Economic Value Added (EVA™) The economic value added EVA TM tells us how much the company increases in value after deduction of employed capital costs based on the WACC calculation from the net operating profit after taxes. For the EVA TM calculation in a division, we ignore income taxes. The economic value added is a modified residual income calculation and got registered by the Stern Steward consulting organisation as their trademark. The EVA TM is the divisional profit +/ - Accounting adjustments, less cost of capital. Many companies refer to the divisional profit as their net profit and make adjustments to distribute onceoff costs, such as for Marketing campaigns or product development costs, over the years the company benefits therefrom. We refer to that as the <?page no="189"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 10-189 matching principle. The costs of capital are the weighted average costs of capital. Weighted Average Costs of Capital are the costs if different interest rates and opportunity costs for equity are considered proportionally to their share in of financing the business. Below, we pretend that VANHUIZEN BV is financed by 30 % equity, 40 % bank loan, with an annual rate of interest of 5.5 %/ a, and 30% bonds, with a coupon rate of 4.5 %/ a. The costs of equity are 17 %/ a (average return on the market). According to the given figures, the weighted average costs of capital are: 30% × 17% + 40% × 5.5% + 30% × 4.5% = 8 8.65 %/ a. The company owes its bank 1,200,000.00 EUR and pays: 5.5% × 1,200,000 = 6 66,000.00 EUR/ a interest. The coupon per annum equals to another capital cost of: 900,000 × 4.5% = 4 40,500.00 EUR. We further assume, interest is already included in the headquarters contribution of 400,000.00 EUR for both divisions and requires adjustments. We reduce the headquarters costs by: 66,000 + 40,500 = 1 106,500.00 EUR. As a result, the headquarter costs now equal: 400,000 - 106,500 = 2 293,500.00 EUR. Each division covers half thereof: 293,500/ 2 = 146,750.00 EUR. The adjustment is required as we compare for EVA TM the net operating profit after taxes to capital costs. Interest does not fall under operational cost. Check Figure 10.6 for the profit calculation: Geldern Pieterburen Total sales 832,000 1,456,000 less variable costs (468,000) (819,000) Variable short-run Contribution Margin 364,000 637,000 less controllable fixed costs (45,000) (48,000) Controllable Contribution Margin 319,000 589,000 less non-avoidable costs (140,000) (260,000) Divisional Contribution Margin 179,000 329,000 less HQ contribution (adjusted) (146,750) (146,750) Divisional NP before taxes 32,250 182,250 Entire NP before taxes less income taxes Net operating profit after taxes NOPAT 214,500 (64,350) 150,150 Vanhuizen BV PERFORMANCE REPORT for 20X1 Figure 10.6: VANHUIZEN BV’s performance clear of interest/ coupon Now, the divisional net profit for GELDERN is amounting to: -21,000 + 66,000/ 2 + 40,500/ 2 = 3 32,250.00 EUR/ a. The divisional net profit for <?page no="190"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 10-190 PIETERBUREN is: 129,000 + 66,000/ 2 + 40,500/ 2 = 1 182,250.00 EUR. 39 For further adjustments we assume, VANHUIZEN BV spent during the last year on advertising 5,000.00 EUR which results in an adjustment for the whole business. The amount is apportioned towards the branches at a 1 : 1 ratio. Advertising is an operational activity and must be deducted from the net operating profit after taxes. 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: 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 result with the initial performance calculation of 108,000 EUR as indicated in Figure 10.3. We reduce this figure (net profit of both divisions) for 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: 129,000 - 21,000 - 153,000 - 5,000 = - -50,000.00 EUR. 39 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 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 are 5 %/ a and apply for a fully bank loan financed acquisition. The costs of capital are then: 5% × 3,000,000 = 1 150,000.00 EUR/ a. Hence, the EVA TM = 150,150 - 150,000 = 1 150.00 EUR. This value indicates a positive performance and reflects the increase in valuation for the investor by the acquisition, even as the value is low. 10.13. Summary For performance measurement, we studied different steps of contribution margin calculation to determine an appropriate performance measure for decisions. Situations for performance measurement can be the assessment of managers' achievements or investment decisions. We introduced most common performance ratios: Return on investment, residual income and economic value added EVA TM and demonstrated their calculations for the case study VANHUIZEN BV. 10.14. Working Definitions Earnings per Share: EPS is based on IAS 33 and divides the earnings available for distribution to ordinary shareholders by the number of ordinary shares outstanding. the case simple, we apply the entire calculation, which gives us the adjusted earnings after taxes. <?page no="191"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 10-191 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. Leverage Effect: The leverage effect makes the return on equity increase based on the debt-to-equity ratio. Residual Income: The residual income is the profit or profit contribution after deduction of allocated capital costs Return on Equity: The return on equity shows the profit after taxation as percentage of the book value of the company. Return on Investment: The return on investment shows the profit as percentage of the investment. Weighted Average Costs of Capital: Weighted average costs of capital (WACC) are capital costs when different interest rates and opportunity costs for equity are considered proportionally to their portions of financing the business. 10.15. Question Bank (1) A profit centre in a production firm records 100,000.00 EUR revenue, 15,000.00 EUR materials, 20,000.00 EUR depreciation and 5,000.00 EUR for utilities. The amount of 85,000.00 EUR is called … 1. Short-run contribution margin. 2. Controllable contribution margin. 3. Divisional contribution margin. 4. Net profit. (2) A company is financed by a bank loan of 100,000.00 EUR with an interest rate of 5 %, bonds to the extent of 500,000.00 EUR with a coupon rate of 4 % and 900,000.00 EUR equity. The expected return on investment is 11 %. How much are the weighted cost of capital? 1. 8.3 % . 2. 4.5 % . 3. 4.2 % . 4. 6.7 % . (3) A company earns a revenue of 120,000.00 EUR. The proportional costs are 34,000.00 EUR and depreciation is amounting to 12,000.00 EUR. The company is half financed (400,000.00 EUR) by a bank loan with an interest rate of 3.5 %. Equity is amounting to 400,000.00 EUR. The expected return on equity is 10 %. How much is the residual income? 1. 34,000.00 EUR . 2. 47,000.00 EUR . 3. 60,000.00 EUR . 4. 46,000.00 EUR . (4) The performance of a division manager should be measured by: 1. Divisional net profit. 2. Divisional contribution margin. 3. Controllable contribution margin. 4. Revenues applicable. (5) The economic value added is: 1. Net operating profit before tax less weighted average cost of capital × capital employed. 2. Net operating profit after tax less weighted average cost of capital × capital employed. <?page no="192"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 10-192 3. Net operating profit before tax less average cost of capital × capital employed. 4. Net operating profit after tax less average cost of capital × equity. 10.16. Solutions 1-1; 2-1; 3-1; 4-3; 5-2. <?page no="193"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-193 11. Accounting for Mergers and Acquisitions 11.1. What is in the Chapter? In this chapter, we demonstrate how to prepare acquisitions and mergers and how to determine the price for a company’s sale transaction. We further show how hostile take-overs work and what impact they can have on the shareholders of the targeted company and the shareholders of the buying one. The case study OHIO FRIED CHICKEN is about a South African chicken restaurant and is used for different scenarios. We show a private purchase, an acquisition by the Malaysian company, AYAM GORENG Sdn. Bhd. as a cross border acquisition and a merger after an unfriendly takeover by LOS POLLOS ASADOS (Pty) Ltd., based in Johannesburg. 11.2. Learning Objectives In this chapter, you learn which Accounting information supports a merger with or an acquisition of another company. In particular, you get to know cross-border acquisitions. It is our aim that you understand the basic differences between acquisitions of a subsidiary and merging of companies in terms of Accounting. 11.3. M&A - Overview Mergers and Acquisitions (M&As) can be strategically motivated, e.g., to increase economics of scale or economics of scope. We skip the screening of the right company to buy, but we show Accounting instruments used to prepare M&As. We assume the company to acquire (target company) has been found already and the purchase price is known. In this textbook we focus on Accounting aspects. We study the case of OHIO FRIED CHICKEN in Worchester in South Africa. We take the seat of a consultant who is in the role of a company appraiser for its acquisition. This means, we consider OHIO FRIED CHICKEN being the target company, the one, we intend to buy. As the firm does not show a legal form, we are buying a privately-owned firm. For the acquisition it means, no audited financial statements are available for valuation. The structure of the consultant’s 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. For teaching purposes, we split under item (5) the case study and discuss different scenarios: (5-1) an acquisition by a private investor, (5-2) an acquisition by the foreign company AYAM GORENG Sdn. Bhd. which leads to the preparation of group statements and (5-3) a merger with another company LOS POLLOS ASADOS (Pty) Ltd. which is a friendly take-over and results in the establishment of a new company. <?page no="194"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-194 11.4. General Description of OHIO FRIED CHICKEN OHIO FRIED CHICKEN is a privatelyowned restaurant in a town in the Western Cape Province. The company was established in 2001 and is for sale in 2014 40 through a local agency. The sale includes all company assets and inventory at the time of transaction. As the company is in private ownership, no liabilities are relevant for the transfer. The purchase price for the company is 895,000.00 ZAR (South African Rand). The company is based in a rented building in the centre of Worcester, Hoog Straat (High Street). The town of Worcester is located in the district Western Winelands, 120 km to the North- East of Cape Town. In the nearby area of its location is a McDonald’s restaurant, a KFC restaurant, a Debonairs Pizza delivery service, an Ocean Fisheries restaurant and a Wimpy. The restaurant has a size of 170 m 2 and comes with a seating area that can host 60 guests and a counter at the back of the restaurant for order taking and takeaways collection. The main dish is deep fried chicken parts and fries. Furthermore, cold drinks are served in the restaurant. The restaurant has no waiter. Guests order at the counter and take their food and their drinks to the tables, if they sit in. Alternatively, customers purchase take-aways. 2 employees are working in the restaurant. For the following considerations we pretend the owner provided us with the “financials”. 11.5. Reading the “Financials” Financials is an informal expression for the recordings of a business. OHIO FRIED CHICKEN is privately-owned and not registered for VAT reduction. The company does not prepare financial statements by law. Its “financials” are some kind of Income-Expenses-Comparison prepared on a spreadsheet. They are not consistent with South African law, nor do they follow international Accounting standards IFRSs. Figure 11.1 shows the financials as provided by OHIO FRIED CHICKEN’s owner for one month. 40 In this chapter, we refer to real Accounting periods for discussing currency exchange rates that applied. <?page no="195"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-195 Figure 11.1: “Financials” provided by OHIO FRIED CHICKEN’s owner <?page no="196"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-196 We take a close look at the ‘financials’: The financials show all expenses and income as paid or received. We read them with the intention to take-over OHIO FRIED CHICKEN and then to establish a limited company in the legal form of a (Pty) Ltd. in compliance with South African law. The financials are no income statement but daily payment records. The owner recorded all expenses paid which means that payments are expenditures at the same time. Depreciation does not show on the financials. In the column “miscellaneous”, we see further expenses. No accurate allocation of expenses to Accounting periods has been made as the recordings are on payment basis. The difference between income and the recorded payments does not give us the profit for the period. In terms of Accounting, we do not consider the payments for “miscellaneous”, “petrol”, etc. as expenses. They merely are cash flows. We know the company only sells on cash basis. Hence, the difference between received income and the above items gives the total operating cash flow. The item “miscellaneous” contains payments for the monthly rent of the restaurant building as well as minor expenditures, like kitchen equipment replacements (spoons, knives etc.) or restaurant repairs (plumbing, electrical maintenance etc.). It further contains electricity bills, water supply, refuse and sewerage. The item “petrol” is for the owner’s car used to run errands. About petrol, we notice that petrol only is paid during the first months. We further assume that the petrol costs might not be linked directly to the business meaning that the owner considers trips from his hometown (Cape Town) to Worcester as business trips and pays them through the company account. These petrol costs do not matter after the business’s acquisition. The item “cleaning / package” is for serviettes, kitchen towels, dishwasher soap etc. The item “wages” is for the salaries of the employees. We assume the owner paid a Bookkeeper/ Accountant in January, as wages are significantly higher in January than during other months. The items “groceries”, “cold drinks”, “spices”, “potatoes”, “chicken” and “frozen food” are for the dishes prepared and sold. They are paid as delivered, e.g., groceries are bought on a daily basis whereas chickens are delivered every 3 … 4 days. The purchase quantities depend on inventories and on the forecasts for the next upcoming days. We do not know anything about waste and spoilage. The information derived from the ‘financials’ reflects the uncertainty which comes with the acquisition of the company. Small businesses that do not prepare financial statements are difficult to understand if we only have the informal “financials” for the evaluation. We need to revise the data to determine a timeline of profits respectively cash flows. See the refining of financials on a MS-Excel sheet below in Figure 11.2. <?page no="197"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-197 Figure 11.2: OHIO FRIED CHICKEN’s refined data sheet For supporting an M&A-decision, the daily information is of minor importance. Daily variations in chicken purchase numbers do not matter. We modify the financials by combining expenses for food and by calculating weekly sums for expenses. We want to detect trends over the periods we got recordings from, which is the interval January 2014 until October 2014. <?page no="198"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-198 Miscellaneous Petrol Clean/ package Wages Cold drinks All Food Expenses Income Cash flow/ w WED 2014-01-01 public holiday - THU 2014-01-02 240.00 97.90 13,799.62 14,137.52 8,673.90 FRI 2014-01-03 38.97 1,058.50 849.70 1,904.96 3,852.13 9,975.50 SAT 2014-01-04 9,120.00 505.90 9,625.90 5,267.65 SUN 2014-01-05 9,398.97 - 97.90 1,058.50 849.70 16,210.48 27,615.55 23,917.05 3,698.50 - SUN 2014-01-12 780.94 610.05 176.02 3,015.75 3,440.70 23,379.76 31,403.22 38,819.61 7,416.39 SUN 2014-01-19 6,348.13 600.10 642.90 3,462.00 1,151.60 20,504.20 32,708.93 36,021.75 3,312.82 SUN 2014-01-26 32.98 600.20 - 3,172.85 2,176.30 11,198.46 17,180.79 35,526.42 18,345.63 SUN 2014-02-02 291.00 500.00 1,046.16 3,767.80 1,931.40 22,707.26 26,331.82 49,348.15 23,016.33 SUN 2014-02-09 10,051.97 450.00 1,747.17 2,367.70 3,429.25 21,435.24 39,481.33 39,421.15 60.18 - SUN 2014-02-16 288.61 560.00 729.83 1,843.38 2,738.90 10,362.62 16,523.34 24,317.05 7,793.71 SUN 2014-02-23 500.10 800.00 458.66 1,295.62 2,683.50 15,667.00 21,404.88 28,061.55 6,656.67 SUN 2014-03-02 15,232.53 200.00 1,225.90 3,007.12 3,429.75 27,386.47 50,481.77 49,167.35 1,314.42 - SUN 2014-03-09 393.80 847.48 52.79 2,015.30 4,303.50 17,260.46 24,873.33 38,725.05 13,851.72 SUN 2014-03-16 7,423.70 500.20 475.28 870.51 2,100.50 13,766.12 25,136.31 22,307.75 2,828.56 - SUN 2014-03-23 2,771.33 300.00 - 1,439.41 2,965.75 13,845.67 21,322.16 22,446.85 1,124.69 SUN 2014-03-30 796.06 600.00 242.76 2,767.00 3,179.00 22,381.29 29,966.11 44,141.60 14,175.49 SUN 2014-04-06 10,227.41 600.10 1,496.68 3,243.21 5,366.45 23,830.93 44,764.78 55,187.85 10,423.07 SUN 2014-04-13 1,036.65 500.00 696.03 865.70 2,312.85 17,798.56 23,209.79 22,924.70 285.09 - SUN 2014-04-20 4,753.72 300.00 722.72 1,407.60 2,097.20 2,882.79 12,164.03 19,399.70 7,235.67 SUN 2014-04-27 189.28 200.00 620.55 575.80 2,117.60 11,524.93 15,228.16 23,949.95 8,721.79 SUN 2014-05-04 9,120.00 - 821.99 2,399.30 3,848.62 25,068.91 41,258.82 45,406.20 4,147.38 SUN 2014-05-11 368.85 400.00 685.50 603.60 2,596.00 11,837.78 16,491.73 23,815.40 7,323.67 SUN 2014-05-18 4,555.55 228.05 336.52 695.78 2,386.00 11,278.36 19,480.26 23,386.90 3,906.64 SUN 2014-05-25 - 200.00 360.40 543.84 2,276.75 17,497.24 20,878.23 28,908.60 8,030.37 SUN 2014-06-01 - - - 815.76 2,748.00 19,568.34 23,132.10 37,875.60 14,743.50 SUN 2014-06-08 9,380.00 323.20 1,179.79 1,679.88 3,956.87 23,534.28 40,054.02 41,996.30 1,942.28 SUN 2014-06-15 228.00 - 581.47 718.00 2,330.50 13,399.10 17,257.07 21,647.90 4,390.83 SUN 2014-06-22 4,036.97 - - 430.80 2,150.87 7,765.48 14,384.12 19,250.60 4,866.48 SUN 2014-06-29 408.50 200.00 635.87 1,435.60 3,002.50 17,862.51 23,544.98 40,172.80 16,627.82 SUN 2014-07-06 9,380.00 - 1,632.53 2,549.08 4,392.85 30,477.26 48,431.72 55,307.80 6,876.08 SUN 2014-07-13 318.00 325.00 524.97 789.80 2,406.50 18,370.17 22,734.44 25,820.10 3,085.66 SUN 2014-07-20 4,391.81 - 1,050.65 1,112.90 2,658.67 12,359.65 21,573.68 26,794.60 5,220.92 SUN 2014-07-27 - - 1,014.50 1,615.50 2,884.10 18,693.09 24,207.19 35,505.60 11,298.41 SUN 2014-08-03 9,849.60 - 1,496.03 2,620.70 3,278.75 22,501.32 39,746.40 51,619.10 11,872.70 SUN 2014-08-10 260.00 - 499.52 574.40 3,160.25 16,634.55 21,128.72 30,846.80 9,718.08 SUN 2014-08-17 6,991.80 406.00 868.00 1,112.90 2,334.00 20,326.79 32,039.49 23,942.50 8,096.99 - SUN 2014-08-24 - - 920.55 1,615.50 2,382.50 10,495.97 15,414.52 31,981.80 16,567.28 SUN 2014-08-31 - - 868.00 1,400.10 3,088.75 26,955.00 32,311.85 45,079.60 12,767.75 SUN 2014-09-07 10,210.59 - 1,398.03 1,400.10 3,425.25 21,118.00 37,551.97 48,363.60 10,811.63 SUN 2014-09-14 54.95 - 65.99 1,539.10 4,907.75 16,561.81 23,129.60 21,606.00 1,523.60 - SUN 2014-09-21 4,951.73 - 695.04 1,639.15 2,201.75 10,350.15 19,837.82 26,450.70 6,612.88 SUN 2014-09-28 163.96 - 1,224.52 1,302.35 2,434.00 14,165.98 19,290.81 36,691.20 17,400.39 SUN 2014-10-05 10,109.60 - 1,384.31 2,580.80 3,218.50 22,520.19 39,813.40 43,962.60 4,149.20 SUN 2014-10-12 126.52 - 1,187.93 1,148.80 5,367.75 16,595.06 26,660.94 26,596.00 64.94 - SUN 2014-10-19 5,321.01 - 670.02 827.70 2,290.25 12,254.56 21,363.54 24,469.80 3,106.26 SUN 2014-10-26 87.00 - 1,101.04 1,759.10 2,756.75 17,619.73 23,323.62 36,794.70 13,471.08 MON 2014-10-27 466.70 2,465.58 2,932.28 6,175.00 TUE 2014-10-28 8,131.37 8,131.37 4,560.50 WED 2014-10-29 420.02 1,005.20 250.00 1,675.22 4,208.40 THU 2014-10-30 1,014.01 9,714.67 10,728.68 4,221.40 FRI 2014-10-31 287.20 2,882.50 678.09 3,847.79 16,550.70 Date Figure 11.3: OHIO FRIED CHICKEN’s weekly calculation of cash profit The weekly operating cash flows indicate that the business sells best around pay days. All weeks next to pay-days (in South Africa at months’ ends) show a peak income for the restaurant. The table in Figure 11.4 shows monthly operating cash flows. It proves that despite of pay-day peaks, the cash flows are nearly equally distributed. We are aware this depends on the spending patterns for miscellaneous expenses and how much prepayments are included therein. In October 2014, the owner claims that there was a chicken disease which made him buy more expensive chicken parts from an alternative supplier. <?page no="199"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-199 Miscellaneous Petrol Clean/ package Wages Cold drinks All Food Income Cash flow/ m January 16,852.02 2,310.35 1,163.84 13,829.10 9,549.70 91,535.30 168,093.38 32,853.07 February 16,953.21 2,010.00 4,960.70 8,873.70 12,281.40 65,224.95 141,184.25 34,792.09 March 20,504.89 2,247.68 770.83 8,207.84 12,548.75 81,234.12 150,458.45 24,944.34 April 16,207.06 1,600.10 3,535.98 6,916.11 11,894.10 62,185.44 133,496.10 31,157.31 May 14,044.40 828.05 2,204.41 4,234.48 13,855.37 79,102.40 147,358.80 33,089.69 June 14,053.47 523.20 2,397.13 4,371.98 11,440.74 67,903.43 128,872.40 28,182.45 July 14,089.81 325.00 4,222.65 7,180.18 14,858.37 81,395.59 157,855.70 35,784.10 August 17,101.40 406.00 4,652.10 6,103.00 11,728.00 90,076.15 163,237.40 33,170.75 September 15,381.23 - 4,500.05 6,167.90 12,968.75 71,971.76 143,405.00 32,415.31 October 15,644.13 - 4,986.86 7,788.30 16,515.75 86,830.83 163,706.10 29,705.35 average 16,083.16 1,025.04 3,339.46 7,367.26 12,764.09 77,746.00 149,766.76 31,609.45 Date Figure 11.4: OHIO FRIED CHICKEN’s monthly operating cash flows So far, we got an idea about the payment situation at OHIO FRIED CHICKEN during the last 10 months. This information helps us to prepare a provisional business plan for OHIO FRIED CHICKEN. 11.6. Business Valuation There is no right or correct value for a business. The price for a business depends on the market, which means it depends on supplies and demands. We can compare the company to other offers to determine whether the price of 895,000.00 ZAR is appropriate. We focus on the financials we received from the agent. Another way for the company valuation is the book value method. The book value is derived from Bookkeeping records. It represents the profits on liquidation for all assets at fair value less all debts at settlement values. It is the value of equity as disclosed on a balance sheet. As no balance sheet is available here, we prepare the valuation based on the gathered information. From a visit of the restaurant, we gained information about its asset and the inventory situation. The assets in the kitchen are deep fryers, a refrigerator and the interior. We estimate the value to be 100,000.00 ZAR, as replacement costs. We assume the assets are writtenoff to an extent of 75 %. Accordingly, the equipment’s fair value is: 25% × 100,000 = 2 25,000.00 ZAR. The value of inventory “all food” is a 3day-consumption, which is calculated based on the average number of working days per months under consideration of the restaurants opening days. It is open from Mondays to Saturdays, which gives us: (365 × 6/ 7)/ 12 = 2 26.07 workdays/ m. Hence, the value of inventory is the monthly food consumption divided by 26.07 and multiplied with 3. It gives: 3 × 77,746 / 26.07 = 8 8,946.61 ZAR. We acknowledge that from an investor’s point of view, the costs of acquisition for OHIO FRIED CHICKEN are overpriced. The fair value of assets in the company is low: For the payment of 895,000.00 ZAR for the restaurant the buyer only receives assets worth: 25,000 + 8,946.61 = <?page no="200"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-200 333,946.61 ZAR and the good reputation of the restaurant. In general, a valuation at book values tells us, how much would be the costs to copy the company. It does not consider intangible assets, like reputation or customer base of the business, as they fall under self-generated goodwill which is not considered in the books. 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 exceeding its book value. An alternative to the estimation based on the book value 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 are discounted based on the rate of interest on the capital market. The discounted cash flows method considers the sum of all future discounted cash flow as value of the company. It tells us how the owner’s 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 owners/ shareholders. The free cash flow is the operating cash flow plus the investing cash flow. It is called ‘free’ because the payments are available for paying dividends to the shareholders or for retiring debts, such as resulting from bank loans. The free cash flow only matters for the valuation of a business once positive. This means that the proceeds from operations less payments for costs and investments result in a positive cash flow. If we assume free cash flows always are paid to the proprietors, its total indicates the return. We must discount future payments to consider the time value of money. Therefore, we discount all free cash flows over the lifetime of the company and calculate their sum. This is 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 ) 1 ( 1 ) 1 ( (with: PV = present value, A = annual payment, i = annual rate of interest, T = number of periods.) The rate of interest ‘i’ is an important factor for the application of the discounted cash flow method. The rate of interest is between the market interest rate paid for loans and the return on similar investments, like a share of McDonald’s Corp. For the weighted average cost of capital WACC calculation, we assume the company’s acquisition is financed at a 60 : 40 ratio. The major portion of the capital is financed by a bank loan with an annual rate of interest <?page no="201"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-201 of 8.5 %/ a. The other half counts as opportunity cost based on a 3 %/ a ROI from McDonald’s shares. Hence, the weighted average costs of capital are: (60% × 8.5 + 40% × 3)/ 100% = 6 6.3 %/ a. From our refined data set we calculate the average monthly operating cash flows (before taxation) as: 32,853.07 + 34,792.09 + 24,944.34 + 31,157.31 + 33,157.31 + 28,182.45 + 35,784.10 + 33,170.75 + 32,415.31 + 29,705.35) / 10 = 3 31,609.45 ZAR/ m. To turn it into an annual payment we multiply the value with 12. OHIO FRIED CHICKEN’s cash flow from operations (before income tax) is: 12 × 31,609.45 = 3 379,313.40 ZAR/ a. So far, we did not consider tax payments, as it does not show in the financials either. However, in contrast to the private pre-owner who pays personnel income taxes on his company’s value increase we must consider income taxes. Following our conventions, the income tax rate is 30 % based on the pre-tax profit. In the case of OHIO FRIED CHICKEN, we ignore depreciation because the non-current assets’ depreciation is low. The company’s cost structure is dominated by material expenses (raw chicken). We further are not aware of any non-expense-cash flows and, therefore, we calculate income taxes based on the operating cash flows: 30 % × 379,313.40 = 113,794.02 ZAR/ a. This means the total cash flow per annum is amounting to 379,313.40 - 113,794.02 = 2 265,519.38 ZAR/ a. The investing cash flow for the investor is the acquisition price paid at 895,000.00 ZAR in the first year. At first, we assume, the company OHIO FRIED CHICKEN exists forever (not realistic). For the above formula, this means T becomes unlimited. In this case (T=∞), the formula can be simplified because the second summand (1/ i × (1+i) T ) approximates zero: i A PV (with: PV = present value, A = annuity, i = rate of interest) Hence, the value of the company is for unlimited T under consideration of weighted average capital cost of 6.3 %/ a: 265,519.38 / 6.3% - 895,000 = 3,319,593.33 ZAR. Note, we deduct the investment cash flow from the present value of operating cash flows as it is paid at “t=0” and does not require discounting. The sum of discounted cash flows tells us what the investor receives from the ownership. Based on discounted cash flows, OHIO FRIED CHICKEN is valued very high. This is caused by the assumption to run the restaurant forever. It is more realistic to consider a shorter useful life of the investment. Although we do not know how long the restaurant is kept, we calculate its value for a 10-years occupation with a sale at the same price as paid for the acquisition thereafter. The valuation requires the application of methods of Investment Appraisal. 11.7. Investment Appraisal Dynamic methods of Investment Appraisal are based on the time value of money. They determine the economic <?page no="202"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-202 efficiency of the business as shown by the present value of payments/ receipts for the purchase and the operation of OHIO FRIED CHICKEN company. For the investment, we assume the company is bought in 2015 and will be sold 10 years later. The sales transaction takes place in 2014 already. Hence, the first element of the payment vector is negative 895,000.00 ZAR which is the from the owner demanded price. In every period (t = 2015 … 2024), the values equal to the operating cash flows as calculated above: 265,519.38 ZAR/ a. This value for the operating cash flows considers income taxes as discussed above. As we don’t have any further information about the sales price in 10 years, we assume the company is sold at the same price as paid for in 2014. This means the company stays at its nominal value - inflation ignored. This consideration gives us a payment of: 265,519.38 + 895,000 = 1 1,160,519.38 ZAR in 2024. The payment vector for a 10-year-occupation is: OFC 10 (t) = {-895,000.00; 265,519.38; 265,519.38; 265,519.38; 265,519.38; 265,519.38; 265,519.38; 265,519.38; 265,519.38; 265,519.38; 1,160,519.38}. The present value for OFC 10 is: -895,000 + 265,519.38 × ((1 + 6.3%) 9 -1) / (6.3% × (1 + 6.3%) 9 ) + 1,160,519.38 / (1 + 6.3%) 10 = 11,517,603.91 ZAR. The difference between the valuation based on book value and the discounted cash flow method is caused by the fact that the business does not require high investments. The non-current assets (deep fryers, refrigerators) are low in value in comparison to the demanded price for OHIO FRIED CHICKEN. At this stage, we cannot say whether the book value of 33,946.61 ZAR and the valuation at discounted cash flows of 1,517,603.91 ZAR is the correct valuation. The company’s value mostly results from its reputation and the customers who frequently buy the food which is both not considered by the book value. Therefore, we ignore the book value for the investment decision. Although its low assets, the company generates profits and cash flows which results in a high valuation applying the discounted cash flow method. The business model leads to a high return on investment which puts it on a high copyrisk. It does not need a formal qualification to run this restaurant. Investments in the deep fryers and refrigerators are low. For that reason, the company is prone to easily be copied. It is therefore necessary to deduct a significant risk value from the valuation along discounted cash flows. Below, we continue the analysis of OHIO FRIED CHICKEN by Investment Appraisal and Risk Analysis to increase the information basis required for the investment decision. We continue with the calculation of the profitability index: T The profitability index is the present value of payments divided by the initial investment cash outflow and gives: 2,632,552.93 / 895,000 = 294.14%. The value is high as the initial cash flow from investing activities is low. We further calculate the internal rate of return. The easiest method to calculate an internal rate of return is by applying the function IRR() in MS-Excel. The internal rate of return of the vector gives: IRR(OFC 10 (t)) = 2 29.67%. If you are happy <?page no="203"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-203 with the calculation continue reading with the financial statement paragraph. For teaching purpose, we explain the calculation of the internal rate of return by a financial schedule in MS-Excel as shown in Figure 13.5. In this table, the figures are discounted with the factor (1 + 6.3%) and disclosed in the line indicated “discounted payment”. The present value is calculated for the Accounting period 2014. The calculation in MS-Excel confirms our result from the discounted cash flow method. 0.063 0 1 2 9 10 t = 2014 t = 2015 t = 2016 t = 2023 t = 2024 OFC (t) 895,000.00 - 265,519.38 265,519.38 265,519.38 1,160,519.38 Discounted payment 895,000.00 - 249,783.05 234,979.35 153,213.43 629,969.83 Present value 1,517,603.91 Interest: 6.30% Figure 11.5: OHIO FRIED CHICKEN’s payments discounted by 6.3 % 41 We apply the goal seek function to calculate the internal rate of return. T The internal rate of return is the rate of interest at which the present value is zero. Check the result for the internal rate of return in Figure 11.6. The percentage is the same as calculated by the IRR() function above. 0.296669698 0 100.00% 2 9 10 t = 2014 t = 2015 t = 2016 t = 2023 t = 2024 OFC (t) 895,000.00 - 265,519.38 265,519.38 265,519.38 1,160,519.38 Discounted payment 895,000.00 - 204,770.25 157,920.13 25,623.12 86,369.18 Present value 0.00 Internal rate of Return: 29.67% Figure 11.6: Calculation of the internal rate of return The calculations support a high company value. In terms of the cash flow calculation and the internal rate of return, OHIO FRIED CHICKEN restaurant is a good investment. its present value of 1,517,603.91 ZAR tells us the value of the project (buying the company and run 41 Values for 2017 ... 2022 are hidden. the restaurant). If we calculate the income for the investor, it is required to consider the tax on capital returns (dividend tax) if the investor is a private person. The value is to be reduced by 25 % (for tax on capital returns in our textbook) and declines to: 1,517,603.91 × (1 <?page no="204"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-204 - 25%) = 1 1,138,202.93 ZAR, if a full dividend declaration is assumed. The calculated internal rate of return is to be compared to the fair market interest rate and is far above the South African inflation rate. The book value of the company is low because of low asset values. Hence, we confirm our statement that the investment is risky. 11.8. Financial Statements For our further considerations about the financial statement implication of the acquisition, we describe 3 scenarios: (a) Private purchase. The company is bought by a private investor. (b) Acquisition by a company. The restaurant is bought by another company which is a holding company. (c) Merger. The restaurant is merged with another company. 11.9. Private Purchase (5-1) In case the company is privately bought the investor pays the owner the selling price of 895,000.00 ZAR and receives all assets of the company in return. The balance sheet of the new established company after the purchase looks as below in Figure 11.7: A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 25,000 Owner's equity 33,947 Intangibles Financial assets Current assets Liabilities Inventory 8,947 Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 0 Total assets 33,947 Total equity and liab. 33,947 Ohio Fried Chicken STATEMENT of FINANCIAL POSITION as at 1.01.2015 Figure 11.7: OHIO FRIED CHICKEN’s balance sheet The balance sheet only shows the restaurant’s assets. The purchase price is not relevant as it is paid to the previous owner. The total of the assets is the carrying value of fixed assets and the inventories. The purchase method applies. We prepare a business plan for OHIO FRIED CHICKEN and a budgeted balance sheet. We plan the company earning a profit as indicated along the financials. The calculation is based on the 10 months average data set. We transfer the average values to annual figures. This gives for the item “other expenses” a value of: 12 × (16,083.16 + 1,025.04 + 3,339.46) = 2 245,371.80 ZAR. For the wages, we calculate: 12 × 7,367.26 = 88,407.12 ZAR. For the item “material expenses” we consider cold drinks and <?page no="205"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-205 all food which gives us: 12 × (12,764.09 + 77,746) = 1 1,086,121.08 ZAR. The income gives: 12 × 149,766.76 = 1,797,201.12 ZAR. For budgeting, we round the figures to the nearest 1,000.00 ZAR and prepare an income statement. Depreciation on the interior is 25,000.00 ZAR based on our assumptions above. Observe the budgeted income statement for the Accounting period 2015 below in Figure 13.8. [ZAR] Revenue 1,797,000 Other income 1,797,000 Materials (1,086,000) Labour (88,000) Depreciation (25,000) Other expenses (245,000) Earnings before int. & taxes (EBIT) 353,000 Interest Earnings before taxes (EBT) 353,000 Ohio Fried Chicken STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.2015 Figure 11.8: Budgeted income statement for OHIO FRIED CHICKEN The profit is transferred to the equity section and increases the investor’s capital, called “owners’ equity”. We assume that the income, materials, wages and other costs are paid on cash. The operating cash flow then is: 1,797,000 - 1,086,000 - 88,000 - 245,000 = 3 378,000.00 ZAR. There are no further cash flows. The item for cash/ bank increases by the total value of 378,000.00 ZAR. Observe the balance sheet as at 31.12.2015 (one year after acquisition) in Figure 11.9: <?page no="206"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-206 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 0 Owner's equity 386,947 Intangibles Financial assets Current assets Liabilities Inventory 8,947 Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 378,000 Total assets 386,947 Total equity and liab. 386,947 Ohio Fried Chicken STATEMENT of FINANCIAL POSITION as at 1.01.2015 Figure 11.9: OHIO FRIED CHICKEN’s budgeted balance sheet [ZAR] 11.10. Acquisition by a Company (5-2) Next, we pretend OHIO FRIED CHICKEN is transferred to a limited company by the name of OHIO FRIED CHICKEN (Pty) Ltd. and bought by AYAM GORENG Sdn. Bhd. thereafter. Together, both form the AYAM GORENG Group. OHIO FRIED CHICKEN (Pty) Ltd. is established by a share issue of 35,000.00 ZAR. This only is a change in terms of the legal form. The new limited company takes over OHIO FRIED CHICKEN restaurant based on its assets at fair values. The remaining value of: 35,000 - 25,000 - 8,946.61 = 1 1,053.39 ZAR is added to the Cash/ Bank account of the new company. The balance sheet of OHIO FRIED CHICKEN (Pty) Ltd. before the acquisition is shown below in Figure 11.10: A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 25,000 Share capital 35,000 Intangibles Reserves Financial assets Retained earnings Current assets Liabilities Inventory 8,947 Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 1,053 Tax liabilities Total assets 35,000 Total equity and liab. 35,000 Ohio Fried Chicken (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.2014 Figure 11.10: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet <?page no="207"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-207 The acquisition of OHIO FRIED CHICKEN (Pty) Ltd. follows: The buyer is AYAM GORENG Sdn. Bhd. 42 in Kuantan. AYAM GORENG Sdn. Bhd. is a holding company. A holding company is a company with the only purpose of holding other companies; it does not have any other business operations. AYAM GORENG Sdn. Bhd. is established by the proprietors with a total contribution of 400,000.00 MYR as share capital. Its reporting currency is Malaysian Ringgit MYR. A C, L Non-current assets [MYR] Equity [MYR] P, P, E Share capital 400,000 Intangibles Reserves Financial assets Retained earnings Current assets Liabilities Inventory Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 400,000 Tax liabilities Total assets 400,000 Total equity and liab. 400,000 Ayam Goreng Sdn. Bhd. STATEMENT of FINANCIAL POSITION as at 31.12.2014 Figure 11.11: AYAM GORENG Sdn. Bhd.’s opening balance sheet AYAM GORENG Sdn. Bhd. buys OHIO FRIED CHICKEN (Pty) Ltd. at the demanded selling price of 895,000.00 ZAR. The currency exchange rate at the time of acquisition is: 1.00 MYR = 3.00 ZAR. Hence, the Ringgit-purchase price of 42 Sdn. Bhd. is sendirian berhad. OHIO FRIED CHICKEN (Pty) Ltd. equals: 895,000 / 3 = 2 298,333.00 MYR. After the acquisition of OHIO FRIED CHICKEN (Pty) Ltd., AYAM GORENG Sdn. Bhd. discloses its balance sheet as in Figure 11.12. <?page no="208"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-208 A C, L Non-current assets [MYR] Equity [MYR] P, P, E Share capital 400,000 Intangibles Reserves Investments 298,333 Retained earnings Current assets Liabilities Inventory Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 101,667 Tax liabilities Total assets 400,000 Total equity and liab. 400,000 Ayam Goreng Sdn. Bhd. STATEMENT of FINANCIAL POSITION as at 1.01.2015 Figure 11.12: AYAM GORENG Sdn. Bhd.’s balance sheet after acquisition If we look at AYAM GORENG Sdn. Bhd.’s balance sheet after the acquisition, we notice the investment and a value of 400,000 - 298,333.33 = 1 101,666.67 MYR left in AYAM GORENG Sdn. Bhd.’s bank account. The investment is calculated based on the Ringgit-valuation of OHIO FRIED CHICKEN (Pty) Ltd. With the acquisition of OHIO FRIED CHICKEN (Pty) Ltd., AYAM GORENG Sdn. Bhd. gains control power over OHIO FRIED CHICKEN (Pty) Ltd. This is the criterion for a group and requires the preparation of group statements by the parent. A group (in terms of Accounting) is a set of companies where the parent gains control over its subsidiary. A parent is the company controlling other group member companies. A subsidiary is a company controlled by a parent. 43 In the case of AYAM GORENG Group, AYAM GORENG Sdn. Bhd. is the parent and OHIO FRIED CHICKEN (Pty) Ltd. is the subsidiary. They prepare group 43 Read our textbook Financial Statements, chapter (8). statements based on Malaysian Financial Reporting Standards and IFRSs. 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, groups prepare notes. Group statements require consolidations. The first group statements are due at the time of acquisition. The reporting currency is the parent’s one: Malaysian Ringgit MYR. In preparation for the consolidation of financial statements, OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet must be transferred to the reporting currency. The currency transfer is required, because the assets, equity and liabilities of <?page no="209"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-209 both companies are added for the aggregated statements. AYAM GORENG Sdn. Bhd.’s single-entity financial statements comply with the Group Accounting policies. For OHIO FRIED CHICKEN (Pty) Ltd.’s single-entity financial statements to comply with the uniform Accounting policies of the group, they are transferred to the reporting currency MYR. No further adjustments are necessary. The adjusted financial statements for OHIO FRIED CHICKEN (Pty) Ltd. are displayed in Figure 11.13: A C, L Non-current assets [MYR] Equity [MYR] P, P, E 8,333 Share capital 11,667 Intangibles Reserves Financial assets Retained earnings Current assets Liabilities Inventory 2,982 Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 351 Tax liabilities Total assets 11,667 Total equity and liab. 11,667 Ohio Fried Chicken (Pty) Ltd. ADJUSTED STATEMENT of FINANCIAL POSITION as at 31.12.2014 Figure 11.13: OHIO FRIED CHICKEN (Pty) Ltd.’s adjusted balance sheet To prepare group statements as at 1.01.2015, which is the acquisition date, AYAM GORENG Sdn. Bhd. runs a capital consolidation. With the acquisition of OHIO FRIED CHICKEN (Pty) Ltd., all assets, equity and liabilities of the business are assigned to the group. Technically, all items of the single-entity balance sheets are added in preparation for calculating the items on the aggregated balance sheet. E.g., cash/ bank of the group equals: 101,666.67 + 351.13 = 102,017.80 MYR. An aggregated balance sheet is an interim balance sheet in preparation for consolidated financial statements the items of which contains the sums of all group member’s balance sheet items. We can say the balance sheets are “added itemwise”. Thereafter, the consolidations can begin. A consolidation is a correction of figures on the balance sheet and/ or income statement that otherwise will be counted twice. Double recognition occurs in the case of AYAM GORENG Group on the aggregated balance sheet. It contains the investment resulting from the parent’s asset side and the equity of the subsidiary, disclosed as the book value of OHIO FRIED CHICKEN (Pty) Ltd., both to the extent of 11,666.67 MYR. As group statements are prepared under the concept of all companies forming one single entity, the fair value of the investment in OHIO FRIED CHICKEN (Pty) Ltd. and the <?page no="210"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-210 equity of OHIO FRIED CHICKEN (Pty) Ltd. are cancelled out. The investment value is 298,333.33 MYR and the equity 11,666.67 MYR. The investment value is based on the purchase method which requires an asset valuation at purchase prices. The purchase of OHIO FRIED CHICKEN (Pty) Ltd. costs 298,333.33 MYR based on the currency exchange rate on the day of transaction. Hence, the capital consolidation results in a high difference on consolidation to the extent of: 298,333.33 - 11,666.67 = 2286,666.66 MYR. This value is disclosed as goodwill in the consolidated financial statements. It represents the faith of the buyer in closing a good deal by the acquisition of the company above its book value. Such acquisitions are made if the buyer trusts to receive high returns from the ownership of a subsidiary that is underrated, meaning recognised at low book values on its balance sheet. Observe the capital consolidation in the consolidation worksheet and in the consolidated financial statements thereafter in Figure 11.14 and Figure 11.15. AYAM GORENG Sdn. Bhd. OHIO FRIED CHICKEN (Pty) Ltd. AGGR. CAP. CONS CONS. F/ S N-cur Assets P,P,E 8,333 8,333 8,333 Int. assets 0 0 Investments 298,333 298,333 (298,333) 0 Goodwill 0 286,667 286,667 cur Assets Inventory 2,982 2,982 2,982 Receivables 0 0 Prepaid exp. 0 0 Cash 101,667 351 102,018 102,017.80 400,000 11,667 411,667 (11,667) 400,000 SH's capital Issued capital (400,000) (11,667) (411,667) 11,667 (400,000) Reserves 0 0 Reval. Reserves 0 0 Retained ear. 0 0 M.I. 0 0 Liabilities Int. bear. liab. 0 0 Payables 0 0 Provisions 0 0 Def. income 0 0 Tax liabilities 0 0 (400,000) (11,667) (411,667) 11,667 (400,000) Figure 11.14: Consolidation worksheet [MYR] For the acquisition of OHIO FRIED CHICKEN (Pty) Ltd., the purchase method along IFRS 3 applies. All assets are measured at fair values at the time of acquisition. We consider the fair value of the interior of OHIO FRIED CHICKEN <?page no="211"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-211 (Pty) Ltd. being 25,000.00 ZAR or 8,333.33 MYR. The date of acquisition is 1.01.2015. According to IFRS 3, the group statements have to consider goodwill to an extent of: 895,000 - 35,000 = 8860,000.00 ZAR or 286,666.66 MYR. This is the difference between the purchase costs and the fair amount of the assets. As discussed earlier the goodwill is very high. This reflects the risk of the investment. Its price was mostly driven by characteristics that cannot be disclosed on the balance sheet: reputation and customer base. A C, L Non-current assets [MYR] Equity [MYR] P, P, E 8,333 Share capital 400,000 Intangibles Reserves Goodwill 286,667 Retained earnings non-ctrl interest 0 Current assets Liabilities Inventory 2,982 Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 102,018 Tax liabilities Total assets 400,000 Total equity and liab. 400,000 Ayam Goreng Sdn. Bhd. CONSOLIDATED STATEMENT of FINANCIAL POSITION as at 1.01.2015 Figure 11.15: AYAM GORENG Sdn. Bhd. consolidated balance sheet We now move to the end of the year 2015, to the balance sheet date 31.12.2015: For the profit calculations, we do the same as in case (a): private purchase. In contrast to the privatelyowned restaurant, the OHIO FRIED CHICKEN (Pty) Ltd. as a limited company pays income taxes in South Africa. Hence, the income statement for OHIO FRIED CHICKEN (Pty) Ltd. now contains tax liabilities. We apply an income tax rate of 30 %/ a. <?page no="212"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-212 [ZAR] Revenue 1,797,000 Other income 1,797,000 Materials (1,086,000) Labour (88,000) Depreciation (25,000) Other expenses (245,000) Earnings before int. & taxes (EBIT) 353,000 Interest Earnings before taxes (EBT) 353,000 Income tax expenses (105,900) Deferred taxes Earnings after taxes (EAT) 247,100 Ohio Fried Chicken (Pty) Ltd. STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.2015 Figure 11.16: OHIO FRIED CHICKEN (Pty) Ltd.’s budgeted income statement A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 0 Share capital 35,000 Intangibles Reserves Financial assets Retained earnings 247,100 Current assets Liabilities Inventory 8,947 Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 379,053 Tax liabilities 105,900 Total assets 388,000 Total equity and liab. 388,000 Ohio Fried Chicken (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.2015 Figure 11.17: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet At the end of the Accounting period 2015, AYAM GORENG Group must prepare group statements. In preparation for the consolidated financial statements, we check the currency exchange rate between South African Rand and Malaysian Ringgit. The rate would be still: 1.00 MYR = 3.00 ZAR. Under the above-mentioned currency exchange rate, OHIO FRIED CHICKEN (Pty) Ltd.’s adjusted balance sheet looks as below in Figure 11.18. As AYAM GPORENG Sdn. Bhd. is a company no dividend tax applies. <?page no="213"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-213 A C, L Non-current assets [MYR] Equity [MYR] P, P, E 0 Share capital 11,667 Intangibles Reserves Financial assets Retained earnings 82,367 Current assets Liabilities Inventory 2,982 Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 126,351 Tax liabilities 35,300 Total assets 129,333 Total equity and liab. 129,333 Ohio Fried Chicken (Pty) Ltd. ADJUSTED STATEMENT of FINANCIAL POSITION as at 31.12.2015 Figure 11.18: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet The consolidation worksheet applies again. No changes for the capital consolidation are made. AYAM GORENG Sdn. Bhd. OHIO FRIED CHICKEN (Pty) Ltd. AGGR. CAP. CONS CONS. F/ S N-cur Assets P,P,E 0 0 0 Int. assets 0 0 Investments 298,333 298,333 (298,333) 0 Goodwill 0 286,667 286,667 cur Assets Inventory 2,982 2,982 2,982 Receivables 0 0 Prepaid exp. 0 0 Cash 101,667 126,351 228,018 228,018 400,000 129,333 529,333 (11,666) 517,667 SH's capital Issued capital (400,000) (11,667) (411,667) 11,667 (400,000) Reserves 0 0 Reval. Reserves 0 0 Retained ear. (82,367) (82,367) (82,367) M.I. 0 0 Liabilities Int. bear. liab. 0 0 Payables 0 0 Provisions 0 0 Def. income 0 0 Tax liabilities (35,300) (35,300) (35,300) (400,000) (129,333) (529,333) 11,667 (517,667) Figure 11.19: Consolidation worksheet in MYR <?page no="214"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-214 A C, L Non-current assets [MYR] Equity [MYR] P, P, E 0 Share capital 400,000 Intangibles Reserves Goodwill 286,667 Retained earnings 82,367 non-ctrl interest 0 Current assets Liabilities Inventory 2,982 Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 228,018 Tax liabilities 35,300 Total assets 517,667 Total equity and liab. 517,667 Ayam Goreng Sdn. Bhd. CONSOLIDATED STATEMENT of FINANCIAL POSITION as at 31.12.2015 Figure 11.20: AYAM GORENG holding’s balance sheet as at 31.12.2015 11.11. Merger (5-3) If two (or more) companies merge, the companies cease to exist as separate entities and form one new legal entity. The new company prepares single-entity financial statements. Very often, equity is shared among the owners of the previous companies. 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. The purchase method applies. Hence, all items are recognised at fair values. A goodwill can exist too. Regarding the consequences in Accounting, we 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 fastfood restaurant chain, based in Johannesburg. On 1.01.2015, LOS POLLOS ASADOS (Pty) Ltd. buys the company OHIO FRIED CHICKEN (Pty) Ltd. with the intention of merger. Before the deal, LOS POLLOS ASADOS (Pty) Ltd. shows the balance sheet as below in Figure 11.21: <?page no="215"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-215 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 4,000,000 Share capital 1,000,000 Intangibles Reserves 6,500,000 Financial assets Retained earnings 0 Current assets Liabilities Inventory 2,000,000 Interest bear liab 1,000,000 Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 2,500,000 Tax liabilities 0 Total assets 8,500,000 Total equity and liab. 8,500,000 Los Pollos Asados (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.2014 Figure 11.21: LOS POLLOS ASADOS (Pty) Ltd.’s balance sheet LOS POLLOS ASADOS (Pty) Ltd. buys OHIO FRIED CHICKEN (Pty) Ltd. at 895,000.00 ZAR which is the purchase price. The price exceeds the fair book value of OHIO FRIED CHICKEN (Pty) Ltd. The difference between the sales transaction price and the fair value following the purchase method equals: 895,000 - 35,000 = 8 860,000.00 ZAR. A goodwill indicates the acquisition of OHIO FRIED CHICKEN (Pty) Ltd. is overpriced. As this purchase leads to a merger, no goodwill can be recognised on the balance sheet. No consolidated financial statements are required. Therefore, a goodwill is transferred straight to profit or loss. A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 4,025,000 Share capital 1,000,000 Intangibles Reserves 6,500,000 Financial assets Retained earnings (860,000) Current assets Liabilities Inventory 2,008,947 Interest bear liab 1,000,000 Accounts receivables Accounts payables Prepaid expenses Badwill Cash/ Bank 1,606,053 Tax liabilities 0 Total assets 7,640,000 Total equity and liab. 7,640,000 Los Pollos Asados (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 1.01.2015 Figure 11.22: LOS POLLOS ASADOS (Pty) Ltd.’s balance sheet after taking-over <?page no="216"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-216 In case of public companies, mergers can be made with or without consent of the targeted company and are carried out on a tender offer basis. A tender offer is an offer to the shareholders to take-over their company either in exchange of a price per share that exceeds the fair market value of the shares or in exchange of shares of the acquirer. After we studied how LOS POLLOS ASADOS (Pty) Ltd. bought OHIO FRIED CHICKEN directly from its owner, we next discuss a situation, where LOS POLLOS ASADOS (Pty) Ltd. makes a tender offer to the owners of OHIO FRIED CHICKEN (Pty) Ltd. to buy the company in exchange of an appropriate price of the shares of LOS POLLOS ASADOS (Pty) Ltd. We refer to Figure 11.21. To determine an appropriate price, we consider the calculation below: The book value of one ordinary 5-ZARshare of LOS POLLOS ASADOS (Pty) Ltd. before the merger is: (8,500,000 - 1,000,000) / 200,000 = 3 37.50 ZAR/ LOS POLLOS ASADOS share. The equivalent of a 5-ZAR-share of OHIO FRIED CHICKEN (Pty) Ltd. is a book value of 5.00 ZAR/ OHIO FRIED CHICKEN share. The owner of OHIO FRIED CHICKEN (Pty) Ltd. receives shares of LOS POLLOS ASADOS (Pty) Ltd. in exchange for the company. No payment is made. We say the take-over is without consideration. We are interested in the calculation of a fair number of shares to be exchanged between LOS POLLOS ASADOS (Pty) Ltd. and the owners of OHIO FRIED CHICKEN (Pty) Ltd. which is not yet the number in the tender offer but a fair (goodwill ignored! ) one. Later we adjust the number to make the deal attractive for OHIO FRIED CHICKEN (Pty) Ltd.’s owners. For our next steps, we assume the share market price equals to the book value. Hence, the book value of OHIO FRIED CHICKEN (Pty) Ltd. is 35,000.00 ZAR. We refer to the book values as in our case study, no company is publicly traded. A fair deal would be an exchange of: 35,000 / 37.50 = 9 933.33 LOS POLLOS ASADOS shares received by the owner of OHIO FRIED CHICKEN in exchange for the company. This makes them shareholders of the merged company. To make the deal more favourable for OHIO FRIED CHICKEN (Pty) Ltd.’s owners, LOS POLLOS ASADOS (Pty) Ltd. increases the offer to 950 shares. We call the difference a premium. A fair price calculation requires that no issue of fresh shares takes place. Hence, LOS POLLOS ASADOS (Pty) Ltd. repurchases 950 own shares at a fair price (here: book value) of 37.50 ZAR/ LOS POLLOS ASADOS shares. The value paid for the treasury shares equals: 950 × 37.50 = 3 35,625.00 ZAR. As the merger transaction price, LOS POLLOS ASADOS (Pty) Ltd. transfers 950 ordinary shares of LOS POLLOS ASADOS (Pty) Ltd. to the owners of OHIO FRIED CHICKEN (Pty) Ltd. This way, the owners of OHIO FRIED CHICKEN (Pty) Ltd. exchanges assets at a fair price of 35,000.00 ZAR to: 950 × 37.50 = 35,625.00 ZAR book value in shares. The proprietors of OHIO FRIED CHICKEN (Pty) Ltd. accept the tender offer. They sell the company to LOS POLLOS ASADOS (Pty) Ltd. for 950 LOS POLLOS ASADOS (Pty) Ltd. ordinary shares. After the deal, the balance sheet of LOS POLLOS ASADOS (Pty) Ltd. discloses the assets of the former OHIO FRIED <?page no="217"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-217 CHICKEN (Pty) Ltd. on its debit side. The item of cash/ bank is reduced by 35,625.00 ZAR due to the repurchase of shares. After the deal’s reassessment, LOS POLLOS ASADOS records a loss on acquisition to the extent of: 35,000 - 35,625 = - -625.00 ZAR. A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 4,025,000 Share capital 1,000,000 Intangibles Reserves 6,500,000 Financial assets Retained earnings (625) Current assets Liabilities Inventory 2,008,947 Interest bear liab 1,000,000 Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 2,465,428 Tax liabilities 0 Total assets 8,499,375 Total equity and liab. 8,499,375 Los Pollos Asados (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 1.01.2015 Figure 11.23: LOS POLLOS ASADOS (Pty) Ltd.’s balance sheet after take-over If a public tender offer (PTO) is made without consent of the target company, the merger is classified a hostile takeover. The difficulty about hostile takeovers is that for conduct of Accounting due diligence on the target company the bidder lacks information because the target company will not provide internal data for business analysis. A common disadvantage of mergers is that companies cannot easily be separated later. 11.12. Financial Statement Analysis The financial statements for OHIO FRIED CHICKEN do not exist, as the company is privately-owned before the sales transaction. We consider OHIO FRIED CHICKEN restaurant as a (Pty) Ltd. company the way we introduced above. The balance sheet as at 1.01.2015 is displayed below: <?page no="218"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-218 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 25,000 Share capital 35,000 Intangibles Reserves Financial assets Retained earnings Current assets Liabilities Inventory 8,947 Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 1,053 Tax liabilities Total assets 35,000 Total equity and liab. 35,000 Ohio Fried Chicken (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.2014 Figure 11.24: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet The income statement is given by the next exhibit, see Figure 11.25. The income statement is based on the data recorded in 2014. [ZAR] Revenue 1,797,000 Other income 1,797,000 Materials (1,086,000) Labour (88,000) Depreciation (25,000) Other expenses (245,000) Earnings before int. & taxes (EBIT) 353,000 Interest Earnings before taxes (EBT) 353,000 Income tax expenses (105,900) Deferred taxes Earnings after taxes (EAT) 247,100 Ohio Fried Chicken (Pty) Ltd. STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.2015 Figure 11.25: OHIO FRIED CHICKEN (Pty) Ltd.’s income statement The balance sheet one Accounting period later is shown in Figure 11.26 and is a kind of forecast calculated on the 10month-observation. We do not call this a budgeted balance sheet as it is based on analytical planning. <?page no="219"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-219 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 0 Share capital 35,000 Intangibles Reserves Financial assets Retained earnings 247,100 Current assets Liabilities Inventory 8,947 Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 379,053 Tax liabilities 105,900 Total assets 388,000 Total equity and liab. 388,000 Ohio Fried Chicken (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.2015 Figure 11.26: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet In preparation for calculating ratios which combine items from the balance sheet with items from the income statement - such as return figures we set up a balance sheet with the average values derived from the beginning and the end of the Accounting period. E.g., the average value of P, P, E therein equals: (25,000 + 0) / 2 = 1 12,500.00 ZAR. A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 12,500 Share capital 35,000 Intangibles Reserves Financial assets Retained earnings 123,550 Current assets Liabilities Inventory 8,947 Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 190,053 Tax liabilities 52,950 Total assets 211,500 Total equity and liab. 211,500 Ohio Fried Chicken (Pty) Ltd. average STATEMENT of FINANCIAL POSITION as at 31.12.2015 Figure 11.27: Average balance sheet for OHIO FRIED CHICKEN (Pty) Ltd. OHIO FRIED CHICKEN (Pty) Ltd. earns a profit of 353,000.00 ZAR before taxes. In order to calculate the return on assets, we divide the value by the total of assets. Accordingly, the return on assets equals: 353,000 / 211,500 = 1 167 %/ a. <?page no="220"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-220 The return on equity equals to the profit after taxes divided by equity: 247,100 / (35,000 + 123,550) = 1 156 %/ a. The net earnings as percentage of sales equal: 247,100 / 1,797,321.12 = 1 14 %/ a. The budgeted number of sales equals: 12 × 149,776.76 = 1 1,797,321.12 ZAR. Regarding the return figures, OHIO FRIED CHICKEN (Pty) Ltd. seems to be an excellent investment opportunity. To measure the impact on the investment on the sales we calculate the fixed asset turnover. It equals: 1,797,321.12 / 35,000 = 5 51. Capital structure and market price analysis do not apply for OHIO FRIED CHICKEN (Pty) Ltd. 11.13. Risk Analysis In this chapter, we only identify the risks for OHIO FRIED CHICKEN (Pty) Ltd. You find Risk Valuation in the next chapter (12) where risk calculations are made based on simulation models. The risks OHIO FRIED CHICKEN (Pty) Ltd. faces are: (A) Reputation risk. (B) Food price increase risk. (C) Staff fluctuation risk. (D) Competitor risk. (E) Asset structure risk. (F) Risk resulting from government restrictions. (G) Currency exchange risk. Ad 6(A): Reputation Risk The sales value of OHIO FRIED CHICKEN (Pty) Ltd. highly depends on its reputation. However, OHIO FRIED CHICKEN (Pty) Ltd.’s customers are not bound to the company. No company can control the loyalty of its customers. Although food is a daily necessity, there is a risk that customers decide to eat less chicken or that a trend develops to visit restaurants less often (e.g., a pandemic). Customer decisions can be based on internal reasons, such as bad food, or on irrational reasons, like rumours. For the buyer of OHIO FRIED CHICKEN (Pty) Ltd. the reputation risk is high. A problem about the food reputation for OHIO FRIED CHICKEN (Pty) Ltd. is caused by its sales structure. The company is focussed only on chicken products which makes it vulnerable to changes in customer demands because it is singlesided. Ad 6(B): Food Price Increase Risk OHIO FRIED CHICKEN (Pty) Ltd.’s cost structure is dominated my materials, in particular by the chicken parts. Food prices are volatile. There can be a lot of reasons why food prices increase. Also, difficulties with a certain supplier can develop which can force the company to make changes regarding suppliers on short notice. An example for the food price risk is the increase in chicken part costs caused by a chicken disease in October 2014 at OHIO FRIED CHICKEN. Ad 6(C): Staff Fluctuation Risk OHIO FRIED CHICKEN very much depends on the staff working in the restaurant. They are the face to the customer. They also do most of the operational management, like forecast planning and material orders, to prevent the restaurant from understocking. Mistakes <?page no="221"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-221 made by the employees can cause spoilage and waste which is an important cost factor in the restaurant industry. Unsatisfied staff can have a noticeable bad impact on the customers, too. On the other hand, friendly staff that builds a good personal customer relationship is very favourable for the business. In the restaurant, the staff is the only visible contact person to the customer. At OHIO FRIED CHICKEN (Pty) Ltd. staff is paid a very low salary. The low salary taken into consideration, there is a risk that staff quits to takes alternative better paying job offers. In hospitality business, career chances for the serving staff are very few. This leads to a low bondage with the employer. Ad 6(D): Competitor Risk There are popular fast-food restaurants in South Africa in the neighbourhood of OHIO FRIED CHICKEN (Pty) Ltd. Many of the restaurants are linked to fast-food chains, like McDonald’s, to benefit from synergies and better purchase terms and conditions. OHIO FRIED CHICKEN (Pty) Ltd. must compete with restaurant chains. Many of the restaurant brands are already present in Worcester, so is KFC which offers similar products. At the same time, the market volume around Worcester is limited. There are only few customers coming from outside of the city to buy lunch/ dinner at OHIO FRIED CHICKEN (Pty) Ltd. However, Worcester is a drive-through city on the way from the Eastern Cape to Cape Town with access to the N1 autobahn. The customers’ demand in fast food in general and in fried chicken products in particular is shared among the restaurants near to the location of OHIO FRIED CHICKEN (Pty) Ltd. Ad 6(E): Asset Structure Risk The structure of the assets is based on a situation where OHIO FRIED CHICKEN (Pty) Ltd. earns a good profit on a very low investment base. The fixed asset turnover is very high. This makes the company vulnerable. The company can be copied easily. All what is needed to open a similar restaurant is a location and some kitchen appliances. No special qualification is required for deep-frying chicken parts. Another risk results from the asset structure. If the company is acquired for 895,000.00 ZAR, the new owner only gets assets at a fair value of less than 35,000.00 ZAR. The rest is for the reputation of the business and the knowledge/ experience of buying and frying chicken. In case the company is closed, the investor is left with kitchen equipment and inventories which almost are impossible to liquidate. To explain the situation of low asset values, we compare OHIO FRIED CHICKEN (Pty) Ltd. to a property investment in Paarl, South Africa. Assume, an investor buys for a similar value as paid for OHIO FRIED CHICKEN a 1 bedroom, kitchen, 1 bathroom apartment and invests 900,000.00 ZAR with the intention to rent it out. If the tenant falls behind with rent payments, the landlord can evict the property and is still left with the apartment worth 900,000.00 ZAR. Hence, the investment in property is less risky than the purchase of a fast- <?page no="222"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-222 food restaurant with almost worthless tangible assets. 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. Also, a lockdown as under the Covid-19 pandemic is an example for government regulations. In case new requirements are implemented the owner of the restaurant must face further costs for certificates and examinations or a lack in revenues. Other risks result from unions regarding 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 value of the profit decreases. Changes of the currency exchange rate have a direct impact on the profit value of a South African investment as it is paid in ZAR. In the long-term run, we notice a significant depreciation of the South African Rand against the Euro. The ZAR was 10.00 ZAR = 1.00 EUR in 2012 and 18.00 ZAR = 1.00 EUR in 2016. The depreciation is: 8/ 10 = 80%. Figure 11.28: Long-term currency exchange rate ZAR-EUR (OFX.com) At the time of the sales offer for OHIO FRIED CHICKEN in 2014 the currency exchange rate was 14.00 ZAR = 1.00 EUR. See the long-term currency exchange chart in Figure 11.28. To demonstrate, how the currency risk works, we assume a European investor bought property in 2014 for 1,000,000.00 ZAR at an exchange rate of 14.00 ZAR = 1.00 EUR. He bought the property with the intention to rent it out for 9,000.00 ZAR/ m. He calculates a rental profit of: 11 × 9,000 = 99,000.00 ZAR. An portion of 9,000.00 ZAR is deducted as costs for property management and repairs. The <?page no="223"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-223 EUR-value of the rental profit is: 99,000 / 14 = 7,071.43 EUR/ a. The return on investment in ZAR equals: 99,000 / 1,000,000 = 9.9%. Now we move to January 2016. The profit is still 99,000.00 ZAR but it is now to be converted to a EUR value of: 99,000 / 18 = 5,500.00 EUR. The investment payment is still to be considered at the 2014 currency exchange rate of 14.00 ZAR = 1.00 EUR - as paid. Hence, the investment payment is: 1,000,000 / 14 = 71,428.57 EUR. The investor calculates his return on investments based on the current EUR-values. It gives him a return to the extent of: 5,500 / 71,428.57 = 7.7%. The return declined by: 2.2% / 9.9% = 22.22%. 11.14. Summary Mergers and Acquisitions require strategic and Accounting valuation of the target firm. Regarding Accounting due diligence, methods of Investment Appraisal and budgeting apply. As a result, budgeted financial statements are prepared. In contrast to a merger where the companies are combined to one legal entity, Group Accounting applies for an acquisition of a subsidiary because the purchased company stays legally independent and prepares its own single-entity financial statements. An important role plays the risk analysis for the purchase decision which includes the identification and evaluation of risks. 11.15. Working Definitions Aggregated Balance Sheet: An aggregated balance sheet is an interim balance sheet in preparation for consolidated financial statements the items of which contain the sums of all group member’s balance sheet items. Consolidation: A consolidation is a correction of figures on the balance sheet and/ or income statement that otherwise will be counted twice. Discounted Cash Flow Method: The discounted cash flow method determines the value of a business as the sum of the present values of all free cash flows. Free Cash Flow: The free cash flow is the operating cash flow plus the investing cash flow. Goodwill: Goodwill is the difference between the paid price for a company and its book value. Group: A group is a set of companies where the parent gains control over its subsidiary. Group Statements: Group statements are a set of financial statement prepared in addition to single-entity financial statements of each group member and report about the entire group a statement of financial position, a statement of comprehensive income, a statement of cash flows and a statement of changes in equity. Holding: A holding company is a company with the only purpose of holding other companies; it does not have any other business operations. Internal Rate of Return IRR: The internal rate of return is the rate of interest at which the present value is zero. Parent: A parent is the company controlling other group member companies. <?page no="224"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 11-224 Profitability Index: The profitability index is the present value of payments divided by the initial investment cash outflow. Subsidiary: A subsidiary is a company controlled by a parent. Tender Offer: A tender offer is an offer to the shareholders to take-over their company either in exchange of a price per share that exceeds the fair market value of the shares or in exchange of shares of the acquirer. 11.16. Question Bank (1) Which statement is correct? 1. A hostile take-over only works with acquisitions. 2. A merger can be national as well as cross border. 3. An acquisition by a company requires considering the company bought as a subsidiary. 4. For buying a target company a public tender offer is required by law. (2) Company A is traded at 100.00 EUR/ s and company B at 60 EUR/ s. Company A’s issued shares are 100,000 s and company B 1,000 s. A makes a PTO to buy B. What is the fair number of shares to be exchanged without compensation? 1. 601 s . 2. 60 s . 3. 600 s . 4. 594 s . (3) Company A buys company B at 300,000.00 EUR when B’s 35,000 shares (nominal value 5.00 EUR/ s) are traded at 8.00 EUR/ s. The retained earnings are 50,000.00 EUR. How much is the goodwill? 1. 0.00 EUR . 2. 50,000.00 EUR . 3. 20,000.00 EUR . 4. 75,000.00 EUR . (4) A company discloses P, P, E at 60,000.00 EUR and cash/ bank at 55,000.00 EUR. The share capital is based on 100,000 shares, currently traded at 2.00 EUR/ s. The company discloses liabilities at 35,000.00 EUR. How much is the book value of the company? 1. 115.000.00 EUR . 2. 80,000.00 EUR . 3. 200,000.00 EUR . 4. 100,000.00 EUR . (5) What is the internal rate of return? 1. The profitability rate of inter-group investments. 2. The effective rate of interest. 3. The discount rate to apply to calculate a zero-present value. 4. Calculated and artificial dividend costs. 11.17. Solutions 1-3; 2-3; 3-4; 4-2; 5-3. <?page no="225"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 12-225 12. Risk Valuation 12.1. What is in the Chapter? In this chapter we cover the identification and measurement of risks for companies. A risk is an uncertain outcome of a factor that affects profit and/ or cash flow. For risk valuation we must know their probability and the probability density function. To combine multiple risks for valuation, we use a risk simulation based on the Mathematical concept of a MonteCarloSimulation. In this chapter we study the case of ROCKS PLC., to learn about financial situations that can cause bankruptcy. This helps us to appraise risks. For teaching the basics of risk simulation, we use the case of WEATHERMAN who sells sunglasses and umbrellas depending on the weather. This is regarded as a single risk. The next case of the consultancy NAMGURO Ltd. covers a multiple risk situation and teaches us how to prepare a risk model for risk valuation based on the value at risk figure. We demonstrate how to calculate the probability for NAMGURO Ltd. becoming insolvent. 12.2. Leaning Objectives Risk Valuation and Risk Management are the task of Management Accountants. The aim is to measure how risky a business is or will be for its investors. The highest damage for the shareholders is to completely lose their invested funds. In this chapter, we teach you risk identification, which brings the major risks of the business to light. Managerial Accounting strives to find ways to minimise, avoid or compensate risks. You learn about a method of risk evaluation for multi-risk situations. After studying this chapter, you understand the technical term risk and can run a MonteCarloSimulation on a spreadsheet to determine profit and cash flow risks for companies. The knowledge helps you to understand how risk management software solutions work. You will be able to calculate bankruptcy probabilities linked to Accounting insolvency and/ or illiquidity. You also understand the risk management ratio value at risk (VaR) and its parameters. 12.3. Bankruptcy due to Over-Indebtedness A business is forced to closed-down by legal requirements once the debts exceed the assets. This happens if losses become that high that the equity is negative. In a limited company, the owners are not held reliable for such a loss as their responsibility is limited to equity. As a consequence, creditors lose all or parts of the funds they are lending the company. For the protection of the creditors, a company must file for bankruptcy once too deep in debts (over-indebtedness) or if payment obligations cannot be fulfilled (illiquidity) anymore. 12.4. C/ S ROCKS PLC To study bankruptcy situations, we look at ROCKS PLC. It shows the balance sheet as below in Figure 12.1 at the beginning of the Accounting period 20X1. <?page no="226"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 12-226 A C, L Non-current assets [GBP] Equity [GBP] P, P, E 2,500 Share capital 10,000 Intangibles Reserves 2,000 Financial assets Retained earnings Current assets Liabilities Inventory Interest bear liab 3,000 Accounts receivables 8,000 Accounts payables Prepaid expenses Provisions Cash/ Bank 4,500 Tax liabilities Total assets 15,000 Total equity and liab. 15,000 Rocks PLC STATEMENT of FINANCIAL POSITION as at 1.01.20X1 Figure 12.1: ROCKS PLC’s balance sheet If ROCKS PLC makes a loss that exceeds 12,000.00 GBP its debts exceed the assets and it must file for bankruptcy. Next, we study this situation: To keep the case study simple, we assume the company’s loss is 13,000.00 GBP and the contra entry is in the short-term liabilities; we make following Bookkeeping entry to record ROCKS PLC’s loss of 13,000.00 GBP: 44 DR P&L-Account.................. 13,000.00 GBP CR Accounts Payables............ 13,000.00 GBP The loss recording reduces and makes ROCK PLC’s equity negative. Study the balance sheet below in Figure 12.2. 44 To keep it simple, we debit a loss in the Profit and Loss account. <?page no="227"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 12-227 A C, L Non-current assets [GBP] Equity [GBP] P, P, E 2,500 Share capital 10,000 Intangibles Reserves 2,000 Financial assets Retained earnings (13,000) Current assets Liabilities Inventory Interest bear liab 3,000 Accounts receivables 8,000 Accounts payables 13,000 Prepaid expenses Provisions Cash/ Bank 4,500 Tax liabilities Total assets 15,000 Total equity and liab. 15,000 Rocks PLC STATEMENT of FINANCIAL POSITION as at 31.12.20X1 Figure 12.2: ROCKS PLC.’s balance sheet Now, the equity is negative -1,000.00 GBP. Why is this situation depicted in Figure 12.2 so bad? The answer lays in an assumed liquidation. We check what happens if the company is liquidated at fair values: ROCKS PLC sells all assets at their carrying values which adds up to 15,000.00 GBP. This is the sum of assets on the balance sheet. Next, ROCKS PLC retires its debts. We ignore transaction costs and penalties for premature repayments. ROCKS PLC must pay: 3,000 + 13,000 = 1 16,000.00 GBP. As the liquidation proceeds only cover 15,000.00 GBP ROCKS PLC cannot settle all its debts. We assume, ROCKS PLC. pays 15,000.00 GBP to its creditors but still is left with payables to the extent of: 16,000 - 15,000 = 1 1,000.00 GBP. In this situation, the owners of ROCKS PLC file for bankruptcy and lose their funds which is worth the company’s equity which is nil as eaten by the loss. Hence, the owners lost all their interest in the company, but they also get away for free leaving the creditors with a claim of 1,000.00 GBP against a bankrupt company. This way, the creditors lost 1,000.00 GBP they lent ROCKS PLC. Their loans became uncollectable as the company does not exist anymore. To protect creditors from those situations, a company cannot continue its operations once its equity becomes negative. In Accounting, we describe ROCKS PLC’s situation as Accounting insolvency. The law forces the company to cease operations and start insolvency procedures immediately. Once bankrupt, a court representative (advisor) takes over the business to assure all creditors are equally refunded. As the liquidation proceeds normally are not sufficient to refund the creditors, they only can expect a portion of the funds lending the business refunded. The bankruptcy procedures are in place to protect the creditors from the company worsen its situation by continuing operations. 12.5. Bankruptcy due to Illiquidity Another reason for bankruptcy is illiquidity which means the company cannot fulfil its payment obligations. <?page no="228"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 12-228 This is caused by debts and negative cash flows. An insolvency is in order once the company has no or negative Cash/ Bank account balance and has no chance for positive cash flows, not from operations nor from borrowing from creditors. Both, either over-indebtedness and/ or illiquidity require the management to file for bankruptcy at the local courthouse. 12.6. Risks Next, we study how to avoid bankruptcy. Mostly, negative and dangerous developments are foreseeable. We call a threat for a company’s bankruptcy a risk. A risk is the outcome of an event by which something happens differently as foreseen or expected. Risks in business are risks that can cause a company’s bankruptcy. A new competitor is a risk for a company because its market share is prone to decline and maybe as part of the competition, it must offer price discounts to its customers. This leads to lower proceeds which become a thread to the financial situation. Risks are a plan/ forecast deviation. In Business and Management, we do not classify risks in good or bad. Any deviation is considered a risk. E.g., a student who expects a 60 % pass grade for an exam has to take the risk that the exam is 40 % or 80 %. We cover both deviations, positive as well as negative ones by the technical term risk. Even as a deviation towards a better exam result is called chance in common language, we call it a risk in business. We refer to this concept as symmetrical risk definition which is necessary for risk simulations. 12.7. Risk Management Valuation of risks and Risk Management aims to control risks of a company. It also tells us the probability for a company’s bankruptcy. Risk taking is normal business. Even with a “risk-free” business model, everyone would try to realise it which leads to a competitor risk. In Risk Management, a company asks itself the two questions below: (1) ‘Should we take a risk linked to a particular business operation? ’ - The answer is: Yes, if the chances linked to the risk outweigh its negative consequences. (2) ‘How many risks can we take? ’ - The ability of risk taking depends on the financial position of the business. A company with a high book value can take more risks than a poor one. For a ‘rich’ company (we mean a company with a high equity value), a loss probably does not exceed equity. Hence, the equity level is regarded as a risk shield. Similar considerations apply for cash flows. A company with high liquidity is safer because negative cash flows do not jeopardize the ability to fulfil future payment obligations. In Risk Management, a risk is understood as the random deviation and is valued by the probability (%) of the deviation from the estimate. In terms of Mathematics, we call the estimate the expected value. We apply the symmetric definition of risk. <?page no="229"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 12-229 In case a risk cannot be calculated by a probability (unknown probability) it will be referred to as an uncertainty. To manage its risks, a company must be able to value them. A risk valuation determines the monetary value of risks which we express in currency units. Remember, the risk in business is a deviation from profit or cash flow. The value of a risk is determined by the damage caused and its probability (%). The product of probability and damage gives the expected value of a risk. V(risk) = D × P (with: V = value, D = damage, P = probability [%].) For instance, a risk that inventory is stolen is the caused damage, e.g., 1,000.00 EUR, multiplied with the probability of theft which is 2 %. Hence, the risk’s value is: 1,000 × 2% = 20.00 EUR. This risk valuation is based on best estimate and does not consider deviations. In terms of Mathematics we say, we calculate the mean but not the standard deviation. Risk management is about the identification, calculation and controlling of risks taken by shareholders and creditors. The risk for these parties losing their funds depends on the volatility of the business's profits and cash flows. A company that applies effective Risk Management avoids or mitigates its risks. Risk Management is a service in favour of the funds providing parties of a business. 12.8. Multiple Risk Taking In general, companies take more than one risk at a time. To calculate the resulting (entire) risk for shareholders and creditors, companies must combine their risks for Risk Valuation. As risks depend mutually on each other, they aggravate or compensate each other. For managing risks, we must understand how they work together. One way of risk combination is by pairing risks and examine their mutual impacts. A company taking 10 single risks that depend on each other then must consider (10 - 1)! = 362,880 risk combinations. For that reason, an examination of risk dependencies in detail is theoretically possible but not applicable in business. The effort exceeds the gain. As an alternative, risk combinations 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. The name MonteCarloSimulation refers to gambling (Monaco). The comparison to gambling is often made in Mathematics as it is assumed that a dice has 6 equal sides - each number got the same probability of appearance. We call diced numbers 1 to 6 are equally distributed. An equal distribution is a distribution where every <?page no="230"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 12-230 number has the same probability to appear. To explain risk simulation, we study events and their probabilities. Every risk depends on an event. The occurrence of the event is measured by probabilities and disclosed as a percentage. 12.9. C/ S WEATHERMAN To deepen your understanding of risks, we discuss the case study WEATHERMAN. See below its data sheet. Data Sheet for WEATHERMAN CClassification: Trading; Probabilities for rain/ sun/ overcast: 40 % / 30 % / 30 %; Profit on umbrella sale: 5.00 EUR/ u; Profit on sunglasses sale: 7.00 EUR/ u. Sales numbers: rain - 100 umbrellas, sun - 60 sunglasses, overcast - 20 umbrellas + 20 sun glasses; VAT ignored. WEATHERMAN is a seller for sunglasses and umbrellas. He is exposed to the weather risk. We only discuss one single risk. The weather is one event with different outcomes. There is a 40 % chance of rain, a 30 % probability for sunshine, and with a probability of 30 % no rain and no sun shine occurs, which means cloudy weather (overcast). For this example, no further weather conditions are relevant. The above-mentioned events exclude each other mutually. Furthermore, they do not depend on each other. We value the risk for WEATHERMAN’s profit. The profit depends on the sales of umbrellas and sunglasses. WEATHERMAN sells 100 umbrellas when it rains, 60 sunglasses when the sun is shining, and with overcast skies, he sells 20 umbrellas and 20 sunglasses. The profit as per umbrella is 5.00 EUR/ u and as per pair of sunglasses it is 7.00 EUR/ u. We calculate the estimate for WEATHERMAN’s profit: 40% × 100 x 5 + 30% × 60 x 7 + 30% × (20 × 5 + 20 × 7) = 398.00 EUR. For budgeting, the expected value is sufficient. However, we know that weather can change. The estimate does not tell the sales deviations which are depending on the weather. We use a random figure generator for the profit simulation. A random figure is equally distributed, it means any percentage between 0 and 100 comes with the same probability. There is a random figure generator ‘RAN#’ on your calculators as well as a MS-Excel function RAND(). <?page no="231"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 12-231 Figure 12.3: Random figure generator on a calculator (Casio) The generator provides us with figures between 0 and 1, such as 0.84. We multiply these random figures with 100 to get figures between 0 and 99. As a result, every figure's probability to be drawn is 1%. 45 For the simulation of the weather, assign the drawn random figures to states below: 0 ... 39 rain. 40 ... 69 sunshine. 70 ... 99 cloudy weather. Now, the RAN# generator can simulate the weather. 40 % of the results indicate rain, 30 % indicate sunshine and another 30 % stand for cloudy weather. It does not matter which specific number is assigned to an event. It is only important to assign 40 figures to rain, 30 figures to sunshine and 30 figures to cloudy weather. Now, we simulate the weather and calculate WEATHERMAN’s profit as a result thereof. We assume, for our first 5 simulation runs the random figure generator gives us: 53, 94, 68, 12, and 30. Observe the profits earned based on the weather simulations below in Figure 12.4: Random umbrellas sold sun glasses sold Profit 53 0 60 420.00 94 20 20 240.00 68 0 60 420.00 12 100 0 500.00 30 100 0 500.00 Average: 416.00 Figure 12.4 WEATHERMAN’s profit simulation 45 Due to rounding, the 0 and the 100 come with a probability of 0.5 % whereas all other 99 figures have a probability of 1 %. Technically, we multiply the results of the random figure generator with 100 and deduct 0.5 from the result. <?page no="232"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 12-232 As it can be read from the table, the average profit is not exactly the estimate of 398.00 EUR. We calculate the estimate as: 40% × 500 + 30% × 420 + 30% × 240 = 3 398.00 EUR. Next, we run more simulations and we see that the average profit now approximates the estimate. Observe below a 10,000 runs profit simulation based on a MS-Excel spreadsheet. Figure 12.5: WEATHERMAN’s profit MS-Excel simulation The WEATHERMAN case study is about one risk only and doesn't require risk combinations. Although the case is very simple it helps us to understand the terminology and principle of risk simulation. 12.10. Simulation of Multiple Risks In the real business world, there are multiple risks with all having an impact on profit and/ or cash flows. For Risk Management, we must identify the risks and study what they depend on. We follow the policy: 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 single random figures. Hence, for a 3 risk case we draw 3 random figures for every simulation run. 12.11. C/ S NAMGURO Ltd. Next, we study NAMGURO Ltd. which is a consultancy. Data Sheet for NAMGURO Ltd. Classification: Consulting; Revenue: 1,000,000.00 EUR/ a; Materials: 50,000.00 EUR/ a; Depreciation: 150,000.00 EUR/ a; Labour: 450,000.00 EUR/ a; Other expenses: 50,000.00 EUR/ a; Fluctuation risk: 20% -> -10 % in revenue and + 15 % in labour; 5 % -> -20 % in revenue and + 25 % in labour; <?page no="233"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 12-233 CCompetitor risk: 30 % -> revenue towards 80 %; Failure risk: 2 % -> 400,000.00 EUR fine; VAT ignored. The company earns an annual revenue of 1,000,000.00 EUR/ a and its estimated profit is 210,000.00 EUR/ a. See the detailed profit calculation for NAMGURO Ltd. below in Figure 12.6: Item [EUR] Revenue 1,000,000 Materials (50,000) Depreciation (150,000) Labour (450,000) Other expenses (50,000) Net profit (EBT) 300,000 Income tax (30%) (90,000) Profit for the period (EAT) 210,000 Namguro Ltd. STATEMENT of COMPREHENSIVE INCOME for year ended 31.12.20X5 Figure 12.6: NAMGURO Ltd.’s statement of comprehensive income NAMGURO Ltd. faces the 3 risks below: (1) Fluctuation Risk: Fluctuation affects revenue and labour: There is a 20 % probability that revenue decreases by 10 % and labour increases by 15 %. Furthermore, there is a 5 % probability that revenue decreases by 20 % and labour increases by 25 %. (2) Competition risk: There is a 30 % probability for a competitor penetrating NAMGURO Ltd.'s market. In that event the revenue will decrease to a level that equals to 80 % of the previous one. No cost adaption for NAMGURO Ltd. is possible on short notice. (3) Failure risk (making mistakes regarding consulting): There is a 2 % risk of a consulting mistake made by NAMGURO Ltd.'s consultants. In the event of a faulty consultation, NAMGURO Ltd. must pay a fine of 400,000.00 EUR. We record the fine as other expenses (OE). For 3 risks three random figures apply. This keeps the risks mutually independent. Observe the risk simulation with 10 runs as below where the random figures RAN# are equally distributed: <?page no="234"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 12-234 RISK 1 RISK 2 RISK 3 Annual Surplus RAN# Effect RAN# Effect RAN# Effect 15 R90; L115 73 27 92,750 3 R90; L115 58 16 92,750 12 R90; L115 16 R80 98 -47,500 27 60 76 210,000 73 49 13 210,000 72 50 30 210,000 6 R90; L115 92 0 OE 450 -267,500 45 34 81 210,000 96 1 R80 78 70,000 33 8 R80 65 70,000 Figure 12.7: Results of NAMGURO Ltd.‘s profit simulation The profit calculations are based on 10 simulation runs, see Figure 12.7: The first simulation run gives a random figure indicating the fluctuation risk. It makes the revenue decline to the 90 % mark and labour costs increase due to new staff employment to 115 % of the previous value. The random figure for the competitor risk is 73. This indicates no change. The random figure for the failure risk is 27 which is with no impact on the income statement either. Line 1 gives the first simulation run’s profit: (90% × 1,000,000 − 50,000 − 150,000 − 115% × 450.000 − 50.000) × (1 − 30%) = 992,750.00 EUR. In line 3, NAMGURO Ltd. makes a loss: 90% × 80% × 1,000,000 − 50,000 − 150,000 − 115% × 450,000 − 50,000 = -- 47,500.00 EUR (no income taxes). Although the fluctuation and competitor risks are independent, both reduce revenue. Hence, due to the competitor risk the revenue drops to 80 % of the already reduced revenue due to fluctuation. The average profit is calculated by the mean of NAMGURO Ltd.'s 10 profit simulation runs to: (92,750 + 92,750 - 47,500 + 3 × 210,000 - 267,500 + 210,000 + 2 × 70,000) / 10 = 8 85,050.00 EUR. So far, we only simulated the mean for the profit. Next, we determine the profit deviation. We calculate the standard deviation for NAMGURO Ltd.'s profit: [0.1 × ((92,750 - 85,050) 2 + (92,750 - 85,050) 2 + (- 47,500 - 85,050) 2 + 4 × (210,000 - 85,050) 2 + (-267,500 - 85,050) 2 + 2 × (70,000 - 85,050) 2 )] 0.5 = 1143,137.21 EUR. In business, the distribution of profits is often assumed to be normally distributed without being proven mathematically. A normal distribution for profit then is indicated by a bellshaped curve as probability-overprofit-function. The peak of the curve is where the mean of profit is. The mean value for NAMGURO Ltd.’s profit of 85,050.00 EUR is the most likely value for the distribution. 12.12. Normal Distributions The equation for a normal distribution is: <?page no="235"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 12-235 (with: μ = mean, σ = standard deviation, f = probability, x = (here profit), e = Euler’s number) The probability (here: f) depends on constant figures and on the mean μ and the standard deviation σ. In other words: once we know the mean and the standard deviation of a distribution, we can calculate it. From a normal distribution we can derive the value at risk. The value at risk is the lowest profit that is achieved by 95 % of all cases. This is the profit value at the right border of the first 5 % interval under the distribution curve. To deal with a normal distribution, we must transfer it to a standard normal distribution. A standard normal distribution is a special normal distribution where the mean is 0 and the standard deviation is 1. The probabilities of a standard normal distribution are given by tables you can download from the internet or find in textbooks for Mathematics and 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 value is 50 % (for the right-hand side half of the distribution). There is no need for describing the left portion of the distribution. <?page no="236"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 12-236 z 0 1 2 3 4 5 6 7 8 9 0 0.0000 0.0040 0.0080 0.0120 0.0160 0.0199 0.0239 0.0279 0.0319 0.0359 0.1 0.0398 0.0438 0.0478 0.0517 0.0557 0.0596 0.0636 0.0675 0.0714 0.0753 0.2 0.0793 0.8320 0.0871 0.0910 0.0948 0.0987 0.1626 0.1064 0.1103 0.1141 0.3 0.1179 0.1217 0.1255 0.1293 0.1331 0.1334 0.1406 0.1443 0.1480 0.1517 0.4 0.1554 0.1591 0.1628 0.1664 0.1700 0.1736 0.1772 0.1808 0.1844 0.1879 0.5 0.1913 0.1950 0.1985 0.2019 0.2054 0.2088 0.2123 0.2157 0.2190 0.2224 0.6 0.2257 0.2291 0.2324 0.2357 0.2389 0.2422 0.2454 0.2486 0.2517 0.2549 0.7 0.2580 0.2611 0.2642 0.2673 0.2704 0.2734 0.2764 0.2794 0.2823 0.2852 0.8 0.2881 0.2910 0.2929 0.2967 0.2995 0.3023 0.3051 0.3078 0.3106 0.3133 0.9 0.3159 0.3186 0.3212 0.3238 0.3264 0.3289 0.3315 0.3340 0.3365 0.3389 1 0.3413 0.3438 0.3461 0.3485 0.3508 0.3531 0.3554 0.3577 0.3599 0.3621 1.1 0.3643 0.3665 0.3686 0.3708 0.3729 0.3749 0.3770 0.3790 0.3810 0.3830 1.2 0.3849 0.3869 0.3888 0.3907 0.3925 0.3944 0.3962 0.3980 0.3997 0.4015 1.3 0.4032 0.4049 0.4066 0.4082 0.4099 0.4115 0.4131 0.4147 0.4162 0.4177 1.4 0.4192 0.4207 0.4222 0.4236 0.4251 0.4265 0.4279 0.4292 0.4306 0.4319 1.5 0.4332 0.4345 0.4357 0.4370 0.4382 0.4394 0.4406 0.4418 0.4429 0.4441 1.6 0.4452 0.4463 0.4474 0.4484 0.4495 0.4505 0.4515 0.4525 0.4535 0.4545 1.7 0.4554 0.4564 0.4573 0.4582 0.4591 0.4599 0.4608 0.4618 0.4625 0.4633 1.8 0.4641 0.4649 0.4656 0.4664 0.4671 0.4678 0.4686 0.4693 0.4699 0.4706 1.9 0.4713 0.4719 0.4726 0.4732 0.4738 0.4744 0.4750 0.4756 0.4761 0.4767 2 0.4772 0.4778 0.4783 0.4788 0.4793 0.4798 0.4803 0.4808 0.4812 0.4817 2.1 0.4821 0.4826 0.4830 0.4834 0.4838 0.4844 0.4846 0.4850 0.4854 0.4857 2.2 0.4861 0.4864 0.4868 0.4871 0.4875 0.4878 0.4881 0.4884 0.4887 0.4890 2.3 0.4893 0.4896 0.4898 0.4901 0.4904 0.4906 0.4909 0.4911 0.4913 0.4916 2.4 0.4918 0.4920 0.0492 0.4925 0.4927 0.4929 0.4931 0.4932 0.4934 0.4936 2.5 0.4938 0.4940 0.4941 0.4943 0.4945 0.4946 0.4948 0.4949 0.4951 0.4952 2.6 0.4953 0.4955 0.4956 0.4957 0.4959 0.4960 0.4961 0.4962 0.4963 0.4964 2.7 0.4965 0.4966 0.4967 0.4968 0.4969 0.4970 0.4971 0.4972 0.4973 0.4974 2.8 0.4974 0.4975 0.4976 0.4977 0.4977 0.4978 0.4979 0.4979 0.4980 0.4981 2.9 0.4981 0.4982 0.4982 0.4983 0.4984 0.4984 0.4985 0.4985 0.4986 0.4986 3 0.4987 0.4987 0.4987 0.4988 0.4988 0.4989 0.4989 0.4989 0.4990 0.4990 Figure 12.8: Probabilities for the standard normal distribution For the case NAMGURO Ltd, we do not have yet a standard normal distribution. We first must transfer the normal distribution for NAMGURO Ltd.’s profit to a standard normal distribution. This means to transfer the x-values (profit) to the z-amounts as listed in the table. The transformation equation from a normal distribution towards a standard normal distribution is: x x z ) ( (with: z = z-amount, μ = mean, σ = standard deviation, x = x-amount) We apply the standard normal distribution for NAMGURO Ltd. to calculate the value at risk for the profit: In case we put the mean of 85,050.00 EUR as x-value into the transformation equation the z-value is: (μ - x*) / σ = (85,050 - 85,050) / 143,137.21 = 0 0. This proves that we transfer towards a <?page no="237"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 12-237 standard normal distribution. Next, we check the z-value for the standard deviation to the right. Its z-value is: (μ - x**) / σ = (85,050 - (85,050 + 143,137.21)) / 143,137.21 = 1 1. This is the value we expected. The table of the standard normal distribution provides the probability for all zvalues that are between 0 and the figures listed. For example, the z-value of 3 gives a probability of 49.87 %, meaning this is the probability of all z-values between 0 and 3. We want to read the probability for NAMGURO Ltd.’s profit that is exceeded by 95 % of all cases. We find this value to the left of the distribution. As the curve for the standard normal distribution is symmetrical, we read the z-value for a 45 % probability on the right-hand side. The z-value can be calculated by interpolation. It amounts to 1.645. The probability for a z-value of 1.645 is 45 %. The value at risk based on a 5% quartile is the profit that is exceeded by a probability of 95 %. The calculation is as follows: we read the z-value for a probability of 45 % from the table for a normal distribution and “retransform” (dissolving the equation towards x) it to the x-value (profit). For NAMGURO Ltd. the VaR 5% for the profit is at z = -1.645. Accordingly: x = - 1.645 × σ + μ = -1.645 × 143.137.21 + 85,050 = - -150,410.71 EUR. NAMGURO Ltd.'s total profit risk is a 5 % probability that the loss is below - 150,410.71 EUR (loss). This means there is a 95 % probability for NAMGURO Ltd. to exceed that profit mark. The value at risk is a common Risk Management figure applied in business and management. 12.13. Bankruptcy Probability We can calculate the probability for NAMGURO Ltd.’s over-indebtedness as percentage. To determine the probability for an overindebtedness, we must know its equity. For our calculations, we assume equity is 100,000.00 EUR. Hence, we have to determine the probability for NAMGURO Ltd.’s loss to exceed -100,000.00 EUR. We put the value of -100,000.00 EUR into the transformation equation and receive a z-value of: z(-100,000) = (- 100,000 - 85,050) / 143,137.21 = - -1.29. We read the probability from the table to be 40.15 %. This means there is a probability of 40.15 % that the z-value is between 0 and 1.29. We want to know the probability that stands for values below -1.29. It is: 1 - 50% - 40.15% = 9.85%. Therefore, there is a 9.85 % chance of filing for bankruptcy based on over-indebtedness for NAMGURO Ltd. if taking the three risks mentioned above. 12.14. C/ S OHIO FRIED CHICKEN (Pty) Ltd. Next, we evaluate the risks for OHIO FRIED CHICKEN (Pty) Ltd., as discussed in chapter (11). Based on the past data, we already prepared a budgeted income statement as below in Figure 12.9. <?page no="238"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 12-238 [ZAR] Revenue 1,797,000 Other income 1,797,000 Materials (1,086,000) Labour (88,000) Depreciation (25,000) Other expenses (245,000) Earnings before int. & taxes (EBIT) 353,000 Interest Earnings before taxes (EBT) 353,000 Income tax expenses (105,900) Deferred taxes Earnings after taxes (EAT) 247,100 Ohio Fried Chicken (Pty) Ltd. STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20Y5 Figure 12.9: Budgeted income statement for 20Y5 We start-off with the consideration of the sales risk: We assume the revenue is normally distributed. Materials can be adjusted to the demand. However, labour and depreciation stay constant. The standard deviation of the revenue is 20 %. We calculate the probability for over-indebtedness under consideration of an equity of 35,000.00 ZAR - as stated on the balance sheet. In case the revenue and the materials increase by 20 %, the profit after taxes is: (120% × (1,797,000 - 1,086,000) - 88,000 - 25,000 - 245,000) × (1 - 30%) = 3346,640.00 ZAR. In case the revenue decreased by 20 % the profit after taxes equals: (80% × (1,797,000 - 1,086,000) - 88,000 - 25,000 - 245,000) × (1 - 30%) = 1 147,560.00 ZAR. In the case of OHIO FRIED CHICKEN (Pty) Ltd., a normal distributed revenue with adjustments for the materials leads to a normal distributed profit after taxes with the mean 247,100.00 ZAR and the standard deviation of: 346,640.00 - 247,100 = 9 99,540.00 ZAR = 247,100 - 147,560. We transfer the normal distribution to a standard normal distribution. The equation is given below. Here, μ = 247,100.00 ZAR and σ = 99,540.00 ZAR. x x z ) ( (with: z = z-amount, μ = mean, σ = standard deviation) <?page no="239"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 12-239 We want to know the critical profit for over-indebtedness. It is x = -35,000.00 ZAR, where the loss exceeds equity. We calculate the compatible z-value: z(- 35,000) = (-35,000 - 247,100) / 99,540 = -22.83. The table for a standard normal distribution shows for: z = 2.83 a probability of 49.77%. The value on the probability density function is left to the mean. Hence, the probability for the company OHIO FRIED CHICKEN (Pty) Ltd.’s Accounting bankruptcy is: 100% - 50% - 49.77% = 0 0.23%. In the next step, we check what happens if OHIO FRIED CHICKEN (Pty) Ltd. takes more risks. We expect the probability for bankruptcy to increase if more risks are considered. We assume besides of the (1) sales risk, there is a (2) competitor risk and (3) a staff risk. For the competitor risk, we consider is a 30 % probability that a competitor opens a restaurant in Worcester next to the location of OHIO FRIED CHICKEN (Pty) Ltd. The new restaurant causes OHIO FRIED CHICKEN (Pty) Ltd.’s revenue to decrease by 40 %. The staff will adjust the material orders to the lower demand. Another risk OHIO FRIED CHICKEN (Pty) Ltd. faces is the (3) staff risk. We assume a probability of 20 % that staff quits. In that case, we consider an increase of 30 % of labour costs due to training expenses. As there are now 3 risks, we prepare a MonteCarloSimulation to combine the risk effects. The simulation is based on 3 risks which are simulated with 3 random figures. It randomly combines risk effects and calculates a profit for every simulation run. In MS-Excel, an equally distributed random figure is created by the RAND() function. This is used for risk 2 and 3. For risk (1), we need a generator for normal distributed random figures. In our case where the mean is 711,000.00 ZAR and the standard deviation is 142,200.00 ZAR, the function is: NORMINV(RAND(),711000,142200). Risk 1 Revenue - Materials new Rev - Materials Run NORMINV(RAND(),7110 00,142200) Rand() IF(RAND()<0.39,0.6*B17,B17) Rand() IF(RAND()<0.21,1.3*88000,8 8000) 1 876,212.68 0.63 876,212.68 0.00 114,400.00 2 651,029.90 0.91 651,029.90 0.53 88,000.00 3 696,900.57 0.39 418,140.34 0.19 114,400.00 4 897,554.14 0.66 897,554.14 0.99 88,000.00 5 766,368.41 0.29 459,821.05 0.78 88,000.00 6 684,339.36 0.92 684,339.36 0.59 88,000.00 7 668,555.95 0.78 668,555.95 0.18 114,400.00 8 707,504.00 0.89 707,504.00 0.15 114,400.00 9 518,167.23 0.59 518,167.23 0.75 88,000.00 10 795,291.06 0.76 795,291.06 0.83 88,000.00 Risk 2 labour Risk 3 Figure 12.10: Risk simulation (MonteCarloSimulation) <?page no="240"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 12-240 rev-mat labour depr other EBT EAT 876,212.68 -114,000.00 -25,000.00 -245,000.00 492,212.68 344,548.88 651,029.90 -88,000.00 -25,000.00 -245,000.00 293,029.90 205,120.93 418,140.34 -114,000.00 -25,000.00 -245,000.00 34,140.34 23,898.24 897,554.14 -88,000.00 -25,000.00 -245,000.00 539,554.14 377,687.90 459,821.05 -88,000.00 -25,000.00 -245,000.00 101,821.05 71,274.74 684,339.36 -88,000.00 -25,000.00 -245,000.00 326,339.36 228,437.55 668,555.95 -114,000.00 -25,000.00 -245,000.00 284,555.95 199,189.17 707,504.00 -114,000.00 -25,000.00 -245,000.00 323,504.00 226,452.80 518,167.23 -88,000.00 -25,000.00 -245,000.00 160,167.23 112,117.06 795,291.06 -88,000.00 -25,000.00 -245,000.00 437,291.06 306,103.74 Ohio Fried Chicken (Pty) Ltd.'s PROFIT and LOSS SIMULATION RESULTS Figure 12.11: Profit and loss simulation Check the profits of 10 simulation runs in Figure 12.11. The first risk gives us normally distributed revenues. The second risk deducts these revenues based on the competitor risk and risk 3 considers the staff risk. Based on the design of our simulation, the figures are normally distributed with regard to the revenue and materials contribution, and they are ‘disturbed’ by the two other risks. We assume that after an appropriate run of simulations the total profit comes out as normally distributed. For the sake of presentation in this textbook we limit the simulation to 10 runs. In order to manage the distribution, we calculate its mean and standard deviation. The mean is: (344,453.21 + 205,120.93 + 23,898.24 + 377,687.90 + 71,274.74 + 228,437.55 + 199,189.17 + 226,452.80 + 112,117.06 + 306,103.74)/ 10 = 2 209,483.10 ZAR. The standard deviation equals: ((344,453.21 - 209,483.10) 2 + (205,120.93 - 209,483.10) 2 + (23,898.24 - 209,483.10) 2 + (377,687.90 - 209,483.10) 2 + (71,274.74 - 209,483.10) 2 + (228,437.55 - 209,483.10) 2 + (199,189.17 - 209,483.10) 2 + (226,452.80 - 209,483.10) 2 + (112,117.06 - 209,483.10) 2 + (306,103.74 - 209,483.10) 2 )/ 10) 0.5 = 109,392.34 ZAR. Again, we want to know the probability for an over-indebtedness case for OHIO FRIED CHICKEN (Pty) Ltd. Now, we consider 3 risks instead of one: The z-value for the loss of 35,000.00 ZAR now is amounting to: z(-35,000) = (- 35,000 - 209,483.10)/ 109,392.34 = - - 2.23. The table reading gives a probability for z = 2.23 to be 48.71 %. The probability for a bankruptcy due to over-indebtedness is: 1 - 50% - 48.71% = 1 1.29%. As we expected, the probability for bankruptcy increased if we add 2 further risks to the simulation model. The number of 10 simulation runs is not sufficient to prove the accuracy of the simulation. A simulation is considered accurate if its mean approximates the estimated value. <?page no="241"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 12-241 12.15. Summary For the management of a company, we must identify and measure its risks. We introduced the value at risk and a mathematically derived (simulation) probability for bankruptcy. A bankruptcy applies in case of an over-indebtedness or illiquidity. The case study ROCKS PLC shows the bankruptcy situation from the Accounting point of view. The case study WEATHERMAN explained the basics of risk simulation. The case study NAMGURO Ltd. demonstrated the combination of multiple risks with a MonteCarloSimulation approach. We applied the MonteCarloSimulation on the case study OHIO FRIED CHICKEN (Pty) Ltd. as well and applied one risk that gives us a normal distribution whereas the other risks are equally distributed. We demonstrated the calculation of the probability for bankruptcy, too. 12.16. Working Definitions Equal Distribution: An equal distribution is a distribution where every number has the same probability to appear. MonteCarloSimulation: A MonteCarloSimulation is a simulation of risks by which every single risk calculation is based on independent random figures in order to study the effect all single risks have together on a particular item, such as profit or cash flow. Risk: A risk is the outcome an event by which something happens differently as foreseen or expected. Risk Management: Risk Management is about the identification, calculation and controlling of risks taken by shareholders and creditors. Uncertainty: In case a risk cannot be calculated by a probability (unknown probability) it will be referred to as an uncertainty. Value at Risk: The value at risk is the lowest profit that is 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. 12.17. Question Bank (1) A standard normal distribution is a distribution where: 1. The estimate is 0 and the standard deviation is 1. 2. The estimate is 1 and the standard deviation is 0. 3. The mean is 0 and the standard deviation is 1. 4. The mean is 1 and the standard deviation is 0. (2) In Risk Management you get 5 observations: {3; 6; 4; 8; 2}. How much is the standard deviation? 1. 4.60 . 2. 2.15 . 3. 4.64 . 4. 0.96 . (3) A company identified 2 risks: (a) a normal distributed sales risk with a mean of 100,000.00 EUR and a standard deviation of 10,000.00 EUR and (b) a cost risk with a probability of 10 % that cost increase by 20%. The risk-free profit is 100,000 - 50,000 = 50,000.00 EUR. What is the best estimate? <?page no="242"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 12-242 1. 50,000.00 EUR . 2. 39,000.00 EUR . 3. 60,000.00 EUR . 4. 49,000.00 EUR . (4) A standard normal distribution for the profit has a mean of 40,000.00 EUR and a standard deviation of 15,000.00 EUR. How much is the probability of a loss? 1. 49.62% . 2. 0.38% . 3. 50.38% . 4. 1.00% . (5) A value at risk VAR 5% is… 1. … the value that is reached by 5 % of all cases. 2. … the value that is exceeded by a probability of 5%. 3. … the value that is exceeded by a probability of 95%. 4. … the value that is reached by 95 % of all cases. 12.18. Solutions 1-3; 2-2; 3-4; 4-2; 5-3. <?page no="243"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 12-243 Section (3): Cost Accounting <?page no="244"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 13-244 13. Structure of Cost Accounting Systems 13.1. What is in the Chapter? In this chapter we start the section cost Accounting in this textbook. The chapter covers an overview of cost Accounting features and the structure of cost Accounting systems. We explain the steps of cost category Accounting, the allocation of overheads to cost centres and the application of overheads to cost objects. The latter one, together with allocating direct costs to cost objects, is called calculation. We also prepare a profitability analysis which is an internal profit and loss statement. The chapter shows the structure step by step along the cost flow. We follow the case study GIULIO'S PIZZA&PASTA Ristorante. 13.2. Learning Objectives A Management Accounting system is the internal part of Accounting. They provide managers with relevant Accounting information that should match their information needs. In this chapter, you learn about the structure of and the cost flow of and through a cost Accounting system. A cost Accounting system calculates products and the company’s, department’s, division’s or cost centre’s profitability for budgeted and actual costs. After studying this chapter, you can describe the major features of cost Accounting and you can recognise parts of the Management Accounting systems when you see them in a company. You also gain knowledge about the procedures in Management Accounting and understand the features of software solutions for cost Accounting. 13.3. Components of Cost Accounting Systems We distinguish Management Accounting and cost Accounting. Cost Accounting is the part of a Management Accounting systems which enables us to calculate cost objects and determine the profitability of organisational units, mostly cost centres. Cost Accounting is based either on budgeted (future) costs or on actual costs. In the latter case, costs are derived from Financial Accounting. A cost Accounting system is either based on all costs (full cost system as in chapter (13) or on partial costs (marginal cost system as in chapter (14). Other parts or Management Accounting are, e.g., Reporting, Variance Analysis, Business Planning, Strategic Controlling etc. A cost Accounting system contains four major components we focus on in the next following paragraphs: (1) Cost category Accounting. (2) Cost centre Accounting. (3) Calculation. (4) Profitability analysis. See Figure 13.1 to study the cost Accounting components and the links in between. We follow this structure and the cost flow therethrough. <?page no="245"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 13-245 Figure 13.1: Management Accounting system We explain cost Accounting based on the data flow indicated by the thick arrows in Figure 13.1. Our cost Accounting system is absorption costing, meaning we work without Cost separation in this chapter and consider full costs. 46 The expression absorption results from the system taking all costs into consideration. If a cost Accounting system is based on marginal costing, only proportional costs are used to determine cost rates and for calculations. Actual cost Accounting is based on Financial Accounting, meaning on Bookkeeping records. You can see the data link between Financial Accounting and Management Accounting. It is indicated by the arrow from the Financial Accounting box to the Management Accounting box at the top of Figure 13.1. Through this link, expenses/ costs data and revenues are transferred to Management Accounting. The data transfer itself is no cost Accounting step. The data do not flow from one system into the next one. Technically, there are two Accounting systems which are based on the same data base. Once the Accountant makes a Bookkeeping entry for, e.g., rent in an integrated Accounting system, the debit entry is available for cost Accounting instantly. If the Bookkeeping entry is… DR Rent......................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR 46 In the next chapter (14) we apply marginal costing. <?page no="246"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 13-246 … its debit entry (rent) is used for cost Accounting. 47 The cash/ bank item is of minor interest as the real accounts do not matter for cost rates and calculations. For teaching purpose, we think of data flows which originate in Financial Accounting and flow into the cost Accounting system. Therefore, we describe a cost Accounting system with its components and data flowing from one box into the next one. Revenues are transferred to Management Accounting too. In the box for the Financial Accounting system, you see a reference to the general ledger. This means, subordinated accounts, like data from the purchase ledger, do not matter for cost Accounting. Below, we discuss the components as disclosed in Figure 13.1. 13.4. Cost Category Accounting The first box is cost category Accounting. A cost category is a certain group of costs with the same purpose, such as rent. The inputs for the cost category Accounting are expenses which are assumed to be congruent to costs (we assume all costs are expenses and vice versa). The output of cost category Accounting are various cost categories divided in direct costs and overheads (indirect costs). In cost category Accounting, expenses are checked regarding their cost relevance (which is fulfilled following our conventions) and divided in direct costs to be assigned to cost objects) and overheads (allocated to cost centres). The classification depends on their link to prod- 47 In this textbook congruence of cost and expenses applies by default. ucts (= goods/ services). Costs for single products are direct costs, costs that apply for more than one product are overheads. Overheads require cost allocations whereas direct costs are assigned straight to goods or services. In a marginal cost Accounting system, the Cost separation also takes place in cost category Accounting. Next, we follow the cost flow of overheads which goes into cost centre Accounting. The other cost flow of direct costs towards calculation is discussed under in the next following paragraph. 13.5. Cost Centre Accounting To support best efficient control a company is divided into organisational units. Management Accounting uses cost centres. Often, companies run a few hundred cost centres. A cost centre is an organisational unit within a company, with a manager taking cost responsibility. Preferably, only one reference unit per cost centre applies. This means that all costs depend on that reference unit. We assign costs directly to cost centres. Directly refers to an assignment without allocations. E.g., room costs can easily be assigned to a building where only one cost centre is located in. If the building hosts more than one cost centre the building costs must be split, e.g., based on the cost centres’ square metres for cost allocation. Cost centre Accounting covers all steps that takes place inside of a cost centre. It is required to completely allocate overheads from cost categories to cost centres and to calculate the cost rates which is the total costs divided by <?page no="247"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 13-247 the reference unit, e.g., costs per machine hour. If actual and budgeted cost data are available in a cost centre, its costs can be monitored by comparison of budgeted to actual costs. This is covered in chapter (15) in this textbook. Cost Monitoring calculates cost variances and reports them to the cost centre managers (efficiency report). See chapter (17) for Reporting. An efficiency report shows where and how much the actual costs deviate from budget. Cost deviations indicate inefficient operations. Next, we cover cost rates: Cost centre Accounting determines the cost rates for the overhead application and calculation. For the calculation of cost centre rates, the total of the cost centre overheads is divided by its output measured in reference units, e.g., machine hours, volume, KWh etc. A cost rate tells us how much costs are spent for one reference unit’s amount of output. Cost rates are frequently calculated based on budgeted costs, which we refer to as predetermined overhead allocation rates POR. Cost rates apply for the allocation of overheads to products. The application of overheads reflects the portion of a cost centres performance which is consumed by the cost object (product/ service). We could say, the product “pays” for the service received in the cost centre. We measure the service received in a cost centre by the reference unit. The reason to determine cost allocations by PORs is that at the time of calculation actual cost rates do not yet exist. As cost centres also can mutually support each other the cost rate calculation requires internal cost allocations. Internal cost allocation means that a receiving cost centre covers the costs of the provider proportionate to the service consumed. Internal cost allocations are measured by reference units, too. In cost Accounting, internal cost allocations are calculated at first and then we determine the cost rates for the product/ service calculation. For now, we skip internal cost allocations as we dedicated the whole chapter (16) thereto. Note the cost centres displayed in Figure 13.1 and the arrows between them. They represent internal cost allocations. The arrow down from the cost centre Accounting box to calculation represents the cost rates for overhead application. If the overhead application is at full costs (absorption costing as in chapter (13)) the arrow from the cost centres to the profitability analysis is only for overor under-applied overheads. In contrast, if a marginal costing applies, only proportional cost rates are calculated, and the fixed costs are transferred to the profitability analysis. This is what is discussed in chapter (14). An overor underapplication of overheads occurs if the cost centre allocates too many or not all overheads to products/ services. The difference is then allocated to the profitability analysis. 13.6. Calculation A calculation determines the unit costs per product (good manufactured or services rendered). Unit costs contain <?page no="248"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 13-248 direct costs, like direct labour or materials. The quantities are derived from the bill of materials and routings. Unit costs further contain portions of applied overheads. The overhead application is determined by multiplying the cost centre rates with a performance received in the cost centre (usage factor). E.g., if the Volkswagen Golf dashboard assembly cost rate is 150.00 EUR/ h and the assembling time for one dashboard is 10 min., the overheads allocated to the product are: 10 × 150/ 60 = 25.00 EUR/ VW-Golf. The sum direct costs and overhead allocations gives the cost of the product/ service. In most of the cases, a company does not manufacture one product but defines a job order which is for more products. In this case we must divide the total costs of a job order by its lot size to calculate the unit costs per product. 13.7. Profitability Analysis The last step in cost Accounting is the profitability analysis, which is very close to the profit and loss calculation in Financial Accounting. We calculate the profit of the company or of portions thereof (cost centre) by deducting costs from revenues. The outcome is the profit/ loss. The profitability analysis can be structured based on the nature of expense method or the cost of sales format. In contrast to Financial Accounting, expenses for taxation and Finance, like interest, are less important for Management Accounting. In Management Accountants we only calculate ‘down to’ the earnings before taxes EBT or even stop at earnings before interest and taxes EBIT. If we apply the cost of sales format, the result of the profitability analysis are single product margins and absolute profit. Single product margins are useful for making product mix decisions. 13.8. C/ S GIULIO'S PIZZA&PASTA RISTORANTE Below, we study cost Accounting with a case study about an Italian Restaurant, GIULIO'S PIZZA&PASTA RISTORANTE in Milano. As in cost Accounting taxes do not matter, the legal form of the restaurant is irrelevant and omitted for this case study. For the sake of simplification, assume the restaurant is in private ownership. We discuss a cost Accounting system in detail following the 4 boxes as disclosed in Figure 13.1. In this chapter we assume the restaurant applies an absorption costing. In the next chapter (14) we repeat the entire case study for marginal costing. Here comes the cost Accounting on full cost basis: Data Sheet for GIULIO'S PIZZA&PASTA RISTORANTE CClassification: Hospitality Management; 3 dishes: pizza, lasagne, cannelloni, wine; Quantities: 50,000 pizza / 20,000 lasagnes / 10,000 cannelloni / 12,000 wines served by the glass; Net selling prices: 9.00 EUR / 8.00 EUR / 8.00 EUR / 5.00 EUR; Unit costs: 5.52 EUR/ pizza / 4.86 EUR/ lasagne / 4.53 EUR/ cannelloni / 2.69 EUR/ wine; 3 cost centres: Kitchen, Restaurant, Delivery; Cost centre costs: 64,960.00 EUR / 63,600.00 EUR / 29,000.00 EUR; <?page no="249"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 13-249 VVAT ignored. GIULIO'S PIZZA&PASTA RISTORANTE bakes pizza and different pasta dishes, such as lasagne and cannelloni. All dishes can be consumed in the restaurant or are delivered by GIULIO'S PIZZA&PASTA RISTORANTE’s takeaway-service. GIULIO'S PIZZA&PASTA RISTORANTE’s dishes are tuna pizza, lasagne and cannelloni. The restaurant buys the pizza dough from a supplier. The same applies for lasagne and cannelloni noodles. The ingredients for the dishes are given by Figure 13.2, which we refer to as the “bill of materials”. It represents the material requirements per product (dish). Bill of materials BOM is a technical term from Industrial Management. As Managerial Accounting originates mostly from production firms, many expressions sound like factory language. We do not want to limit Accounting to certain industries and follow the common technical Accounting terms. For that reason, we call a pizza recipe a bill of materials BOM for pizza. Item Amount Purchase price/ u dough 150 g 0.80 tomato sauce 40 g 0.25/ 10g tuner 75 g 2.00/ 100g cheese 3 slices 0.20/ slice Item Amount Purchase price/ u lasagne noodles 100 g 0.50/ 100g tomato sauce 50 g 0.25/ 10g minced meat 80 g 1.00/ 100g cheese 5 slices 0.20/ slice Item Amount Purchase price/ u cannelloni noodles 100 g 0.50/ 100g cream sauce 50 g 0.20/ 10g cooked ham 60 g 1.20/ 100g cheese 5 slices 0.20/ slice Tuna Pizza BILL OF MATERIALS Lasagne BILL OF MATERIALS Cannelloni BILL OF MATERIALS Figure 13.2: GIULIO'S PIZZA&PASTA Ristorante’s BOM Besides the dishes, GIULIO'S PIZZA&PASTA RISTORANTE offers a Chianti wine served by the glass. The purchase price per 750 ml bottle is 6.00 EUR/ u. <?page no="250"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 13-250 Next to direct materials, GIULIO'S PIZZA&PASTA RISTORANTE records overheads. They are not linked to pizza, pasta dishes or wines. Overheads are indirect costs which cannot be traced to a certain product or service. At GIULIO'S PIZZA&PASTA RISTORANTE, overheads are the salary for the chef at 4,000.00 EUR/ m, the salary for the order manager/ waiter at 2,800.00 EUR/ m, the salary for the delivery driver at 9.00 EUR/ h and depreciation on the restaurant interior, which contains the kitchen appliances (oven) and the depreciation on the delivery car. The acquisition of the oven (for pizza and pasta dishes) is at 24,000.00 EUR and the entire restaurant interior costs 18,000.00 EUR. Both assets are depreciated following straight-line method over 6 years. The delivery vehicle is a pre-owned Fiat bought at 8,000.00 EUR. It is depreciated over the next four years based on straight-line method. The Fiat’s operational costs are 1,000.00 EUR/ m. These costs cover petrol, maintenance and tear & wear parts. Rental costs for the restaurant including water/ electricity supply are amounting to 3,000.00 EUR/ m. For Management Accounting, we ignore VAT. Hence, all costs are net amounts. In cost Accounting, the budgeting procedures starts with the performance planning. This is also called reverse budgeting. Consider the profitability analysis box in Figure 13.1 as starting point. This means we start the planning of costs from the number of pizza and pasta dishes. The performance planning determines the quantities of pizza, lasagne, cannelloni and wines to be sold during the next year. GIULIO’S PIZZA&PASTA RISTORANTE plans 50,000 pizza/ a, 20,000 lasagne/ a and 10,000 cannelloni/ a. Furthermore, GIULIO’S PIZZA&PASTA RISTORANTE estimates to sell wines to the amount of 4,000 bottles/ a of Chianti wine in the restaurant (served by the glass). The delivery service is planned to transport 20,000 dishes per annum. A food delivery takes on average 5 min. All figures come from Marketing Research. Next, we plan costs, beginning with direct costs. Direct costs are materials/ ingredients. No direct labour applies because the chef at GIULIO'S PIZZA&PASTA RISTORANTE prepares all dishes, and his salary is overheads. The calculation of materials is based on the bill of materials and the planned output of dishes and wines. <?page no="251"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 13-251 50,000 Tuna Pizza BILL OF MATERIALS Item Purchase price/ u Total costs dough 150 g 0.80/ 150g 40,000.00 tomato sauce 40 g 0.25/ 10g 50,000.00 tuner 75 g 2.00/ 100g 75,000.00 cheese 3 slices 0.20/ slice 30,000.00 195,000.00 20,000 Lasagne BILL OF MATERIALS Item Purchase price/ u Total costs lasagne noodles 100 g 0.50/ 100g 10,000.00 tomato sauce 50 g 0.25/ 10g 25,000.00 minced meat 80 g 1.00/ 100g 16,000.00 cheese 5 slices 0.20/ slice 20,000.00 71,000.00 10,000 Cannelloni Bill OF MATERIALS Item Purchase price/ u Total costs cannelloni noodles 100 g 0.50/ 100g 5,000.00 cream sauce 50 g 0.20/ 10g 10,000.00 cooked ham 60 g 1.20/ 100g 7,200.00 cheese 5 slices 0.20/ slice 10,000.00 32,200.00 Amount Amount Amount Figure 13.3: GIULIO’S PIZZA&PASTA RISTORANTE’s direct costs based on products 13.9. Cost Category Accounting - C/ S In total, direct materials per annum are amounting to: (1) Dough: 40,000.00 EUR/ a. (2) Tomato sauce: 50,000 + 25,000 = 75,000.00 EUR/ a. (3) Tuner fish: 75,000.00 EUR/ a. (4) Cheese: 30,000 + 20,000 + 10,000 = 60,000.00 EUR/ a. (5) Lasagne noodles: 10,000.00 EUR/ a. (6) Minced: 16,000.00 EUR/ a. (7) Cannelloni noodles: 5,000.00 EUR/ a. (8) Cream sauce: 10,000.00 EUR/ a. (9) Cooked ham: 7,200.00 EUR/ a. Besides the dishes, Chianti wine is a direct cost, too. (10) Chianti wine: 6 × 4,000 = 2 24,000.00 EUR/ a. The total of direct materials for one year is amounting to: 40,000 + 75,000 + 75,000 + 60,000 + 10,000 + 16,000 + 5,000 + 10,000 + 7,200 + 24,000 = 322,200.00 EUR/ a. Next, we plan overheads for GIULIO'S PIZZA&PASTA RISTORANTE. There are indirect materials which we allocate based on percentages, like olive oil and dishwasher liquid (overheads). They are amounting to: 1,440 l olive oil at 2.50 EUR/ l which gives: 1,440 × 2.50 = 3,600.00 EUR/ a and 720 l dishwasher liquid at 0.50 EUR/ l, which results in: 720 × 0.50 = 3 360.00 EUR/ a. <?page no="252"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 13-252 All further costs at GIULIO’S PIZZA&PASTA RISTORANTE are classified as overheads too. They are the salaries and depreciation. In total, GIULIO'S PIZZA&PASTA RISTORANTE’s overheads are as below: (a) Olive oil: 3,600.00 EUR/ a. (b) Dishwasher liquid: 360.00 EUR/ a. (c) Chef’s salary: 4,000 × 12 = 4 48,000.00 EUR/ a. (d) Order manager’s/ waiter’s salary: 2,800 × 12 = 3 33,600.00 EUR/ a. (e) Driver’s salary: 20,000 × (5/ 60) x 9 = 15,000.00 EUR/ a. (f) Depreciation on the stove: 24,000/ 6 = 4 4,000.00 EUR/ a. (g) Depreciation on the restaurant interior: 18,000/ 6 = 3 3,000.00 EUR/ a. (h) Depreciation on the delivery-car: 8,000/ 4 = 2 2,000.00 EUR/ a. (i) Operating costs for the delivery-car: 1,000 × 12 = 1 12,000.00 EUR/ a. (j) Rent for the whole restaurant: 3,000 × 12 = 3 36,000.00 EUR/ a. The overheads add up to: 3,600 + 360 + 48,000 + 33,600 + 15,000 + 4,000 + 3,000 + 2,000 + 12,000 + 36,000 = 157,560.00 EUR/ a. After cost category Accounting, the cost Accounting system shows costs as depicted in Figure 13.4. Check the cost category Accounting box. Figure 13.4: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (1) 13.10. Calculation - C/ S A calculation comprises of two steps: direct cost assignments and allocating overheads. Direct costs are assigned straight to the products, which are pizza, lasagne, cannelloni and the Chianti wines. <?page no="253"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 13-253 Direct costs are assigned to the products as indicated by Figure 13.3. In contrast to the annual material requirements, we now calculate unit costs. Unit costs are costs based on one unit of the product. Additionally, there are direct costs for the Chianti wine. Observe the direct costs in Figure 13.5. 1 Tuna Pizza DIRECT COSTS Item Purchase price/ u Unit costs dough 150 g 0.80/ 150g 0.80 tomato sauce 40 g 0.25/ 10g 1.00 tuner 75 g 2.00/ 100g 1.50 cheese 3 slices 0.20/ slice 0.60 3.90 1 Lasagne DIRECT COSTS Item Purchase price/ u Unit costs lasagne noodles 100 g 0.50/ 100g 0.50 tomato sauce 50 g 0.25/ 10g 1.25 minced meat 80 g 1.00/ 100g 0.80 cheese 5 slices 0.20/ slice 1.00 3.55 1 Cannelloni DIRECT COSTS Item Purchase price/ u Unit costs cannelloni noodles 100 g 0.50/ 100g 0.50 cream sauce 50 g 0.20/ 10g 1.00 cooked ham 60 g 1.20/ 100g 0.72 cheese 5 slices 0.20/ slice 1.00 3.22 1 Wine by the Glass DIRECT COSTS Item Purchase price/ u Unit costs wine 0.25 ml 6/ 0.75ml 2.00 2.00 Amount Amount Amount Amount Figure 13.5: GIULIO’S PIZZA&PASTA RISTORANTE’s direct costs Cost Centre Accounting - C/ S For budgeting and actual Cost Centre costing, GIULIO’S PIZZA&PASTA RISTORANTE divides the company into 3 cost centres. There is the Kitchen, the Restaurant/ Order Management and the Delivery department. GIULIO’S PIZZA&PASTA RISTORANTE calculates overheads per cost centre and thereafter determines its cost rates. The cost rate is calculated by dividing annual costs by the annual performance measured by reference units. Below, we analyse the three cost centres: Kitchen In the Kitchen, the overheads are: (a) Olive oil: 3,600.00 EUR/ a. (b) Dishwasher liquid: 360.00 EUR/ a. <?page no="254"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 13-254 (c) Chef’s salary: 4,000 × 12 = 4 48,000.00 EUR/ a. (f) Depreciation on the stove: 24000/ 6 = 4,000.00 EUR/ a. (j) Rent for the whole restaurant: 3,000 × 12 = 3 36,000.00 EUR/ a. The rent is apportioned over the cost centres based on the floor area. The Kitchen area is 20 m 2 and the Restaurant/ Order Management area is 60 m 2 . Accordingly, 25% of the rent is allocated to the Kitchen, which equals: 0.25 × 36,000 = 9 9,000.00 EUR/ a. The total annual Kitchen-overheads are: 3,600 + 360 + 48,000 + 4,000 + 9,000 = 64,960.00 EUR/ a. Restaurant/ Order Management In the Restaurant/ Order Management department, the overheads are: (d) Order manager/ waiter’s salary: 2,800 × 12 = 3 33,600.00 EUR/ a. (g) Depreciation on the restaurant interior: 18,000/ 6 = 3 3,000.00 EUR/ a. (j) Rent for the entire restaurant: 3,000 × 12 = 336,000.00 EUR/ a. The rent is divided based on the restaurant area relationship. The Restaurant/ Order Management covers 75 % of the rent: 75% × 36,000 = 2 27,000.00 EUR/ a. The total of overheads in the Restaurant/ Order Management equals: 33,600 + 3,000 + 27,000 = 63,600.00 EUR/ a. Delivery In the Delivery department, the overheads are: (e) Driver’s salary, based on 20,000 tours with a duration of 5 minutes and an hourly salary of 9.00 EUR/ h: 20,000 × (5/ 60) × 9 = 1 15,000.00 EUR/ a. (h) Depreciation on the delivery-car: 8,000 / 4 = 2 2,000.00 EUR/ a. (i) Operational costs for the delivery-car: 1,000 × 12 = 1 12,000.00 EUR/ a. The total Delivery overheads add up to: 15,000 + 2,000 + 12,000 = 2 29,000.00 EUR/ a. The costs are allocated to cost objects in Figure 13.6: Check the cost centre Accounting and calculation box. <?page no="255"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 13-255 Figure 13.6: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (2) Next, we calculate cost rates. The cost rate is costs of a cost centre divided by its output related reference unit. The reference unit in the Kitchen is preparation time, measured in minutes. We assume, it takes 3 min to prepare a pizza, and it takes 2 min each to make lasagne or cannelloni. In GIULIO’S PIZZA&PASTA RISTORANTE, the total preparation time is: 3 × 50,000 + 2 × (20,000 + 10,000) = 2 210,000 min (= 3,500 h). The cost rate in the Kitchen is: 64,960 / 3,500 = 1 18.56 EUR/ h = 0.31 EUR/ min. The rates are rounded therefore, we stick to the cost rate measured in EUR/ h for further calculations. The reference unit in the Restaurant/ Order Management is the number of dishes served. This includes wines served at the tables, too. The total amount is: 50,000 + 20,000 + 10,000 + 3 × 4,000 = 92,000 dishes+wines. The cost rate equals: 63,600 / 92,000 = 0 0.69 EUR/ dishes+wines. Costs in the Delivery department do not depend on the output. They are considered fixed costs. The costs are stand-by costs and are not allocated to products. After the cost rate calculations and determination of fixed costs, GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system design contains the values for costs and cost rates as indicated by Figure 13.7. Check the cost centre Accounting and calculation box. <?page no="256"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 13-256 Figure 13.7: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (3) 13.11. Calculation - C/ S The next step completes the calculation. 48 Although materials are direct costs, some materials, e.g., cheese, are used for more than one dish. Those material costs must be divided. In order to debit the direct costs for (2) tomato sauce and for (4) cheese, the Accountant makes the Bookkeeping entries below: DR WIP Pizza.................... 50,000.00 EUR DR WIP Lasagne.................. 25,000.00 EUR CR Purchase (2) ................ 75,000.00 EUR DR WIP Pizza.................... 30,000.00 EUR DR WIP Lasagne.................. 20,000.00 EUR DR WIP Cannelloni............... 10,000.00 EUR CR Purchase (4)................. 60,000.00 EUR We do not consider these Bookkeeping entries as cost allocations, as we follow the BOM for assignments. The technical term is “tracing costs to objects”. Cost tracing is the assignment to Work-in-Process accounts without calculation. Cost tracing applies for direct costs only. 48 In the accounts numbers (1) … (10) refer to items in the text. <?page no="257"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 13-257 D C D C (1) 40,000.00 (5) 10,000.00 (2) 50,000.00 (2) 25,000.00 (3) 75,000.00 (6) 16,000.00 (4) 30,000.00 c/ d 195,000.00 (4) 20,000.00 c/ d 71,000.00 195,000.00 195,000.00 71,000.00 71,000.00 b/ d 195,000.00 b/ d 71,000.00 D C D C (7) 5,000.00 (10) 24,000.00 c/ d 24,000.00 (8) 10,000.00 b/ d 24,000.00 (9) 7,200.00 (4) 10,000.00 c/ d 32,200.00 32,200.00 32,200.00 b/ d 32,300.00 WIP cannelloni WIP chianti WIP pizza WIP lasagne Figure 13.8: GIULIO’S PIZZA&PASTA RISTORANTE’s manufacturing accounts (1) For overheads allocation we prepare cost centre accounts. Every MOHaccount represents one cost centre. In GIULIO’S PIZZA&PASTA RISTORANTE, there are three cost centres. We make debit entries for the overheads (a) … (i). Only the last one (j) rent, requires allocations (based on square metres) and is recorded later. D C D C (a) 3,600.00 (d) 33,600.00 (b) 360.00 (g) 3,000.00 (c) 48,000.00 (f) 4,000.00 D C (e) 15,000.00 (h) 2,000.00 (i) 12,000.00 MOH kitchen MOH restaurant/ order management MOH delivery Figure 13.9: GIULIO’S PIZZA&PASTA RISTORANTE’s manufacturing accounts (2) (j) Rent requires a cost-split to allocate overheads to the cost centres Kitchen and Restaurant/ Order Management. The ratio is given by the cost centre floor areas in square metres. The cost allocation for (j) rent leads to the Bookkeeping entry below: <?page no="258"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 13-258 DR WIP Kitchen.................. 9,000.00 EUR DR WIP Restaurant/ OM............ 27,000.00 EUR CR Rent......................... 36,000.00 EUR D C D C (a) 3,600.00 (d) 33,600.00 (b) 360.00 (g) 3,000.00 (c) 48,000.00 (j) 27,000.00 c/ d 63,600.00 (f) 4,000.00 63,600.00 63,600.00 (j) 9,000.00 c/ d 64,960.00 b/ d 63,600.00 64,960.00 64,960.00 b/ d 64,960.00 D C D C (e) 15,000.00 (j) 36,000.00 (j) 9,000.00 (h) 2,000.00 (j) 27,000.00 (i) 12,000.00 c/ d 29,000.00 36,000.00 36,000.00 29,000.00 29,000.00 b/ d 29,000.00 MOH delivery Rent MOH kitchen MOH restaurant/ order management Figure 13.10: GIULIO’S PIZZA&PASTA RISTORANTE’s manufacturing accounts (3) The balancing figures in the accounts disclosed in Figure 13.10 equal to the costs shown in the calculation box and cost centre Accounting box in Figure 13.7. Next, we discuss the overhead application to products. Pizza The overhead application is based on the cost rates calculated above. The WIP Pizza account receives: 3 × 50,000 × 18.56 × (1/ 60) = 4 46,400.00 EUR from the Kitchen. Furthermore, it receives: 50,000 × 0.69 = 3 34,500.00 EUR from the Restaurant/ Order Management. The Bookkeeping entries are: DR WIP Pizza.................... 46,400.00 EUR CR MOH Kitchen.................. 46,400.00 EUR DR WIP Pizza.................... 34,500.00 EUR CR MOH Restaurant/ OM............ 34,500.00 EUR The unit costs per pizza equal: (195,000 + 46,400 + 34,500) / 50,000 = 5 5.51 800 EUR/ pizza. To avoid high rounding differences, we calculate in 5 digits after the decimal point. <?page no="259"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 13-259 Lasagne The WIP Lasagne account receives: 2 × 20,000 × 18.56 × (1/ 60) = 1 12,373.33 EUR from the Kitchen. Furthermore, it receives: 20,000 × 0.69 = 1 13,800.00 EUR from the Restaurant/ Order Management. The Bookkeeping entries are: DR WIP Lasagne .................. 12,373.33 EUR CR MOH Kitchen .................. 12,373.33 EUR DR WIP Lasagne .................. 13,800.00 EUR CR MOH Restaurant/ OM ............ 13,800.00 EUR The unit costs per lasagne are: (71,000 + 12,373.33 + 13,800) / 20,000 = 4 4.85 867 EUR/ lasagne. Cannelloni The WIP Cannelloni account receives: 2 × 10,000 × 18.56 × (1/ 60) = 6 6,186.67 EUR from the Kitchen. Furthermore, it receives: 10,000 × 0.69 = 6 6,900.00 EUR from the Restaurant/ Order Management. The Bookkeeping entries are: DR WIP Cannelloni............... 6,186.67 EUR CR MOH Kitchen .................. 6,186.67 EUR DR WIP Cannelloni............... 6,900.00 EUR CR MOH Restaurant/ OM ............ 6,900.00 EUR The unit costs per cannelloni equal: (32,200 + 6,186.67 + 6,900) / 10,000 = 4.52 867 EUR/ cannelloni. Chianti The WIP Chianti account receives: 3 × 4,000 × 0.69 = 8 8,280.00 EUR from the Restaurant/ Order Management. The Bookkeeping entry is: DR WIP Chianti.................. 8,280.00 EUR CR MOH Restaurant/ OM ............ 8,280.00 EUR The unit costs per Chianti wine are: (24,000 + 8,280) / 12,000 = 2 2.69 EUR/ Chianti. Check GIULIO’S PIZZA&PASTA RISTORANTE’s accounts in Figure 13.11: <?page no="260"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 13-260 D C D C (1) 40,000.00 (5) 10,000.00 (2) 50,000.00 (2) 25,000.00 (3) 75,000.00 (6) 16,000.00 (4) 30,000.00 c/ d 195,000.00 (4) 20,000.00 c/ d 71,000.00 195,000.00 195,000.00 71,000.00 71,000.00 b/ d 195,000.00 b/ d 71,000.00 Kit 46,400.00 Kit 12,373.33 R/ O 34,500.00 c/ d 275,900.00 R/ O 13,800.00 c/ d 97,173.33 275,900.00 275,900.00 97,173.33 97,173.33 b/ d 275,900.00 b/ d 97,173.33 D C D C (7) 5,000.00 (10) 24,000.00 c/ d 24,000.00 (8) 10,000.00 b/ d 24,000.00 (9) 7,200.00 R/ O 8,280.00 c/ d 32,280.00 (4) 10,000.00 c/ d 32,200.00 32,280.00 32,280.00 32,200.00 32,200.00 b/ d 32,280.00 b/ d 32,200.00 Kit 6,186.67 R/ O 6,900.00 c/ d 45,286.67 45,286.67 45,286.67 b/ d 45,286.67 WIP cannelloni WIP chianti WIP pizza WIP lasagne D C D C (a) 3,600.00 (d) 33,600.00 (b) 360.00 (g) 3,000.00 (c) 48,000.00 (j) 27,000.00 c/ d 63,600.00 (f) 4,000.00 63,600.00 63,600.00 (j) 9,000.00 c/ d 64,960.00 b/ d 63,600.00 Pzz 34,500.00 64,960.00 64,960.00 Lsg 13,800.00 b/ d 64,960.00 Pzz 46,400.00 Cnl 6,900.00 Lsg 12,373.33 Chi 8,280.00 Cnl 6,186.67 c/ d 120.00 64,960.00 64,960.00 63,600.00 63,600.00 b/ d 120.00 D C D C (e) 15,000.00 (j) 36,000.00 (j) 9,000.00 (h) 2,000.00 (j) 27,000.00 (i) 12,000.00 c/ d 29,000.00 36,000.00 36,000.00 29,000.00 29,000.00 b/ d 29,000.00 MOH kitchen MOH restaurant/ order management MOH delivery Rent Figure 13.11: GIULIO’S PIZZA&PASTA RISTORANTE’s manufacturing accounts (4) After the calculation of dishes and wine, the Management Accounting system <?page no="261"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 13-261 discloses the values as depicted in Figure 13.12. Check the cost centre Accounting and calculation box. Figure 13.12: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (4) 13.12. Profitability Analysis - C/ S The last step in cost Accounting is the profit calculation. GIULIO’S PIZZA&PASTA RISTORANTE sells a pizza at 9.00 EUR/ u and lasagne and cannelloni at 8.00 EUR/ u each. A glass of wine costs 5.00 EUR/ u. Based on the budget, the revenue for GIULIO’S PIZZA&PASTA RISTORANTE is: 50,000 × 9 + 20,000 × 8 + 10,000 × 8 + 12,000 × 5 = 7 750,000.00 EUR/ a. The calculation of profit is based on the cost of sales format. 49 A cost of sales format considers the cost of manufacturing allocated to the 49 Read our textbook Basics of Accounting, chapter (28). sold goods/ services. The costs of sales are deducted from revenues to calculate the margin (as the cost of sales contain fixed costs this is no contribution margin). Further down in the calculation procedure, non-manufacturing costs are deducted. The margin is referred to as the gross profit, but this mostly applies for trading companies. 50 GIULIO’S PIZZA&PASTA RISTORANTE calculates a gross profit of 750,000.00 EUR less cost of sales. The costs of sales contain materials and allocated overheads which amount to: 275,900 + 50 Read our textbook Financial Statements, chapter (4). <?page no="262"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 13-262 97,173.33 + 45,286.67 + 32,280 = 4450,640.00 EUR/ a. The value is taken from the WIPaccounts and does not contain rounding differences. The margins - or the gross profits equal: 750,000 - 450,640 = 2 299,360.00 EUR. 51 Check the calculation and profitability analysis box in GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system in Figure 13.13: Figure 13.13: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (5) The rounding difference from the Restaurant/ Order Management cost centre is added to non-manufacturing costs. This means the total of non-manufacturing costs is: 29,000 + 120 = 2 29,120.00 EUR/ a. 52 51 In case we calculate based on unit costs, rounding differences will become a serious problem: Rates are multiplied by high quantities of dishes/ wines. For the unit cost calculation, rounding differences in the Kitchen and Restaurant/ Order Management are not considered, and remain in the cost centres. 750,000 - 5.51 800 × 50,000 - 4.85 867 × 20,000 - 4.52 867 × 10,000 - 2.69 000 × 12,000 - 29,000 = 750,000 - 450,640.10 - 29,000 = 270,359.90 EUR. In order to compare the result, deduct the remaining costs of the cost centre: 270,359.90 - 120 = 270,239.90 EUR. However, 0.10 EUR rounding difference stays due to calculations. 52 In order cross-check the calculations, we add the costs at different states of calculation: 450,640 + 29,120 = 450,640 + 29,000 + 120 = 64,960 + 63,600 + 29,000 + 195,000 + 71,000 + 32,200 + 24,000 = 322,200 + 157,560 = 479,760.00 EUR. This proves the totals of costs do not change. <?page no="263"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 13-263 How it is Done (Cost Accounting) (1) Copy expenses from the Financial Accounting system to the Management Accounting system. (2) Check expenses for cost characteristics. Check further whether costs apply that do not fall under expenses. In the latter case add them to costs as calculated costs. (3) Transfer the direct costs to products’/ job orders’ WIP-accounts (4) Add manufacturing-related overheads to the cost centre accounts. Divide costs in case they apply for more than one cost centre, based on the rule of three following the characteristics of cost centres, like square metres, machine values, head count etc. (5) Run a Cost separation for a marginal cost Accounting system. For absorption cost Accounting skip step (5) and proceed to step (6). (6) In case of non-manufacturing overheads, such as Marketing and Distribution costs, add them to common (non-production-linked) cost centre accounts that are closed-off to the profitability analysis later. (7) In case of (mutually) cost centre support run a cost allocation as in chapter (16) of this textbook. (8) Calculate cost rates by dividing (final) costs of cost centres by their output. (9) Apply overheads based on cost rates and utilisation factors. Add them to the WIP-accounts. (10) Divide the total of costs of job orders/ goods/ services by the lot size for the unit costs of manufacturing. (11) Transfer revenues from Financial Accounting to Management Accounting. Close-off the Revenue account to the Profit 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 run step (11), (12) for single products or product groups. 13.13. Summary A Management Accounting system receives costs from the Financial Accounting system and divides them in direct costs and overheads. The direct costs are assigned to goods/ services whereas overheads are allocated to cost centres. In the cost centre, cost rates are determined for calculation. The unit costs of a product/ service contain direct costs plus portions of overheads. The latter ones are allocated based on the cost centre cost <?page no="264"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 13-264 rates. The profitability analysis calculates the net operating profit for the business. 13.14. Working Definitions 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 calculation. 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. 13.15. Question Bank (1) In an absorption cost Accounting system, the arrow from cost centre Accounting to calculation represents… 1. … proportional cost rates. 2. … full cost rates. 3. … applied overheads based on proportional costs. 4. … applied overheads based on full costs. (2) In an absorption cost Accounting system, a cost centre plans 5,000.00 EUR/ m labour costs. Depreciation is 1,000.00 EUR/ m. The cost centres output is planned to be 100 units. The cost centre records an output of 110 units. How much are applied overheads? 1. 6,500.00 EUR . 2. 6,600.00 EUR . 3. 6,000.00 EUR . 4. 5,000.00 EUR . (3) In Managerial Accounting … 1. … proportional overheads are assigned to the profitability analysis and fixed overheads are assigned to products. 2. … direct costs and overheads are allocated to the profitability analysis. 3. … direct costs are assigned to cost centres and overheads are allocated to products 4. … direct costs are assigned to products and overheads are allocated to cost centres. (4) A company records 26,000.00 EUR labour costs in cost centres, 10,000.00 EUR depreciation and 45,000.00 EUR materials. The planned output is 1,000 units and the actual output is 900 units. The revenue per unit is amounting to 150.00 EUR/ u. How much is the profit per unit if an absorption costing applies? 1. 60.00 EUR/ u . 2. 65.00 EUR/ u . 3. 69.00 EUR/ u . 4. 64.00 EUR/ u . (5) In a production firm, the predetermined overhead allocation rate is 5,500 EUR/ 100 h and based on an absorption costing. The actual overheads are amounting to 5,800.00 EUR and the output is 95 h. Which statement is correct? 1. There are over-applied overheads of 575.00 EUR. 2. There are under-applied overheads of 575.00 EUR. <?page no="265"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 13-265 3. There are over-applied overheads of 275.00 EUR. 4. There are under-applied overheads of 275.00 EUR. 13.16. Solutions 1-4; 2-2; 3-4; 4-1; 5-2. <?page no="266"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 14-266 14. Flexible Budgeting / Marginal Cost Accounting 14.1. What is in the Chapter? In this chapter, we cover the same case study of GIULIO'S PIZZA&PASTA Ristorante, but it is now based on a cost Accounting system with costs divided in proportional and fixed costs. We introduce a marginal cost Accounting system that starts with a cost separation and only uses proportional overheads for the calculation cost rates. All fixed costs are then allocated to profit or loss. You can study the differences by comparing cost calculations and the profitability analysis in chapter (14) to the previous ones in chapter (13). The ones in this chapter follow a flexible budget, the previous ones follow absorption costing. 14.2. Learning Objectives Here, you learn flexible budgeting. After studying this chapter, you can understand how to apply a marginal cost Accounting system and know that it only assigns proportional overheads to the cost rates and thereafter to the products. As no fixed costs are considered cost rates are not biased by allocated fixed costs and thus remain constant. You will learn that the application of proportional costs makes budgeting more reliable as it considers the correct cost behaviour which is advantageous for decision making. After studying this chapter, you understand the difference between marginal costing and absorption costing and know how to apply both systems. You gain the communication skills to discuss the advantage of marginal costing systems over full cost Accounting. You further can describe the problems of full cost Accounting systems when products are added to stock and released therefrom for sales in periods following production. 14.3. Marginal Cost Accounting Systems Here are two technical terms we use in this chapter interchangeable: absorption costing considers all costs, and this means it is a full cost Accounting system. In contrast, a marginal cost Accounting system requires a cost separation, normally prepared in the cost category Accounting. A cost separation spits costs in proportional and fixed costs. Only proportional costs apply for the calculation of cost rates and the product calculation. As proportional product costs represent incremental costs, we call this method marginal cost Accounting. It allows to prepare a budget based on various outputs therefore, we call it flexible budgeting. To explain marginal cost Accounting we refer to the same restaurant example as in chapter (13). Now, we distinguish proportional (variable) and fixed costs. We repeat the difference between variable and proportional. Variable means the costs change based on the cost centre’s performance, which we call the volume. Proportional costs also change but their increase/ decrease depends linear on the volume. Therefore, all proportional costs are variable costs, but not all variable costs are proportional costs. Flexible Budgeting is based on mixed costs. Those consist of a fixed cost <?page no="267"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 14-267 portion and proportional costs. For flexible budgeting, we must separate costs. If we budget costs, the costs at the planned volume level are called planned costs or budgeted costs. In a volume-cost-diagram, planned costs are a point. In contrast, planned costs at (any) volume level are referred to as standard costs. Therefore, standard costs are a linear cost function depending on the volume. In a volume-costdiagram, the standard costs are a line. The point on the standard cost function which represents the cost for the budgeted output is referred to as planned costs. After approval we refer thereto as budgeted costs. We learned already in chapter (13) how to allocate costs to job orders/ products. Costs are classified in cost categories and then allocated to cost centres and products. Following a marginal costing, only proportional costs are considered for the calculation of cost rates (for internal cost allocations and product calculation). The reason is, that only those costs change with the volume. The idea of marginal Accounting is to focus on costs that change. Fixed costs do not depend on the output and therefore are moved to the profitability analysis. This way, they are not used for allocations between cost centres and towards the products. 14.4. Allocation Principles Next, we study cost allocation principles. We cover the three most important principles for cost allocations starting with the most reliable one. The preferable rule for allocations is the cost-bycause principle, meaning a cost object that causes costs is charged therewith. This gives a fair cost allocation. Based on a cost-by-cause principle, proportional costs only apply if goods are manufactured, or services are rendered. They do not apply if no output is produced. In private life, you follow the cost-bycause principle too and call it fair: Who orders a beer in the pub must pay it. Alternative cost allocation principles are the average principle and the carrying capacity principle. Once you follow the average principle all costs are divided equally and thereafter assigned to cost objects. You apply this principle if you have dinner with your friends and decide to share the bill equally. The potential principle charges the strongest cost object. For instance, you assign all overheads to the product, which sells best or gives the highest profit margin. When you go out with your family and your father pays the full bill, the cost allocation principle follows the potential principle for your family dinner. In a sophisticated Management Accounting system, the cost-by-cause principle is the preferred one. It guarantees most fair cost allocations for flexible budgeting. Pinning costs to cost objects allows you to control costs. Changes in cost objects’ quantities result in realistic cost behaviour. In a cost Accounting system, two different assignment types apply. If we assign direct costs, we say we trace them to cost objects. We follow the already existing relationship between costs and cost object. If we assign <?page no="268"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 14-268 overheads, we refer to the technical term allocating. Proportional overheads are allocated to cost objects by the cost-by-cause principle. This requires defining a relationship between costs and cost objects, in other words, we must calculate the portion to be assigned to the goods/ services. Fixed overheads are not caused by the cost objects and therefore, we do not allocate them to products. We charge the Profit and Loss account with them. For flexible budgeting we avoid fixed costs allocations. The reason is, that at low output levels this would overcharge products with costs and gives management distorted cost information (the only guest pays for the whole hotel). 14.5. C/ S GIULIO'S PIZZA&PASTA RISTORANTE Next, we apply flexible budgeting for GIULIO'S PIZZA&PASTA RISTORANTE. This leads to a better (more realistic) cost Accounting system. We separate overheads (Direct costs are always proportional.). Thereafter, we apply cost centre Accounting, calculation and profitability analysis. With a marginal cost Accounting we can plan profit for different volumes, here depending on the number of dishes+wines. Look at the end of this chapter where we disclose some output scenarios and calculated profits therefor (Figure 14.3). For our case study, all direct costs remain the same as in the previous chapter (13), as separating overheads has no impact on the value of direct costs. Below, we repeat the figures: (1) Dough: 40,000.00 EUR/ a. (2) Tomato sauce: 50,000 + 25,000 = 7 75,000.00 EUR/ a. (3) Tuner: 75,000.00 EUR/ a. (4) Cheese: 30,000 + 20,000 + 10,000 = 60,000.00 EUR/ a. (5) Lasagne noodles: 10,000.00 EUR/ a. (6) Minced: 16,000.00 EUR/ a. (7) Cannelloni noodles: 5,000.00 EUR/ a. (8) Cream sauce: 10,000.00 EUR/ a. (9) Cooked ham: 7,200.00 EUR/ a. (10) Chianti wine: 6 × 4,000 = 2 24,000.00 EUR/ a. Regarding overheads, we now change the case study: (a) Olive oil: 3,600.00 EUR/ a. The consumption of olive oil depends proportionally on the number of dishes. However, there is no intention by GIULIO'S PIZZA&PASTA RISTORANTE’s Accountant to plan costs based on millilitres of olive oil consumption. We classify those materials as artificial overheads. Artificial overheads can be allocated to products by the cost-bycause principle. However, they are not, because the effort for correct calculations is not justified by its outcome, which is the accurate cost information. Therefore, we transfer these costs to profit or loss. (b) Dishwasher liquid: 360.00 EUR/ a. The dishwasher liquid consumption is regarded as artificial overheads, too. (c) Chef’s salary was in chapter (13) completely based on fixed costs: 4,000 × 12 = 4 48,000.00 EUR/ a. The chef’s salary now is replaced by mixed costs. The salary contains a fixed portion of 2,250.00 EUR/ m. Furthermore, the chef earns 6.00 EUR/ h of preparation time, no matter which dish he makes. The reference <?page no="269"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 14-269 unit for the Kitchen cost centre is preparation hours, in short: prep-h. For the previous (chapter (13)) output, costs do not change. The chef’s salary is: 27,000 + ((3 × 50,000) + 2 × (20,000 + 10,000)) × 6 × (1/ 60) = 448,000.00 EUR/ a. In case the dish numbers vary, his salary changes as well. (d) Order manager’s/ waiter’s salary: 2,800 × 12 = 3 33,600.00 EUR/ a. The order manager/ waiter is considered as standby costs and does not depend on the number of dishes+wines ordered and served. Stand-by costs are costs, which occur if a company provides resources, without consideration of their use. (e, h, i) Driver’s salary: 20,000 × (5/ 60) x 9 = 115,000.00 EUR/ a, depreciation on the delivery-car: 8,000 / 4 = 2 2,000.00 EUR/ a and operating costs for the delivery-car: 1,000 × 12 = 1 12,000.00 EUR/ a, are replaced now by an outsourced delivery service and thus become proportional costs. The costs per delivery tour are 5.00 EUR/ tour. GIULIO'S PIZZA&PASTA RISTORANTE estimates the number of tours to be 5,800 in the next Accounting period. This means, that 36.25 % of the dishes are delivered and with one tour 5 dishes are transported on average. The restaurant does not deliver wines. (f) Depreciation on the stove: 24,000/ 6 = 4,000.00 EUR/ a. (g) Depreciation on the Restaurant/ Order Management interior: 18,000/ 6 = 3,000.00 EUR/ a. (j) Rent for the restaurant: 3,000 × 12 = 36,000.00 EUR/ a. The cost centre planning is based on mixed costs. For every cost centre i, we set up a 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. We start with the cost function for the Kitchen: C kitchen (X) = PC kitchen × X + FC kitchen . Kitchen In the Kitchen, mixed costs apply. The cost function of the Kitchen depends on the preparation time. The X-value is measured by prep-h. The slope of the cost line is PC K = 6.00 EUR/ prep-h, because of the chef’s salary. No other proportional costs apply in the Kitchen. The fixed costs contain the artificial overheads for olive oil at 3,600.00 EUR/ a and dish washer liquid at 360.00 EUR/ a, the base salary for the chef to the extent of: 12 × 2,250 = 2 27,000.00 EUR/ a, and depreciation on the stove: 24,000 / 6 = 4,000.00 EUR/ a. Additionally, 25 % of the rent, which equals: 0.25 × 36,000 = 9,000.00 EUR/ a is allocated to the Kitchen. The total of all fixed costs gives: FC K = 3,600 + 360 + 27,000 + 4,000 + 9,000 = 4 43,960.00 EUR/ a. The cost line in the Kitchen follows the equation: C Kitchen (X) = 6.00 EUR/ prep-h × X + 43,960.00 EUR/ a. The budgeted costs in the Kitchen are based on the workload of: (3 × 50,000 + 2 × (20,000 + 10,000)) / 60 = 33,500 prep-h and equal: C Kitchen (3,500) = 6 × 3,500 + 43,960 = 64,960.00 EUR/ a. Restaurant/ Order Management In the cost centre Restaurant/ Order Management, all costs are fixed. (d) Order manager’s/ waiter’s salary: 2,800 × 12 = 3 33,600.00 EUR/ a. <?page no="270"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 14-270 (g) Depreciation on the Restaurant/ Order Management interior: 18,000/ 6 = 33,000.00 EUR/ a. (j) Rent for the Restaurant’s/ Order Management’s area of 60 m 2 : 75% × 36,000 = 2 27,000.00 EUR/ a. The total of overheads in the Restaurant/ Order Management equals: FC Rest/ OM = 33,600 + 3,000 + 27,000 = 63,600.00 EUR/ a. The cost function is: C Rest/ OM = 63,600.00 EUR/ a. Delivery Due to the outsourcing, in the Delivery department, costs are now completely variable. The cost function equals: C Delivery (X) = 5.00 EUR/ tour × X. X is the number of tours. The budgeted costs for 5,800 tours are: C Delivery (5,800) = 5 × 5,800 = 2 29,000.00 EUR. The number of tours depends on the volume as we consider a percentage of dishes to be delivered. 80,000 dishes × 36.25% / 5 = 5 5,800 tours. As in chapter (13), we assume deliveries are offered without further charges (for free). The cost Accounting system design for GIULIO'S PIZZA&PASTA RISTORANTE looks as depicted in Figure 14.1. Figure 14.1: GIULIO'S PIZZA&PASTA RISTORANTE’s Management Accounting We study the profitability analysis. In contrast to the unit cost calculation in Figure 13.12 and Figure 13.13, the unit costs now are only based on proportional 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 - as below: <?page no="271"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 14-271 Pizza The costs for the pizza include the direct materials and proportional costs for the chef’s salary and the delivery service. The calculation is based on the planned output of 50,000 pizza. The hours spent on pizza preparation are: 3 × 50,000 / 60 = 2 2,500 prep-h. The proportional costs for the chef based on 2,500 prep-h equal: 6 × 2,500 = 15,000.00 EUR. We must consider the portion of pizza that is delivered by the outsourced service, as well. The delivery service’s costs are proportionally depending on the quantity of pizza, lasagne and cannelloni. Hence, we consider the delivery costs as proportional product costs. The number of delivered pizza equals: 36.25% × 50,000 = 1 18,125 (delivered) pizza. The tour quantity equals: 18,125 / 5 = 3 3,625 tours. The delivery costs for 50,000 pizza equal: 5 × 3,625 = 18,125.00 EUR. The total unit costs per pizza are calculated as proportional costs for all pizza divided by 50,000. The unit costs are: (195,000 + 15,000 + 18,125) / 50,000 = 4 4.56 EUR/ pizza. The value is rounded-off from 4.56 25 EUR/ pizza. Note, cost allocations in the Delivery department are based on the average principle because per tour 5 dishes are delivered. Lasagne The proportional costs per lasagne are direct materials, the chef’s proportional salary and delivery costs. The chef’s costs are based on the prep-h. The preph for lasagne are amounting to: 2 × 53 We multiply by 5 as one tour costs 5.00 EUR and we divide by 5 as one tour transports 5 dishes. 20,000 / 60 = 6 666.67 prep-h. The chef’s proportional costs for the preparation of 20,000 lasagne equal: 6 × 666.67 = 4,000.00 EUR. The number of delivery tours equals: 5 × (20,000 × 36.25%) / 5 = 7,250.00 EUR. 53 The unit costs per lasagne equal: (71,000 + 4,000 + 7,250) / 20,000 = 4 4.11 EUR/ lasagne - rounded-off from 4.11 25 EUR/ lasagne. Cannelloni The proportional cannelloni costs include direct materials, the chef’s proportional costs and delivery costs. The chef’s cost depends on his workload. The quantity of prep-h equals: (2 × 10,000) / 60 = 3 333.33 EUR/ prep-h. The chef’s proportional costs are amounting to: 6 × 333.33 = 2 2,000.00 EUR. The costs for deliveries are half of the delivery costs for lasagne: 7,250 / 2 = 3 3,625.00 EUR. Hence, the proportional costs add up to: 32,200 + 2,000 + 3,625 = 3 37,825.00 EUR. The unit costs per cannelloni are: 37,825 / 10,000 = 3 3.78 EUR/ cannelloni. The value is rounded-off from 3.78 25 EUR/ cannelloni. Chianti The Chianti wine does not require preparation (chef) nor are wines delivered. The only unit costs result from direct materials. They equal: 24,000 / 12,000 = 2.00 EUR/ Chianti. The profitability analysis is based on the planned volume of 50,000 pizza, 20,000 lasagne, 10,000 cannelloni and 12,000 glasses of Chianti wine per year. The <?page no="272"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 14-272 costs of sales are proportional costs only. The difference between revenue and proportional costs is called the contribution margin. The budgeted contribution margin can be displayed as per unit, too. This supports product mix decisions. GIULIO'S PIZZA&PASTA RISTORANTE’s contribution margin equals: 50,000 × 9 + 20,000 × 8 + 10,000 × 8 + 12,000 × 5 - 4.56 25 × 50,000 - 4.11 25 × 20,000 - 3.78 25 × 10,000 - 2 × 12,000 = 750,000 - 372,200 = 3 377,800.00 EUR/ a. 54 All fixed costs are deducted from the contribution margin. The fixed costs contain fixed Kitchen overheads and overheads in the Restaurant/ Order Management cost centre. No fixed costs apply in the Delivery cost centre (outsourcing). The fixed costs add up to: 43,960 + 63,600 = 1 107,560.00 EUR/ a. GIULIO'S PIZZA&PASTA RISTORANTE’s profit is: 377,800 - 107,560 = 270,240.00 EUR/ a. Observe GIULIO'S PIZZA&PASTA RISTORANTE’s Management Accounting system as displayed in Figure 14.2 and compare the profit to Figure 13.13 in the previous chapter. Figure 14.2: GIULIO'S PIZZA&PASTA RISTORANTE’s Management Accounting system 54 For avoiding rounding differences, the calculation is based on original values. The 3 rd and 4 th digit after the decimal point are displayed in lower figures. If you want to 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. <?page no="273"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 14-273 The advantage of flexible budgeting is a more realistic cost planning which depends on different volume levels. The profit can be calculated based on a formula with the structure as below: m j n i i j j j FC X CM X P 1 1 ) ( ) ( (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 = number of products, FC i = fixed costs) At GIULIO'S PIZZA&PASTA RISTORANTE, the contribution margins per product are: CM pizza = 9 - 4.56 25 = 44.43 75 EUR/ u. CM lasagne = 8 - 4.11 25 = 33.88 75 EUR/ u. CM cannelloni = 8 - 3.78 25 = 44.21 75 EUR/ u. CM Chianti = 5 - 2 = 33.00 EUR/ u. We call X 1 the number of pizza, X 2 the number of lasagne, X 3 = the number of cannelloni and X 4 the number of Chianti. The profit function of GIULIO'S PIZZA&PASTA RISTORANTE is given as: P(X 1 , X 2 , X 3 , X 4 ) = 4.43 75 × X 1 + 3.88 75 × X 2 + 4.21 75 × X 3 + 3 × X 4 - 43,960 - 63,600. We check the equation with the budgeted outputs for X j : X 1 = 50,000 pizza, X 2 = 20,000 lasagne, X 3 = 10,000 cannelloni and X 4 = 12,000 Chianti: P (50,000; 20,000; 10,000; 12,000) = 4.43 75 × 50,000 + 3.88 75 × 20,000 + 4.21 75 × 10,000 + 3 × 12,000 - 43,960 - 63,600 = 270,240.00 EUR. This is the value in Figure 14.2. GIULIO'S PIZZA&PASTA RISTORANTE now can plan the profit for different output scenarios. Observe a few scenarios in Figure 14.3: X 1 X 2 X 3 X 4 CM pizza CM lasagne CM canneloni CM Chiant FC kitchen FC rest/ OM NOP 1 1 1 1 4.44 3.89 4.22 3.00 (43,960.00) (63,600.00) (107,544.46) 50,000 20,000 10,000 12,000 221,875.00 77,750.00 42,175.00 36,000.00 (43,960.00) (63,600.00) 270,240.00 55,000 15,000 15,000 10,000 244,062.50 58,312.50 63,262.50 30,000.00 (43,960.00) (63,600.00) 288,077.50 60,000 10,000 10,000 14,000 266,250.00 38,875.00 42,175.00 42,000.00 (43,960.00) (63,600.00) 281,740.00 0 40,000 40,000 12,000 0.00 155,500.00 168,700.00 36,000.00 (43,960.00) (63,600.00) 252,640.00 45,000 25,000 15,000 10,000 199,687.50 97,187.50 63,262.50 30,000.00 (43,960.00) (63,600.00) 282,577.50 30,000 30,000 30,000 0 133,125.00 116,625.00 126,525.00 0.00 (43,960.00) (63,600.00) 268,715.00 Figure 14.3: GIULIO'S PIZZA&PASTA RISTORANTE’s profit planning <?page no="274"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 14-274 Flexible budgeting allows accurate profit calculations based on different product/ service levels. Managers can vary the product mix and output level for checking consequences of their planning on the profit. 14.6. Storing Goods that Include Fixed Costs The impact of flexible budgeting becomes more important for companies that store finished goods or release manufactured goods from stock for sale. When putting goods to stock, the product costs are transferred from the production period to the period of sales. With marginal cost Accounting, only proportional costs are considered as product costs. No deferral of fixed costs distorts profit and loss calculations. 14.7. C/ S LOGA (Pty) Ltd. We discuss the case study LOGA (Pty) Ltd., which is a record label. Data Sheet for LOGA (Pty) Ltd. CClassification: Manufacturing; Production quantities: 1,000,000 CDs / 1,000,000 CDs / 1,000,000 CDs; Sales numbers: 800,000 CDs / 1,100,000 CDs / 1,100,000 CDs; Materials: 0.10 EUR/ CD; Direct labour: 0.30 EUR/ CD; Depreciation: 40,000.00 EUR; supervisor’s salary: 50,000.00 EUR; Distribution costs: 1.00 EUR/ CD; Marketing costs: 150,000.00 EUR; Net selling price: 2.50 EUR/ CD; VAT ignored. As we will demonstrate with the case LOGA (Pty) Ltd., a production firm applying a full cost Accounting system, makes mistakes regarding the profit calculation, by adding finished goods to stock. In a full cost Accounting system, finished goods put on stock include fixed costs. The fixed costs assigned to the finished goods count for profit calculation in periods when the goods are released from stock and sold. As a consequence, the profit is too high in those periods when the company produces and transfers finished goods to stock. It will become too low when goods are released from stock. A better cost planning can be achieved, if cost separation takes place and no fixed costs get allocated to products. A Management Accounting system, based on separated proportional and fixed costs elements is called a marginal costing system. 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. LOGA (Pty) Ltd. records music CDs from local artists, burns them, and distributes them online to wholesalers. In the fiscal year 20X7, LOGA (Pty) Ltd. produces 1,000,000 CDs and sells 800,000 thereof. In 20X8 the business produces 1,000,000 CDs and sells 1,100,000 units. The same production and sales quantities as for 20X8 apply in 20X9. <?page no="275"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 14-275 The direct costs are materials and labour. Material costs per CD are 0.10 EUR/ CD. The value for direct labour is 0.30 EUR/ CD. The overheads are partly manufacturing overheads. Depreciation on production facilities is 40,000.00 EUR/ a. Furthermore, the supervisors’ salary is amounting to 50,000.00 EUR/ a. The distribution costs (non-manufacturing costs) are 1.00 EUR/ CD. The distribution costs are linked to the products and count as their direct costs. We do not allocate them to the cost of manufacturing, as distribution is not linked to production. Fixed Marketing overheads are 150,000.00 EUR/ a. The sales revenue per CD is 2.50 EUR/ CD. We prepare a profitability analysis for the periods 20X7, 20X8 and 20X9. Firstly, we apply (1) a full cost Accounting system (absorption costing), and below a (2) marginal cost Accounting system. We demonstrate the differences. Ad (1): Absorption Costing For the profitability analysis, LOGA (Pty) Ltd. applies a profit and loss account following the cost of sales format. The company applies a first-in-first-out policy for all its inventory movements. As the unit costs are constant, the sequence of movements does not matter. The calculation of cost of sales requires an inventory valuation at the end of the Accounting period. For CDs added to stock, the unit costs are transferred to the Finished Goods account. LOGA (Pty) Ltd. makes a credit entry in the WIPaccount and debits the value to the Finished Goods Inventory account. When CDs are released from stock, they are expensed, which means the CDs are added to the Cost of Sales account. In 20X7, LOGA (Pty) Ltd. produced 1,000,000 CDs, 800,000 CDs are sold, and the remaining 200,000 CDs are transferred to stock. For inventory valuation, a calculation of CDs is necessary: Direct materials and direct labour are: 0.10 + 0.30 = 0 0.40 EUR/ CD. The manufacturing overheads are completely fixed. The fixed overheads per CD include depreciation and the supervisor’s salary. They equal: (40,000 + 50,000) / 1,000,000 = 0 0.09 EUR/ CD 20X7 . The unit costs for 20X7 equal: 0.40 + 0.09 = 0 0.49 EUR/ CD 20X7 . This gives a closing stock of: 200,000 × 0.49 = 9 98,000.00 EUR. In 20X7, the value of the produced CDs equals: 0.49 × 1,000,000 = 4 490,000.00 EUR. For the cost of sales calculation, LOGA (Pty) Ltd. adds the opening value (stock releases) to the manufacturing costs and deducts the value for the CDs put on stock. Observe Figure 14.4. In 20X7, the cost of sales equals: 490,000 - 98,000 = 3 392,000.00 EUR. The revenue is: 800,000 × 2.50 = 2 2,000,000.00 EUR. The non-manufacturing costs are distribution costs plus fixed Marketing costs, which add up to: 1 × 800,000 + 150,000 = 9 950,000.00 EUR. The profit equals: 2,000,000 - 392,000 - 950,000 = 658,000.00 EUR. Observe the profitability analysis as depicted in Figure 14.4. <?page no="276"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 14-276 20X7 20X8 20X9 Sales 2,000,000 2,750,000 2,750,000 less: COS + OV 0 (98,000) (49,000) + Manufactured (490,000) (490,000) (490,000) - Closing stock 98,000 49,000 Gross margin 1,608,000 2,211,000 2,211,000 less: distribution expenses (prop) (800,000) (1,100,000) (1,100,000) less: marketing (fixed) (150,000) (150,000) (150,000) Net operating profit 658,000 961,000 961,000 Figure 14.4: LOGA (Pty) Ltd.’s profitability analysis based on absorption costing In 20X8, the unit costs equal: 0.10 + 0.30 + (40,000 + 50,000) / 1,000,000 = 0 0.49 EUR/ CD 20X8 . The revenue equals: 1,100,000 × 2.50 = 2 2,750,000.00 EUR. The costs of sales result from 200,000 CDs 20X7 , which are released from stock, 1,000,000 CDs 20X8 , which are produced in 20X8, and from which 10 % are put on stock. In the Accounting period 20X9, the 100,000 CDs 20X8 are released from stock and are sold together with 1,000,000 CDs 20X9 . Ad (2): Marginal costing Under a marginal cost Accounting system, only proportional costs are considered for inventory valuation. No fixed costs get allocated to products. The proportional unit costs are the sum of direct materials and direct labour. The unit costs are: 0.10 + 0.30 = 0 0.40 EUR/ CD. As fixed costs for manufacturing are not assigned to products, we deduct them from the gross margin. 20X7 20X8 20X9 Sales 2,000,000 2,750,000 2,750,000 less: COS + OV 0 (80,000) (40,000) + Manufactured (400,000) (400,000) (400,000) - Closing stock 80,000 40,000 Contribution margin 1,680,000 2,310,000 2,310,000 less: depreciation on factory (40,000) (40,000) (40,000) less: supervisor's salary (50,000) (50,000) (50,000) less: distribution expenses (prop) (800,000) (1,100,000) (1,100,000) less: marketing (fixed) (150,000) (150,000) (150,000) Net operating profit 640,000 970,000 970,000 Figure 14.5: LOGA (Pty) Ltd.’s profitability analysis based on marginal costing <?page no="277"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 14-277 With the application of a marginal cost Accounting system, profit differs from the one disclosed in Figure 14.4. Once we calculate the total of all three Accounting periods, we get the same sum, which is: 658,000 + 961,000 + 961,000 = 640,000 + 970,000 + 970,000 = 22,580,000.00 EUR. The reason is, that the CDs put on stock have been completely released after three periods. In case we compare only two Accounting periods, the total of the profits during these periods are different. This is what we refer to as temporary differences. The main question is ‘Which profits are correct? ’ The correct figures are the ones, calculated by the marginal cost Accounting system. The fixed costs for the supervisor and for depreciation must count for the Accounting period they occur in. The profit in the Accounting period 20X7 in Figure 14.4 is too high to the extent of: 658,000 - 640,000 = 18,000.00 EUR. This difference equals the value of fixed costs included in 200,000 CDs 20X7 . The fixed costs therein are: 200,000 × (40,000 + 50,000) / 1,000,000 = 1 18,000.00 EUR. In common language, we say fixed costs are "parked in inventories". The technical term is deferment of fixed costs. The profit in the statement of 20X7 is higher by 18,000.00 EUR, because the fixed costs included in the CD stock do not reduce profit. In the next year, the profit is 961,000.00 EUR for the full cost calculation and 970,000.00 EUR with a marginal costing. The marginal cost Accounting information is correct. Now the full cost Accounting system indicates a lower profit, as by releasing 100,000 CDs from stock: 100,000 × (40,000 + 50,000) / 1,000,000 = 9 9,000.00 EUR fixed costs are expensed, and reduce the actual profit of: 970,000.00 EUR to 961,000.00 EUR. The same effect applies in 20X9. Hence, absorption costing distorts profit, as fixed costs allocated to finished goods are excluded from the profit calculation, if the goods are put on stock. Therefore, fixed costs are deferred. The term deferred indicates, that the fixed costs are considered once the goods are released from stock. When the company releases goods from stock, their costs count for the actual Accounting period. So do the fixed costs included in their unit costs. 14.8. Summary A flexible budgeting is based on production outputs. For unit cost calculations and for profitability analysis it is strongly recommended to only consider proportional costs. This way, the cost allocation is based on the cost-bycause principle and provides managers with fair and unbiased information. For supporting budgeting and decision making, costs can be planned correctly if applying marginal costing. A marginal cost Accounting system provides correct profit calculation, as no fixed costs are deferred. Adding goods to stock does not distort the profit calculation, as only proportional costs are considered. Proportional costs are linked to goods by the costby-cause principle. 14.9. Working Definitions Artificial Overheads: Artificial overheads can be allocated to products by the cost-by-cause principle. However, <?page no="278"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 14-278 they are not, because the effort to calculate correctly is not justified by its outcome. Contribution Margin: The difference between revenue and proportional costs is called the contribution margin. Flexible Budgeting: A cost planning based on marginal costs, is referred to as flexible budgeting. Marginal Costing: A Management Accounting system, based on separated proportional and fixed costs elements is called a marginal costing system. Stand-by Costs: Stand-by costs are costs, which occur, when a company provides resources, without consideration of their use. 14.10. Question Bank (1) In flexible budgeting, the cost rates for the application of overheads … 1. … contain direct costs only. 2. … contain mixed costs only. 3. … contain proportional overheads only. 4. … contain fixed overheads only. (2) In a flexible budgeting the contribution margin for product A is 65.00 EUR/ u and for product B 80.00 EUR/ u. The budgeted volume is 200 units/ a of product A and 400 units/ a of product B. Depreciation is amounting to 10,000.00 EUR/ a. How much is the profit if the product numbers are 400 units/ a of product A and 200 units/ a of product B? 1. 45,000.00 EUR/ a . 2. 42,000.00 EUR/ a . 3. 35,000.00 EUR/ a . 4. 32,000.00 EUR/ a . (3) In flexible budgeting the contribution margin is defined as: 1. Gross selling price less proportional costs. 2. Revenue less total product costs. 3. Revenue less variable costs. 4. Net selling price less total costs. (4) In a marginal cost Accounting system, the predetermined overhead allocation rate is calculated as 46,000 EUR/ 1,000 units. Depreciation is amounting to 20,000.00 EUR. In the actual Accounting period, the total overheads are amounting to 60,000.00 EUR and the output is 1,050 units. Which statement is correct? 1. There are 8,300 EUR under-applied overheads. 2. There are 8,300 EUR over-applied overheads. 3. There are 11,700 EUR under-applied overheads. 4. There are 11,700 EUR over-applied overheads. (5) In a flexible budgeting, the cost rates for the application of overheads contain: 1. Proportional overheads. 2. Direct costs and proportional overheads. 3. Direct costs and fixed overheads. 4. Proportional and fixed overheads. 14.11. Solutions 1-3; 2-4; 3-3; 4-2; 5-1. <?page no="279"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 15-279 15. Cost Monitoring 15.1. What is in the Chapter? Chapter (15) is strictly based on flexible cost Accounting and introduces to monitoring. CROXTON Ltd. is a laptop display manufacturer; we study its cost deviations at planned volume level in April 20X6, at a lower level in May 20X6 and at a higher level in June 20X6. Cost deviations, like consumption and volume variances, are calculated and discussed. We also introduce efficiency reports. 15.2. Learning Objectives After studying this chapter, you know cost monitoring is for checking the efficiency of cost centres, processes or products. It is based on the comparison of actual costs to budget. Any deviation is considered as an inefficiency. You are familiarised with other technical terms for monitoring which are target-performance checking or variance analysis. You further understand that a company performs well if it meets its budget. Then the company works as planned and is likely to reach its profitability objectives. Preferably, regular efficiency checks are made in all cost centres. Each cost centre has a manager who is responsible for its cost consumption. Management Accounting reports to them with a detailed efficiency report that discloses actual costs, the budgeted amounts and deviations. You know efficiency reports as displayed in Figure 15.3 and Figure 15.5 at the chapter’s end. You can divide cost deviations in volume and consumption variances. With received proficiency reports, managers see whether they stayed within their cost limits. In this chapter, we teach you how to monitor cost centres. After studying this chapter, you can calculate the cost variances and understand their meanings. You can prepare and read a cost centre efficiency report. You further learn who is responsible for which cost variances. 15.3. Cost Deviations For the following considerations, we apply a marginal cost Accounting system. This means that we do not check fixed costs as we assume they do not change on short notice. However, all costs in a cost centre are budgeted based on proportional and fixed cost elements. Once the cost centre is in operation, actual costs are recorded and thereafter can be compared to budget. You might ask yourself, why not planning costs generously, as then all actual costs meet the budget easily? Any addon to budgeted costs works as safety cushion and protects managers against cost deviations. The answer lies in the business plan. Managers strive to plan costs as exact and low as possible. Goods and services must be sold on competitive markets where other manufacturers or service providers sell the same or similar goods/ services. To achieve and maintain a share in the <?page no="280"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 15-280 market, companies need to calculate prices as low as possible. Companies who plan their product/ service costs sloppy, are likely to be overtaken by competitors, who produce and sell cheaper. At the first glance, the cost comparison in a cost centre seems to be straight forward. The actual costs should match the budget. A difference in costs is an indicator for a negative deviation, which can be caused by rework, wrong resource application, delays etc. Any positive deviation should not be seen as success but as a faulty budgeting (costs were planned higher than necessary). After monitoring, variance analysis begins. There we determine whether the cost deviations are significant and if so, an investigation of the causes for the cost deviation starts. The analysis of cost deviations is a field for the application of artificial intelligence. Cost comparisons are more difficult if costs are recorded at different volume/ output levels than budgeted. We cannot compare actual costs for 100 units to a budget for 90 units. 15.4. C/ S CROXTON Ltd. We discuss those cases with the case study CROXTON Ltd. which is a manufacturer. 55 See its the data sheet below: Data Sheet for CROXTON Ltd. CClassification: Manufacturing; Periods: April 20X6 / May 20X6 / June 20X6; Fixed costs: 100,000.00 EUR; Proportional costs: 5.00 EUR/ min; 55 In preparation to this case study about a manufacturer, we recommend reading in the textbook Basics of Accounting chapter (25). Planned output: 3,000 u; Planned costs: 160,000.00 EUR; Output: 3,000 u / 2,500 u / 4,000 u; Actual assembling time: 12,000 min / 10,000 min / 16,000 min; Actual labour: 42,000.00 EUR / 38,000.00 EUR / 50,000.00 EUR; Actual energy costs: 20,350.00 EUR / 13,000.00 EUR / 20,000.00 EUR; VAT ignored. CROXTON Ltd. produces laptop displays. The business applies a marginal cost Accounting system. Although all cost categories are recorded separately (Bookkeeping entries), CROXTON Ltd.’s budget is based on total costs (easy to plan). "At total costs" refers to the cost categories, hence, the company does not plan the cost categories separately but all together. CROXTON Ltd. runs a cost separation based on past data. It reveals that its fixed costs are 100,000.00 EUR. The proportional costs in the cost centre Assembling depend on the volume X which is measured in assembling-min. The slope of the cost function is 5.00 EUR/ asbl-min which are the proportional costs. CROXTON Ltd. plans to assemble 3,000 displays during the Accounting periods April, May and June 20X6. Every display requires an assembling time of 4 asbl-min. Hence, 3,000 displays require: 4 × 3,000 = 12,000 asbl-min. The cost function is: C asbl (X) = 5.00 × X asbl + 100,000. The budgeted costs for 12,000 assembling-min are: C asbl (X = 12,000) = 5.00 × 12,000 + 100,000 = 1 160,000.00 EUR. In contrast to the budget, actual costs are recorded for the three cost catego- <?page no="281"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 15-281 ries: labour, energy costs and depreciation. Labour and energy costs depend proportionally on the assembling time. Depreciation is fixed and equals 100,000.00 EUR. 15.5. The Cost-Volume Relationship Before we explain monthly cost situations at CROXTON Ltd., we describe technical terms for their use in costvolume diagrams. The volume in a cost centre is its variable. It determines the cost consumption. The volume represents the planned (budget) and recorded (actual) performance in a cost centre, e.g., how many units are manufactured. We measure the volume in reference units which should depend proportionally on the output (finished goods/ services). E.g., a reference unit is energy measured in kWh for an energy cost centre, and the energy produced depends proportional on the output of the factory, e.g., the number of VW Golfs. In case cost centres support each other, further performance is required for providing cost centres. Then, the performance in a cost centre is its output plus performance provided for supported cost centres. You will learn further details in the next chapter (16). For monitoring, always both, volume and costs, matter. In case of internal cost centre support, monitoring checks costs where they occur (at the sender). 15.6. Actual Volume Equals Budgeted Volume: April 20X6 In April 20X6, the assembling time at CROXTON is exactly 12,000 asbl-min. This is the volume of the cost centre for that month. The actual (a) labour costs L a/ 4-20X6 equal 42,000.00 EUR and energy costs E a/ 4-20X6 are 20,350.00 EUR. Actual total costs for assembling in April are: C asbl/ a/ 4-20X6 = 42,000 + 20,350 + 100,000 = 1 162,350.00 EUR. A cost comparison gives a total cost variance in April 20X6 of: 162,350 - 160,000 = 2 2,350.00 EUR. As the variance is caused by a deviation of resource consumption, we call it ∆c. Figure 15.1 illustrates the cost situation by a cost-volume diagram. After detection of the cost variance, it is the responsibility of the cost centre manager/ Accountant to find the reasons, like rework caused by poor workmanship, by idle time due to workers waiting for instructions, by machine break downs, by deployment of alternative machinery due to maintenance of the planned machine, by giving the job to workers who are charging a higher cost rate when the scheduled worker is on training etc. The variance analysis requires detailed knowledge about the operations of the cost centre: Best, the cost centre manager analysis deviations her-/ himself with support of Management Accounting and reports findings to higher management levels. <?page no="282"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 15-282 Figure 15.1: CROXTON Ltd.’s cost variance in April 20X6 15.7. Actual Volume is below Budgeted Volume: May 20X6 Next, we study variances of costs as well as of volume. In May 20X6, CROXTON Ltd. assembles less displays than scheduled. The output then only is 2,500 displays. The recorded actual labour costs are: L a/ 5-20X6 = 38,000 EUR and the actual energy costs are: E a/ 5-20X6 = 13,000.00 EUR. Depreciation remains D a/ 5-20X6 = 100,000.00 EUR. The actual total costs equal: C asbl/ a/ 5-20X6 = 38,000 + 13,000 + 100,000 = 1 151,000.00 EUR. In contrast to the previous month, the actual reference unit now differs from budget. The mark for the actual costs has been moved to the left (in direction of lower volume) in a cost-volume-diagram. The actual number for X a/ 5-20X6 equals: 2,500 × 4 = 1 10,000 asbl-min. Observe the actual cost mark in Figure 15.2. Figure 15.2: CROXTON Ltd.’s variance in May 20X6 <?page no="283"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 15-283 The simple comparison of actual costs to budgeted costs, such as: 151,000 - 160,000 = - -9,000.00 EUR, does not make sense here because of the difference in volume. In these cases, Management Accountants determine a consumption variance and a volume variance, both based on actual performance which here is 10,000 asbl-min. Check Figure 15.2! For the consumption variance, the standard costs at actual volume must be calculated. They are: C asbl (X=10,000) = 5.00 × 10,000 + 100,000 = 1 150,000.00 EUR. In Figure 15.2, the consumption variance ∆c is: 150,000 - 151,000 = - -1,000.00 EUR. It is common Accounting practice, to express the variance as a percentage based on standard costs: -1,000 / 150,000 = 0 0.67%. The consumption variance is the difference between actual costs and standard costs based on the actual volume. The consumption variance is caused by a different application of resources. The cost centre manager is held responsible for consumption variances. A second variance relevant for Managerial Accounting is the volume variance Δv. The volume variance is the difference between standard costs at actual volume and total planned cost rates multiplied with the actual volume. The volume difference is a cost difference caused by changes in volume. It can be observed in the Manufacturing Overheads account 56 . It shows on the debit side actual costs to the extent of 151,000.00 EUR. On the credit side we 56 Read our textbook Financial Statements, chapter (9). see the value added to the Finished Goods Inventory account based on the predetermined overhead allocation rate. It gives: 10,000 × 160,000 / 12,000 = 1133,333.33 EUR. Hence the overheads are under-applied to the extent of: 151,000 - 133,333.33 = 1 17,666.67 EUR. The under-application of overheads is divided in consumption a volume variance. As the consumption variance is 1,000.00 EUR, the volume variance is: 17,666.67 - 1,000 = 1 16,666.67 EUR. The application of overheads is frequently based on a predetermined overhead allocation rate (POR-rate). The POR-rate 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). For overhead application, we multiply the actual performance with the PORrate. The applied overheads are represented by a line which goes from the point (0/ 0) to the budgeted cost mark in the cost-volume-diagram, in the case of CROXTON Ltd at (12,000/ 160,000). This line is dotted in Figure 15.2. Hence, the volume difference is either overor under-absorbed overheads. For better understanding consider the dotted line as the "refunded costs line", pretending the cost centre is discharged for its costs by "selling" the goods to the stock of finished goods. Differences are not added to products but are added to the Cost of Sales account which later is closedoff to the Profit and Loss account. This way, deviations do not increase <?page no="284"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 15-284 inventory valuations (on the balance sheet) but count for profit or loss. For the CROXTON Ltd. case study, the total planned costs on average, based on the actual reference unit equal: 10,000 × 160,000 / 12,000 = 1 133,333.33 EUR. Accordingly, the volume difference is: ∆v 5/ 20X6 = 133,333.33 - 150,000 = - - 16,666.67 EUR. The relative volume variance in May 2016 is: -16,666.67 / 133,333.33 = - -12.5%. For the cost centre manager, changes in volume are beyond her/ his responsibility as the cost centre's workload depends on external factors, like sales performance, the economy etc. However, if the cost centre performs low due to operational issues, the performance difference is held against the cost centre manager. At the end of the Accounting period, all overheads are applied which includes the consumption variance as well as the volume variance. In May 20X6, the applied overheads equal 133,333.33 EUR. The value is based on full costs because CROXTON Ltd. applies a full cost predetermined overhead allocation rate. The applied overheads are: 10,000 × 160,000/ 12,000 = 1 133,333.33 EUR. The value is added to the WIP-account(s). The variances are added to profit and loss of the Accounting period to the extent of: 1,000 + 16,666.67 = 1 17,666.67 EUR. In general, only the consumption variance ∆c matters for the assessment of performance in cost centres. We say, in case the consumption variance is close to zero, the cost centre works efficiently. At CROXTON Ltd., the detailed cost centre efficiency report is at a low standard as it is not accurate to cost categories. The budgeting on full costs basis does not permit a further deviation analysis. The proficiency report looks as depicted in Figure 15.3: Budget Actual consumption variance ∆c volume variance ∆v Labour [EUR] n/ a 38,000.00 n/ a n/ a Energy [EUR] n/ a 13,000.00 n/ a n/ a Depreciation [EUR] n/ a 100,000.00 n/ a n/ a Total costs [EUR] 160,000.00 151,000.00 -1,000.00 -16,666.67 (non favourable) (non favourable) Rel variance [%] -0.67% -12.50% Performance [asbl-min] 12,000 10,000 Standard costs [EUR] 160,000.00 150,000.00 Overheads applied [EUR] 133,333.33 Over-/ under applied OHs [EUR] -17,666.67 Croxton Ltd. COST EFFICIENCY REPORT May 20X6 Figure 15.3: CROXTON Ltd.’s cost efficiency report May 20X6 <?page no="285"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 15-285 15.8. Actual Volume Exceeding Budgeted Volume: June 20X6 Next, we study a situation where the volume exceeds the budgeted performance. In June 20X6, CROXTON Ltd. produces more displays than scheduled. The number equals 4,000 units. Hence, the output is 16,000 assembling minutes. The actual costs are labour: L a/ 6-20X6 = 50,000.00 EUR, energy costs: E a/ 6-20X6 = 20,000 EUR and depreciation: D a/ 6-20X6 = 100,000.00 EUR. The total costs equal: 50,000 + 20,000 + 100,000 = 1 170,000.00 EUR. The planned costs based on 4,000 displays are amounting to: C asbl (X = 16,000) = 5.00 × 16,000 + 100,000 = 180,000.00 EUR. The consumption variance is: ∆c 6/ 20X6 = 180,000 - 170,000 = 1 10,000.00 EUR. The percentage based on standard costs equals: 10,000 / 180,000 = 5 5.56%. The volume variance is: ∆v 6/ 20X6 = 16,000 × 160,000/ 12,000 - 180,000 = 3 33,333.33 EUR. The percentage based on applied overheads gives: 33,333 / 213,333.33 = 15.63%. A favourable consumption variance is not regarded as a good indicator for the cost centre’s performance. It only says the cost centre works better than scheduled. This indicates merely poor planning standards than a well-done job in the department. For the overhead application, this gives an over-application of overheads. CROXTON Ltd. adds more overheads to the WIP-account than recorded. The company allocates overheads based on the full cost based predetermined overhead allocation rate of: 16,000 × 160,000 / 12,000 = 2 213,333.33 EUR. In contrast, actual costs in the cost centre are only 170,000.00 EUR. The difference of: 213,333.33 - 170,000 = 43,333.33 EUR is credited to the Profit and Loss account and, as a result, reduces the cost of goods sold. Some managers are tempted to cook their efficiency reports, e.g., to earn incentives based on the cost centre performance or to build buffers for times of low performance. They try to increase budgeted costs to make themselves shine due to low cost deviations. This problem is serious in business and is subjected to principle-agent theory. In the case of CROXTON Ltd., the highly favourable variances in June 20X6 indicate poor budgeting. Therefore, the budget needs revision. <?page no="286"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 15-286 Figure 15.4: CROXTON Ltd.’s variance in June 20X6 The cost centre efficiency report for the month June 20X6 is displayed in Figure 15.5. Budget Actual consumption variance ∆c volume variance ∆v Labour [EUR] n/ a 50,000.00 n/ a n/ a Energy [EUR] n/ a 20,000.00 n/ a n/ a Depreciation [EUR] n/ a 100,000.00 n/ a n/ a Total costs [EUR] 160,000.00 170,000.00 10,000.00 33,333.33 (favourable) (favourable) Rel variance [%] 5.56% 15.63% Performance [asbl-min] 12,000 16,000 Standard costs [EUR] 160,000.00 180,000.00 Overheads applied [EUR] 213,333.33 Over-/ under applied OHs [EUR] (+/ -) 43,333.33 Croxton Ltd. COST EFFICIENCY REPORT June 20X6 Figure 15.5: CROXTON Ltd.’s cost efficiency report June 20X6 15.9. Summary A cost centre efficiency report provides information about the performance in a cost centre. The cost centre works well if its consumption variance is low. A negative consumption variance indicates poor budgeting quality because mismanagement tolerances <?page no="287"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 15-287 are granted. The volume difference is caused by different outputs than expected and are outside of the responsibility of cost centre managers. Companies prepare monthly efficiency reports which are based on cost variances. For proficiency reports, a company must budget, and record costs based on a marginal cost Accounting system. 15.10. Working Definitions Consumption Variance: The consumption variance is the difference between actual costs and standard costs based on the actual volume. Volume Variance: The volume variance is the difference between standard costs at actual volume and total planned costs rates multiplied with actual volume. 15.11. Question Bank (1) A company plans an output of 800 units. The planned costs are 12,400.00 EUR. There are 4,000.00 EUR fixed costs. The actual costs are 12,000.00 EUR for 750 products. How much is the volume variance? 1. 375 EUR . 2. 125 EUR . 3. 250 EUR . 4. 325 EUR . (2) In a marginal cost Accounting system, the budgeted cost function over the performance is called: 1. Budgeted costs. 2. Plan costs. 3. Applied overheads. 4. Standard costs. (3) Which statement is wrong? 1. The cost centre manager is responsible for the consumption variance. 2. The volume difference is the difference between standard costs at actual performance less applied overheads. 3. The sum of consumption variance and volume difference is the difference of standard costs at actual performance and actual overheads. 4. The cost centre manager is responsible for the volume difference. (4) If actual costs are below standard costs, the difference is: 1. Favourable. 2. Non-favourable. 3. Not possible. 4. Normal. (5) A company detects a difference between planned costs and actual costs at the budgeted output level. The difference is called: 1. Budget variance. 2. Consumption variance. 3. Standard variance. 4. Volume variance. 15.12. Solutions 1-3; 2-4; 3-4; 4-1; 5-2. <?page no="288"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-288 16. Cost Allocations 16.1. What is in the Chapter? Not all costs are allocated straight from cost categories to cost centres and then to the products. It is very common, that cost centres exchange performance and charge each other for it. This causes a loop in the cost flow. Those cost allocations are subjected to this chapter. The cost flow follows the mutual exchange of cost centres' support. We study the transportation business CLYDBANK Ltd. for its cost allocations between its four cost centres "City Logistics", "Long Distance Logistics", ‘Support" and "Storage". We discuss cost allocations based on onedirectional exchanges for CLYDBANK Ltd. and for another case TUSCAN (Pty) Ltd. Later in the chapter, we discuss a more complex case study HEISFELD Ltd. and cover mutual exchanges calculated by equation method and (for the same case) by iteration method. 16.2. Learning Objectives In this chapter, we teach cost assignments as tracing and as allocations. You learn by 3 case studies how to allocate costs in different situations. After studying this chapter, you understand how cost allocations work and can distinguish different steps in the allocation process. You can apply different cost allocation methods and assess which one is the right one for a case. 16.3. Cost Allocations Cost allocation is the process of assigning costs from one cost object to another one by applying mathematic operations, mostly based on the rule of three. Already discussed overhead applications fall under cost allocations, too. However, we now focus on cost centre support and study the costs exchanged to refund the sending cost centre and to charge the recipient. In contrast to allocations, a cost assignment by tracing does not require mathematical operations but follows a direct (1 : 1) relationship between the cost object and costs. Cost tracing is not discussed in this chapter. Following the cost flow in a Management Accounting system as illustrated in chapter (13/ 14) cost allocations apply at the 3 stages below: 16.4. The 1 st Allocation Overheads are derived from expense accounts in Financial Accounting, such as labour, materials etc., and assigned to cost centres. If more than one cost centre is charged with costs, allocations apply in order to divide costs. E.g., room costs are split between various cost centres based on their square metre number. 16.5. The 2 nd Allocation When performance is exchanged between cost centres, costs are transferred from one cost centre (sender) to another one (receiver) to refund the provider for its support. <?page no="289"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-289 16.6. The 3 rd Allocation Eventually, costs are transferred from cost centres to products based on cost rates. This is also called overhead application. This last step in the cost allocation procedure "refunds" the cost centres and charges the final cost objects (goods manufactured or services rendered) with cost centre costs. All cost allocations can apply in a full cost Accounting systems as well as for marginal cost Accounting. In case of marginal cost allocations, only proportional costs are considered for cost allocations whereas all fixed costs are closed-off to the Profit and Loss account. In an absorption costing (full cost Accounting system) cost rates also include fixed costs which does not require adding fixed costs to profit of loss. 16.7. C/ S CLYDBANK Ltd. We study a simple (because one-directional) cost allocation procedure for the case study CLYDBANK Ltd. CLYDBANK Ltd. is a transportation firm. The company is divided in 4 cost centres. - CC 01: City delivery transportation. - CC 02: Long distance transportation. - CC 03: Support. - CC 04: Storage. The "characteristics" of the cost centres (see: Figure 16.1) are used for cost allocations. They serve as allocation base. E.g., square metres are used for a fair allocation of room costs to cost centres. Note, at CLYDBANK Ltd., not all characteristics are of physical nature, e.g., insurance costs are allocated based on the assets’ costs of acquisition. This makes sense because the insurance covers the acquisition of replacement of machinery. If the insurance covered only the actual value (used machinery) the carrying value would have serve as base. Other characteristics at CLYDBANK Ltd. are the number of employees, square metres of the cost centre floor and working hours. The last characteristics apply for the 3 rd degree cost allocation to calculate the transportation services. Study the cost centre characteristics as disclosed in Figure 16.1. Characteristics CC 01 (city) CC 02 (long distance) CC 03 (support) CC 04 (storage) # of employees 23 50 7 20 Square metres 450 1,100 100 200 Value of machinery 800,000.00 1,500,000.00 20,000.00 500,000.00 Output in hours 10,580 23,000 - 9,200 Clydbank Ltd. COST CENTRE CHARACTERISTICS Figure 16.1: CLYDBANK Ltd.’s cost centre characteristics CLYDBANK Ltd.’s costs are overheads. At CLYDBANK Ltd., 4 cost categories apply: labour, room, insurance and Human Resources HR costs. All overheads are derived from the books of Financial Accounting. The Labour account’s balance <?page no="290"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-290 is 4,120,000.00 EUR, the Room Cost account’s balance 555,000.00 EUR, the Insurance account’s balance is 282,000.00 EUR and the Human Resource HR account’s balance is 120,000.00 EUR. Given that costs equal expenses, all expenses are “transferred” from Financial Accounting at a 1 : 1 relationship to cost Accounting. Check Figure 16.2 for the cost category accounts Labour, Room, Insurance and Human Resources HR: D C D C 4,120,000.00 555,000.00 D C D C 282,000.00 120,000.00 Labour LAB Room ROO Insurance INS Human resources HR Figure 16.2: CLYDBANK Ltd.’s accounts Some overheads are easily traceable to the 4 cost centres, as they got planned/ caused therein. This applies for labour. The values below are derived from payroll Accounting: in CC 01: 920,000.00 EUR, in CC 02: 2,250,000.00 EUR, in CC 03: 350,000.00 EUR and in CC 04: 600,000.00 EUR. Labour is assigned to cost centres as direct cost. In contrast, room costs for the building (depreciation) to the extent of 555,000.00 EUR, insurance costs of 282,000.00 EUR and costs for Human Resource HR of 120,000.00 EUR require allocations to cost centres. We call them 1 st degree allocations. 16.8. The 1 st Allocation - C/ S The first cost allocation takes costs from cost category accounts, like the Room Cost account, Insurance account and Human Resource HR account and adds them to Cost Centre accounts MOH CC 01, MOH CC 02, MOH CC 03 and MOH CC 04. MOH stands for Manufacturing Overheads. At CLYDBANK Ltd., the room costs of 555,000.00 EUR are divided based on square metres. Check the square metre numbers in the cost centres. The cost allocation follows a: 450 : 1,100 : 100 : 200 ratio. We cancel the ratio by dividing all figures by 50. This gives a: 9 : 22 : 2 : 4 ratio. E.g., the room costs allocated to CC 01 are: 555,000 × 9 / (9 + 22 + 2 + 4) = 1135,000.00 EUR. For the other cost centres, we calculate: 330,000.00 EUR, 30,000.00 EUR and 60,000.00 EUR. How it is Done (Cost Allocation) (1) Determine the value of the base figures for cost objects to which the costs are to be assigned. <?page no="291"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-291 (2) Write the figures as an a : b : c ratio. If possible, divide the a-, band c-number by a constant figure (cancellation). (3) Calculate the percentages of the cost objects by dividing the base figure of one cost object by the sum of all base figures: a / (a + b + c) (4) Multiply the total costs with the percentages. The insurance costs allocation to the cost centres is based on the cost of acquisition of insured machinery within a cost centre. The total of insurance costs equals 282,000.00 EUR. The total insurance costs are distributed based on a: 800,000 : 1,500,000 : 20,000 : 500,000 ratio. We cancel to 40 : 75 : 1 : 25. The portion of insurance costs for cost centre CC 01 is: 282,000 × 40 / (40 + 75 + 1 + 25) = 8 80,000.00 EUR. The other cost centres CC 02 … CC 04 are charged with 150,000.00 EUR, 2,000.00 EUR and 50,000.00 EUR respectively. The same approach applies for the Human Resource HR costs. They are allocated based on the head count as: 27,600.00 EUR, 60,000.00 EUR, 8,400.00 EUR and 24,000.00 EUR. We show cost allocations in the accounts. E.g., a cost allocation of insurance costs to cost centre CC 03 is recorded in the books as: DR MOH CC 03.................... 2,000.00 EUR CR Insurance ................... 2,000.00 EUR Check the cost allocations as recorded in Figure 16.3. D C D C 4,120,000.00 (1) 920,000.00 555,000.00 (5) 135,000.00 (2) 2,250,000.00 (6) 330,000.00 (3) 350,000.00 (7) 30,000.00 (4) 600,000.00 (8) 60,000.00 4,120,000.00 4,120,000.00 555,000.00 555,000.00 Labour LAB Room ROO D C D C 282,000.00 (9) 80,000.00 120,000.00 (13) 27,600.00 (10) 150,000.00 (14) 60,000.00 (11) 2,000.00 (15) 8,400.00 (12) 50,000.00 (16) 24,000.00 282,000.00 282,000.00 120,000.00 120,000.00 Insurance INS Human resources HR Figure 16.3: CLYDBANK Ltd.’s accounts <?page no="292"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-292 D C D C (1) 920,000.00 (2) 2,250,000.00 (5) 135,000.00 (6) 330,000.00 (9) 80,000.00 (10) 150,000.00 (13) 27,600.00 c/ d 1,162,600.00 (14) 60,000.00 c/ d 2,790,000.00 1,162,600.00 1,162,600.00 2,790,000.00 2,790,000.00 b/ d 1,162,600.00 b/ d 2,790,000.00 MOH CC 01 MOH CC 02 D C D C (3) 350,000.00 (4) 600,000.00 (7) 30,000.00 (8) 60,000.00 (11) 2,000.00 (12) 50,000.00 (15) 8,400.00 c/ d 390,400.00 (16) 24,000.00 c/ d 734,000.00 390,400.00 390,400.00 734,000.00 734,000.00 b/ d 390,400.00 b/ d 734,000.00 MOH CC 03 MOH CC 04 Figure 16.3: CLYDBANK Ltd.’s accounts (continued) Additionally, we disclose the cost allocations in a table, study Figure 16.4. for the details. By the next step, all cost centre costs are added. We refer thereto as total costs. The total costs for cost centre CC 01 are: 920,000 + 135,000 + 80,000 + 27,600 = 1,162,600.00 EUR. Labour is assigned directly (tracing), whereas room costs, insurance costs and human resources HR costs are allocated based on the characteristics to the cost centres. The total of assigned costs (traced and allocated) equals to the balancing figure of the cost centre accounts in Figure 16.3. E.g., the balancing figure of the MOH CC 01 account is 1,162,600.00 EUR. Check the spreadsheet for cost allocations in Figure 16.4. Characteristics CC 01 (city) CC 02 (long distance) CC 03 (support) CC 04 (storage) # of employees 23 50 7 20 Square metres 450 1100 100 200 Value of machinery 800,000 1,500,000 20,000 500,000 Output in hours 10,580 23,000 - 9,200 Assigned labour costs 920,000 2,250,000 350,000 600,000 Allocations Room costs 135,000 330,000 30,000 60,000 Insurance costs 80,000 150,000 2,000 50,000 HR costs 27,600 60,000 8,400 24,000 total costs 1,162,600 2,790,000 390,400 734,000 Figure 16.4: CLYDBANK Ltd.’s cost allocations to cost centres <?page no="293"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-293 The 2 nd Allocation - C/ S The second degree cost allocations reflect the exchanges of performance between cost centres. In case one cost centre supports another one, the receiving cost centre reimburses the delivering cost centre. The exchanges are recorded as Bookkeeping entries. The sender cost centre is reimbursed by a credit entry and the receiving cost centres are charged for the costs by debit entries. This way, cost flows follow performance. If a cost centre delivers its entire performance to other cost centres it is called an auxiliary cost centre. A cost centre that performs only for the support of other cost centres is called an auxiliary cost centre. Auxiliary cost centres’ accounts are closedoff to receiving cost centre accounts. At CLYDBANK Ltd., cost centre CC 03 falls under auxiliary cost centres. It only facilitates the other cost centres’ work based on the following percentages: 20 % of its performance supports cost centre CC 01, 70 % is for CC 02 and 10 % for CC 04. Once we add the percentages, we recognize the total performance is: 20% + 70% + 10% = 1 100%. This proves that CC 03 is an auxiliary cost centre. The percentages are based on total costs of the cost centre CC 03 after completion of 1 st degree allocations. The total costs of cost centre CC 03 at that stage equal: 350,000 + 30,000 + 2,000 + 8,400 = 390,400.00 EUR. Below, we cover the 2 nd degree allocations which is between CLYDBANK Ltd.’s departments: from cost centre CC 03 to cost centres CC 01, CC 02 and CC 04. As cost centre CC 03 performs to an extent of 20 % for cost centre CC 01, the recipient is charged costs of: 20% × 390,400 = 78,080.00 EUR. We make the Bookkeeping entry (17) as below: DR MOH CC 01.................... 78,080.00 EUR CR MOH CC 03.................... 78,080.00 EUR The other cost centres cover the remaining costs of cost centre CC 03. Cost centre CC 02 covers: 70% × 390,400 = 273,280.00 EUR and cost centre CC 04 is charged: 10% × 390,400 = 3 39,040.00 EUR. Observe Bookkeeping entries (18) and (19) which transfer the provider’s costs to the cost centres CC 02 and CC 04. DR MOH CC 02.................... 273,280.00 EUR CR MOH CC 03.................... 273,280.00 EUR DR MOH CC 04.................... 39,040.00 EUR CR MOH CC 03.................... 39,040.00 EUR In Figure 16.5, all internal cost allocations are recorded as the Bookkeeping entries (17) … (19). <?page no="294"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-294 D C D C (1) 920,000.00 (2) 2,250,000.00 (5) 135,000.00 (6) 330,000.00 (9) 80,000.00 (10) 150,000.00 (13) 27,600.00 c/ d 1,162,600.00 (14) 60,000.00 c/ d 2,790,000.00 1,162,600.00 1,162,600.00 2,790,000.00 2,790,000.00 b/ d 1,162,600.00 b/ d 2,790,000.00 (17) 78,080.00 c/ d 1,240,680.00 (18) 273,280.00 c/ d 3,063,280.00 1,240,680.00 1,240,680.00 3,063,280.00 3,063,280.00 b/ d 1,240,680.00 b/ d 3,063,280.00 D C D C (3) 350,000.00 (4) 600,000.00 (7) 30,000.00 (8) 60,000.00 (11) 2,000.00 (12) 50,000.00 (15) 8,400.00 c/ d 390,400.00 (16) 24,000.00 c/ d 734,000.00 390,400.00 390,400.00 734,000.00 734,000.00 b/ d 390,400.00 (17) 78,080.00 b/ d 734,000.00 (18) 273,280.00 (19) 39,040.00 c/ d 773,040.00 (19) 39,040.00 773,040.00 773,040.00 390,400.00 390,400.00 b/ d 773,040.00 MOH CC 01 MOH CC 02 MOH CC 03 MOH CC 04 Figure 16.5: CLYDBANK Ltd.’s accounts after internal cost allocations In the spreadsheet, the internal cost allocations are disclosed as one line in the bottom part, indicated CC 03 under the header of "Internal Cost Allocations". For the reimbursed cost centre CC 03 therein a negative cost entry to the extent of 390,400.00 EUR is disclosed, which proves that all costs of cost centre CC 03 are covered by the supported cost centres. The cost centres CC 01, CC 02 and CC 04 "pay" for the support from cost centre CC 03 to the extent of 78,080.00 EUR, 273,280.00 EUR and 39,040.00 EUR. <?page no="295"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-295 Characteristics CC 01 (city) CC 02 (long distance) CC 03 (support) CC 04 (storage) # of employees 23 50 7 20 Square metres 450 1100 100 200 Value of machinery 800,000 1,500,000 20,000 500,000 Output in hours 10,580 23,000 - 9,200 Assigned labour costs 920,000 2,250,000 350,000 600,000 Allocations Room costs 135,000 330,000 30,000 60,000 Insurance costs 80,000 150,000 2,000 50,000 HR costs 27,600 60,000 8,400 24,000 1,162,600 2,790,000 390,400 734,000 Internal cost allocations CC 03 78,080 273,280 (390,400) 39,040 1,240,680 3,063,280 0 773,040 Figure 16.6: CLYDBANK Ltd.’s spreadsheet with internal cost allocations 16.9. The 3 rd Allocation - C/ S The last cost allocation is for the product calculation. We call it 3 rd degree overhead allocation. In Manufacturing Accounting this is referred to as the application of overheads. Products are charged by cost centres for the performance received in the production procedure. Working on a product makes it "pay" for the received service per rate. The cost allocations are based on the output of the cost centres. At CLYDBANK Ltd., the outputs are given by the spreadsheet in Figure 16.1. E.g., the output of cost centre CC 01 is 10,580 hours. The cost rates for the 3 rd degree allocation are measured by EUR per reference unit. The reason is, that the costs of the cost centre, after 1 st and 2 nd degree allocations, are divided by the output. This gives the final cost rate. At CLYDBANK Ltd. all cost rates are measured in EUR/ h. However, other reference units are common in Management Accounting as well, such as EUR/ KWh, EUR/ m, etc. In contrast to output cost centres, auxiliary cost centres do not contribute directly to the good production or to service rendering. Therefore, no output related reference unit for auxiliary cost centres applies. The table indicates this by ‘n/ a’ (not applicable) in the cell for the cost rates. At CLYDBANK Ltd., only the cost centres CC 01, CC 02 and CC 04 fall under output cost centres. An output cost centre is a cost centre that works directly for the product. The cost rate for the cost allocation is determined by dividing the final costs by the reference unit. The cost rate of cost centre CC 01 is 1,240,680 / 10,580 = 1 117.27 EUR/ h. As a result, a city delivery (CC 01) that takes 20 min, is charged with: 20 × 117.27 / 60 = 339.09 EUR. The cost rates for the other cost centres are: <?page no="296"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-296 CC 02: 3,063,280 / 23,000 = 1 133.19 EUR/ h and: CC 04: 773,040 / 9,200 = 8 84.03 EUR/ h. Figure 16.7 discloses the cost rates per cost centre as result of the cost allocation process. Characteristics CC 01 (city) CC 02 (long distance) CC 03 (support) CC 04 (storage) # of employees 23 50 7 20 Square metres 450 1100 100 200 Value of machinery 800,000 1,500,000 20,000 500,000 Output in hours 10,580 23,000 - 9,200 Assigned labour costs 920,000 2,250,000 350,000 600,000 Allocations Room costs 135,000 330,000 30,000 60,000 Insurance costs 80,000 150,000 2,000 50,000 HR costs 27,600 60,000 8,400 24,000 1,162,600 2,790,000 390,400 734,000 Internal cost allocations CC 03 78,080 273,280 (390,400) 39,040 1,240,680 3,063,280 0 773,040 Cost rates[MYR/ h] 117.27 133.19 n/ a 84.03 Figure 16.7: CLYDBANK Ltd.’s cost centre rates Cost allocations apply for actual as well as for budgeted costs. The 2 nd degree cost allocations at CLYDBANK Ltd. are in one direction only. Cost centre CC 03 provides other cost centres with performance, but none of these cost centres supports CC 03 in return. Based on our studies of cost allocations at CLYDBANK Ltd. we define a few technical terms for internal cost allocations before we study more complex, mutual, cost exchanges. Check Figure 16.7 when reading the explanations below: 16.10. Technical Terms for Cost Allocations Primary costs are costs of a cost centre that are assigned directly. This includes assignments by the 1 st degree allocation, meaning costs coming straight in from Financial Accounting or are planned inside of the cost centres. Primary costs do not contain portions from any other cost centre. E.g., primary costs of cost centre CC 03 are 390,400.00 EUR. Once costs are assigned by 2 nd degree allocations, further costs are added to the total costs. Total costs are primary costs plus all costs assigned to the cost centre by internal cost allocation (2 nd degree allocation). The total costs of cost centre CC 01 equal: 1,162,600 + 78,080 = 1,240,680.00 EUR. The total costs include primary costs of 1,162,600.00 EUR and secondary costs of 78,080.00 EUR, the latter ones resulting from internal cost allocations. <?page no="297"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-297 Secondary costs are costs charged to a cost centre as a result from internal cost allocations (2 nd degree allocation). After a cost centre receives refunds from other cost centres for internal support - we record a credit entry (discharging) for the costs covered - all remaining costs are final costs. Final costs are primary costs plus secondary costs less discharged (refunded) costs from internal cost allocations (2 nd degree allocation). Internal cost allocations (2 nd degree allocation) become more difficult if the performance exchange is mutual. This means one cost centre supports another one and receives support from the same cost centre in return. In those cases, two cost allocation methods can apply. (1) Equation method. (2) Iteration method. 16.11. Equation Method (1) The equation method considers that all costs are charged and discharged simultaneously. There are two equations for each cost centre, one for the total costs TC i and another one for the final costs FC j . The index for the cost centres is i and j. i stands for the receiving cost centres and j for the providers. The total number of cost centres is n. (i = 1 … n; j = 1 … n). PC i stands for the primary costs of a cost centre. The factor α ij is the portion of the providing cost centre’s (j) performance, received by cost centre i. If cost centre A supports cost centre B to an extent of 35 % of its performance, α BA = 35%. n j j ij i i TC PC TC 0 ) 1 ( 0 n i ij j j TC FC (with: TC = total costs, PC = primary costs, α = percentage of allocation, FC = final costs, i, j = index for cost centres) To study internal cost allocations by the equation method, we discuss the case of TUSCAN (Pty) Ltd. 16.12. C/ S TUSCAN (Pty) Ltd. TUSCAN (Pty) Ltd. is an Accounting firm in Papenburg and runs two cost centres with mutual performance exchange, Management and Accounting. The Management department works for the Accounting department to an extent of 50 %. The Accounting department provides service for Management to an extent of 10 %. The primary costs are: for the Management department: 100,000.00 EUR and for the Accounting department: 400,000.00 EUR. The total costs TC for the departments are: TC A = PC A + α AM × TC M <?page no="298"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-298 TC M = PC M + α MA × TC A At this stage, we do not know the total costs TC i and, hence, we cannot include them in the mutually corresponding equations. The 2 equations need simultaneous (total) cost calculations: TC A = 400,000 + 50% × TC M TC M = 100,000 + 10% × TC A We insert the total cost of the Management department into the first equation and dissolve the equation towards TC A : TC A = 400,000 + 50% × (100,000 + 10% × TC A ) TC A = 450,000 / (1 - 5%) = 4 473,684.21 EUR. The total costs of the Management department are: TC M = 100,000 + 10% × 473,684.21 = 1 147,368.42 EUR. The second step is to determine the final costs of the cost centres: FC A = TC A × (1 - α MA ) FC M = TC M × (1 - α AM ) The calculation gives: FC A = 473,684.21 × (1 - 10%) = 4 426,315.79 EUR FC M = 147,368.42 × (1 - 50%) = 773,684.21 EUR To check the internal cost allocations, we add the final cost of the two departments Accounting and Management: 426,315.79 + 73,684.21 = 5 500,000.00 EUR. The sum proves correct calculations, if it is the total of the primary costs: 400,000 + 100,000 = 5 500,000.00 EUR. Thus, our internal cost allocation did not cause any increase or decrease of costs. 16.13. C/ S HEISFELD Ltd. We now look at another case study HEISFELD Ltd., which got more cost centres than TUSCAN (Pty) Ltd. HEISFELD Ltd. is a consultancy. HEISFELD Ltd. is divided in four cost centres: (1) Concept Development (C). (2) Webdesign (W). (3) Java Programming (J). <?page no="299"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-299 (4) Administration (A). For all cost centers, the performances and outputs are measured by hours (Ch, W-h, J-h, A-h). The outputs are 300 Wh, 500 C-h and 100 J-h. Administration is an auxiliary cost centre because it does not deliver service to customers. The internal cost allocations require performance planning or actual data about the performance to calculate the percentages of performance exchange α ij . For performance planning the internal support relationships are known: HEISFELD Ltd. knows that 6 W-h in the Webdesign cost centre need support from Concepts-Development to the extent of 1 C-h. 1 J-h in the Java Programming cost centre needs support from the Concept Development to the extent of 2 C-h. For 3 W-h in the Webdesign cost centre 1 J-h from the Java Programming cost centre is necessary. Administration is needed to the extent of 1 A-h per 20 J-h, 1 A-h per 3 W-h and 1 A-h per 25 C-h. The performance planning can be displayed by one performance equation per cost centre. In the equation for performance, the output marks the initial performance. E.g., in Concept Development it is 500 C-h. Additions are made for performing support of other cost centres. We name P i the performance of the cost centre i and set up 4 performance equations for 4 cost centres. i = C, W, J or A. The performance equations are: P C = 500 + 2 × P J + (1/ 6) × P W P W = 300 P J = 100 + (1/ 3) × P W P A = (1/ 20) × P J + (1/ 3) × P W + (1/ 25) × P C E.g., in the first equation, the units for the factor in front of the second summand is 2 C-h per J-h and the fraction in front of the third summand is 1 C-h per 6 W-h. Once we insert the performances the units of the fractions in front of the summands cancel out. E.g., the performance equation for the cost centre C is: P c = 500 C-h + (2 C-h/ J-h) × P j [in: J-h] + (1 C-h/ 6 W-h) × P W [in: W-h]. We can read from the 1 st equation that the performance in the Concept Development department P C is for the output and for the support of Java Programming and Webdesign. At this stage of the calculation, we do not know the hours performed in the single cost centres - except of in the Webdesign cost centre. Webdesign does not support others and only works for its own output to the extent of 300 W-h. We now dissolve the equations. As P W is known, we can calculate P J : P J = 100 J-h + (1 J-h / 3 W-h) × 300 W-h = 100 J-h + 100 J-h = 2 200 J-h. P C depends on only known parameters at this stage. Hence, P C = 500 + 2 × 200 + (1/ 6) × 300 = 9 950 Ch. The last value is for the performance in the Administration cost centre: P A = (1/ 20) × 200 + (1/ 3) × 300 + (1/ 25) × 950 = 1148 A-h. In the Figure 16.8 each arrow represents a summand in the performance equations. E.g., the P C = 500 + 50 + 400 equation reads as follows: 500 Ch is the output which is represented by <?page no="300"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-300 the arrow that goes out of the box for Concept Development. 50 C-h is the arrow which goes from Concept Development to Webdesign and 400 C-h is the arrow from Concept Development to Java Script. Observe Figure 16.8 for the internal performance relationships. Add the performance figures assigned to the outgoing arrows and check the performance calculation. We refer to the Java Programming cost centre. The performance is: 100 + 100 = 2 200 J-h. For the Administration, performance equals: 10 + 100 + 38 = 1148 A-h. The performance for Concept Development equals: 500 + 400 + 50 = 9 950 C-h, and the Webdesign’s performance is only for the output, which is amounting to 300 W-h. Figure 16.8: HEISFELD Ltd.’s performance structure To give the performance relationships a better structure, we express every exchange by α as a percentage. The calculation of α-values is the major purpose of the performance planning. The αvalue is required for the cost allocation equations and facilitates the calculation of cost allocations. The percentage α ij gives us the relative performance of the exchanged performance. The unit of α ij is %. See below the factors α ij . α JA = 10/ 148 = 6 6.76% α WJ = 100/ 200 = 5 50% α WA = 100/ 148 = 6 67.57% α WC = 50/ 950 = 5 5.26% α CA = 38/ 148 = 2 25.68% α JC = 400/ 950 = 4 42.11%. Once α is known, we can determine total and final costs. We read the primary costs from the table in Figure 16.9. As we run a full cost Accounting system both, the proportional and the fixed costs, matter. Hence, the costs for Webdesign are: 10,100 + 20,000 = 3 30,100.00 EUR, for <?page no="301"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-301 Concepts: 53,200.00 EUR, for Java Programming 24,000.00 EUR and for Administration 47,360.00 EUR. Webdesign Concepts Java Progr Admin Prim Costs, prop [EUR] 10,100 33,000 4,000 7,360 Prim Costs, fixed [EUR] 20,000 20,200 20,000 40,000 sum 30,100 53,200 24,000 47,360 Figure 16.9: HEISFELD Ltd.’s primary costs The equations for the total costs of the cost centres add primary costs and secondary costs from sending cost centres. The equation of the total cost TC j are: TC C = 53,200 + (38/ 148) × TC A TC W = 30,100 + (100/ 200) x TC J + (100/ 148) × TC A + (50/ 950) × TC C TC J = 24,000 + (10/ 148) × TC A + (400/ 950) × TC C TC A = 47,360.00 EUR We prefer fractions over percentages to determine the total and final costs in this textbook as it avoids rounding differences. At first, we calculate the total costs for the Concept Development: TC C = 53,200 + (38/ 148) × 47,360 = 6 65,360.00 EUR. By the next step, we calculate the total costs in the Java Programming cost centre: TC J = 24,000 + (10/ 148) × 47,360 + (400/ 950) × 65,360 = 5 54,720.00 EUR. The total costs in the Website Design cost centre are: TC W = 30,100 + (100/ 200) × 54,720 + (100/ 148) × 47,360 + (50/ 950) × 65,360 = 92,900.00 EUR. Now, we can determine the final costs per cost centre. We take the equation for the final costs and determine FC j for all four cost centres Concepts C, Webdesign W, Java Programming J and Administration A. Already at this stage, we <?page no="302"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-302 know the finial costs of the Administration cost centre FC A . As Administration is an auxiliary cost centre its final costs are zero. FC C = TC C × (1 - (400/ 950) - (50/ 950)) = 3 34,400.00 EUR FC W = TC W × (1 - 0) = 992,900.00 EUR FC J = TC J × (1 - (100/ 200)) = 2 27,360.00 EUR FC A = 0.00 EUR To check the calculation, we follow a fundamental Management Accounting rule, which states that the total of costs does not change due to allocations. Accordingly, the total of the primary costs equals to the total of final costs. Here, 30,100 + 53,200 + 24,000 + 47,360 = 34,400 + 92,900 + 27,360 = 154,660.00 EUR. As the totals match, we can be confident that our allocations are correct. However, this only is a check - no guarantee for correct values is given. After calculating final costs per cost centre, we can determine the cost rates for overhead application. The cost rates are calculated in advanced. We refer thereto as predetermined overhead allocation rates (POR). The formula for calculating the rates is POR i = FC i / output i . HEISFELD Ltd.’s POR-rates are: 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 The case HEISFELD Ltd. is simple as only 6 exchange relationships between 4 cost centres exist. However, with full mutual exchanges there would be 12 exchanges between 4 cost centres which can make our equation solving more complicated. If you consider that in a normal company a few hundred cost centres exists, you’ll understand the need for an alternative method of cost rate calculation which can be supported by software solutions. 16.14. Iteration Method (2) The reason for the application of the iteration method is that computers, on which we run the cost allocation routines, are not good at dissolving equations. However, a computer is good at computing, that is why it is called a computer. Next, we present a cost allocation method suitable for software solutions. It is called iteration, derived from the Latin word ire (= to walk). It works like the equation method, but the cost allocations are made step by step. This means we start the cost calculation of total costs from primary costs and add secondary costs step by step. The first step is based on the primary costs and further steps are based on the previously allocated costs. After the total cost calculation, final costs are determined. As more iterations we <?page no="303"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-303 compute, as more accurate costs become. To show the iterations, we prepare an MS-Excel spreadsheet. It is displayed in Figure 16.10 and the following Figures for the HEISFELD Ltd. case. In the top lines, the spreadsheet shows mutual cost centre support structure. The structure is indicated by values for α. For most accurate calculations, the αvalues are shown as fractions. However, MS-Excel discloses them as a digital figure. For instance, α JA - which represents the percentage of the Administration support for the Java Programming cost centre - is entered in as: 10/ 148. The display on MS-Excel shows 0.067567568, which we round to the nearest 1/ 100 percentage for display. To demonstrate the accuracy of the calculations, the display in Figure 16.10 is with multiple digits after the decimal point. The α-values result from the performance planning (above). See them below as percentages. 0.067567568 now shows as 6.76%. α JA = 10/ 148 = 6.76% α WJ = 100/ 200 = 50% α WA = 100/ 148 = 67.57% α WC = 50/ 950 = 5.26% α CA = 38/ 148 = 25.68%. α JC = 400/ 950 = 42.11%. to: Concept development Webdesign Java programming Admin from: Concept development 0 0.052631579 0.421052632 0 Webdesign 0 0 0 0 Java programming 0 0.5 0 0 Administration 0.256756757 0.675675676 0.067567568 0 Figure 16.10: HEISFELD Ltd.’s cost centre support structure Like the equation method, the iteration process calculates the total costs at first. The total costs include primary costs and costs received from other cost centres. In contrast to the equation method, the cost allocations now work step-by-step. The first cost portion received from the sending cost centres results from primary costs. Concept Development receives: (38/ 148) × 47,360 = 1 12,160.00 EUR from Administration. Website Design receives from Concept Development secondary costs to the extent of: (50/ 950) × 53,200 = 2 2,800.00 EUR, from Java Programming to the extent of: (100/ 200) × 24,000 = 1 12,000.00 EUR and from Administration to the extent of: (100/ 148) × 47,360 = 3 32,000.00 EUR. In total, the received costs add up to: 2,800 + 12,000 + 32,000 = 4 46,800.00 <?page no="304"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-304 EEUR. Java Programming cost centre receives: (400/ 950) × 53,200 = 2 22,400.00 EUR from the Concept Development cost centre and: (10/ 148) × 47,360 = 3,200.00 EUR from Administration. In total, the received costs’ sum is: 22,400 + 3,200 = 2 25,600.00 EUR. Administration does not receive costs as it is an auxiliary cost centre. In the lower part of Figure 16.11, the sent costs are recorded. They equal to: Concept Development: 2,800 + 22,400 = 25,200.00 EUR. Website Design: 0.00 EUR. Java Programming: 12,000.00 EUR. Administration: 12,160 + 32,000 + 3,200 = 4 47,360.00 EUR. By the next iteration step, the cost transfer is based on the costs from the previous allocation step only. The costs received by Concept Design from the 1 st step are 12,160.00 EUR. The costs received by the 2 nd step equal to zero, because the sending cost centre (Administration) does not receive support from other cost centres. Website Design receives costs from the Concept Development to the extent of: (50/ 950) × 12,160 = 6 640.00 EUR, from Java Programming to the extent of: (100/ 200) × 25,600 = 12,800.00 EUR and from Administration zero. The total value of received costs is: 640 + 12,800 = 1 13,440.00 EUR. The cost received by Java Programming equals: (400/ 950) × 12,160 = 5 5,120.00 EUR from Concept Development and zero from Administration. The costs sent by the 2 nd step equal to: Concept Development: 640 + 5,120 = 5,760.00 EUR Website Design: 0.00 EUR Java Programming: 12,800.00 EUR Administration: 0.00 EUR Although an approach that contains a lot of iteration steps becomes more and more accurate, we are aware that after a while the figures that are disclosed at 2 digits after the decimal point do not change significantly anymore by further iterations. For our case study, we terminate the iteration procedure after 3 runs. After the calculation of total costs, the final costs are calculated as total costs less stepwise sent costs. This is a similar approach to the equation method. Study the figures depicted in Figure 16.11 for HEISFELD Ltd. You will notice that the iteration process arrives the same final costs as the equation method. <?page no="305"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-305 to: Concept development Webdesign Java programming Admin from: Concept development 0 0.052631579 0.421052632 0 Webdesign 0 0 0 0 Java programming 0 0.5 0 0 Administration 0.256756757 0.675675676 0.067567568 0 Total costs: Primary costs (0 step) 53,200.00 30,100.00 24,000.00 47,360.00 received costs 1 st step 12,160.00 46,800.00 25,600.00 0.00 received costs 2 nd step 0.00 13,440.00 5,120.00 0.00 received costs 3 rd step 0.00 2,560.00 0.00 0.00 65,360.00 92,900.00 54,720.00 47,360.00 Sent costs: Sent 1 st step 25,200.00 0.00 12,000.00 47,360.00 Sent 2 nd step 5,760.00 0.00 12,800.00 0.00 Sent 3 rd step 0.00 0.00 2,560.00 0.00 30,960.00 0.00 27,360.00 47,360.00 Final costs: 34,400.00 92,900.00 27,360.00 0.00 Figure 16.11: HEISFELD Ltd.’s iteration process In the case study HEISFELD Ltd., the allocation is based on budgeted and full costs. In case the company applies a marginal cost Accounting system, it only takes proportional costs into consideration. There is no need to run an internal cost allocation based on fixed costs, as all fixed costs are closed-off to the Profit and Loss account. To show the procedure in a marginal cost Accounting system, we apply the internal cost allocation based on the iteration method for proportional primary costs. Check Figure 16.9 for the primary costs. It gives: PC W,prop = 10,100.00 EUR, PC C,prop = 33,000.00 EUR, PC J,prop = 4,000 and PC A,prop = 7,360.00 EUR The iteration process is disclosed in Figure 16.12. To cross-check the results, we apply the equation method based on proportional costs too. TC C = 33,000 + (38/ 148) × TC A TC W = 10,100 + (100/ 200) x TC J + (100/ 148) × TC A + (50/ 950) × TC C TC J = 4,000 + (10/ 148) × TC A + (400/ 950) × TC C TC A = 7,360.00 EUR <?page no="306"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-306 At first, we calculate the total costs for Concept Development: TC C = 33,000 + (38/ 148) × 7,360 = 3 34,889.73 EUR By the next step, we calculate the total costs in the Java Programming cost centre: TC J = 4,000 + (10/ 148) × 7,360 + (400/ 950) × 34,889.73 = 1 19,187.71 EUR The total costs in the Website Design cost centre are: TC W = 10,100 + (100/ 200) × 19,187.71 + (100/ 148) × 7,360 + (50/ 950) × 34,889.73 = 26,503.13 EUR Now, we can calculate the final costs of the cost centres. FC C = TC C × (1 - (400/ 950) - (50/ 950)) = 1 18,363.02 EUR FC W = TC W × (1 - 0) = 226,503.13 EUR FC J = TC J × (1 - (100/ 200)) = 9 9,593.86 EUR FC A = 0.00 EUR We compare the sum of final costs to the total of proportional primary costs: 18,363.02 + 26,503.13 + 9,593.86 = 54,460.01 EUR. The total of the proportional primary costs equals: 33,000 + 4,000 + 10,100 + 7,360 = 5 54,460.00 EUR. See below the result of the iteration process. Although figures are disclosed at 2 digits after the decimal point MS-Excel calculates more precisely in the background. Check Figure 16.12. <?page no="307"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-307 to: Concept development Webdesign Java programming Admin from: Concept development 0 0.052631579 0.421052632 0 Webdesign 0 0 0 0 Java programming 0 0.5 0 0 Administration 0.256756757 0.675675676 0.067567568 0 Total costs: Primary costs (0 step) 33,000.00 10,100.00 4,000.00 7,360.00 received costs 1 st step 1,889.73 8,709.82 14,392.03 0.00 received costs 2 nd step 0.00 7,295.48 795.68 0.00 received costs 3 rd step 0.00 397.84 0.00 0.00 34,889.73 26,503.13 19,187.71 7,360.00 Sent costs: Sent 1 st step 15,631.58 0.00 2,000.00 7,360.00 Sent 2 nd step 895.14 0.00 7,196.02 0.00 Sent 3 rd step 0.00 0.00 397.84 0.00 16,526.71 0.00 9,593.85 7,360.00 Final costs: 18,363.02 26,503.13 9,593.85 0.00 Figure 16.12: HEISFELD Ltd.’s iteration process based on proportional costs For cost monitoring based on cost centre efficiency checks, HEISFELD Ltd. must run a 1 st degree allocation and check variances based on cost centre data. As we mentioned in the previous chapter (15), cost monitoring takes place at the senders and before internal cost allocations. To detect deviations where they occur, monitoring checks the auxiliary cost centres, too. Based on incremental costs, the predetermined overhead allocation rates are: POR C,prop = FC C,prop / Output C = 18,363.02 / 500 = 3 36.73 EUR/ C-h POR W,prop = FC W,prop / Output W = 26,503.13 / 300 = 8 88.34 EUR/ W-h POR J,prop = FC J,prop / Output J = 9,593.85 / 100 = 9 95.94 EUR/ J-h POR A,prop : n/ a In a marginal cost Accounting system, all fixed costs, here to the extent of 20,000 + 20,200 + 20,000 + 40,000 = 100,200.00 EUR, are closed-off to the Profit and Loss account. We provide an overview of the procedure of performance planning and cost allocations below. Note, that we must calculate/ plan performance at first and before cost allocations can take place: <?page no="308"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-308 How it is Done (Performance Planning) (1) Determine the output of the cost centres, such as goods/ services for reverse budgeting. (2) Find an appropriate reference unit which is proportionally depending on the output and on the costs. (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 for 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. (6) Divide the exchanged support by the total performance of a cost centre to calculate the percentage of performance exchange α AB . How it is Done (Cost Allocations) (1) Calculate the total costs as the sum of primary costs and costs for receiving support from other cost centres. In a marginal cost Accounting system, only proportional costs apply. (2) Record the receiving support from other cost centres as percentage × total costs, such as for the costs cost centre A is charged by cost centre B: α AB × TC B . (3) Prepare an equation system for the total costs of every cost centre that contains all primary costs PC and the sum of percentages of costs from supporting cost centres for received performance. (4) Dissolve the equation system for the total costs of the cost centres TC i . In case mutual cost allocations exist solve the equation system by equation method or in more complex cases by iteration method. (5) Determine the final costs FC j . Prepare equations for every cost centre that is based on its total costs and deduct the percentages α of total costs that are for support of other cost centres to determine the final costs FC j . (6) Divide final costs FC by the output of the cost centres to calculate the cost rates. No cost rates for auxiliary cost centres apply. <?page no="309"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-309 16.15. Summary Management Accounting systems apply multiple cost allocations to determine costs for cost objects. There is a 1 st degree allocation required to assign overheads to cost centres. The 2 nd degree cost allocation considers the performance exchange between cost centres. Mutual support relationships require an equation method or can be calculated by iteration method. The 3 rd degree cost allocation is based on cost centre cost rates. The allocation charges products with costs and refunds the cost centres where the product has been manufactured or the service been rendered. Another technical term for the latter allocation is overhead application. Cost allocations do not change the total of costs in a company. This effect can be used to crosscheck cost allocation results (in an Accounting exam). 16.16. Working Definitions Auxiliary Cost Centre: A cost centre that performs only for the support of other cost centres is called an auxiliary cost centre. Cost Allocation: Cost allocation is the process of assigning costs from one cost object to another one by applying mathematic operations, mostly based on the rule of three. Final costs: Final costs are primary costs plus secondary costs less discharged (refunded) costs from internal cost allocations. Output Cost Centre: An output cost centre is a cost centre that works directly for the product. Primary Costs: Primary costs are costs of a cost centre that are assigned directly. Secondary Costs: Secondary costs are costs charged to a cost centre as a result from internal cost allocations. Total Costs: Total costs are primary costs plus all costs assigned to the cost centre by internal cost allocations. 16.17. Question Bank (1) An auxiliary cost centre C records 12,000.00 EUR prime costs and gets 4,000.00 EUR allocated costs from a room cost centre. It supports 2 cost centres A and B with 40 % and 60 %. How much are allocated costs? 1. 4,800 / 7,200 / (12,000) . 2. 6,400 / 9,600 / 0 . 3. 6,400 / 9,600 / (16,000) . 4. 6,400 / 9,600 / 16,000 . (2) Cost centre X got total costs of 25,000.00 EUR. 5,000.00 EUR are allocated to cost centre Y and 20,000.00 EUR are output. Which exchange ratio is correct? 1. α XY = 20 % . 2. α YX = 20 % . 3. α XY = 25 % . 4. α YX = 25 % . (3) A company divides 34,000.00 EUR by head count. The cost centres A, B, C, D got 23 / 45 / 62 / 40 employees. How much costs are allocated to cost centre C? 1. 6,200.00 EUR . 2. 21,080.00 EUR . <?page no="310"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 16-310 3. 12,400.00 EUR . 4. 8,000.00 EUR . (4) A cost centre in a production firm receives insurance costs from an insurance cost centre. The insurance covers damages at replacement values. Which would be an appropriate allocation base? 1. Cost of acquisition. 2. Carrying amounts. 3. Gross purchase price. 4. Liquidation values. (5) Two cost centres exchange performance mutually. Cost centre A receives 30 % of cost centre B. Cost centre B receives 50 % of cost centre A. In both cost centres the primary costs are 10,000.00 EUR. How much are total costs in cost centre A? 1. 15.294.12 EUR . 2. 11,304.35 EUR . 3. 17,647.06 EUR . 4. 13,043.48 EUR . 16.18. Solutions 1-3; 2-2; 3-3; 4-2; 5-1. <?page no="311"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 17-311 17. Reporting 17.1. What is in the Chapter? As cost information is needed to control the business, prepare budgets, make calculations, monitoring results, run profitability checks etc., it must be brought to the managers’ attention. This is studied by this chapter. We show what contents needs reporting and how to design reports. We discuss the case study LEBUHRAYA Ltd. a production firm for wine bottles. You’ll see its Bookkeeping records and how to develop a report e.g., the statement of cost of goods sold and a profitability analysis. 17.2. Learning Objectives The role of Management Accountants within a company can be described as internal consultant. They calculate appropriate cost information, like cost and ratios, for controlling the business. We prepare you for this job and give you an example how it is done. Accountants support managers with data. Commonly, information is structured in form of reports. Reports can be linked to cost objects, include business graphics, like timeline or pie diagrams, or the show ratios, such as return figures or market shares. After studying this chapter, you understand the development of a manufacturing report for a production firm. You are aware how to prepare reports and you know how to read them. 17.3. Providing Information as an Accounting Task Within a company, a lot of information about resource consumption and costs is available. It is based on budgeting and recording business activities. One of the major difficulties in Accounting is to filter the available data to provide managers with useful controlling information. For this objective, Management Accountants prepare reports which often are based on cost allocations towards cost objects. Reports contain comparisons and ratios, such as for performance and liquidity. The field of reporting is wide and depends on the managers' need and preferences. In literature, reporting is always compared to a cockpit. The situation in aviation is very similar to business. The role of Management Accounting is like to "design and maintain the cockpit" Maintaining refers to the task to provide the right information in different situations. A modern cockpit is based on a primary flight display with different screens to show in various flight phases. Reporting is the field in Accounting that deals with cockpit design. In an aircraft a lot of information is available, mostly derived from air pressure, engine parameters, gyroscopes, compass and GPS. The engineers’ task is to collect the data, filter and analyse them and disclose (only) data which are important for a specific phase of flight. E.g., a pilot can fly straight and level with information about attitude, direction, altitude and speed. This is on the main display with <?page no="312"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 17-312 an attitude/ direction/ bank ancle indicator in the centre and airspeed and altitude bands at the left and right border. However, during flights further checks are conducted in special situations which require further information about the aircraft, like fuel levels, engine temperatures, cabin pressure and power settings. For navigation purpose, the pilot switches to a GPS screen etc. The cockpit display fulfils all those special information needs. Very similar to aviation, managers are shown standard reports in normal situations. But additionally, data support for special situations is required. This is referred to as exceptional reporting. E.g., an exceptional report is needed if a cost deviation occurs, and the manager must determine its reasons and find a cure to keep costs at bay. Next, we demonstrate two examples for a manufacturing report. We could say, we only build one cockpit screen - not the entire cockpit. We prepare these two reports: - Cost of goods sold (COS) report. - Profitability statement. 17.4. C/ S LEBUHRAYA We study the case of LEBUHRAYA Ltd. See below its data sheet. We derive the reporting information from its books and thereafter design reports. Data Sheet for LEBUHRAYA Ltd. CClassification: Manufacturing; Opening values: 20,000.00 EUR in RMinventory; 5,000.00 EUR in WIP; Purchase: 100,000.00 EUR; direct materials: 55,000.00 EUR; indirect materials 50,000.00 EUR; Direct labour 180,000.00 EUR; indirect labour: 20,000.00 EUR; Depreciation: 80,000.00 EUR; Administration: 50,000.00 EUR; Marketing: 10,000.00 EUR; Addition to finished goods: 300,000.00 EUR; Cost of sales: 150,000.00 EUR; 225,000.00 EUR in revenue; VAT ignored. On its balance sheet, LEBUHRAYA Ltd. discloses the opening values for inventory in its Raw Material Inventory account: 20,000.00 EUR and Work-in-Process account: 5,000.00 EUR. During the Accounting period 20X6, LEBUHRAYA Ltd. records purchases to the extent of 100,000.00 EUR. The materials used in production are 55,000.00 EUR direct materials and 50,000.00 EUR indirect materials. The indirect materials are added to the Manufacturing Overheads account. Furthermore, LEBUHRAYA Ltd. records labour to an extent of 200,000.00 EUR. 180,000.00 EUR is direct labour and assigned to work-in-process. The remaining portion of 20,000.00 EUR is indirect labour. LEBUHRAYA Ltd. adds indirect labour to the Manufacturing Overheads account. Another manufacturing overhead is depreciation. LEBBUHRAYA (Pty) Ltd.’s depreciation on the production facilities is amounting to 80,000.00 EUR/ a. Non-manufacturing overheads apply for administration to the extent of 50,000.00 EUR and Marketing 10,000.00 EUR. At first, we record the costs received from Financial Accounting. Figure 17.1 shows the opening values. <?page no="313"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 17-313 D C D C OV 20,000.00 OV 5,000.00 Raw materials inventory RMI Work in process-20X6 WIP Figure 17.1: LEBUHRAYA Ltd.’s opening values The opening value in the WIP-account indicates job orders in Production that have been started in prior Accounting periods but are not finished yet. The value of 5,000.00 EUR in LEBUHRAYA Ltd.’s WIP-account contains labour, materials and applied overheads from 20X5. (1 … 3) On 2.01.20X6, LEBUHRAYA Ltd. records labour and purchases. As we do not intend to prepare financial statements in this chapter, only Managerial Accounting information is relevant. Hence, we only make Bookkeeping entries excluding VAT and can ignore most of the real accounts, e.g., Accounts Payables and the Cash/ Bank account. By the Bookkeeping entry (2), the Purchase account is closed-off to the Inventory account. DR Purchase..................... 100,000.00 EUR CR Cash/ Bank.................... 100,000.00 EUR DR Inventory.................... 100,000.00 EUR CR Purchase..................... 100,000.00 EUR DR Labour....................... 200,000.00 EUR CR Cash/ Bank.................... 200,000.00 EUR (4) LEBUHRAYA Ltd. records depreciation on 31.12.20X6. DR Depreciation ................. 80,000.00 EUR CR Acc. Depr.................... 80,000.00 EUR (5 … 9) For Management Accounting, LEBUHRAYA Ltd. prepares a WIPaccount and a Manufacturing Overheads account. Direct materials and labour are assigned to the WIP-account. Indirect materials, indirect labour and depreciation is added to manufacturing overheads. On 1.03.20X6, the Management Accountant allocates materials, labour and depreciation to the WIP-account and MOH-account. DR WIP Account.................. 55,000.00 EUR CR Inventory Account............ 55,000.00 EUR <?page no="314"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 17-314 DR MOH Account.................. 50,000.00 EUR CR Inventory Account............ 50,000.00 EUR DR WIP Account.................. 180,000.00 EUR CR Labour....................... 180,000.00 EUR DR MOH Account.................. 20,000.00 EUR CR Labour....................... 20,000.00 EUR DR MOH Account.................. 80,000.00 EUR CR Depreciation................. 80,000.00 EUR (10) LEBUHRAYA Ltd. applies overheads completely. 150,000.00 EUR are transferred from the MOH-account to the WIP-account. The Bookkeeping entries are recorded on 15.03.20X6. DR WIP Account.................. 150,000.00 EUR CR MOH Account.................. 150,000.00 EUR (11) With the job orders recorded, LEBUHRAYA Ltd. produces 405,000 wine bottles. 300,000 wine bottles thereof are completed on 31.03.20X6. LEBUHRAYA Ltd. closes one job order and puts 300,000 wine bottles on stock. The cost of manufacturing per wine bottle are 1.00 EUR/ u (given for this case study). The value of the finished goods inventory equals: 1 × 300,000 = 3 300,000.00 EUR. DR Finished Goods Inventory..... 300,000.00 EUR CR WIP Account.................. 300,000.00 EUR (12) On 4.04.20X6, 150,000 wine bottles are sold at a net selling price of 1.50 EUR/ u. The total revenue is: 1.50 × 150,000 = 2 225,000.00 EUR. The revenue is recorded on 5.04.20X6. DR Cash/ Bank.................... 225,000.00 EUR CR Revenue...................... 225,000.00 EUR (13) For the sale 150,000 wine bottles are released from stock. They become costs and require a debit entry in the Cost of Sales account. The movement of goods is recorded on 4.04.20X6. DR COS Account.................. 150,000.00 EUR CR FG Inventory................. 150,000.00 EUR (14; 15) No further business activities take place. We record Administration and Marketing costs, both on 30.06.20X6. They represent non-manufacturing overheads. <?page no="315"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 17-315 DR Administration............... 50,000.00 EUR CR Cash/ Bank.................... 50,000.00 EUR DR Marketing.................... 10,000.00 EUR CR Cash/ Bank.................... 10,000.00 EUR Check LEBUHRAYA Ltd.’s accounts to familiarise yourself with its profit calculation in Figure 17.2. D C D C OV 20,000.00 (5) 55,000.00 OV 5,000.00 (11) 300,000.00 (2) 100,000.00 (6) 50,000.00 (5) 55,000.00 c/ d 15,000.00 (7) 180,000.00 120,000.00 120,000.00 (10) 150,000.00 c/ d 90,000.00 b/ d 15,000.00 390,000.00 390,000.00 b/ d 90,000.00 D C D C (1) 100,000.00 (2) 100,000.00 ... (1) 100,000.00 (12) 225,000.00 (3) 200,000.00 (14) 50,000.00 (15) 10,000.00 Raw materials inventory INV Work in process-20X6 WIP Purchase-20X6 PUR Cash/ Bank C/ B D C D C (3) 200,000.00 (7) 180,000.00 (4) 80,000.00 (9) 80,000.00 (8) 20,000.00 200,000.00 200,000.00 Labour-20X6 LAB Depreciation-20X6 DPR D C D C (11) 300,000.00 (13) 150,000.00 P&L 225,000.00 (12) 225,000.00 c/ d 150,000.00 300,000.00 300,000.00 b/ d 150,000.00 D C D C (13) 150,000.00 P&L 150,000.00 (14) 50,000.00 P&L 50,000.00 FG inventory FGI Revenue-20X6 REV Cost of sales-20X6 COS Administration-20X6 ADM Figure 17.2: LEBUHRAYA Ltd.’s accounts <?page no="316"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 17-316 D C D C (15) 10,000.00 P&L 10,000.00 COS 150,000.00 REV 225,000.00 ADM 50,000.00 MKT 10,000.00 EBT 15,000.00 225,000.00 225,000.00 b/ d 15,000.00 Marketing-20X6 MKT Profit and Loss-20X6 P&L Figure 17.2: LEBUHRAYA Ltd.’s accounts (continued) On the statement of financial position, LEBUHRAYA Ltd. discloses: 15,000 + 90,000 + 150,000 = 2 255,000.00 EUR in inventories. The value contains raw materials, work-in-process and finished goods. The Profit and Loss account has not been closed-off to the Retained Earnings account yet. Furthermore, the Cash/ Bank account is not balanced-off either, as it does not matter for our purpose of reporting manufacturing costs. To inform managers at LEBUHRAYA Ltd. about the cost of sales structure and about the profit earned with 150,000 wine bottles, providing T-accounts won’t be appropriate. The Management Accountant prepares a report which states the information required. We design a report as a cost of sales statement for the Accounting period 20X6. We study this report in Figure 17.3. <?page no="317"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 17-317 Item Amount OV Raw materials 20,000 Purchases 100,000 120,000 Closing stock raw materials (15,000) Indirect materials (50,000) Total direct materials 55,000 Direct labor 180,000 Prime cost 235,000 Applied overheads 150,000 385,000 OV Work in process WIP 5,000 390,000 Closing stock work in process WIP (90,000) COST of MANUFACTURING 300,000 OV FG inventory 0 Closing stock of FG inventory (150,000) COST of GOODS SOLD COS 150,000 Lebuhraya Ltd. STATEMENT of COST of GOODS SOLD as for the period ended 31.12.20X6 Figure 17.3: LEBUHRAYA Ltd.’s statement of COS The report shows data about the costs of manufacturing and costs of sales for the Accounting period 20X6. The costs of manufacturing are linked to 300,000 wine bottles completed in production. As half of them are sold during the Accounting period 20X6, the costs of sales are calculated by deducting the closing stock of finished goods from the costs of manufacturing: 300,000 - 150,000 = 1 150,000.00 EUR. 4 steps are necessary to calculate the cost of manufacturing. The report reflects these 4 steps. It contains 4 sections linked to the calculation steps. We calculate the costs of manufacturing as a sum of materials, labour and overheads. The last step is the adjustment of inventory. We discuss the steps below in detail: (1) Calculation of materials. (2) Calculation of labour. (3) Application of overheads. (4) Adjustments for opening and closing stock of finished goods. 17.5. Calculation of Materials (1) The calculation of the costs of manufacturing starts-off from the opening value of raw materials. The first calculation determines the direct cost of materials. The calculation is based on the opening value of raw materials plus purchases less closing stock. Furthermore, indirect materials are deducted because they are <?page no="318"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 17-318 considered as part of the applied overheads later. The calculation of direct materials gives: 20,000 + 100,000 - 15,000 - 50,000 = 5 55,000.00 EUR. 17.6. Calculation of Labour (2) For the LEBUHRAYA Ltd. case study, labour is direct labour to the extent of 180,000.00 EUR. Indirect labour is not considered at this part of the report, as it is included in applied overheads. After adding direct labour, the costs of manufacturing are: 55,000 + 180,000 = 235,000.00 EUR. 17.7. Application of Overheads (3) Regarding overheads, we do not bother the managers with details. The report adds 150,000.00 EUR applied overheads to the calculation. In case further information is required, the Accountant can offer to run a ‘data drill down’ and provide more details about the cost centre costs. After adding overheads, the costs of manufacturing are: 235,000 + 150,000 = 385,000.00 EUR. 17.8. Adjustments (4) The calculated costs of manufacturing do not yet consider the closing balance of the WIP-account nor its opening value. The opening value matters, as it represents production costs from previous Accounting periods. At the same time, costs for goods not yet finished are not supposed to be included in the costs of manufacturing. For this reason, the opening value of the WIP-account is added, and the closing balance is deducted. The costs of manufacturing then equal: 385,000 + 5,000 - 90,000 = 300,000.00 EUR. 17.9. COS-Report Although the costs of manufacturing can be derived from the accounts, the statement of cost of sales in Figure 17.3 provides more user-friendly information. Consider that managers of production departments mostly are engineers and not Accountants. In case the recipient of the report has further information needs, she/ he will ask the Accountant for support. E.g., it could be required to see the unit costs of manufacturing which are: 300,000 / 300,000 = 1 1.00 EUR/ u. Another information need could be about costs transferred to the next Accounting period. Here, the production manager spends 90,000.00 EUR on the production of 105,000 wine bottles that are not completed yet. These bottles are the opening value in the WIP-account in the next Accounting period. The department preworked the wine bottles, which means bottles to the unit costs of 90,000 / 105,000 = 0 0.86 EUR/ u remain in the cost centre. If work is not completed, goods are not transferred to stock. Therefore, the WIP-account does not get discharged and the costs stay with the cost centre. On the other hand, in our case the cost centre benefitted from 5,000.00 EUR opening value in work-in-process. Cost centre managers must know direct labour and overheads. The value for purchases, the closing stock etc. are less important, as those cannot be changed in the cost centre. However, labour costs and overheads can. Working overtimes, extra shifts, rework etc. are factors that can have an impact on the cost centre <?page no="319"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 17-319 efficiency and thus, they are of high interest. The same applies for the overheads which depend on decisions made by the manager, such as indirect materials consumption, indirect labour, cost centre administration, contributions to other cost centres etc. To learn about its cost deviations, LEBUHRAYA Ltd. must prepare an efficiency report as discussed in chapter (15). Here, another report is prepared, which focusses on the profitability analysis. See Figure 17.4. Item Amt. Sales 225,000 COST of GOODS SOLD (150,000) Gross margin 75,000 Extraordinary income 0 Gross income 75,000 Further expenses Administration (50,000) Marketing (10,000) Net operating profit 15,000 Lebuhraya Ltd. STATEMENT of PROFITABILITY for the period ended 31.12.20X6 Figure 17.4: LEBUHRAYA Ltd.’s profitability analysis 17.10. Summary Management Accountants provide information in 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 prepare exceptional reports too. Often business graphics, like charts and pie diagrams are included to the reports to make information more user-friendly. 17.11. Question Bank (1) A report discloses purchases at 10,000.00 EUR, an opening value of raw materials at 2,500.00 EUR, a closing stock of raw materials of 1,000.00 EUR and indirect materials of 4,000.00 EUR to be allocated by the application of overheads. How much is the total of direct materials? 1. 10,000.00 EUR . 2. 12,500.00 EUR . 3. 11,500.00 EUR . 4. 7,500.00 EUR . <?page no="320"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 17-320 (2) Which items do you find on the cost of goods sold report? 1. Primary costs, closing stock of WIP, applied overheads. 2. Prime costs, closing stock of WIP, applied overheads. 3. Prime costs, opening value of finished goods, total of overheads. 4. Primary costs, closing stock of finished goods, total of overheads. (3) A report of profitability analysis discloses a gross margin of 33,000.00 EUR, rental income of 4,000.00 EUR, interest of 1,000.00 EUR and Marketing expenses of 2,000.00 EUR. Which statement is correct? 1. The net profit is amounting to 26,000.00 EUR. 2. The net profit after tax is amounting to 18,200.00 EUR. 3. The net profit is amounting to 23,800.00 EUR. 4. The net profit after tax is amounting to 23,800.00 EUR. (4) Which are prime costs? 1. Direct labour and total of materials. 2. Direct labour and direct materials. 3. Originally assigned costs before internal cost allocations. 4. Labour and materials. (5) What is the difference between unit cost of manufacturing and unit costs of goods sold? 1. A difference results from production in different Accounting periods at different costs. 2. None. 3. The sales margin. 4. Inventory changes: add opening value and deduct closing stock. 17.12. Solutions 1-4; 2-2; 3-4; 4-2; 5-1. <?page no="321"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 18-321 18. Job Order Costing (Manufacturing Accounting) 18.1. What is in the Chapter? The chapter (18) deals with Manufacturing Accounting as job order costing and the next following chapter (19) as process costing. In Manufacturing Accounting, we calculate the unit costs per product. In chapter (18) we study MAHKOTA (Pty) Ltd., a production firm for cell phone pouches. The company produces 2 distinguishable types of goods in separate job orders. We study how job order costing works and how it leads to the calculations 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 both products for product mix decisions. A second case study WEIXDORF (Pty) Ltd. shows a more complex job order costing system, and we consider closing stocks. 18.2. Learning Objectives Manufacturing Accounting is relevant for Financial Accounting (inventory valuation) 57 as well as for Management Accounting (calculation). We covered a job order costing system already in chapter (4) for the product calculation at PENOR PLC. In this chapter (18) you learn that job order costing is based on internal job orders. After studying this chapter, you understand calculation and the account structure applied for calculations in Industrial Management. 57 Read our textbook Financial Statements, chapter (9). 18.3. Calculations Calculations tell us the unit cost of manufacturing for goods/ services. Manufacturers control production based on internal job orders and assign direct and overheads thereto. At the end of the production procedure - when goods are finished and added to stock - the total costs of the job order (batch costs) are divided by the number of goods (lot size) which gives us the unit costs of manufacturing. Note, costs of manufacturing only consider costs linked to production. A job order is an internal order for production of goods or parts thereof. A job order is recorded in a Job Order account or its reconciliation account: Work-in-Process account. All direct costs are added to the job order (WIP-account). Overheads in a department (cost centre) are at first collected in MOHaccounts and thereafter transferred to products based on performance related allocations (overhead application). In Manufacturing Accounting, the overhead allocation is based on a predetermined overhead allocation rate. An overhead application means that costs are transferred from the Manufacturing Overheads account to the WIP-account. The value of applied overheads is calculated by multiplying the actual performance with the (predetermined) overhead allocation rate. The latter one is calculated as planned manufacturing overheads divided by <?page no="322"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 18-322 the planned performance in a cost centre. It is measured in currency unit divided by reference unit, e.g., in EUR/ machine hours, MYR/ per kWh, USD/ m etc. The application of overheads is shown as an arrow from cost centre Accounting to the calculation box in Figure 13.1. A company that applies a marginal cost Accounting system, will only apply proportional overheads. In contrast, production firms applying absorption costing apply full overheads. Therefore, predetermined overhead allocation rates are either based on proportional costs or full costs. Applying overheads by predetermined allocation rates can causes differences between actual overheads and applied overheads. This results in an overhead deviation. We notice such an overhead deviation in the Manufacturing Overhead Account. If it is not closed-off to the Work-in-Process account completely, a positive or negative balance stays. A debit balanced Manufacturing Overheads account indicates underapplied overheads - a credit balanced Manufacturing Overheads account indicates over-applied overheads. In those cases, the Manufacturing Overheads accounts are closed-off to the Cost of Sales account which means through profit or loss. 58 How it is Done (Job Order Costing) (1) Record Bookkeeping entries for basic accounts, like labour, depreciation, administration etc. (2) Divide costs in manufacturing costs and non-manufacturing costs. (3) Prepare Job Order accounts for internal job orders, mostly linked to products. (4) Prepare Manufacturing Overhead accounts per cost centre. Plan cost rates for cost centres by dividing budgeted overheads by planned performance of the cost centre. (5) Assign direct costs, such as direct labour and direct materials, to the job orders. Make debit entries in the Job Order accounts. (6) Add manufacturing overheads to the Manufacturing Overhead account. (7) Apply overheads based on the predetermined overhead allocation rate per job order. Calculate the value for the transferred manufacturing overheads by multiplying the actual job order quantity with the predetermined overhead allocation rate. Make debit entries in the Job Order accounts and credit the Manufacturing Overhead account. 58 Find an introduction to and case study (REGENT BIKE (Pty) Ltd.) about Manufacturing Accounting in the textbook Basics of Accounting, chapter (25). <?page no="323"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 18-323 (8) Once a job order is finished, goods are transferred to the Finished Goods Inventory account. Make a debit entry in the Finished Goods Inventory account and credit the value to the Job Order account. For unit cost calculation, divide the total costs of the finished goods by the lot size of the job order. (9) Balance-off the Job Order accounts. Use the Workin-Process account as summary account. Its balance is to be disclosed as inventory of work-in-process on the balance sheet. (10) Close-off the Manufacturing accounts to the Cost of Goods Sold COS account for overor underapplied overheads. (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 revenue. (13) Add all non-manufacturing costs to the Profit and Loss account. (14) Calculate profit. 18.4. C/ S MAHKOTA (Pty) Ltd. We introduce the first case study for a job order costing system: the manufacturer, MAHKOTA (Pty) Ltd. MAHKOTA (Pty) Ltd. is a company in Melbourne producing cell phone pouches. MAHKOTA (Pty) Ltd. applies an absorption costing system. Data Sheet for MAHKOTA (Pty) Ltd. CClassification: Manufacturing; Issued capital: 50,000.00 AUD; Bank loan: 300,000.00 AUD; interest 10,500.00 AUD/ a; P, P, E: 200,000.00 AUD; depreciation: 40,000.00 AUD; products: A / B Purchase: 120,000.00 AUD; closing stock 17,000.00 AUD; Direct materials: 12,000.00 AUD/ a / 17,000.00 AUD/ a; Labour: 300,000.00 AUD/ a; labour for administration: 94,000.00 AUD/ a; POR: 16.00 AUD/ h; production time: 9,875 h / 9,875 h; Batch costs: 110,500.00 AUD / 78,750.00 AUD; Underapplied overheads: 4,000.00 AUD; Production quantities: 13,000 u / 9,000 u; Sales factor: 80% / 65%; Net selling prices: 20.00 AUD/ u / 28.00 AUD/ u; GST ignored. On 2.01.20X2, MAHKOTA (Pty) Ltd. is established by the owners’ contribution of 50,000.00 AUD. MAHKOTA (Pty) Ltd. takes a bank loan of 300,000.00 AUD that requires an annual payment of interest to the extent of 10,500.00 AUD/ a. (1) On 2.01.20X2, MAHKOTA (Pty) Ltd.’s Accountant records the business inception. <?page no="324"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 18-324 DR Cash/ Bank.................... 50,000.00 AUD CR Issued Capital............... 50,000.00 AUD (2; 3) The bank loan is recorded one day later. However, the interest for the bank loan is recorded at the time of its payment, which is on 31.12.20X2. DR Cash/ Bank.................... 300,000.00 AUD CR Interest Bear. Liabilities... 300,000.00 AUD DR Interest..................... 10,500.00 AUD CR Cash/ Bank.................... 10,500.00 AUD We acknowledge that interest is not linked to production. It is classified as non-manufacturing overheads. (A capitalization of borrowing costs is possible; however, it does not apply in the case of MAHKOTA (Pty) Ltd.) (4, 5) MAHKOTA (Pty) Ltd. buys machinery at 200,000.00 AUD and depreciates them in accordance with straight-line method without residual value and over 5 years. Depreciation commences at the beginning of 20X2 (full year). Depreciation for 20X2 equals: 200,000 / 5 = 440,000.00 AUD/ a. We record the acquisition on 3.01.20X2 and depreciation thereon on 31.12.20X2. DR P, P, E Account.............. 200,000.00 AUD CR Cash/ Bank.................... 200,000.00 AUD DR Depreciation................. 40,000.00 AUD CR Acc. Depr. .................. 40,000.00 AUD (6 … 10) MAHKOTA (Pty) Ltd. buys materials at 120,000.00 AUD and uses 103,000.00 AUD thereof for production. MAHKOTA (Pty) Ltd. manufactures 2 pouch types: pouch-A: a normal protection for the back of the cell phone and pouch-B: same as pouch-A but with a flap to cover the screen. Pouch-A receives 12,000.00 AUD/ a direct materials per year and pouch-B gets 17,000.00 AUD/ a. The remaining materials are charged to the Manufacturing Overheads account. On 15.01.20X2, MAHKOTA (Pty) Ltd. adds the purchases to raw material inventories. 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 <?page no="325"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 18-325 For production, MAHKOTA (Pty) Ltd. defines two job orders. Job order pouch-A (to produce pouches-A) and the other one for pouches-B. 59 All direct materials are assigned to job orders, meaning to the WIP Pouch-A account and WIP Pouch-B account. The following Bookkeeping entries apply on 15.01.20X2. DR WIP Pouch-A .................. 12,000.00 AUD CR Inventory.................... 12,000.00 AUD DR WIP Pouch-B .................. 17,000.00 AUD CR Inventory.................... 17,000.00 AUD The materials allocated to the Manufacturing Overheads account add up to: 120,000 - 12,000 - 17,000 - (120,000 - 103,000) = 7 74,000.00 AUD. DR MOH Account.................. 74,000.00 AUD CR Inventory.................... 74,000.00 AUD (11) We add depreciation to the manufacturing cost centre. DR MOH Account.................. 40,000.00 AUD CR Depreciation ................. 40,000.00 AUD (12 … 14) MAHKOTA (Pty) Ltd.’s labour costs are amounting to 300,000.00 AUD. All labour classifies as overheads, 94,000.00 AUD thereof is for administration. This means 94,000.00 AUD are non-manufacturing overheads. The remaining value of: 300,000 - 94,000 = 206,000.00 AUD is added to the Manufacturing Overheads account. On 15.01.20X2, MAHKOTA (Pty) Ltd. records labour as below: DR Labour....................... 300,000.00 AUD CR Cash/ Bank.................... 300,000.00 AUD DR Administration............... 94,000.00 AUD CR Labour....................... 94,000.00 AUD DR MOH Account.................. 206,000.00 AUD CR Labour....................... 206,000.00 AUD (15; 17) The application of overheads is based on a predetermined overhead al- 59 The WIP-account is the reconciliation account for all Job Order accounts. We call a Job Order account for Pouch A ‘WIP Pouch-A’ The name of the reconciliation location rate of 16.00 AUD/ h. The production time is the reference unit in the account is WIP-account and does not carry a number or designator. <?page no="326"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 18-326 manufacturing cost centre. The predetermined overhead allocation rate is based on planned overheads (320,000.00 AUD) and 20,000 h production time. This gives: 320,000 / 20,000 = 116.00 AUD/ h. The actual production time in the manufacturing cost centre is 19,750 h. Half of the production time is spent on pouches-A and the other half on pouches-B. The overheads allocated to each product are: 9,875 × 16 = 158,000.00 AUD. The application of overheads results in two Bookkeeping entries, recorded on 30.09.20X2. DR WIP Pouch-A.................. 158,000.00 AUD CR MOH Account.................. 158,000.00 AUD DR WIP Pouch-B.................. 158,000.00 AUD CR MOH Account.................. 158,000.00 AUD MAHKOTA (Pty) Ltd. applies less overheads than it allocated to the Manufacturing Overheads account. This means the overheads are under-applied: The difference is amounting to: 74,000 + 40,000 + 206,000 - 2 × 158,000 = 4,000.00 AUD. The Manufacturing Overheads account is closed-off to the Cost of Goods Sold COS account. DR COS Account.................. 4,000.00 AUD CR MOH Account.................. 4,000.00 AUD MAHKOTHA (Pty) Ltd. completes the production of 13,000 pouches-A and 9,000 pouches-B. The batch costs are amounting to 110,500.00 AUD for pouches-A and to 78,750.00 AUD for pouches-B. (18; 19) The unit costs per pouch-A equal: 110,500 / 13,000 = 8 8.50 AUD/ u and for pouch-B to: 78,750 / 9,000 = 8.75 AUD/ u. The calculation is based on the number of the goods transferred to stock. On 31.10.20X2, the finished goods are stored in inventory. The value of the finished pouches-A equals: 8.50 × 13,000 = 110,500.00 AUD. The value of the finished pouches-B equals: 8.75 × 9,000 = 78,750.00 AUD. MAHKOTA (Pty) Ltd. records the additions to stock on 31.10.20X2. 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 (20 … 23) On 24.11.20X2, MAHKOTA (Pty) Ltd. sells 80 % of the pouches-A and 65 % of pouches-B. The sale requires 4 Bookkeeping entries. The first two thereof are for the inventory movements. The costs of sales for the pouches are based on the unit costs of manufacturing and equal (pouch-A): 80% × 13,000 × 8.50 = 8 88,400.00 AUD and <?page no="327"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 18-327 (pouch-B): 65% × 9,000 × 8.75 = 551,187.50 AUD. The Accountant adds them to the cost of goods sold. 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 The net selling price per pouch-A at MAHKOTA (Pty) Ltd. is 20.00 AUD/ u, and per pouch B it is 28.00 AUD/ u. The revenue equals (pouch-A): 80% × 13,000 × 20 = 2 208,000.00 AUD and (pouch-B): 65% × 9,000 × 28 = 1 163,800.00 AUD. We record the revenue on 24.11.20X2. DR Cash/ Bank.................... 208,000.00 AUD CR Revenue...................... 208,000.00 AUD DR Cash/ Bank.................... 163,800.00 AUD CR Revenue...................... 163,800.00 AUD Observe the profit calculation and the accounts for MAHKOTA (Pty) Ltd.’s pouch production in Figure 18.1. D C D C (1) 50,000.00 (3) 10,500.00 c/ d 50,000.00 (1) 50,000.00 (2) 300,000.00 (4) 200,000.00 b/ d 50,000.00 (22) 208,000.00 (6) 120,000.00 (23) 163,800.00 (12) 300,000.00 c/ d 91,300.00 721,800.00 721,800.00 b/ d 91,300.00 Cash/ Bank C/ B Issued capital ISS D C D C c/ d 300,000.00 (2) 300,000.00 (3) 10,500.00 P&L 10,500.00 b/ d 300,000.00 Interest bearing liabilities IBL Interest-20X2 INT Figure 18.1: MAHKOTA (Pty) Ltd.’s accounts <?page no="328"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 18-328 D C D C (4) 200,000.00 c/ d 200,000.00 (5) 40,000.00 (11) 40,000.00 b/ d 200,000.00 D C D C c/ d 40,000.00 (5) 40,000.00 (6) 120,000.00 (7) 120,000.00 b/ d 40,000.00 Property, plant, equipment PPE Depreciation-20X2 DPR Acc depr ACC Purchase-20X2 PUR D C D C (7) 120,000.00 (8) 12,000.00 (10) 74,000.00 (15) 158,000.00 (9) 17,000.00 (11) 40,000.00 (16) 158,000.00 (10) 74,000.00 (14) 206,000.00 c/ d 4,000.00 c/ d 17,000.00 320,000.00 320,000.00 120,000.00 120,000.00 b/ d 4,000.00 (17) 4,000.00 c/ d 17,000.00 Raw materials inventory RMI Manufacturing overheads MOH D C D C (8) 12,000.00 (18) 110,500.00 (9) 17,000.00 (19) 78,750.00 (15) 158,000.00 c/ d 59,500.00 (16) 158,000.00 c/ d 96,250.00 170,000.00 170,000.00 175,000.00 175,000.00 b/ d 59,500.00 b/ d 96,250.00 WIP pouch-A WIP pouch-B D C D C (12) 300,000.00 (13) 94,000.00 (13) 94,000.00 P&L 94,000.00 (14) 206,000.00 300,000.00 300,000.00 Labour-20X2 LAB Administration-20X2 ADM D C D C (17) 4,000.00 P&L 143,587.50 (18) 110,500.00 (20) 88,400.00 (20) 88,400.00 c/ d 22,100.00 (21) 51,187.50 110,500.00 110,500.00 143,587.50 143,587.50 b/ d 22,100.00 Cost of sales-20X2 COS FG inventory pouch-A FGA Figure 18.1: MAHKOTA (Pty) Ltd.’s accounts (continued) <?page no="329"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 18-329 D C D C (19) 78,750.00 (21) 51,187.50 P&L 371,800.00 (22) 208,000.00 c/ d 27,562.50 (23) 163,800.00 78,750.00 78,750.00 371,800.00 371,800.00 b/ d 27,562.50 FG inventory pouch-B FGB Revenue-20X2 REV D C D C COS 143,587.50 REV 371,800.00 c/ d 123,712.50 P&L 123,712.50 ADM 94,000.00 b/ d 123,712.50 INT 10,500.00 EBT 123,712.50 371,800.00 371,800.00 R/ E 123,712.50 b/ d 123,712.50 Profit and Loss-20X2 P&L Retained earnings R/ E Figure 18.1: MAHKOTA (Pty) Ltd.’s accounts (continued) We prepare a profitability analysis for MAHKOTA (Pty) Ltd. that displays the earned profit for single products. The adjustment of cost of sales for the under-applied overheads is assigned to other costs therein. Together with the cost for administration, total costs are 4,000 + 94,000 = 9 98,000.00 AUD. Interest is a non-manufacturing cost item and is not part of cost of goods sold (no capitalisation of borrowing costs). A B Revenue 208,000 163,800 Other income 208,000 163,800 COS, non-adjusted (88,400) (51,188) 119,600 112,613 Other costs Earnings before int and taxes (EBIT) Interest Earnings before taxes (EBT) Mahkota Pty Ltd. STATEMENT of PROFITABILITY for the year ended 31.12.20X2 232,213 (98,000) 134,213 (10,500) 123,713 Figure 18.2: MAHKOTA (Pty) Ltd.’s profitability analysis The profitability analysis in Figure 18.2 follows the contribution margin format. To prove the consistency with the double entry system, we prepare a pro-forma <?page no="330"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 18-330 balance sheet for MAHKOTA (Pty) Ltd. as at 31.12.20X2. As the case study is intended for Management Accounting, no income taxes are considered. Observe the balance sheet in Figure 18.3. A C, L Non-current assets [AUD] Owners' capital [AUD] P, P, E 160,000 Share capital 50,000 Intangibles Reserves Financial assets R/ E 123,713 Current assets Liabilities Inventory 222,413 Interest bear liab 300,000 A/ R A/ P Prepaid expenses Provisions Cash/ Bank 91,300 Tax liabilities 473,713 473,713 Mahkota Pty Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X2 Figure 18.3: MAHKOTA (Pty) Ltd.’s pro-forma balance sheet So far, we studied the structure of a job order costing system with the case study MAHKOTA (Pty) Ltd. 18.5. C/ S WEIXDORF Ltd. We discuss next a more complicated case but follow the same concept as for the previous case study. We discuss a company with more products and more cost centres. We also show the effect of goods being stored in inventory. The company WEIXDORF Ltd. produces 3 different types of ice cream (banana, lemon, strawberry) in 2 cost centres: Production and Filling. Data Sheet for WEIXDORF Ltd. Classification: Production; Accounting period: 20X3; Issued capital: 5,000.00 EUR; Bank loan: 50,000.00 EUR; interest 2.5 %/ a; pay-off: 1,000.00 EUR/ a; P, P, E ice cream: 20,000.00 EUR; depreciation: 5,000.00 EUR/ a; P, P, E filling: 14,500.00 EUR; depreciation: 2,900.00 EUR/ a; salvage value: 2,900.00 EUR (filling machine); Purchase containers: 43,200.00 EUR; Purchase milk: 84,000.00 EUR; purchase Fruits: 24,000.00 EUR; Labour: 270,000.00 EUR/ a; thereof: administration: 70,000.00 EUR/ a / production: 200,000.00 EUR/ a; Total production quantity: 75,000 container/ a; thereof: banana: 22,000 container/ a / lemon: 25,000 container/ a / strawberry: 25,000 container/ a; Budgeted maintenance: 12,000.00 EUR; Actual maintenance: 12,375.00 EUR; POR ice cream: 2.16 EUR/ h; POR filling: 0.77 EUR/ container; Sales quantities: banana: 21,500 containers / lemon 23,790 containers / strawberry: 25,000 containers; Net selling price per ice container: banana: 8.00 EUR / lemon: 8.50 / strawberry: 8.20 EUR; Perish factor on closing stock: 75%; VAT applicable. <?page no="331"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 18-331 The company WEIXDORF Ltd. manufactures ice creams for restaurants and hotels. The ice cream is sold in 2-litres-containers. WEIXDORF Ltd. is established on 2.01.20X3 by a share issue of 1,000 ordinary shares at 50.00 EUR/ s. WEIXDORF Ltd. registers at the revenue service for reduction of input-VAT on 2.01.20X3. We record the incorporation on the same day as Bookkeeping entry (1), 2.01.20X3: DR Cash/ Bank.................... 50,000.00 EUR CR Issued capital............... 50,000.00 EUR For financing, WEIXDORF Ltd. takes a bank loan to the extent of 50,000.00 EUR on 3.01.20X3. The bank loan requires a constant pay-off payment which is due at the yearends to the extent of 1,000.00 EUR/ a. The rate of interest is 2.5 %/ a. It is to be paid at the end of the Accounting periods as well. We record the bank loan on 3.01.20X3 and the payment for interest and pay-off on 31.12.20X1 as Bookkeeping entries (2 … 4). Bookkeeping entry (3) contains the disclosure of short-term liabilities for the pay-off in 20X4. 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 WEIXDORF Ltd.’s manufacturing operations take place in two cost centres: one for production and another one for container filling and labeling. On 3.01.20X3, WEIXDORF Ltd. buys an ice cream machine for 24,000.00 EUR (gross value). The company depreciates the machine following straight-line method over 4 years. No residual value is considered. For the second cost centre, WEIXDORF Ltd. acquires a filling machine at costs of acquisition of 14,500.00 EUR. Depreciation on the filling machine follows straight-line method over 4 years as well, however, WEIXDORF Ltd. estimates to sell the machine after its useful life at 2,900.00 EUR net selling price. We make Bookkeeping entries for the acquisitions on 3.01.20X3 as (5), (7) and for depreciation on 31.12.20X3 as (6), (8), see below: DR P, P, P Account.............. 20,000.00 EUR DR VAT.......................... 4,000.00 EUR CR Cash/ Bank.................... 24,000.00 EUR <?page no="332"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 18-332 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 WEIXDORF Ltd. purchases 2-litres-containers (empty), milk and fruits. It buys the 72,000 2-litres-containers at 0.60 EUR/ p cost of purchase, 120,000 litres of milk at 0.70 EUR/ l (net value) and 24,000 kg of fruits at 1.00 EUR/ kg (net value) during the Accounting period 20X3. The volume of 1 kg fruits is 1 litre. We record the purchases on 4.01.20X3 as Bookkeeping entries (9 … 11). 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 Labour is amounting to 270,000 EUR/ a. A portion of 70,000 EUR thereof is for administration/ management and the other 200,000.00 EUR are for 4 workers in production/ filling equally distributed. At WEIXDORF Ltd., 3 workers are employed in the Production department and 1 worker in the Filling department. We record labour as Bookkeeping entry (12). A value of 70,000.00 EUR is assigned to the Administration department - observe Bookkeeping entry (13). For job order costing, we define 2 cost centre-related accounts as Manufacturing Overheads Ice Cream Production account (MOP) and Manufacturing Overheads Filling account (MOF). On 31.12.20X3, we assign labour to the Manufacturing Overheads accounts as Bookkeeping entries (14, 15). 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 <?page no="333"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 18-333 DR MOP Ice Cream Production..... 150,000.00 EUR CR Labour....................... 150,000.00 EUR DR MOF Filling .................. 50,000.00 EUR CR Labour....................... 50,000.00 EUR WEIXDORF Ltd. plans to produce 75,000 2-litres-containers (filled with ice cream). The estimate for maintenance leads to budgeted 12,000.00 EUR. The value is allocated to the departments based on the cost of acquisition for the ice cream production machine and the filling machine. At that stage, WEIXDORF Ltd. calculates the predetermined overhead allocation rate for the ice cream production based on labour, depreciation and estimated maintenance as: (150,000 + 5,000 + 12,000 × 20,000 / (14,500 + 20,000)) / 75,000 = 2 2.16 EUR/ ICE. ICE is the output reference unit and refers to a 2 litre container filled with ice cream. The predetermined overhead allocation rate for Filling is: 50,000 + 2,900 + 12,000 × 14,500 / (14,500 + 20,000)) / 75,000 = 0 0.77 EUR/ ICE. The actual value for maintenance equals 12,375.00 EUR. It is apportioned to departments based on the costs of acquisition for their machinery. The MOP Ice Cream Production account is charged with: 12,375 × 20,000 / (14,500 + 20,000) = 7 7,173.91 EUR and the MOF Filling account with: 12,375 × 14,500 / (14,500 + 20,000) = 5 5,201.09 EUR. We allocate depreciation and maintenance to the cost centres by Bookkeeping entries (16 … 20) on 31.12.20X3. DR MOP Ice Cream Production..... 5,000.00 EUR CR Depreciation ................. 5,000.00 EUR DR MOF 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 MOP Ice Cream Production..... 7,173.91 EUR CR Maintenance .................. 7,173.91 EUR DR MOF Filling .................. 5,201.09 EUR CR Maintenance .................. 5,201.09 EUR During 20X3, WEIXDORF Ltd. produces 22,000 containers of banana ice cream, 60 In total 72,000 containers with 144,000 litres of ice cream. and 25,000 containers of lemon and strawberry ice cream each. 60 <?page no="334"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 18-334 We prepare for each flavour of ICE a single WIP-account: WIP Banana account, WIP Lemon account and a WIP Strawberry account. At first, the purchases are allocated to inventory accounts and later to the above mentioned WIPaccounts. The Bookkeeping entries (21 … 23) allocate the materials to inventory. 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 The materials are purchased on demand which means, no closing stock of raw materials applies. The containers are allocated based on production quantities to WIP-accounts. The containers for the banana ice cream are valued at: 22,000 × 0.60 = 1 13,200.00 EUR. The containers for the lemon and the strawberry ice cream are valued at: 25,000 × 0.60 = 15,000.00 EUR each. We record the material allocations as Bookkeeping entries (24 … 26). 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 The weight/ volume of the ice cream is based on 120,000 litres of milk and 24,000 kg of fruits at a density of 1 kg/ l. The volume of milk and fruits equals: 120,000 + 24,000 = 1 144,000 litres ice cream. This volume correlates with: 144,000 / 2 = 7 72,000 2-litres-containers. Hence, the milk and the fruits can be allocated based on the production quantities (ICE). The cost of milk for banana ice cream is: 84,000 × 22,000 / 72000 = 25,666.67 EUR. The cost of milk for the lemon and strawberry ice cream equals: 84,000 × 25,000 / 72000 = 2 29,166.67 EUR each. The cost of bananas is: 24,000 × 22,000 / 72000 = 7 7,333.33 EUR. The cost of lemons/ strawberries equals: 24,000 × 25,000 / 72000 = 8 8,333.33 EUR each. We record the following stock releases as Bookkeeping entries (27 … 32). DR WIP Banana................... 25,666.67 EUR CR Raw Materials Milk........... 25,666.67 EUR <?page no="335"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 18-335 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 DR WIP Strawberry............... 8,333.33 EUR CR Raw Materials Fruits......... 8,333.33 EUR The allocation of overheads is based on predetermined overhead allocation rates. The rates are 2.16 EUR/ ice for Production and 0.77 EUR/ ice in the Filling department. Hence, the overheads allocated to the Banana ice cream are: 2.16 × 22,000 = 4 47,520.00 EUR for Production overheads and: 0.77 × 22,000 = 16,940.00 EUR for Filling overheads. The overheads allocated to Lemon and Strawberry ice cream are: 2.16 × 25,000 = 5 54,000.00 EUR each for Production overheads and: 0.77 × 25,000 = 19,250.00 EUR for Filling overheads. Check the Bookkeeping entries (33 … 38): DR WIP Banana................... 47,520.00 EUR CR MOH Ice Cream Production..... 47,520.00 EUR DR WIP Lemon.................... 54,000.00 EUR CR MOH Ice Cream Production..... 54,000.00 EUR DR WIP Strawberry............... 54,000.00 EUR CR MOH Ice Cream Production..... 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 The under-applied overheads are calculated by closing-off the Manufacturing Overhead accounts to the Cost of Goods Sold account: <?page no="336"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 18-336 DR Cost of Goods Sold........... 6,653.91 EUR CR MOP Ice Cream Production..... 6,653.91 EUR DR Cost of Goods Sold........... 2,661.09 EUR CR MOF Filling.................. 2,661.09 EUR After ice cream production and filling are completed, goods are added to stock. The total costs of manufacturing can be taken from the WIP-accounts. We record the inventory movements as Bookkeeping entries (39 … 41): 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 The unit costs of manufacturing for a 2litres-container filled with banana ice cream are: 110,660/ 22,000 = 5 5.03 EUR/ ice. The unit costs of manufacturing for a 2-litres-container filled with lemon or strawberry ice cream are: 125,750 / 25,000 = 5 5.03 EUR/ ice. During the Accounting period 20X3, WEIXDORF Ltd. sells 21,500 containers banana ice cream at 8.00 EUR/ ice, 23,790 containers lemon ice cream at 8.50 EUR/ ice and all strawberry ice cream at 8.20 EUR/ ice. All prices are net of VAT. The remaining stock expires to an extent of 75 % and is written-off as spoilage. The revenue equals: 21,500 × 8 + 23,790 × 8.50 + 25,000 × 8.20 = 5 579,215.00 EUR. It is recorded by Bookkeeping entry (42): DR Cash/ Bank.................... 695,058.00 EUR CR VAT.......................... 115,843.00 EUR CR Revenue...................... 579,215.00 EUR The inventory movements for the sold ICEs are based on the calculated unit costs. Inventory movements refers to the stock release and the recording as costs of goods sold. For the banana ice cream, the inventory movements are: 21,500 × 5.03 = 1 108,145.00 EUR. For lemon ice cream, they are: 23,790 × 5.03 = 1119,663.70 EUR and for strawberry ice cream: 25,000 × 5.03 = 1 125,750.00 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 <?page no="337"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 18-337 DR Cost of Goods Sold........... 125,750.00 EUR CR FG Inventory Strawberry...... 125,750.00 EUR The remainder in the Finished Goods Banana Inventory account equals: 110,660 - 108,145 = 2 2,515.00 EUR. A portion of 75% thereof perishes and is written-off as spoilage/ waste: 2,515 × 75% = 1,886.25 EUR. The remainder in the Finished Goods Lemon Inventory account equals: 125,750 - 119,663.70 = 6,086.30 EUR. A portion of 75% thereof is spoilage/ waste: 6,086.30 × 75% = 4,564.73 EUR. The Accountant makes Bookkeeping entries for the spoilage/ waste as below: 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 Figure 18.4 shows WEIXDORF Ltd.’s accounts. D C D C (5) 20,000.00 c/ d 20,000.00 c/ d 5,000.00 (6) 5,000.00 20,000.00 20,000.00 5,000.00 5,000.00 b/ d 20,000.00 b/ d 5,000.00 P, P, E ice cream maker Acc depr ice cream maker ACP D C D C (5) 4,000.00 (42) 115,843.00 (6) 5,000.00 (16) 5,000.00 (7) 2,900.00 (8) 2,900.00 (17) 2,900.00 (9) 8,640.00 7,900.00 7,900.00 (10) 16,800.00 (11) 4,800.00 (18) 2,475.00 c/ d 76,228.00 115,843.00 115,843.00 b/ d 76,228.00 Value added tax VAT Depreciation-20X3 DPR Figure 18.4: WEIXDORF Ltd.’s accounts D C D C (9) 43,200.00 (21) 43,200.00 P&L 579,215.00 (42) 579,215.00 (10) 84,000.00 (22) 84,000.00 579,215.00 579,215.00 (11) 24,000.00 (23) 24,000.00 151,200.00 151,200.00 Purchase-20X3 PUR Revenue-20X3 REV <?page no="338"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 18-338 D C D C (9) 43,200.00 (21) 43,200.00 P&L 579,215.00 (42) 579,215.00 (10) 84,000.00 (22) 84,000.00 579,215.00 579,215.00 (11) 24,000.00 (23) 24,000.00 151,200.00 151,200.00 Purchase-20X3 PUR Revenue-20X3 REV D C D C (12) 270,000.00 (13) 70,000.00 (13) 70,000.00 P&L 70,000.00 (14) 150,000.00 (15) 50,000.00 270,000.00 270,000.00 70,000.00 70,000.00 Labour-20X3 LAB Administration-20X3 ADM D C D C (7) 14,500.00 c/ d 14,500.00 c/ d 2,900.00 (8) 2,900.00 14,500.00 14,500.00 2,900.00 2,900.00 b/ d 14,500.00 b/ d 2,900.00 P, P, E filling machine Acc depr filling machine ACF D C D C (14) 150,000.00 (33) 47,520.00 (15) 50,000.00 (36) 16,940.00 (16) 5,000.00 (34) 54,000.00 (17) 2,900.00 (37) 19,250.00 (20) 7,173.91 (35) 54,000.00 (19) 5,201.09 (38) 19,250.00 COS 6,653.91 COS 2,661.09 162,173.91 162,173.91 58,101.09 58,101.09 MOH ice cream making MOP MOH filling MOF D C D C (18) 12,375.00 (19) 5,201.09 (21) 43,200.00 (24) 13,200.00 (20) 7,173.91 (25) 15,000.00 (26) 15,000.00 12,375.00 12,375.00 43,200.00 43,200.00 Maintenance-20X3 MTN RM inventory container RMC D C D C (22) 84,000.00 (27) 25,666.67 (23) 24,000.00 (30) 7,333.33 (28) 29,166.67 (31) 8,333.33 (29) 29,166.67 (32) 8,333.33 84,000.00 84,000.00 24,000.00 24,000.00 RM inventory milk RMM RM inventory fruits RMF Figure 18.4: WEIXDORF Ltd.’s accounts (continued) <?page no="339"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 18-339 D C D C (24) 13,200.00 (39) 110,660.00 (25) 15,000.00 (40) 125,750.00 (27) 25,666.67 (28) 29,166.67 (30) 7,333.33 (31) 8,333.33 (33) 47,520.00 (34) 54,000.00 (36) 16,940.00 (37) 19,250.00 110,660.00 110,660.00 125,750.00 125,750.00 WIP banana WIB WIP lemon WIL D C D C (26) 15,000.00 (41) 125,750.00 MOP 6,653.91 P&L 362,873.70 (29) 29,166.67 MOF 2,661.09 (32) 8,333.33 FGB 108,145.00 (35) 54,000.00 FGL 119,663.70 (38) 19,250.00 FGS 125,750.00 125,750.00 125,750.00 362,873.70 362,873.70 WIP strawberry WIS Cost of sales-20X3 COS D C D C (39) 110,660.00 COS 108,145.00 (40) 125,750.00 COS 119,663.70 WST 1,886.25 WST 4,564.73 c/ d 628.75 c/ d 1,521.57 110,660.00 110,660.00 125,750.00 125,750.00 b/ d 628.75 b/ d 1,521.57 FG inventory banana FGB FG inventory lemon FGL D C D C (41) 125,750.00 COS 125,750.00 FGB 1,886.25 P&L 6,450.97 FGL 4,564.73 125,750.00 125,750.00 6,450.98 6,450.97 FG inventory strawberry FGS Waste-20X3 WST D C D C COS 362,873.70 REV 579,215.00 c/ d 97,048.23 P&L 97,048.23 WST 6,450.97 97,048.23 97,048.23 ADM 70,000.00 b/ d 97,048.23 INT 1,250.00 EBT 138,640.33 579,215.00 579,215.00 ITL 41,592.10 b/ d 138,640.33 D C R/ E 97,048.23 c/ d 41,592.10 P&L 41,592.10 138,640.33 138,640.33 b/ d 41,592.10 Profit and Loss-20X3 P&L Retained earnings R/ E Income tax liabilities ITL D C c/ d 1,000.00 (3) 1,000.00 b/ d 1,000.00 Accounts payables A/ P Figure 18.4: WEIXDORF Ltd.’s accounts (continued) <?page no="340"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 18-340 Observe the financial statements in Figure 18.5 and Figure 18.6: [EUR] Revenue 579,215 Other income 579,215 Cost of sales (362,874) Other expenses (76,451) Earnings before int. & taxes (EBIT) 139,890 Interest (1,250) Earnings before taxes (EBT) 138,640 Income tax expenses (41,592) Deferred taxes Earnings after taxes (EAT) 97,048 Weixdorf Ltd. STATEMENT of PROFIT & LOSS and other COMPREHENSIVE INCOME for the year ended 31.12.20X3 Figure 18.5: WEIXDORF Ltd.’s income statement A C, L Non-current assets [EUR] Equity [EUR] P, P, E 26,600 Share capital 50,000 Intangibles Reserves Financial assets Retained earnings 97,048 Current assets Liabilities Inventory 2,150 Interest bear liab 48,000 Accounts receivables Accounts payables 77,228 Prepaid expenses Provisions Cash/ Bank 285,118 Tax liabilities 41,592 Total assets 313,868 Total equity and liab. 313,868 Weixdorf Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 18.6: WEIXDORF Ltd.’s balance sheet 18.6. Summary A job order costing system is designed to calculate products in a manufacturing company. The job order costing system is based on Work-in-Process WIP-accounts and Manufacturing Overheads MOH-accounts. The allocation of overheads charges the goods <?page no="341"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 18-341 with their share of overheads caused by their usage of production facilities. It results in a debit entry in the Workin-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 POR. Any deviation between actual overheads and applied overheads is closed-off to the Cost of Sales account and changes the operational profit for the period. 18.7. 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 with cost centre overheads that is based on budgeted overheads and budgeted cost centre outputs. 18.8. Question Bank (1) A production firm plans 12,000.00 EUR overheads and a performance of 1,000 units. The actual overheads are 12,500.00 EUR for 950 units. Which statement is correct? 1. There is an under-application of overheads of 1,100.00 EUR. 2. There is an over-application of overheads of 1,100.00 EUR. 3. There is an under-application of overheads of 600.00 EUR. 4. There is an over-application of overheads of 600.00 EUR. (2) What is the correct Bookkeeping entry for an over-application of overheads? 1. DR MOH account; CR WIP account. 2. DR WIP account; CR MOH account. 3. DR MOH account; CR COS account. 4. DR COS account; CR MOH account. (3) Which item should not be recorded in a MOH account? 1. Rent for the factory building. 2. Insurance costs for production facilities. 3. Maintenance expenses. 4. Depreciation on delivery van. (4) A manufacturing company records direct labour of 2,000.00 EUR, direct materials of 5,000.00 EUR and applied overheads of 3,500.00 EUR. All 100 goods are finished and added to stock. 40 goods are sold. Which Bookkeeping entry is wrong? 1. DR WIP account 3,500 EUR; CR MOH account 3,500 EUR. 2. DR COS account 2,100 EUR; CR MOH account 2,100 EUR. 3. DR FGI account 10,500 EUR; CR WIP account 10,500 EUR. 4. DR COS account 4,200 EUR; CR FGI account 4,200 EUR. (5) What is the adjustment of cost of sales for? 1. For unsold goods. 2. For interest. 3. For over-applied overheads. <?page no="342"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 18-342 4. For other income. 18.9. Solutions 1-1; 2-3; 3-4; 4-2; 5-3. <?page no="343"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 19-343 19. Process Costing (Manufacturing Accounting) 19.1. What is in the Chapter? In this chapter (19) we study process costing which applies for manufacturing in a production line. The purpose of process costing is the same as of job order costing. Consider process costing as a special form of job order costing which applies in special situations. As the products follow an identical sequence of production steps, a process costing is a simplification in comparison to job order costing. It only works for production lines. For all other structures of manufacturing, a job order costing system is required. The case study EDEWECHT (Pty) Ltd. is about a shoe manufacturer. We use the case for process costing introduction and discuss how to deal with inventories left in production (WIP) as unfinished goods. 19.2. Learning Objectives In this chapter, you learn alternative calculations for line production. You learn about the account structure and the cost flow in a process costing system. You will see how the goods' unit costs increase along their flow through the production line. After studying this chapter, you understand and can apply a process costing system. You also can calculate goods produced in a production line after finished as well as when still under production. You can distinguish a job order costing system from a process costing system. You know how to calculate goods not yet finished based on equivalent units and can consider opening stock in production (WIP) based on different cost categories and at different percentages of completion for calculation. 19.3. Principle of Process Costing Process costing follows a multiple-step calculation. With every step of production, the unit costs of manufacturing increase. Every department allocates its costs to the goods produced therein. The unit costs per production step are accumulated in the WIPaccounts. The costs of prior production steps are debited to the WIPaccount of the next following step. This way, the unit costs increase along the production line. The last production step finishes the goods and completes the unit costs of manufacturing calculation. After production, goods are put to finished goods inventories. We make a debit entry in the Inventories account and credit the WIPaccount. Process costing systems apply only when manufacturing is organised following the same sequence of production steps, such as in industries, where raw materials are converted into homogeneous products. Examples are brick production, paper production or breweries. You also can apply process costing for service providers who apply the same workflow for all services, like a revenue service or a doctor’s clinic. For a process costing, it is required that a permanent flow of goods/ documents exists. Units are often indistinguishable. Costs are allocated monthly to the goods produced during that time. <?page no="344"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 19-344 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 moves from one production step to the next one. We assume that a batch leaves a step of production after completion and then is transferred to the next one. The account structure and the Bookkeeping entries in a process costing system are similar to a job order costing. However, the interpretation of Bookkeeping entries is different: in a process costing system, the Work-in- Process account is linked to cost centres (not to job orders). Overheads are added to the Work-in-Process accounts directly and then allocated to the units of production (no MOH account). The cost allocation to the departments is the same as in a job order costing system. Costs are debited to the WIPaccounts. A Manufacturing Overheads account often is omitted as overheads are added straight to the WIP-account. The reason is that there is a 1: 1 relationship between WIPand MOHaccount. Therefore, we can combine them. However, some companies gather overheads in a Manufacturing Overhead account at first and allocate them by one application step. In a process costing system, costs ‘stick to the units of production’. After leaving a cost centre, its costs are assigned to the next cost centre in line. This procedure continues following the line of production until goods are finished in the last cost centre which assigns costs to the Inventory of Finished Goods account. Note, as the previous costs centres are discharged, we make Bookkeeping entries like: DR WIP i - CR WIP i-1 (i represents the sequence of cost centres). We demonstrate the Bookkeeping entries with the case study EDEWECHT (Pty) Ltd. How it is Done (Process Costing) (1) Record Bookkeeping entries in basic accounts, like labour, depreciation, administration etc. (2) Divide costs in manufacturing costs and non-manufacturing costs. (3) Prepare Work-in-Process accounts for every production step. (4a) Prepare Manufacturing Overhead accounts for the cost centres, where the production steps take place in. Apply overheads. (4b) Alternatively: debit the manufacturing overheads to the Work-in-Process accounts directly. (5.1) If the products are finished within a production step, divide the total costs of the Work-in-Process account by the number of products completed therein. (5.2) If the products are not finished completely within a production step, transform the product quantities to equivalent units. Calculate the equivalent unit as percentage of completion × number of unfinished <?page no="345"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 19-345 goods. For finished goods, the equivalent unit per product is 1. Divide the costs of the current production step by the number of equivalent units. The costs of previous production steps are allocated to the products by the product quantity (not by equivalent units! ) Not completed goods are not transferred to the next production step and show as the balancing figure (debit balanced) in the Work-in-Process account. Completed products are transferred to the next Work-in-Process account. (6) Transfer completed (regarding the production step) goods to the Work-in-Process account that represents the next following production step. Product values are numbers of goods × unit costs. (7) Once the goods are finished, transfer them to the Finished Goods Inventory account. Make a debit entry in the Finished Goods Inventory account and credit the value to the (last) Work-in-Process account. For unit cost calculation, divide the total costs of the finished goods by the number of finished goods. (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. (11) Debit the cost of sales to the Profit and Loss account. (12) Calculate the profit. 19.4. C/ S EDEWECHT (Pty) Ltd. Next, we illustrate the concept by a case study of a shoe manufacturer. We observe three production steps at EDEWECHT (Pty) Ltd. and apply a process costing system for its shoe calculation. Data Sheet for EDEWECHT (Pty) Ltd. CClassification: Manufacturing; Period: 20X4; Three production steps: body manufacturing, sole fixing and leather treatment; purchases: 160,000.00 EUR; Labour: 540,000.00 EUR; includes indirect labour of 450,000.00 EUR; Depreciation: 120,000.00 EUR; Splitting ratios: materials: 1 : 2 : 1 / labour: 1 : 1 : 1 / indirect labour: 3 : 1 : 1 / depreciation: 0 : 0 : 1; Production quantity: 10,000 u; completed 9,500 u thereof; Percentage of completion for remainder: 20 %; Sales quantity: 8,000 u; net selling price: 175.00 EUR/ u; VAT ignored. EDEWECHT (Pty) Ltd. produces shoes in 3 production steps. They are: (1) Manufacturing the shoe body. (2) Sole fixing. <?page no="346"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 19-346 (3) Leather treatment. Operations are organised in a line. All shoes go through all three production steps in the above-mentioned sequence. EDEWECHT (Pty) Ltd.’s cost centre structure follows the production steps. In cost centre CC-001 the shoe body is manufactured. In cost centre CC-002 the sole is glued under the shoe body and in cost centre CC-003, EDEWECHT (Pty) Ltd. performs a leather treatment. All shoes are manufactured in a first-in-first-out order. EDEWECHT (Pty) Ltd. does not distinguish its shoes (no job orders are issued per pair of shoes). During the Accounting period 20X4, EDEWECHT (Pty) Ltd. records the following costs for purchases and total materials (no closing stock applies; all purchases are used in production): 160,000.00 EUR, for labour: 540,000.00 EUR, included therein: indirect labour in manufacturing: 450,000.00 EUR and for depreciation on production facilities: 120,000.00 EUR. No non-manufacturing costs exists. EDEWECHT (Pty) Ltd. records the costs in its accounts. Observe Figure 19.1. D C D C (1) 160,000.00 (2) 160,000.00 (2) 160,000.00 D C D C (3) 540,000.00 (4) 120,000.00 Purchases-20X4 PUR RM inventory RMI Labour-20X4 LAB Depreciation-20X4 DPR D C D C ... (1) 160,000.00 (4) 120,000.00 (3) 540,000.00 Cash/ Bank C/ B Acc depr ACC Figure 19.1: EDEWECHT (Pty) Ltd.’s accounts We allocate manufacturing costs to the three cost centres. For the allocation of materials, a 1 : 2 : 1 ratio regarding the cost centres CC-001, CC-002 and CC-003 applies. Accordingly, 40,000.00 EUR are assigned to cost centre CC-001, 80,000.00 EUR to cost centre CC-002 and another 40,000.00 EUR to cost centre CC-003. The allocation of the other costs is similar: The allocation of direct labour follows a 1 : 1 : 1 ratio and the allocation of indirect labour is at a 3 : 1 : 1 ratio. Depreciation only applies in cost centre CC-003. (5 … 8) EDEWECHT (Pty) Ltd. records the costs for materials, labour and depreciation in the cost centres as below: <?page no="347"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 19-347 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 Study Figure 19.2 for the accounts. D C D C (1) 160,000.00 (2) 160,000.00 (2) 160,000.00 (5) 160,000.00 D C D C (3) 540,000.00 (6) 90,000.00 (4) 120,000.00 (8) 120,000.00 (7) 450,000.00 540,000.00 540,000.00 Purchases-20X4 PUR RM inventory RMI Labour-20X4 LAB Depreciation-20X4 DPR D C D C ... (1) 160,000.00 (4) 120,000.00 (3) 540,000.00 D C D C (5) 40,000.00 (5) 80,000.00 (6) 30,000.00 (6) 30,000.00 (7) 270,000.00 (7) 90,000.00 340,000.00 200,000.00 Cash/ Bank C/ B Acc depr ACC WIP CC-001 (body) WIP CC-002 (sole) Figure 19.2: EDEWECHT (Pty) Ltd.’s accounts <?page no="348"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 19-348 D C (5) 40,000.00 (6) 30,000.00 (7) 90,000.00 (8) 120,000.00 280,000.00 WIP CC-003 (leather) Figure 19.2: EDEWECHT (Pty) Ltd.'s accounts (continued) No opening value for work-in-process applies at EDEWECHT (Pty) Ltd. in 20X4. EDEWECHT (Pty) Ltd. starts the production of 10,000 shoes in the Accounting period 20X4. 61 9,500 shoes are completed and transferred to stock. 500 shoes remain in the cost centre CC-003 for leather treatment and are shown as balancing figure of the WIP CC-003 account. These shoes are still under production. The leather treatment of the 500 remaining shoes is only completed to an extent of 20 %. Hence, only 20 % of manufacturing costs in that cost centre are allocated to these shoes. In the cost centre CC-001, all costs for materials and labour are assigned to 10,000 shoes. This results in unit costs of: 340,000 / 10,000 = 3 34.00 EUR/ u after the first production step. Once the shoes are transferred to cost centre CC-002, their costs are added to the WIPaccount CC-002. The Accountant records the transfer by Bookkeeping entry (9): DR WIP CC-002................... 340,000.00 EUR CR WIP CC-001................... 340,000.00 EUR The total costs in cost centre CC-002 include materials, labour plus unit costs for 10,000 shoes from the previous production step. The costs in cost centre CC- 002 equal: 80,000 + 30,000 + 90,000 + 340,000 = 5 540,000.00 EUR. Again, the cost centre costs are allocated to 10,000 shoes. The unit costs for the shoes completed in cost centre CC-0002 are: 540,000 / 10,000 = 5 54.00 EUR/ u. After completion of production step (2), all 10,000 shoes are transferred to the next cost centre CC-003. This requires transferring the shoe values of 54.00 EUR/ u for all shoes to cost centre CC- 003. The total value equals: 10,000 × 54 = 5 540,000.00 EUR. We completely discharge the WIP CC- 002 account and add its costs to the WIP CC-003 account. DR WIP CC-003................... 540,000.00 EUR CR WIP CC-002................... 540,000.00 EUR At this stage, the accounts for the cost centres are shown in Figure 19.3. 61 A unit of shoes is a pair of shoes. <?page no="349"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 19-349 D C D (5) 40,000.00 (9) 340,000.00 (5) 80,000.00 (10) 540,000.00 (6) 30,000.00 (6) 30,000.00 (7) 270,000.00 (7) 90,000.00 340,000.00 (9) 340,000.00 540,000.00 WIP CC-001 (body) WIP CC-002 (sole) D C (5) 40,000.00 (6) 30,000.00 (7) 90,000.00 (8) 120,000.00 (10) 540,000.00 820,000.00 WIP CC-003 (leather) Figure 19.3: EDEWECHT (Pty) Ltd.’s WIP-accounts So far, we covered the basics of a process costing system. Once all production steps are completed, the last WIPaccount for cost centre CC-003 would be closed-off to the Finished Goods Inventory account. Shoes to the extent of 820,000.00 EUR would be added to stock. One pair of shoes would be valued at: 820,000 / 10,000 = 82.00 EUR/ u. 19.5. Uncompleted Production Steps Next, we study what happens, if a production company does not complete a production step. At EDEWECHT (Pty) Ltd., we consider the last production step has not been completed. Only 9,500 shoes finish leather treatment, the remainder is still under production at the yearend. The percentage of completion for those shoes is 20 %. We take the cost of manufacturing from the WIP CC-002 account on the credit side and continue the case study EDEWECHT (Pty) Ltd. with the recording of the 3 rd cost centre CC-003. All 10,000 shoes arrived in cost centre CC-003. Hence, the costs of previous production steps are 540,000.00 EUR. In the Leather Treatment cost centre, costs for materials, labour, and depreciation apply to the extent of: 40,000 + 30,000 + 90,000 + 120,000 = 2 280,000.00 EUR and are to be assigned to shoes. Only 9,500 units are completed and transferred to finished goods. There are still 500 shoes in the cost centre with leather treatment completed to only a percentage of 20 %. 19.6. Equivalent Units Calculation In a process costing system uncompleted products are represented by equivalent units. <?page no="350"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 19-350 An equivalent unit is the quantity of goods calculated as number × percentage of completion. Equivalent units apply to allocate costs to not yet finished goods. Costs are assigned to products based on their level of completion. In cases when all products are completed, we transfer the costs to all products. If all products are completed to a certain percentage, we do the same. Only in cases if some products are completed and others are not, we must allocate costs to equivalent units. This means, for the cost allocation of half-finished goods only half of the quantity counts, products completed to a degree of 10 % will count 1/ 10 etc. The equivalent unit replaces two half completed products by one finished one or 10 products completed at a degree of 10 % by one finished product. Below, we apply the concept of cost allocation based on equivalent units for EDEWECHT (Pty) Ltd.: At EDEWECHT (Pty) Ltd.’s cost centre CC-003, 9,500 shoes are finished in the Leather Treatment - but for 500 shoes the leather treatment is only completed to a degree of 20 %. EDEWECHT (Pty) Ltd. cannot assign the cost centre CC- 003’s costs equally to all 10,000 units. The unfinished goods only cover 20 % of the unit costs for finished goods. For cost allocations, we replace 500 uncompleted shoes by: 500 × 20% = 1 100 equivalent units. Hence, the total costs of cost centre CC-003 are allocated to: 9,500 + 100 = 99,600 equivalent units. This gives: 280,000 / 9,600 = 2 29.17 EUR/ u in value to be added to every completed shoe (9,500). The calculation of the unit costs for completed shoes gives: 54 + 29.17 = 8 83.17 EUR/ u. (11) The total value of shoes added to the finished goods inventory equals: 9,500 × 83.17 = 7 790,115.00 EUR. DR FG Inventory................. 790,115.00 EUR CR WIP CC-003................... 790,115.00 EUR The value of the remaining 500 uncompleted shoes in cost centre CC-003 equals to the balancing figure of the Work-in-Process CC-003 account. It is: 820,000 - 790,115 = 2 29,885.00 EUR. To cross-check the value, we calculate the 500 uncompleted shoes. The costs added in cost centre CC-003 thereto are only 20 % of the value added to completed shoes. Accordingly, the unit costs per uncompleted shoe are: 54 + 20% × 29.17 = 5 59.84 EUR/ u. The calculation of the closing stock is based on 500 uncompleted shoes and gives: 500 × 59.84 = 29,920.00 EEUR. The comparison to the balancing figure reveals a rounding difference of 29,885 - 29,920 = 2 25.00 EUR. 19.7. Profit Calculation - C/ S We continue the case study to determine EDEWECHT (Pty) Ltd.’s profit. (12; 13) EDEWECHT (Pty) Ltd. sells 8,000 shoes at a net selling price of 175.00 EUR/ u. The revenue is: 175 × 8,000 = 1,400,000.00 EUR. The cost of sales equal: 83.17 × 8,000 = 6 665,360.00 EUR. <?page no="351"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 19-351 DR Cash/ Bank.................... 1,400,000.00 EUR CR Revenue...................... 1,400,000.00 EUR DR Cost of Sales................ 665,360.00 EUR CR FG Inventory................. 665,360.00 EUR The gross profit equals: 1,400,000 - 665,360 = 7 734,640.00 EUR. The calculation is shown in the accounts in Figure 22.4. D C D C (1) 160,000.00 (2) 160,000.00 (2) 160,000.00 (5) 160,000.00 D C D C (3) 540,000.00 (6) 90,000.00 (4) 120,000.00 (8) 120,000.00 (7) 450,000.00 540,000.00 540,000.00 Purchases-20X4 PUR RM inventory RMI Labour-20X4 LAB Depreciation-20X4 DPR D C D C ... (1) 160,000.00 (4) 120,000.00 (12) 1,400,000.00 (3) 540,000.00 Cash/ Bank C/ B Acc depr ACC D C D C (5) 40,000.00 (9) 340,000.00 (5) 80,000.00 (10) 540,000.00 (6) 30,000.00 (6) 30,000.00 (7) 270,000.00 (7) 90,000.00 340,000.00 (9) 340,000.00 540,000.00 D C D C (5) 40,000.00 (11) 790,115.00 (11) 790,115.00 (13) 665,360.00 (6) 30,000.00 c/ d 124,755.00 (7) 90,000.00 790,115.00 790,115.00 (8) 120,000.00 b/ d 124,755.00 (10) 540,000.00 c/ d 29,885.00 820,000.00 820,000.00 b/ d 29,885.00 WIP CC-003 (leather) FG inventory FGI WIP CC-001 (body) WIP CC-002 (sole) Figure 19.4: EDEWECHT (Pty) Ltd.’s accounts <?page no="352"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 19-352 D C D C P&L 1,400,000.00 (12) 1,400,000.00 (13) 665,360.00 P&L 665,360.00 Revenue-20X4 REV Cost of goods sold-20X4 COS D C COS 665,360.00 P&L 1,400,000.00 GP 734,640.00 1,400,000.00 1,400,000.00 b/ d 734,640.00 Profit and Loss-20X4 P&L Figure 19.4: EDEWECHT (Pty) Ltd.'s accounts (continued) 19.8. Summary In a process costing system, the calculation is based on the value added to units per cost centre. The value is carried forward to the next following production step. In a process costing system, Work-in-Process accounts represent cost centres. Direct costs and overheads are allocated to the Workin-Process accounts. The value added to every unit is the cost of a cost centre divided by the number of units completed therein. The last WIP-account is closed-off to the Finished Goods Inventory account once all goods are completed. If goods are not completed, their calculation is based on equivalent units. 19.9. Working Definition Equivalent Unit: An equivalent unit is the quantity of goods calculated as number × percentage of completion. 19.10. Question Bank (1) Which statement is wrong? 1. In a process costing system, costs are calculated on process cost rates. 2. In a process costing system, the closing amount the WIP account is transferred to the next production step. 3. In a process costing system, the MOH account is not required. 4. In a process costing system, equivalent units are used of production is not completed. (2) A company produces 500 goods and completes 450 thereof. The remaining goods are completed to an extent of 20 %. How much are the equivalent units? 1. 500 . 2. 475 . 3. 450 . 4. 460 . (3) In a process costing system production of 400 units takes place in 2 cost centres. In both cost centres labour is 5,000.00 EUR. Materials apply in the first cost centre to the extent of 800.00 EUR. Depreciation <?page no="353"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 19-353 in the 2 nd cost centre is 1,000.00 EUR. How much are the unit costs of manufacturing if all goods are completed? 1. 31.50 EUR . 2. 27.00 EUR . 3. 29.50 EUR . 4. 17.00 EUR . (4) In a process costing system, a manufacturer records in the last production step: 10,000.00 EUR from previous production steps and 8,550.00 EUR for labour. The output is 900 goods, and 100 goods are completed to a percentage of 50%. What is the value of stock (FG) additions? 1. 17,573.68 EUR . 2. 17,100.00 EUR . 3. 1,450.00 EUR . 4. 16,695.00 EUR . (5) In a process costing system with 4 production steps, how many Bookkeeping entries in the form DR WIP account; CR WIP account take place at least? 1. 0 . 2. 3 . 3. 4 . 4. 5 . 19.11. Solutions 1-1; 2-4; 3-3; 4-2, 5-2. <?page no="354"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 20-354 20. Multiple-Level Contribution Margin Accounting 20.1. What is in the Chapter? A product calculation and profitability analysis which is based on marginal Costing requires a fixed cost management. We cover fixed costs by two alternatives methods in the next following chapters. Chapter (20) deals with multiple-level contribution margin accounting. We discuss how a hotel chain allocates fixed costs to different divisions (houses) in the case study FLINDERS Ltd. We study the allocation of fixed costs to different aggregation levels. This chapter is followed by activity based costing. 20.2. Learning Objectives A management of fixed costs is important, because nowadays fixed costs dominate the cost mix in many companies. A marginal cost Accounting system excludes fixed costs from cost rates for internal cost allocations and for calculation because they do not matter for short-term decisions. Hence, companies must manage their fixed costs by an extra system. You learn in this chapter how fixed cost management works. After studying this chapter, you know how to structure fixed costs and how to allocate them to cost centres on different levels. You will understand that fixed cost allocations follow dependencies of and responsibilities for costs. You develop an awareness of the problem of fixed cost allocations for decision making and you can run a multiple-level contribution margin Accounting system. 20.3. The Structure of a Profitability Analysis System In a multiple-level contribution margin Accounting system, the profitability analysis works in different levels of cost allocations. Every fixed cost management system is combined with marginal costing. Hence, a cost separation takes place in cost category Accounting and the cost rates for internal cost allocations and for calculation are based on proportional costs. Fixed costs only are considered in the profitability analysis. Starting from revenues and the deduction of proportional costs for goods/ services the first step is to calculate the contribution margin CM1. Thereafter further fixed costs are deducted from the (previous) contribution margins and allocated to various product/ cost centre aggregation levels. After each deduction of fixed costs, we arrive at a contribution margin which we indicate in ascending order. At first, only variable costs of the products are deducted from revenues which gives the first contribution margin CM1. Therefrom fixed costs for products are deducted if those only apply for the specific product types. We call that the contribution margin CM2. Next, we form product groups at which we allocate further fixed costs. After fixed costs for groups of products are deducted, we determine the contribution margin CM3. Besides, product groups, plants or distribution channels can be used to define groups of cost objects. The process is continued to the last contribution margin which is the profit <?page no="355"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 20-355 of the whole company. Figure 20.2 shows such a profitability analysis for the case study FLINDERS Ltd. which we discuss in this chapter. For the approach of a multiple-level contribution margin Accounting (multiple CMA), matches of fixed costs to cost objects must be identified to support a fixed cost management that avoids cost allocations based on average principle. If costs cannot be allocated to certain cost objects, they move to the next lower level. The lowest level is the whole company. A multiple-level CMA assigns fixed costs but strictly avoids value-based cost allocations. Multiple-level contribution margin Accounting is an extension of a marginal cost Accounting system. Companies applying the cost of sales format for their profitability analysis extend their calculations by contribution margin Accounting and assign fixed costs to different levels of aggregations of cost objects and organisational units. The cost allocations provide Marketing with valuable information and support product mix and distribution channel decisions. A multiple-level CMA fails if fixed costs only can be allocated to the company. 20.4. C/ S FLINDERS Ltd. We study multiple-level Contribution Margin Accounting with the Hospitality Management case study FLINDERS Ltd. It is about a hotel chain that runs hotels in Berlin and Amsterdam. Find below the data sheet for FLINDERS Ltd. Data Sheet for FLINDERS Ltd. CClassification: Hospitality Management; Period: 7/ 20X6 (actual); Hotels: B-Charlottenburg; B-Lichtenberg; B-Moabit; B-Zehlendorf; AMS- Duivendrecht; Room quantity: 36 / 25/ 18 / 29 / 120; Prices per stay (1 person): 130.00 EUR / 110.00 EUR / 105.00 EUR / 130.00 EUR / 90.00 EUR; Occupation [stays/ m]: 860 / 560 / 490 / 550 / 3,400; Proportional costs: 15.00 EUR/ stay; Labour (fixed): 42,000.00 EUR/ m / 39,000.00 EUR/ m / 36,000.00 EUR/ m / 39,000.00 EUR/ m / 57,000.00 EUR/ m; Depreciation: 25,000.00 EUR/ m / 9,000.00 EUR/ m / 6,000.00 EUR/ m / 27,000.00 EUR/ m / 60,000.00 EUR/ m; Gym costs: 4,500.00 EUR/ m / 4,500.00 EUR/ m / 4,500.00 EUR/ m / n/ a / n/ a; purchases: B: 23,500.00 EUR/ m; AMS: 18,000.00 EUR/ m; HR and management costs: 56,000.00 EUR/ m; VAT ignored. FLINDERS Ltd. is a hotel chain. It runs 4 hotels in Berlin (Charlottenburg, Zehlendorf, Moabit and Lichtenberg). Another hotel is in Amsterdam Duivendrecht. Three of the German hotels (Charlottenburg, Moabit and Lichtenberg) have a gym and employ a PE-instructor. Every hotel runs a restaurant. The purchases (groceries, kitchen tools etc.) for all restaurants in Berlin are made in Charlottenburg. The hotel in Amsterdam- Duivendrecht runs its own procurement office. The Human Resource department and the management for all hotels is based in Berlin Lichtenberg. The Berlin hotels are small hotels with 18 to 36 rooms. The hotel in Amsterdam Duivendrecht is bigger (120 rooms). The net <?page no="356"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 20-356 room rates per stay 62 in Berlin are in a range from 105.00 EUR/ stay to 130.00 EUR/ stay depending on the district where the hotel is. The hotel in Amsterdam charges 90.00 EUR/ stay. For the actual calculations below, the room numbers do not matter. Only the quantity of stays counts for the profitability analysis. We call the hotels' reference unit "stays". Observe the basic data recorded for the Accounting period July 20X6 for the 5 hotels in Figure 20.1. Amsterdam Charlottenburg Lichtenberg Moabit Zehlendorf Duivendrecht #-rooms 36 25 18 29 120 net price / stay 130.00 110.00 105.00 130.00 90.00 Stays (nights rented out) 860 560 490 550 3,400 Berlin Figure 20.1: FLINDERS Ltd.’s sales information for 7/ 20X6 The revenue is calculated by multiplying the net room rates with the stays. E.g., for the hotel in Berlin Charlottenburg the revenue equals: 130 × 860 = 1 111,800.00 EUR. The proportional costs are given for FLINDERS Ltd. As most of the costs in the hotels are fixed costs, only room cleaning costs depend on the number of stays. The proportional costs for all hotels equal: 15.00 EUR/ stay. E.g., in the hotel in Charlottenburg, the proportional costs are: 15 × 860 = 1 12,900.00 EUR. The contribution margin-1 (CM1) is calculated by deducting proportional costs from revenues. The contribution margin- 1 (CM1) for the hotel in Charlottenburg equals: 111,800 - 12,900 = 9 98,900.00 EUR. The contribution margin of all hotels together must cover the fixed costs of the company. The total of the five CM1s adds up to: 98,900 + 53,200 + 44,100 + 63,250 + 255,000 = 5 514,450.00 EUR. 62 A stay is the occupation of one room for 1 person and 1 night. The overheads for the 5 hotels include fixed labour, depreciation, fixed gym costs, purchase costs (not for the goods purchased but the cost of the Procurement office) and the Human Resources/ Management department costs. The total of the fixed overheads equals: 213,000 + 127,000 + 13,500 + 41,500 + 56,000 = 4 451,000.00 EUR. As the comparison tells us, FLINDERS Ltd. earns a profit, as the CM1s together cover its total of fixed costs: 514,450 - 451,000 = 6 63,450.00 EUR. We say: FLINDERS Ltd.’s net profit is 63,450.00 EUR. The next question is: Where (in which hotel) does FLINDERS Ltd. earn the profit? The purpose of contribution margin Accounting is to assign fixed costs to cost objects to understand, what happens, in case the cost objects change or are given up. <?page no="357"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 20-357 We study the FLINDERS Ltd.’s hotel case more in the details. The fixed costs which can be linked to the 5 hotels directly, are fixed labour costs, depreciation and in some hotels gym costs. The three cost categories are assigned straight to the hotels. E.g., if a hotel has no gym, no gym costs apply. No allocations of fixed costs between hotels are made. The difference between the CM1s and fixed overheads per hotel gives the contribution margins-2 (CM2s). A negative CM2 indicates, the hotel makes a loss. The negative contribution margin represents a loss even before further deductions of fixed costs. At FLINDERS Ltd., this applies for the hotel in Moabit and in Zehlendorf. Next, the fixed costs per hotels group are calculated. The costs of the central purchase department are for all hotels in Berlin. We form hotel groups "Berlin" and "Amsterdam". The hotel in Amsterdam Duivendrecht runs its own procurement. We do not allocate costs for central procurement to single hotels but assign them to the groups "Berlin" and "Amsterdam". We start in Berlin: For the next contribution margin, we add all CM2s for the hotels in Berlin. It gives: 27,400 + 700 - 2,400 - 2,750 = 2 22,950.00 EUR. The sum of the contribution margins in Berlin must cover the procurement costs of 23,500.00 EUR. As the calculation reveals, the hotels in Berlin do not contribute to profit, because the CM3 in Berlin is negative: 22,950 - 23,500 =- -550.00 EUR. In contrast, the contribution margin-3 for the hotel in Amsterdam, equals: 138,000 - 18,000 = 1 120,000.00 EUR. On the next level we form a group ‘all hotels’ which also represents the entire company. We add the two CM3s: -550 + 120,000 = 1 119,450.00 EUR. From this value, all fixed costs for the central Human Resource/ Management department are deducted. This gives us the contribution margin-4, which is FLINDERS Ltd.'s net operating profit: 119,450 - 56,000 = 6 63,450.00 EUR. Observe the calculation as depicted in Figure 20.2. It summarizes the above discussed multiple-level calculation of profits for the 5 FLINDERS Ltd.-hotels. <?page no="358"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 20-358 Amsterdam Charlottenburg Lichtenberg Moabit Zehlendorf Duivendrecht Revenue 111,800 61,600 51,450 71,500 306,000 Prop costs (cleaning) (12,900) (8,400) (7,350) (8,250) (51,000) CM 98,900 53,200 44,100 63,250 255,000 Labour (fixed) (42,000) (39,000) (36,000) (39,000) (57,000) Depreciation (fixed) (25,000) (9,000) (6,000) (27,000) (60,000) Gym expenses (4,500) (4,500) (4,500) CM 2 27,400 700 (2,400) (2,750) 138,000 138,000 Purchase (18,000) CM 3 120,000 HR, management Operating profit -56,000 63,450 Berlin Flinders Ltd. CONTRIBUTION MARGIN ACCOUNTING 22,950 (23,500) (550) 119,450 Figure 20.2: FLINDERS Ltd.’s multiple-level CMA Contribution margin Accounting does not apportion costs from shared resources (no allocations apply). By contribution margin Accounting, managers can assign overheads to various cost objects and groups thereof to make decisions on different levels of aggregation. In terms of cost theory, a multiple-level contribution margin Accounting strictly applies the cost-bycause principle. If it works out to assign fixed costs to cost objects and groups thereof, the multiple-level CMA is preferred over an activity based costing. As mentioned above, a multiple-level CMA fails if costs only can be assigned to the entire company. Then the information is useless, as it does not help managers for decision making. In those cases, an activity based costing system should be applied as discussed in the next chapter (21). 20.5. Summary Multiple-level contribution margin Accounting assigns fixed costs to cost objects on different levels. No allocation based on the average principle towards cost objects takes place. The managers can study what fixed costs are for, which gives them valuable information for fixed cost management and product mix decisions. 20.6. Question Bank (1) In a multiple contribution margin Accounting, the last costs deducted are: 1. Product group related costs. 2. Product related fixed costs. 3. Contribution margin. 4. Costs for the entire company. (2) A company produces 2 products A and B. The contribution margin for A is 6.00 EUR and for B 8.00 <?page no="359"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 20-359 EUR. Both product quantities are 1,000 units. The product related fixed costs are 2,500.00 EUR and 3,000.00 EUR respectively. The fixed costs linked to the entire company are 5,000.00 EUR. How much is profit? 1. 9,000.00 EUR . 2. 7,500.00 EUR . 3. 3,500.00 EUR . 4. 5,000.00 EUR . (3) What is a contribution margin? 1. Proceeds less cost of sales. 2. Revenue less product costs. 3. Proceeds less proportional costs. 4. Revenue less proportional costs. (4) What is the allocation principle with a multiple-level contribution margin Accounting? 1. Average principle. 2. Cost-by-cause principle. 3. Direct assignment by tracing. 4. Group allocations. (5) What cost Accounting system is a multiple-level margin Accounting linked to: 1. Marginal cost Accounting. 2. Activity Based Costing. 3. Absorption costing. 4. Full cost Accounting system. 20.7. Solutions 1-4; 2-3; 3-4; 4-2; 5-1. <?page no="360"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 21-360 21. Activity Based Costing 21.1. What is in the Chapter? In this chapter about activity based costing, you learn about a modern Controlling approach based on business processes. Activity based costing is an alternative to multiple-level contribution margin accounting. We recommend the application of activity based costing, if the CMA does not work, meaning, if fixed costs cannot be allocated to cost objects or groups thereof. In those cases, the contribution margins remain small, and a huge block of fixed costs remains. Why do we prefer CMA? It is because of an activity based costing is based on the average principle for cost allocation. This is what we only accept after a cost allocation following the cost-by-cause principle failed. Here, we introduce the concept of an activity based costing system (ABC) and discuss its application for the airline company TORQUAY Ltd. We focus on their fixed costs in the Ticketing, Re-scheduling and Advertising departments. To point out the conceptual differences, we compare the costs allocations made by ABC to those resulting from a traditional cost Accounting system. Further, we discuss activity based management which is about making changes of the business operations and budgeting costs for processes and business activities. We apply the same case TORQUAY Ltd. for activity based management (ABM). 21.2. Learning Objectives Activity based costing (ABC) became a popular Management Accounting instrument during the last decades. It is linked to business reengineering. It is based on business activities and process chains. In this chapter you learn how ABC assigns costs to business processes, which are sequences of business activities crossing departmental borders. You will understand that in an ABC system, costs are allocated by cost drivers. A cost driver is a factor that determines the consumption of fixed costs. A cost driver looks like a reference unit, but you will learn that the difference is that the cost driver does not cause costs. It only divides costs for stand-by resources. After studying this chapter, you know how ABC works and you can distinguish it from a marginal costing paired with contribution margin Accounting. You can discuss and decide about the right cost Accounting system for the management of fixed costs. 21.3. Theoretical Background for ABC ABC apportions fixed costs to business activities. The allocation of overheads is not based on the cost-bycause principle but on the average principle. Therefore, ABC is not alternative to a marginal cost Accounting system. It only applies if other methods of fixed cost management fail. The cost drivers in use do not allow a fair cost allocation. A cost driver is a unit which measures activity perfor- <?page no="361"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 21-361 mances, and which influences the resource allocation thereto. Allocations based cost drivers only divide fixed costs. The main difference between a reference unit (traditional Cost Accounting) and a cost driver (ABC) becomes obvious in a situation if they are zero. Zero reference units means no proportional costs apply and nothing is produced. As the cost driver is linked to fixed costs, a zero-value for a cost driver means, no activity takes place, but fixed costs exist. ABC deals with stand-by overheads. An example for stand-by costs is a fire brigade: If nothing burns no activity takes place, but the costs for the fire fighters still exist. We do not recommend applying ABC for product calculations. Neither do we endorse software which uses ABC for product calculations. Cost allocations per average lead to volatile unit costs. If the cost driver is low, cost rates become very high. This is a useful information for decision making regarding business reengineering but should be avoided for product calculations. The main reason for the introduction of ABC are today’s cost structures. Many overheads are now fixed costs. This is caused by how companies work and what kind of resources apply. With machinery replacing direct work, product costs include less proportional costs but contain more maintenance, depreciation and supervision costs. Therefore, the application of a marginal cost Accounting system with a percentage of variable costs of 2 …5 %, can become useless for management support. For that reason, Accountants strive to look for factors that change (drive) costs. Most costs are driven by activities. Therefore, it makes sense to study activities for cost management. In contrast, in a traditional marginal cost Accounting system, costs are assigned and allocated based on the costby-cause principle. Considering the discussed cost structure, we only can allocate proportional costs to the goods. This would be less than 5 % of the total costs. In contrast, ABC allocates all (total) costs to activities based on the average principle. E.g., in procurement, costs for order management are completely fixed costs. Proportional costs do not exist, because no costs in the procurement department depend on the number of finished goods. Therefore, we define the order quantity or the number of order items as major cost driver. Although the costs in the procurement division are not output-related, they can be controlled and budgeted by cost drivers. A cost driver (CD) is a factor process costs depend on. Fixed costs are not changed by cost drivers, but management makes decisions about the allocation of resources to, e.g., procurement, based on the order quantity. 21.4. How does ABC Work? ABC assigns costs to cost centres like a traditional cost Accounting system (a combination of a marginal cost Accounting and a contribution margin Accounting). Unlike in a traditional Cost-Accounting system, costs of the cost centres are structured following their dependency on cost drivers and allocated to cost <?page no="362"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 21-362 pools. A cost pool is a portion of costs which depends on the same cost driver. No internal cost allocations take place in ABC. All costs allocated to cost pools are divided by the activity numbers to determine the process cost rate. The currency of the process cost rate is, e.g., EUR/ CD. In ABC the reference unit is replaced by cost drivers. For the application, these are minor differences but in terms of Management Accounting they have a significant effect on how to manage costs. We study an example from the university to make the concept understood. A ‘How is it done’ section is following. 21.5. Activity Costs for a Professor We want to implement a cost management system in a faculty. Its 1 st degree cost allocation assigns salary, office costs and computer costs to the cost centre (Teaching department). This cost allocation is followed by defining cost pools. To determine the values, an Accountant interviews the professors and identifies business processes they work on and how much time they spend thereon. The answer could be that the professors claim, that giving classes and lesson preparation takes 60 % of their workload, 30 % is for research and 10 % is spent on administration duties. Therefore, the Accountant defines three cost pools, (1) for teaching, which depends on the cost driver weekly classes, (2) for research, which depends on the number of research projects, and (3) for administration, which depends on the number of meetings the professors must attend. Based on the interview result, e.g., the cost pool Teaching carries 60 % of the cost centre costs. The next step is the calculation of the process cost rate per activity, by dividing the allocated costs by the cost driver numbers. A process cost rate is the total of costs assigned to an activity divided by the activity’s CD-amount. A process cost rate represents the costs spent on average on a one-time-execution of an activity/ business process. We now calculate process costs for a class taught 4 lessons per week: Assume, the costs allocated to the cost centre are 500,000.00 EUR/ a. Teaching receives: 60% × 500,000 = 300,000.00 EUR/ a. All professors together teach 200 classes/ week during the year, which is their workload. This gives a process cost rate for teaching of: 500,000 × 60% / 200 = 1,500 EUR/ weekly classes. Calculating a class requires determining the weekly workload. This is the 3 rd cost allocation. A class taught 4 lessons per week for one year costs: 4 × 1,500 = 6,000.00 EUR. 21.6. Business Process Calculation ABC assigns fixed costs that can be allocated by cost drivers, to cost pools. In the cost pools, process cost rates for activities are calculated. For business process calculation, all activities included in a business process need to be calculated by multiplying the process cost rates PCR with their usage factor. A usage factor tells us how often (at how many CDs) an activity is performed within a business process. (If we calculate the business process Flight Check-in/ Boarding at an air- <?page no="363"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 21-363 port, the activity Passport Check is included at least 5 times therein. Hence, its usage factor is 5.) A business process is a sequence of activities to serve a product. Examples for business processes are treatment of complaints at a department store, checking your tax statement at the revenue service, exam enrolment at the university etc. Activities are the elements of business processes. How it is Done (Activity Based Costing) (1) Record/ Plan costs in cost centres. (1 st cost allocation) (2) Design business process models that contain activities in cost centres. (3) Identify cost drivers for activities. (4) Define cost pools which contain activities that depend on the same cost drivers. The cost pool can cross department borders. (5) Allocate resources to cost pools. The resource allocation is based on interviews with cost centre experts. In the interviews, the workload per cost pool is determined. Use percentages provided by the experts or time records to calculate a cost allocation ratio between cost pools. Allocate costs based on the ratios. (6) Measure/ plan the activity numbers and express them in cost driver units. (7) Divide the costs per cost pool by the cost driver values to calculate the process cost rate PCR. The unit of the process cost rate is EUR/ CD-value. (8) Measure/ plan the cost driver number per product. This is the utility factor for an activity linked to the product. (9) Aggregate activities to business processes based on business process models. (10) Calculate goods/ services that apply the activities/ business process by multiplying the process cost rates with the utility factor. (11) Add the process costs of business processes along the activities therein. 21.7. Case Study TORQUAY Ltd. We study ABC for an airliner. TORQUAY Ltd. runs a traditional cost Accounting system. Operation department’s cost allocation is based on the reference unit seat-kilometers (number of seats available × distance measured in km). TORQUAY Ltd. applies a marginal cost Accounting system. See below its data sheet: Data Sheet for TORQUAY Ltd. CClassification: Aviation; <?page no="364"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 21-364 RRoutes: Europe / FarEast; Aircraft: 787 (250-seater) / 777 (400seater); Distance: 468 km / 5,349 km; Monthly ticket quantity: 6,000 / 11,500; net ticket price per flight: 400.00 EUR/ passenger / 900.00 EUR/ passenger; Fuel costs per flight: 20,000.00 EUR / 70,000.00 EUR; Depreciation: 1,100,000.00 EUR/ m; Labour: 120,000.00 EUR/ m; Airport landing fees: 50,000.00 EUR/ flight; Ticket sales costs: 2,000,000.00 EUR/ m; Check-in costs: 120.00 EUR/ passenger; VAT ignored. TORQUAY Ltd. daily (30 days/ month) operates two routes: - Route Europe: 468 km, sells per month 6,000 tickets at 400.00 EUR/ flight. The aircraft is a Boeing 787 (250-seater). - Route FarEast: 5,349 km, sells per month 11,500 tickets at 900.00 EUR/ flight. The aircraft is a Boeing 777 (400-seater). Check the revenues in Figure 21.1. Europe FarEast Revenue 2,400,000 10,350,000 Figure 21.1: TORQUAY Ltd.’s revenue Monthly depreciation on both aircrafts (together) is 1,100,000.00 EUR/ month. Labour equals 40,000.00 EUR/ month for the pilots and 80,000.00 EUR/ month for the rest of the crew. The airport fees (APF) amount to 50,000.00 EUR per landing and take-off circle (= per flight). Fuel costs are 20,000.00 EUR/ flight for the Europe flight and 70,000.00 EUR/ flight for the FarEast route. The Ticket Sales Office charges 2,000,000.00 EUR per month (TKT). The airport company charges 120.00 EUR per check-in. (CKI) Along this cost information, we calculate the Europe and the FarEast route based on a traditional cost Accounting system. Later in this chapter, we calculate the cost for the Ticket Sales Office based on an ABC. 21.8. Traditional Cost-Accounting System - C/ S Observe direct costs and overheads in Figure 21.2. The route calculation contains airport costs for check-in-service and fuel costs as direct costs. The airport company costs (CKI) per Europe flight are: 6,000 × 120 = 7 720,000.00 EUR/ m. For the FarEast flights, the airport company charges: 11,500 × 120 = 1,380,000.00 EUR/ m. The fuel costs (FUE) are disclosed per month: 30 × 20,000 = 6 600,000.00 EUR/ m for the Europe route and: 30 × 70,000 = 2,100,000.00 EUR/ m for the FarEast route. Overheads are recorded in the Manufacturing Overhead account. They contain depreciation (DPR), take-off and landing fees (APF), Ticket Sales Office costs (TKT) and labour (LAB) for the pilots and the crew. The total overheads equal: <?page no="365"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 21-365 1,100,000 + 3,000,000 + 2,000,000 + 120,000 = 6 6,220,000.00 EUR/ m. The overhead application is based on seat-km. The seat-km-number on the Europe route is: 468 × 250 = 1 117,000 seat-km. The FarEast flight with a 400seater aircraft gets: 5,349 × 400 = 2,139,600 seat-km. The overheads to the Europe route equal: (117,000 / (117,000 + 2,139,600)) × 6,220,000 = 322,494.02 EUR/ m. The Overhead allocation to the FarEast route gives: (2,139,600 / (117,000 + 2,139,600)) × 6,220,000 = 5 5,897,505.98 EUR/ m. D C D C DPR 1,100,000.00 Eur 322,494.02 CKI 720,000.00 APF 3,000,000.00 FE 5,897,505.98 FUE 600,000.00 TKT 2,000,000.00 MOH 322,494.02 c/ d 1,642,494.02 LAB 120,000.00 1,642,494.02 1,642,494.02 6,220,000.00 6,220,000.00 b/ d 1,642,494.02 Manufacturing Overheads MOH WIP Europe W_E D C CKI 1,380,000.00 FUE 2,100,000.00 MOH 5,897,505.98 c/ d 9,377,505.98 9,377,505.98 9,377,505.98 b/ d 9,377,505.98 WIP FarEast WFE Figure 21.2: TORQUAY Ltd.’s accounts The route calculation shows in Figure 21.3. As the net operating profit indicates, the two routes are almost equally profitable. Europe FarEast Revenue 2,400,000 10,350,000 direct costs: - Check-in expenses (720,000) (1,380,000) - Fuel expenses (600,000) (2,100,000) Overheads (322,494) (5,897,506) Net operating profit 757,506 972,494 Figure 21.3: TORQUAY Ltd.’s calculation based on a traditional cost Accounting system <?page no="366"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 21-366 The product manager of the FarEast route is unhappy about the overhead allocation based on seat-km. Due to the longer distance, the FarEast route covers an unreasonably high portion of the overheads. Many overheads, like ticket sale costs, take-off and landing fees and check-in costs, do not depend on the distance. Therefore, they overcharge the FarEast route. 21.9. Activity Based Costing (partial) - C/ S TORQUAY Ltd. now establishes a partial ABC system. The Ticket Sales Office is turned into an ABC cost center. To implement ABC only in certain areas is common in Accounting. The cost allocations following marginal costing in many departments are quite effective and do not need additional ABC. Only in departments, where managers do not find sufficient direct costs but good cost drivers, ABC makes sense. At TORQUAY Ltd., we calculate cost centre costs and define cost pools. Regarding the cost allocations, the process costs are allocated based on the time spent on activities. To determine the activity durations, TORQUAY Ltd. runs an activity analysis for the Ticket Sales Office. The activity analysis reveals that 60 % of the time in the Ticket Sales Office is for flight bookings. The cost driver is the number of tickets. 20 % of the time in the Ticket Sales Office is spent on passengers’ re-schedulings. Every month, there are 500 re-schedulings for the Europe route and 1,100 for the FarEast route. 20 % of the time in the Ticket Sales Office is spent on flight offer making. The offer number is 2,000 per month. The quantity of offers is equally distributed over the routes. TORQUAY Ltd. defines three cost pools for the Ticket Sales Office cost centre. The cost pool Ticketing depends on the CD ticket number. The cost pool Rescheduling depends on the cost driver re-scheduled trips. The cost pool Advertising depends on the offer quantity. The total costs of the Ticket Sales Office are still 2,000,000.00 EUR/ m. The allocation of the overheads to the cost pools gives: 60% × 2,000,000 = 1 1,200,000.00 EUR/ m for Ticketing, 20% × 2,000,000 = 400,000.00 EUR/ m for Re-scheduling and another 400,000.00 EUR/ m for Advertising. The cost driver values are the sold tickets, which equal: 6,000 + 11,500 = 117,500 sold tickets/ m. The quantity of rescheduled trips equals: 5 500 + 1,100 = 1,600 rescheduled trips/ m and 2,000 offers/ m are made every month. Observe the calculation of the process cost rates for the activities Ticketing, Rescheduling and Advertising in Figure 21.4. The process cost rate for Ticketing equals: 1,200,000 / 17,500 = 6 68.57 EUR/ sold ticket. The process cost rate for Rescheduling equals: 400,000 / 1,600 = 2 250.00 EUR/ re-scheduled trip and the process cost rate for Advertising equals: 400,000 / 2,000 = 2 200.00 EUR/ offer. <?page no="367"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 21-367 Cost pool Costs CD PCR Ticketing 1,200,000 17,500 68.57 Rescheduling 400,000 1,600 250.00 Advertising 400,000 2,000 200.00 Figure 21.4: TORQUAY Ltd.’s ABC cost centre Sales Office The new Accounting system for the Ticket Sales Office changes the route calculation. The overheads now do not contain the Ticket Sales Office’s overheads anymore. The reduction of 2,000,000.00 EUR causes seat-km-based allocated overheads to decrease. The overheads allocated to the Europe route now equal: (6,220,000 - 2,000,000) × ((117,000 / (117,000 + 2,139,600)) = 2218,798.19 EUR/ m. The FarEast route carries: (6,220,000 - 2,000,000) × ((2,139,600 / (117,000 + 2,139,600)) = 4,001,201.81 EUR/ m. The costs for the Ticket Sales Office are spit following the cost driver consumption. The Europe route’s Ticketing’s costs equal: 6,000 × 68.57 = 4 411,428.57 EUR/ m. The FarEast route’s Ticketing’s costs are: 11,500 × 68.57 = 7 788,571.43 EUR/ m. The calculation of the Rescheduling and Advertising costs follows the same structure and is disclosed in Figure 21.5. Europe FarEast Revenue 2,400,000 10,350,000 Direct costs: - Check-in expenses (720,000) (1,380,000) - Fuel expenses (600,000) (2,100,000) ABC: - Ticketing (411,429) (788,571) - Rescheduling (125,000) (275,000) - Advertising (200,000) (200,000) Overheads (218,798) (4,001,202) Net profit 124,773 1,605,227 Figure 21.5: TORQUAY Ltd.’s route calculation on a partial ABC system As a result of ABC-costing, the net operational profits change significantly. However, the total profit over both routes remains unchanged. ABC only changes the allocation to routes. The calculation based on ABC does not follow the cost-by-cause principle. However, the cost information provided by ABC is closer to the business process characteristics and the activity trigger mechanism. The new profits prove the FarEast route earns a higher net operational profit than the Europe flights. This should have an impact on management decisions about the product mix (offered flight destinations). <?page no="368"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 21-368 21.10. Activity-based Management Caution! ABC 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 ABC only allocates costs, the total of costs does not depend on the cost drivers. Therefore, changes of processes do not change costs. For cost management based on ABC, costs must be changed by decisions, followed by a new ABCcalculation. Activity based management (ABM) is a management process based on activity-based costing information. In ABM, cost decisions come first. After deciding about costs, cost pooling, calculation of process cost rates for activities and business process calculation follow. This procedure is different to marginal costing. In a marginal cost Accounting system, managers change the business process (avoiding double work, reruns of activities etc) and then costs change automatically according to the new volumes. With ABM, business process numbers and costs are not interrelated. If the manager ceteris paribus halves the process runs, but does not make any cost adjustment, the cost rate per process will double. An increase of process numbers reduces the process cost rate. Process cost rates merely reflect capacity loads in the cost pools. This aspect of ABC is important for understanding ABM. For this reason, we discuss an ABM example for TORQUAY Ltd. We distinguish 2 scenarios for a changed business model. 21.11. 1 st Scenario - C/ S TORQUAY Ltd.’s consultants suggest charging the passenger 190.00 EUR per re-scheduled trip. Furthermore, they suggest transferring the advertising activities (flight offers) to a Marketing agency. The agency would charge the customer 100.00 EUR per offer. Accordingly, they want to cut total costs by 15 % in the Ticket Sales Office and reduce the ticket prices by 3 %. We consider for ABC a 6 : 2 ratio for Ticketing and Rescheduling costs. There are no cost allocations for Advertising. The question is, whether TORQUAY should make these changes. To support the decision, TORQUAY Ltd. runs an ABM analysis considering suggested cost cuts and activity changes. The decision depends on the total of profits. This example is a typical situation in ABM. To assess the new plans, TORQUAY Ltd. prepares a cost plan alternative. The cost calculation starts in the Ticket Sales Office cost centre. Its total costs are: (1 - 15%) × 2,000,000 = 11,700,000.00 EUR/ m. The costs are divided at a 6 : 2 ratio, which assigns: (6/ 8) × 1,700,000 = 1 1,275,000.00 EUR/ m to Ticketing and: 1,700,000 - 1,275,000 = 425,000.00 EUR/ m to Re-Scheduling. Observe the changes in the process cost rates shown in Figure 21.6. <?page no="369"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 21-369 Cost pool Costs CD PCR Ticketing 1,250,000 17,500 71.43 Rescheduling 425,000 1,600 265.63 Advertising 0 Figure 21.6: TORQUAY Ltd.’s alternative activity analysis The profitability analysis now is based on the adjusted ticket prices. The revenue decreases by 3 % and then equals: 2,400,000 × (1 - 3%) = 2 2,328,000.00 EUR/ m for the Europe route and 10,350,000 × (1 - 3%) = 1 10,039,500 EUR/ m for the FarEast route. The Re-scheduling fees amount to 190.00 EUR/ re-scheduling. According to the values, there is revenue from rescheduling fees for the Europe route of: 500 × 190 = 9 95,000.00 EUR/ m. The fees for the FarEast route are: 1,100 × 190 = 209,000.00 EUR/ m. The alternative profitability analysis is disclosed in Figure 21.7. The total profit for both routes equals: 322,817.88 + 1,653,682.12 = 1 1,976,500.00 EUR/ m. Previously, it was 1,730,000.00 EUR/ m. The question is whether TORQUAY Ltd. must run an alternative profitability analysis for making the decision. The answer is no, as the total of profit does not depend on the allocation of costs. Europe FarEast Revenue 2,328,000 10,039,500 Reschedule fees 95,000 209,000 direct costs: - Check-in expenses (720,000) (1,380,000) - Fuel expenses (600,000) (2,100,000) ABC: - Ticketing (428,571) (821,429) - Rescheduling (132,813) (292,188) - Advertising 0 0 Overheads (218,798) (4,001,202) Net operating profit 322,818 1,653,682 Figure 21.7: TORQUAY Ltd.’s alternative profitability analysis An ABC here only is required to assess the process cost rates. The Accountant must decide together with the Ticket Sales Office manager, whether the process cost rates for the activities are acceptable. As the cost rates are higher than before, Ticketing and Re-scheduling have more resources available for their activities. We could summarise the situation as, the Ticket Sales Office employees got an easier job and TORQUAY Ltd. is losing money. Hence, TORQUAY Ltd. should not follow the consultants’ advice. <?page no="370"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 21-370 21.12. 2 nd Scenario - C/ S TORQUAY Ltd. makes another change to its business concept and now cuts costs in the Ticket Sales Office by 25 %. In this case the process cost rates for the activities drop below the previous level, as shown in Figure 21.8. Cost pool Costs CD PCR Ticketing 1,125,000 17,500 64.29 Rescheduling 375,000 1,600 234.38 Advertising 0 Figure 21.8: TORQUAY Ltd.’s process cost rates, 2 nd amendment Now, the employees in the Ticket Sales Office get less resources (less time) for their work. Less resources means for example, there is one officer less working for the hotline and the remaining colleagues must take over her/ his calls. The question of whether the higher workload works out in the department, cannot be answered by Accounting. The Accountant only computes the process cost rates. The decision about the acceptance of the minimum of process cost rates is subjected to decisions made by department management. The manager must decide whether the workers can manage the higher workload. The process cost rate tells how much costs/ resources are assigned to a onetime-execution of one ticketing or rescheduling activity. In many companies - in particular in affiliated companies - process cost rates are compared between divisions. If the process cost rate in one department is doable, it will be possible to run the activity at that same rate somewhere else. TORQUAY Ltd. decides to go for the 25 % cost cut in the Ticket Sales Office and measures the profit for both routes thereafter. Observe Figure 21.9: Europe FarEast Revenue 2,328,000 10,039,500 Reschedule fees 95,000 209,000 Direct costs: - Check-in expenses (720,000) (1,380,000) - Fuel expenses (600,000) (2,100,000) ABC: - Ticketing (385,714) (739,286) - Rescheduling (117,188) (257,813) - Advertising 0 0 Overheads (218,798) (4,001,202) Net profit 381,300 1,770,200 Figure 21.9: TORQUAY Ltd.’s profitability analysis, 2 nd amendment <?page no="371"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 21-371 The total profit equals: 381,300.02 + 1,770,199.98 = 2 2,151,499.00 EUR/ m and exceeds the previous and the initial amounts. TORQUAY Ltd.’s manager should go for the changes. We see that the profit relationship between the routes has changed. Along the initial profitability analysis, the profit ratio was 44% : 56% as Europe : FarEast. After the application of ABC, it became 7% : 93% and after the cost cut following the second suggestion, it is 15% : 85 %. The latter change about the profit portions is caused by the price cut and shows in the revenue figures. A 3 % price cut on the FarEast route means: 10,350,000 - 10,039,500 = 3 310,500.00 EUR/ m. This is more than on the Europe flights. At the same time, the costs are changed for both routes to the same extent. This results in an imbalance of profit changes. A further aspect to be taken into consideration is the Marketing perspective of the product changes. An ABM that changes business processes the customer does not see, does not make us worry. However, here TORQUAY Ltd. changed the price and re-scheduling terms. Both is visible to the passengers. The Marketing director is in charge to check whether these changes have an impact on the customers’ booking behaviour as TORQUAY Ltd. competes with other airlines on the same routes. 21.13. Summary ABC and ABM are concepts based on the assignment of fixed costs to business processes activities. This gives the company transparency of its activities’ cost structure. The cost allocation following ABC is helpful for the management of fixed costs. Decisions about the business processes and resource allocations thereto, should be based on ABC if there are only few proportional costs. ABC cannot replace a marginal cost Accounting system. As ABC allocates fixed costs to products, it should not be applied for product calculations. ABM focusses on changes of processes and products based on ABC information. 21.14. Working Definitions Activity: Activities are the elements of business processes. Activity Based Management: Activity-based management is a management process based on activity-based costing information. Business Process: A business process is a sequence of activities to serve a product or service. Cost Driver: A cost driver is a factor 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 CDvalue. 21.15. Question Bank (1) What is the difference between a cost driver and a reference unit? 1. A reference unit depends proportional on the output. <?page no="372"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 21-372 2. None. 3. A cost driver is more accurate as it refers to activities. 4. A cost driver measures the cost of a cost pool in compliance with the cost-by-cause principle. (2) In a cost pool, labour costs are 5,000.00 EUR and Depreciation 3,000.00 EUR. Activity A takes 35 % of the time and activity B the rest. Activity A’s cost driver is 500 and activity B’s cost driver 300. What is the process cost rate of activity A? 1. 10.00 EUR/ CD . 2. 3.50 EUR/ CD . 3. 10.40 EUR/ CD . 4. 5.60 EUR/ CD . (3) Which statement is wrong? 1. An ABC system allocates costs based on the average principle. 2. An ABC system cost functions based on cost drivers are always linear cost functions. 3. In an ABC system fixed costs become proportional process costs. 4. In an ABC system, no mutual cost allocations between activities take place. (4) What is the best strategy in ABM? 1. Add workload to departments/ cost pools where process cost rates are low. 2. Add workload to departments/ cost pools where the process cost rates are high. 3. A high process cost rate indicates a high loading factor for an activity. 4. A process cost rate indicates the proportional costs per business process. (5) In a cost pool an activity shows a process cost rate of 50.00 EUR/ CD. The activity quantity is 2,000 CDs. When increasing the activity output by 500 CDs, further 25,000.00 EUR depreciation apply. How much cost 10 CDs? 1 500.00 EUR . 2. 625.00 EUR . 3. 1,000.00 EUR . 4. 400.00 EUR . Solutions 1-1; 2-4; 3-3; 4-2; 5-1. <?page no="373"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 21-373 Section (4): Asian Perspectives <?page no="374"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 22-374 22. Business Plan - ZAMZAM Restaurant In this chapter, we show a real business plan for a Malaysian company. The business plan was prepared by Sabri Shaker as an assignment for KPA1133 Management Accounting for Control and Decision Making in winter semester 2016/ 2017 in the study program for the master’s degree in Business Management and Administration. All data have been modified to keep the real data secret. ZAMZAM restaurant is a restaurant in the centre of Kuantan, next to big malls. It offers Arabic food with high quality service and high product diversification. The restaurant employs a staff of 35 full time employees. Figure 22.1: ZAMZAM restaurant (2) <?page no="375"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 22-375 The company offers a supermarket and catering service, where the dishes of the restaurant are offered for take away, too. We study the business plan for 2017/ 2018. The fiscal year starts on 1.04. and ends on 31.03. The business plan for the year 2017/ 2018 is prepared in quarters by ZAMZAM restaurant which means the 1 st quarter is from 1.04.2017 to 30.06.2017, the 2 nd quarter from 1.07.2017 to 30.09.2017 etc. The sales plan at ZAMZAM restaurant is based on its dishes. It is very detailed as you can observe in Figure 22.2. [MYR] Revenue plan amount prices/ u Apr. - Jun. 2017 RICE-Dishes: 425,124.00 chicken mandy 2,201 16.00 35,200.00 mandy lamb 2,120 16.00 33,904.00 lamb kabab 1,960 16.00 31,360.00 chicken kabab 2,700 15.00 40,500.00 lamb mandy big 900 45.00 40,500.00 lamb haneeth 1,072 16.00 17,152.00 chicken haneeth 2,063 16.00 33,008.00 Set A(3-6 person) 245 140.00 34,300.00 Set A(8-10 person) 132 250.00 33,000.00 whole grilled lamb 63 900.00 56,700.00 whole lamb for Aqiqah 55 1,200.00 66,000.00 lamb mandy (2-3 person) 70 50.00 3,500.00 Figure 22.2: Sales plan for rice dishes (detailed) The value of 425,124.00 MYR is the total of the rice dishes’ revenue. The sales plan has been aggregated by dish groups. E.g., the dishes ‘Chicken Mandy, Mandy Lamb … Lamb Mandy (2- 3 person) have been aggregated to the group Rice Dishes. The dishes are the same as on the menu. The figures are the sum of all dishes within a dish group. <?page no="376"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 22-376 [MYR] Revenue plan Apr. - Jun. 2017 Jul. - Sept. 2017 Oct. - Dec. 2017 Jan. - Mrch. 2017 RICE-Dishes: 425,124.00 494,330.00 717,422.00 570,717.00 GRILLS : 122,867.00 155,539.00 130,497.00 118,847.00 SPECIALITY RICE DISHES: 80,744.00 79,006.00 73,480.00 79,656.00 SANDWICHES: 74,050.00 76,840.00 67,460.00 63,620.00 COLD APPERTIZERS 150,434.00 195,487.00 155,270.00 128,729.00 SOUPS: 5,390.00 6,860.00 2,800.00 4,080.00 YEMENI DISHES: 72,168.00 79,908.00 51,428.00 29,136.00 DESSERTS and CAKES: 10,668.00 21,325.00 11,410.00 11,676.00 BEVERAGES: 62,624.00 64,050.00 54,032.00 52,126.00 Total 1,004,069.00 1,173,345.00 1,263,799.00 1,058,587.00 Figure 22.3: ZAMZAM restaurants sales plan The cost planning cannot be made on the forecasts, as the ordered dishes depend on the customers’ actual demands which can vary. Ingredients go into different dishes which makes it difficult to plan material costs accurately. For this reason, ZAMZAM restaurant applies a periodic inventory system and does not order the ingredients by dish forecasts based on recipes. The inventory is maintained by the restaurant manager based on the actual consumption. We here only describe a rough estimate of material costs in the restaurant’s kitchen department. The cost plan is based on the number of dishes. See Figure 22.4 for the production plan which gives the number of planned units per dishes. The unit count is not specific about the size of the dish. A unit can be a whole lamb dish for 8 persons as well as a coke. [MYR] Production plan [#] Apr. - Jun. 2017 Jul. - Sept. 2017 Oct. - Dec. 2017 Jan. - Mrch. 2017 RICE-Dishes: 13,579 14,074 15,067 12,726 GRILLS : 6,474 8,112 6,715 6,086 SPECIALITY RICE DISHES: 4,261 4,194 3,878 4,199 SANDWICHES: 7,405 7,684 6,746 6,362 COLD APPERTIZERS: 14,295 19,280 15,275 12,735 SOUPS: 539 686 280 408 YEMENI DISHES: 5,091 8,045 3,347 1,953 DESSERTS and CAKES: 2,184 5,381 2,799 2,549 BEVERAGES: 13,033 13,104 10,871 10,362 Total 66,861 80,560 64,978 57,380 Figure 22.4: ZAMZAM Restaurant’s production plan in units [#] The materials plan is based on the units of production. Materials are measured in Pounds. One unit of production (= one dish) requires 2 Pounds. Furthermore, materials require overstocking due to security levels. The buffer stock level equals to 15 % of the material requirements. ZAMZAM Restaurant calculates a Pound by 4.00 MYR. <?page no="377"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 22-377 The materials plan is given by Figure 22.5. [MYR] MATERIALS PLAN ['pounds'] Apr. - Jun. 2017 Jul. - Sept. 2017 Oct. - Dec. 2017 Jan. - Mrch. 2017 RICE-Dishes: 27,158 28,148 30,134 25,452 GRILLS : 12,948 16,224 13,430 12,172 SPECIALITY RICE DISHES: 8,522 8,388 7,756 8,398 SANDWICHES: 14,810 15,368 13,492 12,724 COLD APPERTIZERS 28,590 38,560 30,550 25,470 SOUPS: 1,078 1,372 560 816 YEMENI DISHES: 10,182 16,090 6,694 3,906 DESSERTS and CAKES: 4,368 10,762 5,598 5,098 BEVERAGES: 26,066 26,208 21,742 20,724 direct requirements 133,722 161,120 129,956 114,760 additions to stock 20,058 24,168 19,493 17,214 less opening amount (34,590) (20,058) (24,168) (19,493) Amount to purchase 119,190 165,230 125,281 112,481 Purchase costs [MYR] 476,761.20 660,918.80 501,125.60 449,922.40 Figure 22.5: ZAMZAM Restaurant’s materials plan Besides materials, labour is a major cost factor for ZAMZAM Restaurant. Labour is relevant for the chefs/ cooks, for waiters as well as for the management. Labour is calculated based on the production quantities measured and forecasted in dishes/ drinks, which we refer to as units. ZAMZAM Restaurant considers all labour costs being direct labour. The production function to calculate the workforce is based on a unit’s labour requirement of 0.08 h/ unit. The hourly rate at ZAMZAM Restaurant is 12.00 MYR/ h. [MYR] LABOUR PLAN [units] Apr. - Jun. 2017 Jul. - Sept. 2017 Oct. - Dec. 2017 Jan. - Mrch. 2017 RICE-Dishes: 13,579 14,074 15,067 12,726 GRILLS : 6,474 8,112 6,715 6,086 SPECIALITY RICE DISHES: 4,261 4,194 3,878 4,199 SANDWICHES: 7,405 7,684 6,746 6,362 COLD APPERTIZERS: 14,295 19,280 15,275 12,735 SOUPS: 539 686 280 408 YEMENI DISHES: 5,091 8,045 3,347 1,953 DESSERTS and CAKES: 2,184 5,381 2,799 2,549 BEVERAGES: 13,033 13,104 10,871 10,362 Total units of production 66,861 80,560 64,978 57,380 Direct labour required [h] 5,349 6,445 5,198 4,590 Direct labour costs [MYR] 64,186.56 77,337.60 62,378.88 55,084.80 Figure 22.6: ZAMZAM Restaurant’s labour plan <?page no="378"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 22-378 ZAMZAM Restaurant prepares a plan for manufacturing overheads and nonmanufacturing overheads. The manufacturing overheads depend on labour hours. One labour hour leads to 5.50 MYR/ h variable overheads. The rate is based on the cost planning. Hence, in the first quarter, variable overheads equal: 5,349 × 5.5 = 2 29,419.50 MYR. Additional to the variable manufacturing overheads, there are fixed manufacturing overheads of 28,705.00 MYR to be considered per quarter. The selling and administrative costs are planned directly based on their estimated figures. See the overhead plan in Figure 22.7: [MYR] OVERHEAD PLAN [MYR] Apr. - Jun. 2017 Jul. - Sept. 2017 Oct. - Dec. 2017 Jan. - Mrch. 2017 MANUFACTURING OHs Variable OHs 29,418.84 35,446.40 28,590.32 25,247.20 Fixed OHs 28,705.00 28,705.00 28,705.00 28,705.00 NON-MANUFACTURING OHs Materials and consumable 950.00 950.00 950.00 950.00 General repair on maintenan 2,100.00 2,100.00 2,100.00 2,100.00 Telephone & mail charges 450.00 450.00 450.00 450.00 Office Expenses 300.00 300.00 300.00 300.00 Work safety consciousness 390.00 390.00 390.00 390.00 Office stationery 210.00 210.00 210.00 210.00 Computer Expenses 150.00 150.00 150.00 150.00 Staff travelling 0.00 0.00 0.00 3,750.00 Entertainment 0.00 0.00 0.00 2,000.00 Donation 3,200.00 0.00 3,200.00 0.00 Rental expenses 18,500.00 18,500.00 18,500.00 18,500.00 Advertising and publicity 1,500.00 1,500.00 1,500.00 1,500.00 Insurance 3,625.00 3,625.00 3,625.00 3,625.00 Total overheads 89,498.84 92,326.40 88,670.32 87,877.20 Figure 22.7: ZAMZAM Restaurant’s overhead plan After costs are calculated they are disclosed in the comprehensive cost plan. You find the comprehensive cost plan in Figure 22.8. [MYR] COST PLAN Apr. - Jun. 2017 Jul. - Sept. 2017 Oct. - Dec. 2017 Jan. - Mrch. 2017 Materials 476,761.20 660,918.80 501,125.60 449,922.40 Labour 64,186.56 77,337.60 62,378.88 55,084.80 Overheads 31,375.00 28,175.00 31,375.00 33,925.00 Total costs 572,322.76 766,431.40 594,879.48 538,932.20 Figure 22.8: ZAMZAM Restaurant’s comprehensive cost plan The profit calculation is a comparison between revenue and costs. Income taxes only become relevant at the year end. Hence, the earnings per quarter before taxes are added for the calculation of the annual pre-tax profit of: <?page no="379"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 22-379 431,746.24 + 406,913.60 + 668,919.52 + 519,654.80 = 2 2,027,234.16 MYR. To keep the case study simple regarding tax calculations, ZAMZAM calculates the total income taxes by a rate of 30 % based on the annual earnings before taxes. See the profitability plan in Figure 22.9. Note, we put the tax calculation at the end of the Accounting period in March. [MYR] PROFITABILITY PLAN Apr. - Jun. 2017 Jul. - Sept. 2017 Oct. - Dec. 2017 Jan. - Mrch. 2017 Revenue 1,004,069.00 1,173,345.00 1,263,799.00 1,058,587.00 less Total of costs -572,322.76 -766,431.40 -594,879.48 -538,932.20 Earnings before taxes EBT 431,746.24 406,913.60 668,919.52 519,654.80 Total EBT per year 2,027,234.16 Income taxes -608,170.25 Earnings after taxes 1,419,063.91 Figure 22.9: ZAMZAM Restaurant’s profitability plan By the next step, ZAMZAM Restaurant calculates liquidity. The opening value in cash/ bank equals 27,152.50 MYR. ZAMZAM Restaurant adds the proceeds resulting from revenues. As the GST will be paid and transferred to the Malaysian revenue service immediately, GST is ignored for the business plan. To calculate the cash flows, we consider the payment terms. Regarding the proceeds, the customers pay on cash to an extent of 97 %. Only 3 % of the revenues is considered as payables. About the materials, 95 % of the material costs are paid in the actual Accounting period, the remaining price is paid in the next year. Labour is paid in full during the Accounting period the salary is for. The overheads are paid completely, except of non-cash overheads, such as depreciation. The liquidity is the value the opening value and all cash flows exceed ZAMZAM Restaurant’s payments. The total cash budget is displayed in Figure 22.10: [MYR] LIQUIDITY PLAN Opening value 27,152.50 415,543.39 766,335.19 1,371,156.11 Proceeds (97%) 973,946.93 1,138,144.65 1,225,885.03 1,026,829.39 Proceeds (3%) 27,152.50 30,122.07 35,200.35 37,913.97 Materials (95%) -452,923.14 -627,872.86 -476,069.32 -427,426.28 Materials (5%) -10,000.00 -23,838.06 -33,045.94 -25,056.28 Labour -64,186.56 -77,337.60 -62,378.88 -55,084.80 Overheads -89,498.84 -92,326.40 -88,670.32 -87,877.20 add non cash OHs (depr) 3,900.00 3,900.00 3,900.00 3,900.00 Liquidity 415,543.39 766,335.19 1,371,156.11 1,844,354.91 Figure 22.10: ZAMZAM Restaurant’s cash plan <?page no="380"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 22-380 ZAMZAM Restaurant does not prepare a budgeted balance sheet. The business plan is completed by the calculation of liquidity. By the next step the management of ZAMZAM Restaurant must approve the business plan version and declare it a budget. <?page no="381"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 23-381 23. CVP-Analysis - POTO Travel&Tours Sdn. Bhd. This chapter covers the cost-volumeprofit analysis for the travel agency POTO TRAVEL&TOURS Sdn. Bhd. in Kuala Lumpur. The company is owned by BUMIPUTERA TRAVEL COMPANY. The case study was prepared by Fadhilah Hanis Kamil as individual assignment for the course KPA 1133 Management Accounting for Control and Decision Making for the master study program in Business Management and Administration at UMP Universiti Malaysia Pahang during the winter semester 2016/ 2017. POTO TRAVEL&TOURS Sdn. Bhd. employs a staff of 40 workers in 2 branches. The last Accounting period’s revenue exceeded 20,000,000.00 MYR. The case study does not focus on the entire business but on one product which is the trip to Bali, Indonesia. See their website advertising the trip, e.g., starting on 26.10.2017 in Figure 23.1: Figure 23.1: POTO TRAVEL&TOUR Sdn. Bhd.’s Bali trip The trip takes 4 days and 3 nights. The trips start in Kuala Lumpur International Airport KLIA, Malaysia. The trip details are shown on the website www.pototravel.com. See Figure 23.2 for the details. <?page no="382"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 23-382 Figure 23.2: POTO TRAVEL&TOURS Sdn. Bhd.’s Bali trip offer Note, data of POTO TRAVEL&TOURS Sdn. Bhd. have been modified for privacy reasons. The cost calculation of the trip contains variable costs, such as flight costs which is the economy flex tariff of MALINDO AIR, hotel costs, tours as stated in the program and dishes. The fixed costs are for the planning and administration, which includes allocated portions of the staff salary, admin work, utilities, souvenirs, tour guide etc. There are further fixed costs for transportation in a rented 30-seater bus. The Figure 23.3 gives a detailed overview on the costs of the trip. Data have <?page no="383"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 23-383 been modified due to privacy protection. Note, even if the variable costs are seen as depending on the demand only, costs cannot be adjusted on short notice. E.g., the flight costs are booked in advance on the customer’s name and cannot be transferred to another customer. Hence, the variable costs do not adjust automatically to the guests' bookings. POTO TRAVEL&TOURS Sdn. Bhd. must consider trip cancellation costs for its calculation, too. [MYR] Cost plan VARIABLE COSTS flight ticket KUL - DPS operated by MALINDO 938.10 AIR, economy flex, flight number OD 324 hotel costs, 3 nights at 154.82 MYR/ n 464.46 tour Uluwatu temple 9.78 tour Kecak dance 32.58 tour Tampak siring 4.89 tour Gunung berapi kintamani 4.89 tour Sebatu coffee plantation 32.58 tour Tegalalang rice field 4.89 tour Taman ayun mengwi 4.89 tour Tanah Lot temple 9.77 tour Pendawa beach 2.62 106.89 breakfast at KLIA 3.00 dinner D'Sambail Nasi Kotak 5.87 breakfast Saras Rumah Makan 7.98 lunch Ayam Rulan Lunak Malioboro 17.75 dinner Ayam Bakar Wong Solo 13.98 breakfast Saras Rumah Makan 6.68 lunch Suling Bali 24.44 dinner 'special dinner' 40.60 breakfast Saras Rumah Makan 7.33 lunch Natrabu Minang 24.44 152.07 total variable costs per traveller 1,661.52 FIXED COSTS planning and administration 9,838.24 transportation in rented 30-seater-bus 3,200.00 total fixed costs per trip 13,038.24 Bali-tour Figure 23.3: Bali tour cost planning The revenue per Bali tour is 2,748.00 MYR. The maximum number of travellers is 30 as limited by the bus. A contribution income sheet, like the ones in chapter (8), is prepared for POTO TRAVEL&TOURS Sdn. Bhd. We keep in <?page no="384"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 23-384 mind that the calculation is only for one product offered by the travel agency. S ales of 1 trips Ite m T otal P e r unit S ales 2,748.00 2,748.00 Variable expens es (1,661.50) (1,661.50) C ontribution m argin 1,086.50 1,086.50 les s : Fixed expens es (13,038.24) Net profit (11,951.74) C O NT RIB UT IO N INC O M E S T AT E M E NT Figure 23.4: Contribution income statement for the Bali trip To determine the maximum of profit, we enter the figure of 30 guests in the field ‘Trips’. This will promise POTO TRAVEL&TOURS Sdn. Bhd. to earn a profit of 19,556.76 MYR. See the calculation in Figure 23.5: S ales of 30 trips Ite m T otal P e r unit S ales 82,440.00 2,748.00 Variable expens es (49,845.00) (1,661.50) C ontribution m argin 32,595.00 1,086.50 les s : Fixed expens es (13,038.24) Net profit 19,556.76 C O NT RIB UT IO N INC O M E S T AT E M E NT Figure 23.5: Maximum profit for the Bali trip With the goal seek function of MS Excel we determine the break-even quantity of travellers, where POTO TRAVEL&TOURS Sdn. Bhd. does not earn a profit, nor does it lose money. The break-even traveller number is 12, compare this to the contribution income statement in Figure 23.6: S ales of 12 trips Ite m T otal P e r unit S ales 32,976.61 2,748.00 Variable expens es (19,938.37) (1,661.50) C ontribution m argin 13,038.24 1,086.50 les s : Fixed expens es (13,038.24) Net profit 0.00 C O NT RIB UT IO N INC O M E S T AT E M E NT Figure 23.6: Break-even point calculation for the Bali trip <?page no="385"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 23-385 Based on the knowledge of the breakeven point, POTO TRAVEL&TOURS Sdn. Bhd. can now make changes to the tour concept and simulate cost changes. We presented this kind of what-if-analysis in the previous chapter and do not repeat it here. <?page no="386"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 24-386 24. M&A - Hengyuan Refining Company Bhd. As an example for Asian Mergers&Acquisitions, we describe the take-over of Shell Refining Company (Federation of Malaya) Bhd. by the holding company Malaysia Hengyuan International Limited called MHIL. The take-over results in an acquisition with consideration paid. The company Shell Refining Company (Federation of Malaya) Bhd. was not merged to the buyer’s company but is held as subsidiary. The sale was completed on 22.12.2016. MHIL is now controlled by Hengyuan Holdings which itself is owned by Shandong Hengyuan Petrochemical Co. Ltd., a private Chinese refiner in Dezhou. Shandong Hengyuan Petrochemical Company Limited (SHPC) is a manufacturer for petrochemicals, such as diesel oil, liquefied gas, propylene, propane, polypropylene, tert-butyl alcohol, oil slurry, asphalt, tert-pentene, ethybenzene and other petroleum related products. SHPC has staff of 1,700 employees. The target company is Shell Refining Company (Federation of Malaya) Bhd. and is by us referred to as SRC. Later, in 2017, the company changed its name in: Hengyuan Refining Company Berhad which we use the abbreviation HRC for. SRC was incorporated in 1960 and is listed at the Kuala Lumpur Stock Exchange (Main Market of Bursa Securities) since 1962. HRC is today the second largest refinery in Malaysia and based in Port Dickson. The majority shareholder is MHIL holding 51.02% of the shares. Hence the ultimate controlling shareholder is SHPC. HRC refines and produces 120,000 barrels per day petroleum products and employs 500 contractors and members of direct staff. 90 % of its products are sold and used in Malaysia. For further information about HRC, visit www.hrc.com.my. Other shareholders holding more than 10 % of the shares are the Malaysian Employees Provident fund (16.7 %) and PNB Permodalan Nasional Berhad fund management company (11.5 %), both are state-owned organisations in Malaysia. To understand the business and the situation the company was in, we show SRC’s financial statements as at 31.12.2016. All figures are provided in million Malaysian Ringgit (mMYR). The financial statements have been prepared under Malaysian Financial Reporting Standards, International Financial Reporting Standards and the requirements of the Company’s Act, 1965 in Malaysia. We adjusted the format of financial statements to make it fit into the textbook format. By this some figures have been adjusted/ rounded to apply the forms in this textbook. Data have been extracted from internet sources completely. <?page no="387"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 24-387 [mMYR] Revenue 8,365 Other income 40 8,405 Purchases (7,550) Manufacturing and general admin (269) Depreciation (195) Other expenses (6) Earnings before int. & taxes (EBIT) 385 Interest (49) Earnings before taxes (EBT) 336 Shell Refining Company (Federation of Malaya) Bhd. STATEMENT of PROFIT & LOSS and other COMPREHENSIVE INCOME as at eoy 2016 Figure 24.1: SRC’s income statement [HRC’s annual report 2016] A C, L Non-current assets [mMYR] Equity [mMYR] P, P, E 851 Share capital 300 Intangibles 51 Reserves prepaid lease 2 Retained earnings 710 Financial assets Current assets Liabilities Inventory 826 Interest bear liab 1,330 Accounts receivables 993 Accounts payables 739 Prepaid expenses Accrued expenses Cash/ Bank 356 Provisions Tax liabilities Total assets 3,079 Total equity and liab. 3,079 Shell Refining Company (Federation of Malaya) Bhd. STATEMENT of FINANCIAL POSITION as at 31.12.2016 Figure 24.2: SRC’s balance sheet as at 31.12.2016 [FT.com] Note, the balance sheet got rounding differences as figures are rounded to the next million Ringgit. The book value of SRC as at 31.12.2016 was: 3,079 - 1,330 - 739 = 1 1,010 million MYR. All shares of SRC have a nominal value of 1.00 MYR/ share. This means there are 300,000,000 shares outstanding. The book value per share as at 31.12.2016 is: 1,010,000,000 / 300,000,000 = 3 3.37 MYR/ share. MHIL bought 153,000,000 shares with a cash consideration of 66,300,000.00 USD. Regarding the currency exchange <?page no="388"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 24-388 rate on 22.12.2016 the value was 274,979.250.00 MYR. This gives a purchase price of: 274,979.250 / 153,000,000 = 1 1.80 MYR/ share. To gain an overview of the share prices of HRC’s shares at the Kuala Lumpur Stock Exchange, we study the dates next to the acquisition. As we can notice, the share price closed at 2.00 MYR/ s that day. Date Open High Low Close Adj Close Volume 20 12 2016 2.29 2.35 2.11 2.11 2.11 1,377,200 21 12 2016 2.11 2.14 2.08 2.09 2.09 1,829,000 22 12 2016 2.09 2.10 1.99 2.00 2.00 3,354,400 23 12 2016 2.05 2.05 2.02 2.03 2.03 823,100 27 12 2016 2.03 2.21 2.03 2.07 2.07 2,075,800 28 12 2016 2.08 2.14 2.08 2.12 2.12 1,107,300 29 12 2016 2.12 2.13 2.06 2.08 2.08 839,300 30 12 2016 2.08 2.09 2.02 2.03 2.03 1,811,300 HISTORICAL SHARE PRICE DATA HRC Figure 24.3: HRC’s share prices at the time of acquisition - one week, daily Date Open High Low Close Adj Close Volume 31 08 2016 3.05 3.12 3.03 3.06 3.06 1,957,500 30 09 2016 3.06 3.13 3.04 3.05 3.05 1,422,300 31 10 2016 3.04 3.09 2.79 2.8 2.8 2,077,000 30 11 2016 2.74 2.75 1.99 2.03 2.03 19,159,200 31 12 2016 2.03 2.92 2.02 2.82 2.82 28,590,300 31 01 2017 2.82 4.1 2.8 3.82 3.82 22,464,300 28 02 2017 3.87 3.9 3.38 3.52 3.52 15,705,800 31 03 2017 3.56 3.97 3.56 3.81 3.81 9,359,100 30 04 2017 3.81 6.3 3.76 5.45 5.45 27,900,000 31 05 2017 5.44 6.2 4.86 5.3 5.3 17,743,500 30 06 2017 5.36 7.99 5.33 7.86 7.86 33,917,700 31 07 2017 7.99 8.31 7.15 7.97 7.97 16,809,000 HISTORICAL SHARE PRICE DATA HRC Figure 24.4: HRC’s historical share price data - one year, monthly On 1.02.2016 SRC’s board of director received a letter from RHB Investment Bank Berhad that informed them that MHIL had entered into a conditional sale and purchase agreement with Shell Overseas Holdings Limited SOHL for the acquisition of 153,000,000 SRC shares held by SOHL. The consideration was 66,300,000.00 USD. The take-over offer (in English: public tender offer PTO) was conditional, as it was still to be approved by the authorities whether the shareholder(s) are allowed to sell their shares. Here, the bidder agreed to buy a certain block of shares which fulfils the requirements to announce a take-over. <?page no="389"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 24-389 A sale and purchase agreement SPA is an announcement of a take-over. At the time of the SPA the share price was 4.94 MYR/ share. The share trading was suspended that day at closing price of 4.94 MYR/ share on 1.02.2016. The price reopened at 3.50 MYR/ share, which is a drop of (4.94 - 3.50) / 4.94 = 2 29%. Date Open High Low Close Adj Close Volume 29 01 2016 4.87 5.02 4.86 4.94 4.94 330,600 02 02 2016 4.94 4.94 4.94 4.94 4.94 03 02 2016 3.5 3.96 3.46 3.68 3.68 6,829,800 04 02 2016 3.76 3.77 3.46 3.5 3.5 3,671,000 HISTORICAL SHARE PRICE DATA HRC Figure 24.5: SRC’s historical share price data, daily It is obvious, the company was sold for a bid price which was far below the fair market value and below the book value of the company. The reason for the low purchase price of the SRC shares is that the company suffered from deficits over the past years 2011 - 2014 due to the low crude oil price. It was intended and announced to sell the company or to transform it to an import/ export/ storage terminal in 2014 already. We noticed the share price increased after the acquisition offer. It went up to 2 MYR/ share at the time of the take-over. Hence, MHIL bought the shares at a discounted market price. After taken-over, HRC’s share price went up to almost 8 MYR/ share in July 2017. The Chinese investor changed the company by applying advanced refining technology and increased the capacity and upgraded the fuel quality from EURO II standard to EURO V requirements. Huge investments have been made during the last years. The acquisition of SRC was a measure to increase the refining and trading capacity for Shandong Hengyuan Petrochemical Co. Ltd. <?page no="390"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 25-390 25. Process Costing - MTBE Malaysia Sdn. Bhd. We next show a real business Process Costing application. The Process Costing is based on the findings of Kartik Shaarnmugan Krishnasamy as assignment for the KP1133 module Management Accounting for Control and Decision Making in the master study program Business Management and Administration during winter semester 2016/ 2017. MTBE Malaysia Sdn. Bhd. is a Kuantan based firm for the production and sale of methyl-tertiary-butyl-ether. The company is owned by PETROLIAM NASIONAL BERHAD (PETRONAS). Figure 25.1: MTBE Malaysia Sdn. Bhd. The process costing applies at MTBE Malaysia Sdn. Bhd. for the process of propane de hydrogenation (PDH). The process is the production of propylene from propane. The process contains 2 steps: (1) feed drying and (2) fractionation. At the beginning of the Accounting period 2016, the below given opening values are recorded in 1,000 MYR (tMYR) for the relevant accounts. In contrast to the textbook examples, this case study starts-off after the initial bookkeeping entries are recorded. Hence, no basic Bookkeeping entries such as depreciation are made in this chapter. However, we call the values after the costs have been recorded opening values (OV). The <?page no="391"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 25-391 opening values can be assets, stock levels or annual costs. See the accounts in Figure 25.2: D C D C OV 35,000.00 OV 15,000.00 D C D C OV 550,400.00 OV 45.00 RM inventory FG inventory Propane inventory Hydrogen inventory D C D C OV 0.33 OV 340.00 D C D C OV 25.00 OV 5,440.00 Natural gas-fuel inventory Raw water inventory Heavies inventory Cooling water inventories D C D C OV 16.90 OV 1,054.00 D C D C OV 78,030.00 OV 120.00 Demineralised water inventory Electricity Nitrogen low pressure inventory Steam high pressure D C D C OV 2,800.00 OV 3,150.00 D C D C OV 1,890.33 OV 2,090.33 Labour (manpower) Maintenance Depreciation feed dryer Depreciation fractionation D C D C OV 10,000.00 OV 21,000.00 Administration WIP feed dryer Figure 25.2: Accounts The below mentioned Bookkeeping entries are made to assign costs to the WIP and MOH-accounts. All values are in tMYR. <?page no="392"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 25-392 (Note, it is not common to record Bookkeeping entries on tMYR. They should be made accurate to the Ringgit. We only do this here to keep the figures small for teaching purposes.) For chemical processes, it is quite common that most of the costs are materials as the facilities work mostly automatically. For that reason, most of the costs are direct materials. (1) Use of raw materials: DR WIP Feed Dryer............... 35,000.00 tMYR CR Inventory.................... 35,000.00 tMYR (2) Use of Propane: DR WIP Feed Dryer............... 55,040.00 tMYR CR Propane Inventory............ 55,040.00 tMYR (3) Use of 40 % of hydrogen rich gas: DR WIP Feed Dryer............... 18.00 tMYR CR Hydrogen Inventory........... 18.00 tMYR (4) Use of heavies: DR WIP Feed Dryer............... 0.33 tMYR CR Heavies Inventories.......... 0.33 tMYR (5) Use of cooling water to an extent of 30 %: DR WIP Feed Dryer............... 102.00 tMYR CR Cooling Water Inventory...... 102.00 tMYR (6) Use of natural gas-fuel to an extent of 40 %: DR WIP Feed Dryer............... 10.00 tMYR CR Natural Gas-Fuel Inventory... 10.00 tMYR (7) Use of raw water to an extent of 50 %: DR WIP Feed Dryer............... 2,720.00 tMYR CR Raw Water Inventory.......... 2,720.00 tMYR (8) Use of demineralised water to an extent of 55 %: <?page no="393"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 25-393 DR WIP Feed Dryer............... 9.29 tMYR CR Demineralised Water Inventory 9.29 tMYR (9) Use of electricity to an extent of 35 %: DR WIP Feed Dryer............... 368.90 tMYR CR Electricity.................. 368.90 tMYR (10) Use of nitrogen low pressure to an extent of 30 %: DR WIP Feed Dryer............... 23,409.00 tMYR CR Nitrogen Low Pressure........ 23,409.00 tMYR (11) Use of steam, high pressure, to an extent of 30 %: DR WIP Feed Dryer............... 36.00 tMYR CR Steam High Pressure.......... 36.00 tMYR (12) Consumption of labour (manpower) to an extent of 45 %: DR WIP Feed Dryer............... 1,260.00 tMYR CR Labour....................... 1,260.00 tMYR (13) Use of maintenance to an extent of 40 %: DR WIP Feed Dryer............... 1,260.00 tMYR CR Maintenance .................. 1,260.00 tMYR (14) Depreciation on the feed dryer: DR WIP Feed Dryer............... 1,890.33 tMYR CR Depreciation Feed Dryer...... 1,890.33 tMYR (15) ‘Transfer’ from feed dryer to fractionation: DR WIP Fractionation ............ 97,603.86 tMYR CR WIP Feed Dryer............... 97,603.86 tMYR (16) Use of 60 % of hydrogen rich gas: <?page no="394"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 25-394 DR WIP Fractionation............ 27.00 tMYR CR Hydrogen Inventory........... 27.00 tMYR (17) Use of cooling water to an extent of 70 %: DR WIP Fractionation............ 238.00 tMYR CR Cooling Water Inventory...... 238.00 tMYR (18) Use of natural gas-fuel to an extent of 60 %: DR WIP Fractionation............ 15.00 tMYR CR Natural Gas-Fuel Inventory... 15.00 tMYR (19) Use of raw water to an extent of 50 %: DR WIP Fractionation............ 2,720.00 tMYR CR Raw Water Inventory.......... 2,720.00 tMYR (20) Use of demineralised water to an extent of 45 %: DR WIP Fractionation............ 7.61 tMYR CR Demineralised Water Inventory 7.61 tMYR (21) Use of electricity to an extent of 65 %: DR WIP Feed Dryer............... 685.10 tMYR CR Electricity.................. 685.10 tMYR (22) Use of nitrogen low pressure to an extent of 70 %: DR WIP Fractionation............ 54,621.00 tMYR CR Nitrogen Low Pressure........ 54,621.00 tMYR (23) Use of steam, high pressure, to an extent of 70 %: DR WIP Fractionation............ 84.00 tMYR CR Steam High Pressure.......... 84.00 tMYR <?page no="395"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 25-395 (24) Consumption of labour (manpower) to an extent of 55 %: DR WIP Fractionation ............ 1,540.00 tMYR CR Labour....................... 1,540.00 tMYR (25) Use of maintenance to an extent of 60 %: DR WIP Fractionation ............ 1,890.00 tMYR CR Maintenance .................. 1,890.00 tMYR (26) Depreciation on the fractionation facilities: DR WIP Fractionation ............ 2,090.33 tMYR CR Depreciation Fractionation... 2,090.33 tMYR (27) "Transfer" from fractionation process to finished goods inventories: DR Finished Goods............... 161,521.90 tMYR CR WIP Fractionation ............ 161,521.90 tMYR (28) Sale of 90 % of finished goods: 90% × (15,000 + 161,521.90) = 1 158,869.71 tMYR. The amount is recorded as cost in the Cost of Sales account: DR COS Account.................. 158,869.71 tMYR CR Finished Goods............... 158,869.71 tMYR (29) The revenue equals 238,304,551.50 MYR: DR Cash/ Bank.................... 238,304.55 tMYR CR Revenue...................... 238,304.55 tMYR Observe the profit calculation in the accounts. Check Figure 25.3: <?page no="396"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 25-396 D C D C OV 35,000.00 (1) 35,000.00 OV 15,000.00 (28) 158,869.71 (27) 161,521.90 176,521.90 158,869.71 D C D C OV 55,040.00 (2) 55,040.00 OV 45.00 (3) 18.00 (16) 27.00 45.00 45.00 RM inventory FG inventory Propane inventory Hydrogen inventory D C D C OV 0.33 (4) 0.33 OV 340.00 (5) 102.00 (17) 238.00 340.00 340.00 D C D C OV 25.00 (6) 10.00 OV 5,440.00 (7) 2,720.00 (18) 15.00 (19) 2,720.00 25.00 25.00 5,440.00 5,440.00 Natural gas-fuel inventory Raw water inventory Heavies inventory Cooling water inventories D C D C OV 16.90 (8) 9.29 OV 1,054.00 (9) 368.90 (20) 7.61 (21) 685.10 16.90 16.90 1,054.00 1,054.00 D C D C OV 78,030.00 (10) 23,409.00 OV 120.00 (11) 36.00 (22) 54,621.00 (23) 84.00 78,030.00 78,030.00 120.00 120.00 Demineralised water inventory Electricity Nitrogen low pressure inventory Steam high pressure D C D C OV 2,800.00 (12) 1,260.00 OV 3,150.00 (13) 1,260.00 (24) 1,540.00 (25) 1,890.00 2,800.00 2,800.00 3,150.00 3,150.00 D C D C OV 1,890.33 (14) 1,890.33 OV 2,090.33 (26) 2,090.33 Labour (manpower) Maintenance Depreciation feed dryer Depreciation fractionation Figure 25.3: Accounts <?page no="397"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 25-397 D C D C OV 10,000.00 P&L 10,000.00 OV 21,000.00 (15) 97,603.86 (1) 35,000.00 (2) 55,040.00 (3) 18.00 (4) 0.33 (5) 102.00 (6) 10.00 (7) 2,720.00 (8) 9.30 (9) 368.90 (10) 23,409.00 (11) 36.00 (12) 1,260.00 (13) 1,260.00 (14) 1,890.33 c/ d 44,520.00 142,123.86 142,123.86 b/ d 44,520.00 D C D C (15) 97,603.86 (27) 161,521.90 (28) 158,869.71 P&L 158,869.71 (16) 27.00 (17) 238.00 (18) 15.00 (19) 2,720.00 (20) 7.61 (21) 685.10 (22) 54,621.00 (23) 84.00 (24) 1,540.00 (25) 1,890.00 (26) 2,090.33 161,521.90 161,521.90 Administration WIP feed dryer WIP fractionation Cost of sales COS D C D C P&L 238,304.55 (29) 238,304.55 ... ... (29) 238,304.55 D C COS 158,869.71 Rev 238,304.55 Adm 10,000.00 EBT 69,434.84 238,304.55 238,304.55 b/ d 69,434.84 Revenue Cash/ Bank Profit and Loss P&L Figure 23.3: Accounts (continued) <?page no="398"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 26-398 26. Activity Based Costing - CAHAYA BAKERY This chapter covers a Malaysian bakery that tests the application of an Activity Based Costing system. The case was prepared by Tengku Hasanul Firdaus Tengku Ibrahim as an assignment for the KPA 1133 Management Accounting for Control and Decision Making project in the master study program Business Management and Administration at UMP Universiti Malaysia Pahang during the winter semester 2016/ 17. CAHAYA BAKERY is located at Jalan Air Putih in Kemaman, in the Terengganu province. CAHAYA BAKERY is privately owned. The bakery offers two product lines. - Standard products - Special occasion products Standard Products The first product line is for standard products, such as buns, pastry and cakes. The goods are sold through the bakery and a local burger stall. Furthermore, CAHAYA BAKERY delivers buns and pastry for local primary and secondary school canteens. Special Occasion Products The second product line is special orders, such as wedding cakes, birthday cakes etc. The special order products are prepared following the customers’ requirements such as for decoration. They are ordered for school sports days, eid celebration hamper in companies or any open house event. CAHAYA BAKERY employs a staff of 4 permanent workers. Figure 26.1: CAHAYA BAKERY The application of the ABC-system is based on data of the fiscal year 2015. The profitability analysis for the Accounting period 2015 is shown by Figure 26.2. <?page no="399"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 26-399 [MYR] Revenue 286,000.00 Other income 286,000.00 Materials (62,500.00) Labour (24,000.00) Manufacturing OHs (115,000.00) Gross margin 84,500.00 Selling and admin Delivery costs (2,450.00) Marketing costs (6,000.00) General admin costs (5,800.00) Net operating income 70,250.00 Cahaya bakery PROFITABILITY ANALYSIS for the year ended 31.12.2015 Figure 26.2: CAHAYA BAKERY’s profitability analysis Cost category [MYR] Production Department Shop equipment depreciation 50,000.00 Shop utilities 42,000.00 Shop builing lease 23,000.00 115,000.00 General Administrative Department Administrative wages and salaries 4,000.00 Office equipment depreciation 500.00 Administrative building lease 1,300.00 5,800.00 Marketing Department Marketing wages and salaries 4,500.00 Selling expenses 1,500.00 6,000.00 Total Overhead Cost 126,800.00 COST DETAILS Figure 26.3: Cost details for overheads CAHAYA BAKERY prepares the cost pools as below: ‘Customer Orders’ depending on the number of customer orders, ‘Product Design’ depending on the number of product designs, ‘Order Size’ depending <?page no="400"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 26-400 on the number of machine hours and ‘Customer Relation’ which depends on the number of active customers of CAHAYA BAKERY. The cost pool ‘Others’ is not linked to activities. For that reason, the cost pool does not have a cost driver. The cost allocation of overheads to the cost pools is made based on interviews with the cost centre manager. In most cases the cost allocation is based on the time spent on activities. See the result of the cost allocations to cost pools. Customer Orders Product Design Order Size Customer Relation Other Totals Production Department Shop equipment depreciation 20% 0% 60% 0% 20% 100% Shop utilities 0% 10% 50% 0% 40% 100% Shop builing lease 0% 0% 0% 0% 100% 100% General Administrative Department Administrative wages and salarie 15% 5% 10% 30% 40% 100% Office equipment depreciation 30% 0% 0% 25% 45% 100% Administrative building lease 0% 0% 0% 0% 100% 100% Marketing Department Marketing wages and salaries 22% 8% 0% 60% 10% 100% Selling expenses 10% 0% 0% 70% 20% 100% Activity Cost Pools Figure 26.4: Percentage of cost to activities We assign the costs below and the cost drivers to the cost pools. The data are the result of cost allocations based on interviews made with managers at CAHAYA BAKERY. Customer Orders Product Design Order Size Customer Relation Other Production Department Shop equipment depreciation 10,000.00 0.00 30,000.00 0.00 10,000.00 Shop utilities 0.00 4,200.00 21,000.00 0.00 16,800.00 Shop builing lease 0.00 0.00 0.00 0.00 23,000.00 General Administrative Department Administrative wages and salarie 600.00 200.00 400.00 1,200.00 1,600.00 Office equipment depreciation 150.00 0.00 0.00 125.00 225.00 Administrative building lease 0.00 0.00 0.00 0.00 1,300.00 Marketing Department Marketing wages and salaries 990.00 360.00 0.00 2,700.00 450.00 Selling expenses 150.00 0.00 0.00 1,050.00 300.00 Total 11,890.00 4,760.00 51,400.00 5,075.00 53,675.00 Activity Cost Pools Figure 26.5: Result of cost allocations <?page no="401"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 26-401 Cost pool Costs CD PCR Customer orders 11,890.00 6,000 1.98 Product design 4,760.00 1,000.00 4.76 Order size 51,400.00 6,000.00 8.57 Customer relations 5,075.00 800.00 6.34 Other 53,675.00 126,800.00 Figure 26.6: ABC cost centre at CAHAYA BAKERY The unit of the cost drivers is orders, designs, machine hours and customers. For the activity ‘Other’ there is no cost driver given as the activity is not induced by its amounts. By the next step, CAHAYA BAKERY calculates the business processes for the standard product and the custom product based on the activity rates PCR. Cost pool PCR CD #CD costs Customer orders 1.98 orders 5,000 9,908.33 Product design 4.76 designs 0 0.00 Order size 8.57 machine hours 3,333 28,552.70 38,461.03 Cost pool PCR CD #CD costs Customer orders 1.98 orders 1,000 1,981.67 Product design 4.76 designs 1,000 4,760.00 Order size 8.57 machine hours 2,667 22,847.30 29,588.97 Standard product of CAYARA BAKERY Custom product of CAYARA BAKERY Figure 26.7: Activity based product calculation CAHAYA BAKERY prepares a new profitability analysis as below: <?page no="402"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 26-402 Standard Custom Revenue 228,800.00 57,200.00 Direct costs Direct Materials (52,000.00) (10,500.00) Direct labour (20,400.00) (3,600.00) Delivery (2,085.00) (365.00) total ABC costs (38,461.03) (29,588.97) Margin 115,853.97 13,146.03 Not attributable OHs Customer relations Other Net operating income CAHAYA BAKERY ACTIVITY BASED PROFITABILITY ANALYSIS for the year ended 31.12.2015 (5,075.00) (53,675.00) 70,250.00 Figure 26.8: Profitability analysis based on ABC-costing Due to ABC, CAHAYA BAKERY knows the margins for its products. The ABCcosting is on an aggregated level, but it shows that the margin of the standard products is higher than with the custom products. The activity analysis shows that the costs for the custom products mostly are production hours which result from the fact that the special occasion cakes require more work. A calculation of products based on Activity Based Costing is in general not recommended. The costs for the Production department, the General Administrative department and the Marketing department do not depend on the number of products. They are determined by the division managers and budgeted during the annual planning. However, in this case study, the absolute value of allocated fixed overheads to products does not matter. It is more important to know how costs are allocated to products. As the same cost drivers apply for both products, the cost allocation is fair among them. Based on ABC-costing unit costs per standard product are: 115,853.97 / 5,000 = 2 23.17 MYR/ u and per custom product: 13,146.03 / 1,000 = 13.15 MYR/ u. This indicates that CAHAYA BAKERY earns significantly higher profits with its standard products. At the same time the standard products and custom products share the fixed costs at an almost equal ratio, exactly at a 38 : 29 ratio. A result of the ABC calculation could be to change the product mix in favour of the standard product. The fixed costs at CAHAYA BAKERY are difficult to cut, which implies producing more standard products uses the capacity of the Production department more efficiently. Most of the custom product’s resources are consumed in the Production department. Before cost changes are planned in a new calculation run, Marketing should be consulted regarding the side effects of an alteration of the product mix. The result could be to reduce custom products by increase of prices therefor and to produce more standard products, which could be sold through a new <?page no="403"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 26-403 distribution channel, e.g., by internetdelivery service or further sales stall. <?page no="404"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 27-404 27. Abbreviations ABC Activity Based Costing ABM Activity Based Management Acc Accounting Acc Accumulated Acc Depr Accumulated Depreciation, in accounts: AcD Acc IL Accumulated Impairment Loss Adj Adjustment alu Aluminium AMS Amsterdam AP Airport fees A/ P Accounts Payables APC Airport Company Costs (for check-in) A/ R Accounts Receivables / a per annum, per year AUD Australian Dollar B Berlin 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) CF Cash Flow CFO Chief Financial Officer, Accountant CFS Statement of Cash Flows <?page no="405"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 27-405 CM Contribution Margin CMA Contribution Margin Accounting CMRatio Contribution Margin Ratio CPA Chartered Professional Accountant COS Cost of Sales, Cost of Goods Sold CR Credit Recorded, Credit Entry CVP Cost Volume Profit CVPA Cost Volume Profit Analysis, CVP-analysis D damage D Debit / d per day DcE Decoration Costs Δ PC Delta Proportional Costs Dep Department Depr, DprDepreciation DIS Discount (Rate) DOL Degree of Operating Leverage DOL(CF) Degree of Operating Leverage - Cash Flow 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 FGd Finished Goods, doors FGI Inventory of Finished Goods account FGL Finished Goods, lemon FGS Finished Goods, strawberry FGw Finished Goods, windows FIFO First-in-first-out Fin Finance <?page no="406"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 27-406 fst 90°-Fastener FUE Fuel costs GBP British Pound Sterling GP Gross Profit GR Garden Route GST Goods and Service Tax, same as Value Added Tax VAT HGB Handelsgesetzbuch hin Hinge HQ Headquarters IAS International Accounting Standards IASB International Accounting Standards Board IBL Interest Bearing Liabilities iCF Cash Flow from Investing Activities ID Identifier, Identification Number IFRS International Financial Reporting Standards IL Impairment Loss Inc. Incorporation (USA) INS Insurance account INT Interest account Inv Inventory IRM Inventory of raw materials I/ S Income Statement ISS Issued Capital IT Income Taxes ITL Income Tax Liabilities JO Job Order KB KIRSTENBOSCH (Pty) Ltd. kg Kilogram KL Kuala Lumpur ky kayak, #ky = number of kayaks Lab Labour LAB Labour account Liab Liability, Liabilities Lst Loss on settlement Ltd. Limited company LoD Loss on Disposal m Metre MA Management Accounting M/ A Management and Administration M&A Mergers and Acquisitions MASB Malaysian Accounting Standards Board Mat Materials, Material Costs McT Mc Toy GmbH MG Merchandise Goods MIA Malaysian Institute of Accounting <?page no="407"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 27-407 MOF Manufacturing Overheads account for the Filling department MOI Memorandum of Incorporation Moh Manufacturing Overheads MOH 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 account MYR Malaysian Ringgit NoE Nature of Expense method NOP Net Operating Profit NOPAT Net Operating Profit After Taxes NP Net Profit NPO Non-Profit Organisation NSP Net Selling Price oCF Cash Flow from Operating Activities OE Owners Equity OEP Other Expenses OM Order Management OTH Other Costs out Outsourcing P Probability P Profit P out Profit for outsourcing scenario pan Pane P&L Profit and Loss PC Proportional costs PC Primary Costs PE Physical Education P.I. Profitability Index PLC Public Limited Company (in the UK) PoD Profit on Disposal PPE Property, Plant and Equipment account P, P, E Property, Plant and Equipment PRE Prepaid Expenses PRT Payroll Tax PRT Pro Rata Temporis, per rate (Pty) Ltd. Proprietary limited company (in Australia, South Africa) PTO Public Tender Offer PUR Purchases PV Present Value R South African Rand R/ D Refer to Drawer <?page no="408"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 27-408 R/ E Retained Earnings Res, RES Reserves Rev Revenue, Sales RI Residual Income RM Malaysian Ringgit (currency in Malaysia) RMF Raw Material Inventory - Fruit account RMI Raw Material Inventory account RMM Raw Material Inventory - Milk account RNT Rent account R.O. Returns Outwards RoA Register of non-current Assets ROO Room Costs 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 SFP Statement of Financial Position ShD Shareholder for Dividend sht Sheet SOH Service Overheads, Service Overheads account SPA Sales and Purchase Agreement 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 V Value VAT Value Added Tax, same as Goods and Service Tax GST VDI Verein Deutscher Ingenieure / w per week W_E Work in Process - Europe account WFE Work in Process - FarEast account WIB Work in Process - Banana Ice Cream account WIL Work in Process - Lemon Ice Cream account WIP Work in Progress, Work-in-Process WIS Work in Process - Strawberry Ice Cream account <?page no="409"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 27-409 WP Wirtschaftsprüfer, auditor Wst Waste ZAR South African Rand σ Standard deviation μ Mean <?page no="410"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 28-410 28. Table of Figures Figure 1.1: Accounts 1.19 Figure 3.1: PENOR PLC’s statement of financial position as at 1.01.20X1 3-29 Figure 3.2: IFRSs website for standards download 3-30 Figure 3.3: PENOR PLC’s accounts 3-31 Figure 3.4: PENOR PLC’s accounts 3-33 Figure 3.5: PENOR PLC’s purchases in 20X1 3-36 Figure 3.6: PENOR PLC’s accounts 3-36 Figure 3.7: Direct materials for windows 3-39 Figure 3.8: Direct materials for doors 3-39 Figure 3.9: Accounts 3-42 Figure 3.10: PENOR PLC’s income statement 3-45 Figure 3.11: PENOR PLC’s bank loan calculation 3-46 Figure 3.12: PENOR PLC’s bank loan’s financial schedule 3-47 Figure 3.13: Disclosure of PENOR PLC’s bank loan 3-47 Figure 3.14: PENOR PLC’s balance sheet 3-48 Figure 3.15: PENOR PLC’s statement of cash flows 3-49 Figure 3.16: PENOR PLC’s statement of changes in equity 3-50 Figure 4.1: PENOR PLC’s bank loan 4-56 Figure 4.2: Management Accounting accounts 4-61 Figure 4.3: Manufacturing Accounting’s accounts after 1 st allocation 4-67 Figure 4.4: Cost of manufacturing report 4-71 Figure 4.5: Cost of goods sold report 4-73 Figure 4.6: Management Accounting’s accounts 4-74 Figure 4.7: Profitability Analysis 4-77 Figure 4.8: Pro forma balance sheet based on Management Accounting data 4-78 Figure 4.9: Revenue plan 4-79 Figure 4.10: Interest and pay-off schedule 4-80 Figure 4.11: Cost plan 4-80 Figure 4.12: Profitability plan 4-80 Figure 4.13: Budgeted balance sheet (annual) 4-81 Figure 4.14: Business plan for PENOR PLC 4-82 Figure 6.1: KIRSTENBOSCH (Pty) Ltd.’s revenue plan 6.94 Figure 6.2: KIRSTENBOSCH (Pty) Ltd.’s interest and pay-off schedule 6.95 Figure 6.3: KIRSTENBOSCH (Pty) Ltd.’s cost plan 6.95 Figure 6.4: KIRSTENBOSCH (Pty) Ltd.’s profitability plan 6-96 Figure 6.5: KIRSTENBOSCH (Pty) Ltd.’s liquidity plan 6.97 Figure 6.6: KIRSTENBOSCH (Pty) Ltd.’s pro-forma balance sheet 6.99 Figure 6.7: KIRSTENBOSCH (Pty) Ltd.’s statement of cash flows 6.100 Figure 6.8: McTOY GmbH’s revenue plan 6.102 Figure 6.9: McTOY GmbH’s master data sheet 6-102 Figure 6.10: McTOY GmbH’s cost plan (partial) 6-104 Figure 6.11: McTOY GmbH’s routing information (1) 6.104 Figure 6.12: McTOY GmbH’s routing information (2) 6.105 Figure 6.13: McTOY GmbH’s cost plan (partial) 6-105 <?page no="411"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 28-411 Figure 6.14: McTOY GmbH’s bank loan 6-106 Figure 6.15: McTOY GmbH’s aggregated cost plan 6.107 Figure 6.16: McTOY GmbH’s profit plan 6-108 Figure 6.17: McTOY GmbH’s liquidity plan 6-109 Figure 6.18: McTOY GmbH’s budgeted balance sheet 6-110 Figure 6.19: Mr Schluchman’s / MOBILE TARTE FLAMBEE GmbH’s revenue plan 6-114 Figure 6.20: Mr Schluchman’s / MOBILE TARTE FLAMBEE GmbH’s cost plan 6-115 Figure 6.21: Mr Schluchman’s / MOBILE TARTE FLAMBEE GmbH’s profitability plan 6-117 Figure 6.22: Mr Schluchman’s / MOBILE TARTE FLAMBEE GmbH’s liquidity plan 6-118 Figure 6.23: Mr Schluchman’s / MOBILE TARTE FLAMBEE GmbH’s balance sheet 6-120 Figure 7.1: STAFFORD (Pty) Ltd.’s accounts 7-127 Figure 7.2: STAFFORD (Pty) Ltd.’s accounts 7-127 Figure 7.3: STAFFORD (Pty) Ltd.’s income statement 7-130 Figure 7.4: STAFFORD (Pty) Ltd.’s balance sheet 7-130 Figure 7.5: DANNING (Pty) Ltd.’s cost volume records 7-132 Figure 7.6: DANNING (Pty) Ltd.’s Cost separation by scatter graph method 7-134 Figure 7.7: Workings for regression analysis 7-135 Figure 7.8: Marked areas in the linear function Y(X) 7-137 Figure 7.9: calculation of the slope of Y(X) 7-138 Figure 7.10: Areas A and C for the function Y(X) 7-139 Figure 7.11: Areas A and C as well as B and D for the function Y(X) 7-140 Figure 7.12: Function Y(X) = a × X +b 7-141 Figure 8.1: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (1) 8-148 Figure 8.2: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (2) 8-149 Figure 8.3: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (3) 8-149 Figure 8.4: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (base case) 8-150 Figure 8.5: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (online-shop) 8-151 Figure 8.6: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (bungee jumping) 8-151 Figure 8.7: DEERFIELD TOURS (Pty) Ltd.’s calculation of the adjusted net selling price 8-152 Figure 8.8: Observations 8-154 Figure 8.9: DEERFIELD TOURS (Pty) Ltd.’s break-even point (internet campaign) 8-155 Figure 8.10: Standard normal distribution table 8-156 Figure 8.11: DEERFIELD TOURS (Pty) Ltd. 2-product statement 8-157 Figure 8.12: DEERFIELD TOURS (Pty) Ltd.’s 2-product statement (2) 8-158 Figure 8.13: Goal seek function break-even point calculation 8-158 Figure 8.14: DEERFIELD TOURS 2-product statement (3) 8-159 Figure 9.1: DEERFIELD TOURS (Pty) Ltd. break-even point 9-162 Figure 9.2: DEERFIELD TOURS (Pty) Ltd.’s/ profit calculation (1 additional traveller) 9-163 Figure 9.3: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (11 travellers) 9-163 Figure 9.4: EMS KAYAK GmbH’s profit and cash flow calculation (1) 9-166 Figure 9.5: EMS KAYAK GmbH’s Accounting break-even point (2a) 9-167 Figure 9.6: EMS KAYAK GmbH’s profit and cash flow calculation (2b) 9-168 Figure 9.7: EMS KAYAK GmbH’s cash break-even point (2b) 9-168 Figure 9.8: EMS KAYAK GmbH’s financial break-even point (2c) 9-169 Figure 9.9: EMS KAYAK GmbH’s financial break-even point (2c) 9-170 Figure 9.10: EMS KAYAK GmbH’s profit and cash flow calculation (3) 9-170 Figure 9.11: EMS KAYAK GmbH’s profit and cash flow calculation (4) 9-171 <?page no="412"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 28-412 Figure 9.12: EMS KAYAK GmbH’s profit and cash flow calculation (5) 9-172 Figure 9.13: EMS KAYAK GmbH’s profit and cash flow calculation (6) 9-173 Figure 9.14: EMS KAYAK GmbH’s profit and cash flow calculation (7) 9-173 Figure 9.15: Graphical implication of the outsourcing effect 9-174 Figure 9.16: EMS KAYAK GmbH’s profit and cash flow plan for the farming out case 9-175 Figure 9.17: EMS KAYAK GmbH’s break-even point 9-176 Figure 10.1: Profitability analysis for the GELDERN branch 10-180 Figure 10.2: Profitability analysis for the PIETERBUREN branch 10-180 Figure 10.3: Performance figures for VANHUIZEN BV 10-183 Figure 10.4: Profit calculation VANHUIZEN BV 10-184 Figure 10.5: VANHUIZEN BV’s performance report (alternative capital structure) 10-187 Figure 10.6: VANHUIZEN BV’s performance clear of interest/ coupon 10-189 Figure 11.1: “Financials” provided by OHIO FRIED CHICKEN’s owner 11-195 Figure 11.2: OHIO FRIED CHICKEN’s refined data sheet 11-197 Figure 11.3: OHIO FRIED CHICKEN’s weekly calculation of cash profit 11-198 Figure 11.4: OHIO FRIED CHICKEN’s monthly operating cash flows 11-199 Figure 11.5: OHIO FRIED CHICKEN’s payments discounted by 6.3 % 11-203 Figure 11.6: Calculation of the internal rate of return 11-203 Figure 11.7: OHIO FRIED CHICKEN’s balance sheet 11-204 Figure 11.8: Budgeted income statement for OHIO FRIED CHICKEN 11-205 Figure 11.9: OHIO FRIED CHICKEN’s budgeted balance sheet [ZAR] 11-206 Figure 11.10: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet 11-206 Figure 11.11: AYAM GORENG Sdn. Bhd.’s opening balance sheet 11-207 Figure 11.12: AYAM GORENG Sdn. Bhd.’s balance sheet after acquisition 11-208 Figure 11.13: OHIO FRIED CHICKEN (Pty) Ltd.’s adjusted balance sheet 11-209 Figure 11.14: Consolidation worksheet [MYR] 11-210 Figure 11.15: AYAM GORENG Sdn. Bhd. consolidated balance sheet 11-211 Figure 11.16: OHIO FRIED CHICKEN (Pty) Ltd.’s budgeted income statement 11-212 Figure 11.17: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet 11-212 Figure 11.18: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet 11-213 Figure 11.19: Consolidation worksheet in MYR 11-213 Figure 11.20: AYAM GORENG holding’s balance sheet as at 31.12.2015 11-214 Figure 11.21: LOS POLLOS ASADOS (Pty) Ltd.’s balance sheet 11-215 Figure 11.22: LOS POLLOS ASADOS (Pty) Ltd.’s balance sheet after taking-over 11-215 Figure 11.23: LOS POLLOS ASADOS (Pty) Ltd.’s balance sheet after take-over 11-217 Figure 11.24: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet 11-218 Figure 11.25: OHIO FRIED CHICKEN (Pty) Ltd.’s income statement 11-218 Figure 11.26: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet 11-219 Figure 11.27: Average balance sheet for OHIO FRIED CHICKEN (Pty) Ltd. 11-219 Figure 11.28: Long-term currency exchange rate ZAR-EUR (OFX.com) 11-222 Figure 12.1: ROCKS PLC’s balance sheet 12-226 Figure 12.2: ROCKS PLC.’s balance sheet 12-227 Figure 12.3: Random figure generator on a calculator (Casio) 12-231 Figure 12.4 WEATHERMAN’s profit simulation 12-231 Figure 12.5: WEATHERMAN’s profit MS-Excel simulation 12-232 Figure 12.6: NAMGURO Ltd.’s statement of comprehensive income 12-233 Figure 12.7: Results of NAMGURO Ltd.‘s profit simulation 12-234 <?page no="413"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 28-413 Figure 12.8: Probabilities for the standard normal distribution 12-236 Figure 12.9: Budgeted income statement for 20Y5 12-238 Figure 12.10: Risk simulation (MonteCarloSimulation) 12-239 Figure 12.11: Profit and loss simulation 12-240 Figure 13.1: Management Accounting system 13-245 Figure 13.2: GIULIO’S PIZZA&PASTA Ristorante’s BOM 13-249 Figure 13.3: GIULIO’S PIZZA&PASTA RISTORANTE’s direct costs based on products 13-251 Figure 13.4: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (1) 13-252 Figure 13.5: GIULIO’S PIZZA&PASTA RISTORANTE’s direct costs 13-253 Figure 13.6: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (2) 13-255 Figure 13.7: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (3) 13-256 Figure 13.8: GIULIO’S PIZZA&PASTA RISTORANTE’s manufacturing accounts (1) 13-257 Figure 13.9: GIULIO’S PIZZA&PASTA RISTORANTE’s manufacturing accounts (2) 13-257 Figure 13.10: GIULIO’S PIZZA&PASTA RISTORANTE’s manufacturing accounts (3) 13-258 Figure 13.11: GIULIO’S PIZZA&PASTA RISTORANTE’s manufacturing accounts (4) 13-260 Figure 13.12: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (4) 13-261 Figure 13.13: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (5) 13-262 Figure 14.1: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting 14-270 Figure 14.2: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system 14-272 Figure 14.3: GIULIO’S PIZZA&PASTA RISTORANTE’s profit planning 14-273 Figure 14.4: LOGA (Pty) Ltd.’s profitability analysis based on absorption costing 14-276 Figure 14.5: LOGA (Pty) Ltd.’s profitability analysis based on marginal costing 14-276 Figure 15.1: CROXTON Ltd.’s cost variance in April 20X6 15-282 Figure 15.2: CROXTON Ltd.’s variance in May 20X6 15-282 Figure 15.3: CROXTON Ltd.’s cost efficiency report May 20X6 15-284 Figure 15.4: CROXTON Ltd.’s variance in June 20X6 15-286 Figure 15.5: CROXTON Ltd.’s cost efficiency report June 20X6 15-286 Figure 16.1: CLYDBANK Ltd.’s cost centre characteristics 16-289 Figure 16.2: CLYDBANK Ltd.’s accounts 16-290 Figure 16.3: CLYDBANK Ltd.’s accounts 16-291 Figure 16.4: CLYDBANK Ltd.’s cost allocations to cost centres 16-292 Figure 16.5: CLYDBANK Ltd.’s accounts after internal cost allocations 16-294 Figure 16.6: CLYDBANK Ltd.’s spreadsheet with internal cost allocations 16-295 Figure 16.7: CLYDBANK Ltd.’s cost centre rates 16-296 Figure 16.8: HEISFELD Ltd.’s performance structure 16-300 Figure 16.9: HEISFELD Ltd.’s primary costs 16-301 Figure 16.10: HEISFELD Ltd.’s cost centre support structure 16-303 Figure 16.11: HEISFELD Ltd.’s iteration process 16-305 Figure 16.12: HEISFELD Ltd.’s iteration process based on proportional costs 16-307 Figure 17.1: LEBUHRAYA Ltd.’s opening values 17-313 Figure 17.2: LEBUHRAYA Ltd.’s accounts 17-315 Figure 17.3: LEBUHRAYA Ltd.’s statement of COS 17-317 Figure 17.4: LEBUHRAYA Ltd.’s profitability analysis 17-319 Figure 18.1: MAHKOTA (Pty) Ltd.’s accounts 18-327 Figure 18.2: MAHKOTA (Pty) Ltd.’s profitability analysis 18-329 Figure 18.3: MAHKOTA (Pty) Ltd.’s pro-forma balance sheet 18-330 Figure 18.4: WEIXDORF Ltd.’s accounts 18-337 <?page no="414"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 28-414 Figure 18.5: WEIXDORF Ltd.’s income statement 18-340 Figure 18.6: WEIXDORF Ltd.’s balance sheet 18-340 Figure 19.1: EDEWECHT (Pty) Ltd.’s accounts 19-346 Figure 19.2: EDEWECHT (Pty) Ltd.’s accounts 19-347 Figure 19.3: EDEWECHT (Pty) Ltd.’s WIP-accounts 19-349 Figure 19.4: EDEWECHT (Pty) Ltd.’s accounts 19-351 Figure 20.1: FLINDERS Ltd.’s sales information for 7/ 20X6 20-356 Figure 20.2: FLINDERS Ltd.’s multiple-level CMA 20-358 Figure 21.1: TORQUAY Ltd.’s revenue 21-364 Figure 21.2: TORQUAY Ltd.’s accounts 21-365 Figure 21.3: TORQUAY Ltd.’s calculation based on a traditional cost Accounting system 21-365 Figure 21.4: TORQUAY Ltd.’s ABC cost centre Sales Office 21-367 Figure 21.5: TORQUAY Ltd.’s route calculation on a partial ABC system 21-367 Figure 21.6: TORQUAY Ltd.’s alternative activity analysis 21-369 Figure 21.7: TORQUAY Ltd.’s alternative profitability analysis 21-369 Figure 21.8: TORQUAY Ltd.’s process cost rates, 2 nd amendment 21-370 Figure 21.9: TORQUAY Ltd.’s profitability analysis, 2 nd amendment 21-370 Figure 8.1: ZAMZAM restaurant (2) 22-374 Figure 22.2: Sales plan for rice dishes (detailed) 22-375 Figure 8.3: ZAMZAM restaurants sales plan 22-376 Figure 8.4: ZAMZAM Restaurant’s production plan in units [#] 22-376 Figure 8.5: ZAMZAM Restaurant’s materials plan 22-377 Figure 8.6: ZAMZAM Restaurant’s labour plan 22-377 Figure 8.7: ZAMZAM Restaurant’s overhead plan 22-378 Figure 8.8: ZAMZAM Restaurant’s comprehensive cost plan 22-378 Figure 8.9: ZAMZAM Restaurant’s profitability plan 22-379 Figure 8.10: ZAMZAM Restaurant’s cash plan 22-379 Figure 10.1: POTO TRAVEL&TOUR Sdn. Bhd.’s Bali trip 23-381 Figure 23.2: POTO TRAVEL&TOURS Sdn. Bhd.’s Bali trip offer 23-382 Figure 10.3: Bali tour cost planning 23-383 Figure 10.4: Contribution income statement for the Bali trip 23-384 Figure 10.5: Maximum profit for the Bali trip 23-384 Figure 10.6: Break-even point calculation for the Bali trip 23-384 Figure 14.1: SRC’s income statement [HRC’s annual report 2016] 24-387 Figure 14.2: SRC’s balance sheet as at 31.12.2016 [FT.com] 24-387 Figure 14.3: HRC’s share prices at the time of acquisition - one week, daily 24-388 Figure 14.4: HRC’s historical share price data - one year, monthly 24-388 Figure 14.5: SRC’s historical share price data, daily 24-389 Figure 23.1: MTBE Malaysia Sdn. Bhd. 25-390 Figure 23.2: Accounts 25-391 Figure 23.3: Accounts 25-396 Figure 26.1: CAHAYA BAKERY 26-398 Figure 26.2: CAHAYA BAKERY’s profitability analysis 26-399 Figure 26.3: Cost details for overheads 26-399 Figure 26.4: Percentage of cost to activities 26-400 Figure 26.5: Result of cost allocations 26-400 Figure 26.6: ABC cost centre at CAHAYA BAKERY 26-401 <?page no="415"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 28-415 Figure 26.7: Activity based product calculation 26-401 Figure 26.8: Profitability analysis based on ABC-costing 26-402 <?page no="416"?> Berkau/ Darun: Management Accounting (2 nd Asia Edition) 29-416 29. Literature Atkinson, A.A. et al. [2016]: Management Accounting. 6 th edition. London. Atrill, P.; McLaney, E. [2018]: Management Accounting for Decision Makers. 9 th edition. London. Berkau, C. [2021]: Basics of Accounting. 6th edition, Munich. Berkau, C. [2021]: Financial Statements, 6th edition Munich. Berkau, C. 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