<?page no="0"?> Carsten Berkau 6th Edition Management Accounting 6th Edition Be r ka u Management Accounting Management Accounting is written for students in international Business Management study programs. It covers the widely applied syllabus of Cost Accounting and Management Accounting at universities on bachelor’s and master’s level. The book is based on more than 20 years’ academic teaching experience in Germany and at international universities in South Africa, Malaysia, China, the Netherlands and South Korea. In this text book, the application of methods and instruments comes first. Management Accounting follows a case study based approach. All cases are taken from previous exam papers and explained in detail. The text book starts with a case study of a manufacturing company and compares Financial Accounting to Management Accounting. It covers two point of views: (1) a General Management view, with aspects of business planning, cost-volume-profit analysis, degree of operating leverage, mergers and cross-border acquisitions and risk valuation. (2) a Cost Accounting view with Management Accounting systems, flexible budgeting, cost allocations, performance measurement and monitoring, reporting, calculation, manufacturing accounting (job order and process costing), activity based costing and multi-level contribution margin Accounting. On the UVK website, numerous exam tasks and complete solutions thereto are available in English. www.uvk.de ISBN 978-3-7398-3028-5 Auch als E-Book 53028_Umschlag.indd 1 53028_Umschlag.indd 1 24.03.2020 13: 26: 46 24.03.2020 13: 26: 46 <?page no="1"?> Carsten Berkau Accounting <?page no="3"?> Carsten Berkau Accounting Edition UVK Verlag · München <?page no="4"?> Bibliografische Information der Deutschen Bibliothek Die Deutsche Bibliothek verzeichnet diese Publikation in der Deutschen Nationalbibliografie; detaillierte bibliografische Daten sind im Internet über <http: / / dnb.ddb.de> abrufbar. ISBN 978-3- Das Werk einschließlich aller seiner Teile ist urheberrechtlich geschützt. Jede Verwertung außerhalb der engen Grenzen des Urheberrechtsgesetzes ist ohne Zustimmung des Verlages unzulässig und strafbar. Das gilt insbesondere für Vervielfältigungen, Übersetzungen, Mikroverfilmungen und die Einspeicherung und Verarbeitung in elektronischen Systemen. © UVK Verlag Einbandgestaltung: Susanne Fuellhaas, Konstanz <?page no="5"?> 1. Conventions 1-4 2. Introduction to Management Accounting 2-11 3. Case Study PENOR PLC - Financial Accounting 3-16 4. Case Study PENOR PLC - Managerial Accounting 4-41 5. Characteristics of Management Accounting and Major Differences to Financial Accounting 5-72 6. Cost Planning / Business Plan 6-82 7. Cost Concepts, Cost Behaviour and Cost Separation 7-113 8. Cost Volume Profit Analysis (CVP-Analysis) 8-134 9. Degree of Operating Leverage (DOL) 9-150 10. Performance Measurement 10-167 11. Accounting for Mergers and Acquisitions 11-180 12. Risk Valuation 12-211 13. Structure of Cost Accounting Systems 13-230 14. Flexible Budgeting / Marginal Cost Accounting 14-252 15. Cost Monitoring 15-265 16. Cost Allocations 16-274 17. Reporting 17-297 18. Job Order Costing (Manufacturing Accounting) 18-307 19. Process Costing (Manufacturing Accounting) 19-328 20. Multiple-Level Contribution Margin Accounting 20-339 21. Activity Based Costing 21-344 22. Abbreviations 22-357 23. Table of Figures 23-363 24. Literature 24-368 <?page no="6"?> This text book is based on the syllabus of Controlling / Managerial Accounting classes we teach in Germany, Malaysia, South Korea and South Africa. As we strive to make our students able to apply the methods, our teaching is case study based. We introduce methods as simple as possible and explain their application by cases. After studying this text book, you can do Management Accounting yourself and understand how Management Accountants do their job. What is new in the 6 th edition? We introduced the ‘What is in the Chapter? ’ paragraphs to provide you with an overview at the beginning of every chapter. It is followed by a learning objectives paragraph. We also added the data sheet boxes to the text which helps you to overview case studies. All accounts have been reworked that they now come with 3 letter codes and nominal accounts with the year on the account name. At the end of every chapter, you now find a question bank and solutions to test your knowledge. Due to the new IFRS standards for the disclosure and valuation of financial instruments we had to adjust the case study PENOR Ltd. in chapter (3) as the effective interest method now applies. With the 6 th edition we revised and simplified the entire text. We now focus more strictly on the application of Management Accounting methods. Managerial Accounting is a text book for the bachelor’s and for the master’s degree level. For its understanding, a basic level of Accounting knowledge is required. We refer at our other text books: ‘Berkau: Basics of Accounting’ and ‘Berkau: Financial Statements’. In order to ‘jump-start’ Management Accounting we begin with a casebased description of Financial Accounting. We explain the basics of Bookkeeping and financial statement preparation by the fictional manufacturer PENOR PLC. This helps you to review Financial Accounting. If you are new in Accounting, the chapter gives you a quick tour through Financial Accounting as needed to understand Managerial Accounting. In the next following chapter, PENOR PLC is used again, now introducing Management Accounting. We compare Financial Accounting to Managerial Accounting and show your in which regards Financial Accounting is more (too much) and where Management Accounting becomes wider and deeper than financial statements. As Managerial Accounting is supports two fields of management, we show 2 different angles in the chapters of this text book: (1) Accounting for General Management. (2) Cost Accounting. Ad (1): Accounting for General Management If the general managers’ work, Accounting information about the entire company is required. We cover aspects, like budgeting, break-even analysis or degree of operating leverage. We also discuss mergers and acquisitions and risk management. <?page no="7"?> Ad (2): Cost Accounting Cost Accounting takes place in the departments. We cover cost Accounting systems and their features in detail, focus on cost allocations and monitoring and show alternative methods for calculations and the management of fixed costs. The case-based teaching method requires that you study the provided case studies with perseverance, best you take a calculator and recalculate the tables and accounts. Take the time to understand the calculations properly! We are keen to explain every calculation in detail and print results in bold figures for you to find them easily. For the application of methods, you also find the ‘How it is Done’ sections, which are written like a recipe in a cooking book. We thank Dr. Jürgen Schechler from UVK-Lucius publishers in Munich, who is the lector for all our books. His great support allows us to produce our text books in short intervals. For our students he makes the text books affordable by controlling the cost of printing. Under www.uvk.digital/ 9783739830285, we put study materials (tasks and detailed solutions) online. In order to contact us, write to ‘book@prof-berkau.de’. Feel free to follow us on twitter: ‘@CBerkau’. Enjoy Managerial Accounting! Cape Town, in February 2020 Keabetswe Sylvia Berkau Prof. Dr. Carsten Berkau <?page no="8"?> The below listed conventions apply to simplify case studies. These conventions are about legal forms, tax rates, formats etc. They apply for this text book and examples and exercises you can find online on the UVK- Lucius.de-website. The conventions are the same as in the Basics. At this stage of studying Accounting, you might not understand the conventions completely. We only put them at the beginning of the book for you to find them upfront. They apply for the entire text book. Here, they come in alphabetic order: Accounting Periods: Accounting periods always start on 1.01.20XX and end on 31.12.20XX. Furthermore, to keep the examples transferable to later classes, we indicate the decade by an X, as in 20X4. X is followed by Y and Z. Accounting Technical Terms: At the end of a chapter you find short explanations for new technical terms. They help you to easily understand the content. These are explanations for beginners in Accounting. The Accounting technical terms are not as formal and precise as the definitions provided by the IASB. The Accounting technical terms in the chapters are redundant but consistent. Account Names: All names of accounts in the text book for Bookkeeping entries are written with capital letters in the text, such as ‘Cash/ Bank account’. We intend you to focus the accounts for financial statement preparation. However, an account not subjected to our recordings is written with small letters. Assume there is a bank account with Deutsche Bank and we refer to that account. In that situation, the writing is with small letters: bank account. We do not make Bookkeeping entries therein, but Deutsche Bank AG does. However, the Cash/ Bank account applicable to calculate the item cash/ bank on the balance sheet is part of our Accounting work. Alphabetic Order: For all lists, we apply an alphabetic order. Basics: The Basics are our text books Berkau: Basics of Accounting, part 1: Bookkeeping and Financial Accounting and Berkau: Basics of Accounting, part 2: Managerial Accounting. They introduce you to Accounting concepts without consideration of International Accounting standards IFRSs. Bookkeeping Entries: All Bookkeeping entries are printed in bold and cover a whole page’s width. This way, we move them into the centre of the page to give them special attention. <?page no="9"?> Bookkeeping Entries: We write the Bookkeeping entries as debit entries and credit entries. DR stands for debit recorded and CR for credit recorded. All Bookkeeping entries are printed in bold. See, e.g., the Bookkeeping entry for the acquisition of a motor vehicle: DR Motor Vehicle................ 20,000.00 EUR DR VAT.......................... 4,000.00 EUR CR Cash/ Bank.................... 24,000.00 EUR When writing Bookkeeping entries in the text, account names always are written with capital letters, such as Motor Vehicle account. In contrast, when writing ‘The item is added to motor vehicles’ we do not refer to the account but to the assets or the balance sheet item ‘motor vehicles’. The identifier for Bookkeeping entries always comes in brackets, such as Bookkeeping entry (1). You find the identifiers in the accounts, too. Calculations: In 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 to zero. The final result is printed in bold and comes always with two digits after the decimal point and the currency unit. Printing results bold helps you to find calculated numbers in the text. All calculations are accurate to the EUR-cent or any other currency as 1/ 100-amounts. Case Studies: We keep case studies in this text book as easy as possible. Stories are kept simple in order to focus on Accounting. Sometimes you’ll get the impression the examples are too easy and, thus, unreal. However, our aim is not story-telling and Accounting cases can easily become quite complex anyway. Case Study Text: Cash Flow Separation: An operating cash flow is a cash flow that does not result from investing nor financing activities. Interest payments in this text book are always regarded as financing cash flow, even as IAS 7.33 allows its recognition as operating or financing cash flow. Companies: For the text book, the legal form of companies does not matter much. Legal forms are country-wise different and are not subject to the Accounting syllabus per se. However, in contrast to IFRSs we do not refer to companies as “entities”. The IFRS-expression is chosen for standardisation purpose. Once you the word “entity” in the IFRSs, just remember they are referring to companies. The IFRSs avoid referrals to legal aspects of national law <?page no="10"?> for a wide validity of a company’s definition. Although the standards always say entity, we apply the technical terms “business”, “firm” and “company” instead and interchangeably to each other. Most companies are limited companies in this text book, such as GmbH, AG, Pty Ltd., PLC, Inc. etc. Cost-Expense-Congruence: By default costs are expenses and vice versa. Country: In this new edition, almost all cases take place in countries where IFRSs apply for single entity financial statements. Therefore, the currency for the examples is mainly not EUR but a currency that applies in those countries. Currency Unit: For all examples, the currency unit is based on the country in the case study. We use the common 3 letter codes for abbreviations, such as ZAR for South African Rand or GBP for British Pound. Data Format in Tables: In tables, negative figures are disclosed in brackets. E.g., (7.50) equals to -7.50 EUR. In all tables, the currency is indicated. Data Sheets Deferred Payment of Income Taxes: No deferred payments are made to the revenue service in our case studies. Taxes are calculated at the year-end and are added to short-term liabilities, mostly to the Income Tax Liabilities account. For German companies, § 249 HGB applies and taxes are disclosed as provisions. How it is Done: (1) You find How-it-is Done sections in this text book. (2) They offer you very short and clear instructions for your Accounting work. Income Taxes: A simplified income tax model applies. Income taxes are amounting to 30 % of the pre-tax profit EBT. Financial Statements for Taxation: We do not intend to deepen your knowledge in tax calculations. However, tax statements are relevant to ascertain income taxes liabilities and deferred taxes. We apply a simplified tax calculation model. Group Accounting: For Group Accounting and Joint Venture Accounting, we assume all involved companies prepare financial statements along IFRSs and prepare the single entity financial statements as at 31.12.20XX. <?page no="11"?> Names: We always use names for companies and write them with capital letters. E.g., SCHULZE-BRAMMELKAMP Ltd. No links to actual existing persons or companies are intended. In case we refer to real firms we make that clear in the text. You can search for the case studies by names online. We only use them once for a case study, so they work as identifiers. Language: This text book is written in South African English. Learning Objectives and Summaries: Every chapter starts by the learning objectives and ends by a summary. Legal Forms of a Business: For this text book, we normally use Ltd., (Pty) Ltd., Sdn. Bhd., Bhd., AG, GmbH, UG, PLC, Inc. etc. If no legal form has been mentioned together with the company’s name you can assume the company is privately-owned, such as SANDPIPER BOOKS for a privately-owned bookstore. Length of a Month/ Year: 1 month = 21.5 days = 4.3 weeks. 1 year = 12 months = 365 days = 52 weeks. Level of Precision: We work accurate to 2 digits after the decimal point. Results from workings are rounded, too. You can use rounded figures to continue calculations, e.g., in examinations or case study workings. Ourselves, we calculate mostly in MS- Excel; hence, calculations in the background are more precise than displayed and visible. Financial statements show figures rounded to the nearest full currency amount. No digits after the decimal point show. Rounding is a minor problem. Literature: The main source of preparing financial statements are the standards issued by the International Accounting Standard Board IASB. We do not compare academic positions on Accounting and, as a consequence, mostly quote the standards. However, at the end of the text book, we advise further readings for you. Non-existing Items: In case something has not been mentioned in a case study it won’t exist. Sometimes case studies have been cut short in order to get a point across more clearly. Payment Terms: In this text book, payments and receipts for all kind of taxes and for dividends are due in the next Accounting period. Furthermore, we ignore any consequence on income tax resulting from profits carried forward or backwards. <?page no="12"?> Presentation of Accounts: Accounts are displayed in the easiest format possible, which is the T-format. They contain a 3 letter indicator used for 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: 20,000.00 4,000.00 24,000.00 Figure 1.1: Accounts Abbreviations are listed at the end of this text book. Pro-Rata-Temporis Calculation of Depreciation and Interest: Although given as annual rates, depreciation and interest are calculated on a pro rata temporis (PRT) basis 1 only accurate to the full month. Pro rata temporis is Latin and means proportional to the time. Monthly depreciation is calculated as annual depreciation divided by 12. In case the company is in possession of the asset for a shorter period than a full year, a month counts for depreciation if the asset is deployed for the major duration thereof. If the asset is bought on 6.01.20X1 the January will be relevant for depreciation. If the asset is sold on 28.12.20X1 the December counts for depreciation, too. If the asset is sold on 5.12.20X1, the December won’t be considered for depreciation. Interest rates are given on an annual basis with only annual compounding. For loans taken for shorter periods than a year, interest is calculated on a pro rata temporis basis accurate to the month, too. The monthly rate of interest is the annual rate divided by 12. The interest is compounded annually and paid at the end of the Accounting period. For a bank loan of 100,000.00 EUR taken on 4.06.20X4 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 in order to point thereto, such as 11.06.20X4. In general, pay-off payments take place at the end of the Accounting period. If not, the calculation is to be made in intervals. In case of extra payoff payments at the end of each quarter the interest must be calculated for 4 quarterly periods separately. Interest is only calculated for debts, such as bank loans, bonds etc. No <?page no="13"?> overdraft of the bank account is considered. We do not check a bank loan’s balance during the Accounting period for overdrafts and calculate interest thereon. An exception is chapter (37) in the Basics-1 that deals with bank account reconciliations. Overdrawn bank accounts at the end of the Accounting period require a recognition as liability on the statement of financial position. Interest and pay-off are always paid instantly at the year-ends which means the credit entry is made in the Cash/ Bank account and never in the Accounts Payables account. Quotation of Law Texts/ Standards: Law texts are quoted like ‘§ 266 II HGB’ or ‘IAS 1.68’. We use the original law names and no translations thereof. Hence, the HGB is the German Civic Code, called in German: Handelsgesetzbuch (HGB). In this text book, we quote German law paragraphs mostly without section references but IFRSs standards with paragraph reference. Note, that IFRS paragraphs can be subject to changes. Sequence of Bookkeeping Entries: The sequence of Bookkeeping entries comes along the logical procedure defined by the text structure. Sometimes this differs from the timeline of business activities. However, Bookkeeping identifiers do not tell the sequence of recording. If there is the acquisition of assets and later (31.12.) these assets are writtenoff by recording depreciation, we cover these Bookkeeping entries together in the text, although the acquisition might take place on 2.01.20XX and its depreciation is recorded on 31.12.20XX. Statement of Financial Position: We focus on general purpose balance sheets. Tax Calculations: We follow a very simplified tax calculation model. The total income taxes are calculated by multiplying the pretax profit (=earnings before taxes) with the total income tax rate. In our model the total income tax rate is 30 %. In particular, we ignore any national taxation details, such as untaxable (free) amounts or differences linked to classifications. Tax on Capital Returns (Dividend Tax): The tax on capital returns is an income tax. The rate on capital returns is 25 % based on the capital return amount in this text book. Note, the tax on capital returns is no income tax for the company, although it is owed by the company on behalf of its shareholders. The tax on capital returns is a withholding tax in most countries. 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 and some U.S. states such as Delaware, Alaska, consumers pay VAT - or sometimes referred to as sales tax when buying goods or services. In this text book, we apply one single VAT <?page no="14"?> account. This is different to German Bookkeeping, where input-VAT and output-VAT is recorded in separate accounts. The VAT rate in our text books is 20 %. We ignore reduced VAT rates as levied in many countries for food, books etc. VAT Reduction: It is assumed that every company discussed in this book is registered for VAT reduction. In Germany registration for VAT reduction is the default case. In Germany, only micro companies can opt for no VAT reduction. This requires actively to address that classification at the German revenue service. Work-in-Process Account: We apply the Work-in-Process account as reconciliation account for all job orders and call it Work-in-Process. We also apply a Work-in-Process account for single job orders but then add the job order ID thereto. I.e., a Work-in-Process 1234 account represents the job order 1234. Writing Accounting Terms: We write Accounting and Bookkeeping with capital letters. We use also caps for names, e.g. of departments, and for all disciplines in a university, like Marketing, Controlling etc. WWW We provide you with a lot of exercises and further materials. Pls., check the website: www. uvk.digital/ 9783739830285. Most of the exercises are exam tasks from Hochschule Osnabrück or its partner universities, mainly in South Africa, China, South Korea and Malaysia, we gave our Accounting students in recent years. 10-20-30 Rule: In this text book, 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 %. <?page no="15"?> 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 entire 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 period’s profit and cash flow, Management Accounting addresses future activities, like in budgeting, and monitors and adjusts actual data in order to keep the business on track. No legal requirements, such as IFRSs, apply for Management Accounting. Management Accounting is merely based on production theory and cost theory. The information managers need to know in order to control their business are different to findings derived from financial statements. Only few small businesses can be controlled by Financial Accounting information but the majority of companies installs 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 in order to reduce reaction time. Most managers plan and monitor their business on a monthly basis. 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 as distributed units. 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 with regard to keep Bookkeeping records and prepare financial and tax statements and Management Accounting which includes the maintaining of Accounting records, the planning and monitoring of activities/ products and reporting. Under Finance falls taking custody of the company’s funds and liquidity planning. The aim of the Management Accounting system is to provide managers with true and relevant data which enables them to make good economic decisions. <?page no="16"?> We cover the below described chapters, allocated to three sections in the book: Section (1): Management Accounting and Financial Accounting. Section (2): Management Accounting for general management. Section (3): Cost Accounting. Section (1): Management Accounting and Financial Accounting In the first section, we use the case study PENOR PLC in order to speed 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 along 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 in general. Section (2): Management Accounting for General Management In chapter (6), the business plan which was introduced for PENOR PLC case study already 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 along a full cost Accounting system and gets you through the complete planning procedure. 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 as you have to understand how costs change with different business scenarios. 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 at the point (0/ 0) the cost curve initially lays above the revenues. At the break-even point the cost curve meets the revenue curve. Thereafter the revenue exceeds costs. The chapter shows how to apply a what-if analysis in order to facilitate output volume and product mix decisions and to predict the profitability when adjusting to their 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 output and/ or revenue. <?page no="17"?> The chapter (10) describes methods of performance measurement. All major performance ratios are explained by the case study VANHUIZEN BV. Problems of interpretations are shown in chapter (9). The next following chapters are linked to mergers and acquisitions. Mergers occur when 2 companies are combined in one new firm. An acquisition is the purchase of another company for holding. In chapter (11) we present Accounting due diligence work for company valuations in preparation of 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 for fail. Section (3): Cost Accounting Cost Accounting covers methods of how costs are allocated within a company. The chapter is placed behind the Management Accounting for general management section in order to refer to the Accounting principles covered before. In chapter (13), we introduce the structure of a cost Accounting system and show the features of its components, such as cost separation, cost centre Accounting, calculation and profitability analysis. In particular, we discuss the cost flow through a Management Accounting system. By the case study GIULIO’s PIZZA&PASTA RISTORANTE we explain every single step in a Management Accounting system. 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. In order to compare the systems, we apply the same Italian restaurant case study. We cover cost monitoring in chapter (15) and show how to calculate and read cost deviations in order to analyse reasons for failing the cost plans. The chapter (16) is about cost allocations. Cost allocations is a major concept regarding Management Accounting. When departments exchange performance, cost allocations apply in order to refund the rendering department and charging 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. The upcoming chapters in this text book are as follows: <?page no="18"?> ( 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. <?page no="19"?> Section (1): Management Accounting and Financial Accounting <?page no="20"?> What is in the Chapter? In this chapter (3) Case Study PENOR PLC - Financial Accounting, we discuss a manufacturer for aluminium windows and doors in the UK. The case study starts from Bookkeeping entries. We prepare financial statements in compliance with IFRSs. We deliberately show aspects specific for the preparation of financial statements, such as changes in purchase prices, special payment terms and prepaid costs. We also cover the disclosure of liabilities following IAS 1 and IFRS 9. We repeat Financial Accounting and set up a full set of financial statements that comprises a statement of financial position, a statement of comprehensive income, a statement of changes in equity and a statement of cash flows. Leaning Objectives: We show how a European company prepares financial statements and what information can be derived therefrom for Management Accounting. We follow the idea that in real businesses financial statements are available and Managerial Accounting is derived from Accounting records. For understanding Management Accounting, some knowledge about Accounting concepts is essential. After studying this chapter, you learned/ repeated Financial Accounting and you see what information can be used for controlling the business. You also gain an awareness of the differences between Financial Accounting and Management Accounting. As the chapters (3) and (4) are much in the details, we therefor recommend them for self-study. We start-off with Financial Accounting. Financial Accounting is required by national law and makes a company report to their owners, legal entities and other parties interested in its financial position, its profit and cash flows. Companies that are publicly owned prepare a set of financial statements in compliance with IAS 1.10: We cover the story of PENOR PLC from its establishment on and observe its activities during the first Accounting period. 2 We cover 3 aspects of PENOR PLC in the next two chapters: (A) Inception. (B) Financial Accounting. (C) Management Accounting. Ad (A): Inception <?page no="21"?> DR Cash/ Bank.................... 400,000.00 GBP CR Issued Capital............... 400,000.00 GBP 400,000 400,000 400,000 400,000 Figure 3.1: PENOR PLC’s statement of financial position as at 1.01.20X1 <?page no="22"?> Ad (B): Financial Accounting 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 In order to study the standards, you can register at www.IFRS.org and then download the 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. <?page no="23"?> Figure 3.2: IFRSs website for standards download DR Interest Bearing Liabilities. 20,000.00 GBP CR Short-term Liabilities....... 20,000.00 GBP 400,000.00 6,000.00 400,000.00 200,000.00 20,000.00 20,000.00 200,000.00 6,000.00 20,000.00 20,000.00 Figure 3.3: PENOR PLC’s accounts <?page no="24"?> Data Sheet for PENOR PLC DR P, P, E...................... 150,000.00 GBP DR VAT.......................... 30,000.00 GBP CR Cash/ Bank.................... 180,000.00 GBP DR Depreciation................. 30,000.00 GBP CR Acc. Depr. CNC-Saws.......... 30,000.00 GBP <?page no="25"?> DR Rent......................... 97,500.00 GBP CR Cash/ Bank.................... 97,500.00 GBP DR Prepaid Expenses............. 7,500.00 GBP CR Rent......................... 7,500.00 GBP 400,000.00 6,000.00 400,000.00 200,000.00 20,000.00 180,000.00 97,500.00 20,000.00 200,000.00 6,000.00 20,000.00 20,000.00 150,000.00 30,000.00 30,000.00 30,000.00 97,500.00 7,500.00 7,500.00 Figure 3.4: PENOR PLC’s accounts <?page no="26"?> DR Purchase..................... 600,000.00 GBP DR VAT.......................... 120,000.00 GBP CR Cash/ Bank.................... 720,000.00 GBP 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 DR Purchase..................... 600,000.00 GBP DR VAT.......................... 120,000.00 GBP CR Accounts Payables............ 720,000.00 GBP <?page no="27"?> 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 DR Purchase..................... 270,000.00 GBP DR VAT.......................... 54,000.00 GBP CR Cash/ Bank.................... 324,000.00 GBP 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 DR Purchase..................... 1,250,000.00 GBP DR VAT.......................... 250,000.00 GBP CR Cash/ Bank.................... 1,500,000.00 GBP <?page no="28"?> DR Cash/ Bank.................... 15,000.00 GBP CR VAT.......................... 2,500.00 GBP CR Return Outwards.............. 12,500.00 GBP DR Purchase..................... 20,000.00 GBP DR VAT.......................... 4,000.00 GBP CR Cash/ Bank.................... 24,000.00 GBP Figure 3.5: PENOR PLC’s purchases in 20X1 <?page no="29"?> 400,000.00 6,000.00 400,000.00 200,000.00 20,000.00 15,000.00 180,000.00 6,062,280.00 97,500.00 720,000.00 270,000.00 720,000.00 48,000.00 31,200.00 324,000.00 1,500,000.00 24,000.00 20,000.00 200,000.00 6,000.00 20,000.00 20,000.00 150,000.00 30,000.00 2,700.00 30,000.00 120,000.00 2,500.00 90,000.00 1,010,380.00 120,000.00 8,000.00 5,200.00 54,000.00 250,000.00 4,000.00 30,000.00 97,500.00 7,500.00 7,500.00 270,000.00 Figure 3.6: PENOR PLC’s accounts <?page no="30"?> 600,000.00 13,500.00 12,500.00 450,000.00 600,000.00 40,000.00 26,000.00 270,000.00 1,250,000.00 20,000.00 16,200.00 16,200.00 16,200.00 1,750,000.00 500,000.00 250,000.00 250,000.00 250,000.00 400,000.00 400,000.00 5,051,900.00 Figure 3.6: PENOR PLC’s accounts (continued) 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 <?page no="31"?> DR Payroll tax.................. 400,000.00 GBP CR Cash/ Bank.................... 400,000.00 GBP DR Cash/ Bank.................... 6,062,280.00 GBP CR VAT.......................... 1,010,380.00 GBP CR Revenue...................... 5,051,900.00 GBP The valuation of finished goods is called calculation. Figure 3.7: Direct materials for windows <?page no="32"?> Figure 3.8: Direct materials for doors <?page no="34"?> 400,000.00 6,000.00 400,000.00 400,000.00 198,500.00 20,000.00 400,000.00 15,000.00 180,000.00 6,062,280.00 97,500.00 720,000.00 270,000.00 48,000.00 31,200.00 324,000.00 1,500,000.00 24,000.00 1,100,000.00 500,000.00 400,000.00 1,455,080.00 6,675,780.00 6,675,780.00 1,455,080.00 Figure 3.9: Accounts <?page no="35"?> 20,000.00 198,500.00 6,260.61 6,260.61 20,000.00 6,260.61 6,260.61 6,260.61 6,000.00 158,760.61 204,760.61 204,760.61 158,760.61 20,000.00 20,000.00 150,000.00 150,000.00 20,000.00 150,000.00 30,000.00 2,700.00 30,000.00 30,000.00 120,000.00 2,500.00 30,000.00 90,000.00 1,010,380.00 120,000.00 8,000.00 5,200.00 54,000.00 250,000.00 4,000.00 334,380.00 1,015,580.00 1,015,580.00 334,380.00 30,000.00 30,000.00 97,500.00 7,500.00 30,000.00 90,000.00 97,500.00 97,500.00 90,000.00 90,000.00 7,500.00 7,500.00 990,000.00 270,000.00 7,500.00 720,000.00 990,000.00 990,000.00 990,000.00 1,190,000.00 200,000.00 1,190,000.00 1,190,000.00 1,190,000.00 Figure 3.9: Accounts (continued) <?page no="36"?> 600,000.00 13,500.00 12,500.00 12,500.00 450,000.00 600,000.00 40,000.00 26,000.00 270,000.00 1,250,000.00 20,000.00 3,242,500.00 3,256,000.00 3,256,000.00 3,242,500.00 3,242,500.00 16,200.00 16,200.00 16,200.00 16,200.00 16,200.00 1,750,000.00 500,000.00 250,000.00 250,000.00 2,000,000.00 250,000.00 2,000,000.00 2,000,000.00 500,000.00 500,000.00 2,000,000.00 2,000,000.00 400,000.00 400,000.00 5,051,900.00 5,051,900.00 80,000.00 80,000.00 60,000.00 60,000.00 80,000.00 60,000.00 100,000.00 100,000.00 9,500.00 9,500.00 100,000.00 9,500.00 37,500.00 37,500.00 15,600.00 15,600.00 37,500.00 15,600.00 Figure 3.9: Accounts (continued) <?page no="37"?> 5,000.00 5,000.00 322,251.50 332,251.50 5,000.00 332,251.50 3,242,500.00 5,051,900.00 2,000,000.00 2,461,751.50 80,000.00 90,000.00 60,000.00 30,000.00 100,000.00 6,260.61 9,500.00 335,490.89 37,500.00 2,461,751.50 2,461,751.50 15,600.00 100,647.27 335,490.89 5,000.00 234,843.62 332,251.50 335,490.89 335,490.89 2,461,751.50 12,500.00 5,704,251.50 5,704,251.50 2,461,751.50 2,461,751.50 234,843.62 234,843.62 100,647.27 100,647.27 200,000.00 234,843.62 100,647.27 34,843.62 234,843.62 234,843.62 34,843.62 34,843.62 34,843.62 Figure 3.9: Accounts (continued) <?page no="38"?> 5,051,900 332,252 5,384,152 (2,922,400) (2,000,000) (30,000) (90,000) 341,752 (6,261) 335,491 (100,647) 234,844 Figure 3.10: PENOR PLC’s income statement 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 <?page no="39"?> 200,000 6,000 20,000 180,000 180,000 5,400 20,000 160,000 160,000 4,800 20,000 140,000 140,000 4,200 20,000 120,000 120,000 3,600 20,000 100,000 100,000 3,000 20,000 80,000 80,000 2,400 20,000 60,000 60,000 1,800 20,000 40,000 40,000 1,200 20,000 20,000 20,000 600 20,000 0 Figure 3.11: PENOR PLC’s bank loan calculation <?page no="40"?> 198,500 (26,000) (25,400) (24,800) (21,200) (20,600) (198,500) 204,761 (178,761) 184,399 (158,999) 164,013 (139,213) 41,170 (19,970) 20,600 - - - - - (0) Figure 3.12: PENOR PLC’s bank loan’s financial schedule 198,500 6,261 (26,000) 178,761 178,761 5,638 (25,400) 158,999 158,999 5,015 (24,800) 139,213 139,213 4,391 (24,200) 119,404 119,404 3,766 (23,600) 99,570 99,570 3,140 (23,000) 79,710 79,710 2,514 (22,400) 59,825 59,825 1,887 (21,800) 39,911 39,911 1,259 (21,200) 19,970 19,970 630 (20,600) (0) Figure 3.13: Disclosure of PENOR PLC’s bank loan <?page no="41"?> 120,000 400,000 34,844 639,852 158,761 16,200 1,544,380 7,500 1,455,080 100,647 2,238,632 2,238,632 Figure 3.14: PENOR PLC’s balance sheet <?page no="42"?> 6,062,280 (2,917,200) 15,000 (97,500) (1,100,000) (400,000) (500,000) 1,062,580 (180,000) (180,000) 400,000 198,500 (6,000) (20,000) 572,500 1,455,080 Figure 3.15: PENOR PLC’s statement of cash flows <?page no="43"?> 400,000 400,000 234,844 234,844 (200,000) (200,000) 34,844 (34,844) 0 400,000 34,844 0 434,844 Figure 3.16: PENOR PLC’s statement of changes in equity 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 Financial Statements. 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="44"?> 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. Solutions: 1-3; 2-4; 3-2; 4-4; 5-3. <?page no="45"?> 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) Case Study PENOR PLC - Managerial Accounting shows what aspects of Financial Accounting can be neglected and where new aspects become relevant for controlling of the business. We also demonstrate that a company cannot be controlled by its financial statements only as detailed data for departments and for periods shorter than a year are missing. We give an overview of Management Accounting and explain budgeting, cost monitoring and calculation of products and profit. As the case is linked to Industrial Management, calculations follow manufacturing Accounting. We also introduce reporting and disclosure a statement of cost of goods manufactured and cost of goods sold and prepare a business plan for PENOR PLC. Learning Objectives: In this chapter you gain an overview of Management Accounting. The chapter helps you to develop a clear understanding of Management Accounting based on a case study. After reading this chapter you understand how Management Accounting works. We introduce main technical terms and concepts This chapter helps you to get easily through the rest of the textbook. Management Accounting is Accounting for managers. In contrast to Financial Accounting it meets the information requirements of managers who are in 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 the monitoring aspect of Management Accounting too much. 12 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 to discuss only basic aspects of Management Accounting in this introduction chapter. A detailed discussion of the therein mentioned concepts is covered by the next following chapters. We continue the case study by item (C) based on the sequence announced in chapter (3). 13 Ad (C): Management Accounting Financial Accounting and Managerial Accounting are similar regarding recording and calculating - even the formulas and Bookkeeping entries are the same, but both Accounting concepts follow different purposes. Managerial Accounting provides information about profitability in order to help managers to control the business. For that reason, Management Accounting <?page no="46"?> is much in the details. Financial Accounting reports to owners and creditors based on legal requirements annually and in regard to the entire business entity (firm, company). The question you might ask yourself is: ‘Can we not just control a business by financial statements? ’. The answer surprisingly is: Yes, but only if the company is extremely small and the owner keeps an overview in order to make good management decisions. To proof the point, we set up 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 monthly expenses and is based on a performance analysis. The rule for the managers in charge of a department is: Do not spend more and once you exceed your budget, request approval from the financial director 14 . Financial Accounting reports annually the entire expenses for both departments, say 11,576.31 EUR. In contrast, Management Accounting budgets 2 × 500.00 EUR/ m and compares it to the actual costs. If one manager spent 3,500.00 EUR in March, the financial statements won’t show. A Management Accounting system will set alarms off after March, most probably on 10.04.20XX, which might be the reporting day. For the control of the business we need detailed and monthly information about budgeted and actual costs which is more viable than just an item on the annual income statement 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 enterprise. You can understand Managerial Accounting as a programming of managers based on threshold values to not exceed on a monthly basis - called budget. In contrast, it is less advisable to control a company by its financial statements. However, financial statements are a good and by Auditing proven source of information. Below, we mention a few management information taken from financial statements: <?page no="47"?> All the above information (1) … (5) can be derived from the financial statements and is available to investors, owners and all other parties interested in the business. Running a company, we must understand how the business processes work and what affects the company’s profit and cash flow. Managers need detailed information and they must know them as early as possible in order to react if something goes wrong. Next, we check the benefits a shareholder expects form the ownership of shares of a company and how to measure it. The owners put the management in charge to achieve their objectives. Management Accounting supports managers to fulfil the investors’ requirements. To control a business to the benefit of its owners purely follows economic goals. In general, companies are in the pursuit of returns. A return is a ratio that gives a profit as percentage of investments. The investors’ return is a dividend which reflects a remuneration for investing the funds. Companies work on behalf of their owners. Hence, companies must strive to increase their dividends declared and fair market values, particularly when listed publicly. Commonly, a company’s value is high when it is profitable and declares high dividends. Profitable investments increase the investors’ 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. From the point of view of the shareholders, the profit after taxes attributable to dividends is called earnings. A ratio widely applied is earnings per share EPS. We refer to the EPS ratio in chapter (10). In contrast to the dividend yield, EPS tells us the highest dividend payable per share. In contrast, the dividend yield indicates how much dividend per investment has been paid. <?page no="48"?> Management Accounting must advice managers how to maximise the pre-tax profit. 17 In order to maximise profit some basic rules apply: - Produce goods at low costs and sell them on the market at a high price. - Use assets wisely, make sure the assets operate at high capacity loads! Make good investment decisions. - Plan the company’s business processes and their costs precisely and at minimum costs possible. - Avoid costly deviations from plans, like rework, delays, waste and spoilage. Based on the above advices, we formulate the basic questions for Management Accountants who support operational management to answer: - Question 1: What does the product/ service cost? - Question 2: Is the business successful/ profitable? - Question 3: How much are future costs of production/ service rendering and of the administration process? - Question 4: Does/ will the company generate cash? - 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. By the next steps we refer to PENOR PLC again. We prepare a kind of parallel Accounting 18 , but: (C1) We simplify aspects of Financial Accounting that follows IFRSs but are of no or minor interest for business control. (C2) We describe Management Accounting’s basic features by following its cost flow through cost centres, product and profit calculation and answer the five Management Accounting questions once we obtain the answers thereto. Ad (C1): Simplification of Accounting Data <?page no="49"?> 200,000 6,000 20,000 180,000 180,000 5,400 20,000 160,000 160,000 4,800 20,000 140,000 140,000 4,200 20,000 120,000 120,000 3,600 20,000 100,000 100,000 3,000 20,000 80,000 80,000 2,400 20,000 60,000 60,000 1,800 20,000 40,000 40,000 1,200 20,000 20,000 20,000 600 20,000 0 Figure 4.1: PENOR PLC’s bank loan In Management Accounting the major focus is on costs. Items of the balance sheet are of relevant for preparing a budgeted balance sheet only. A cost is a reduction of resources by operations intended by the company. One of the relevant characteristics of a cost is that it reflects a consumption of a resource. A company that pays for materials but does not use them won’t record a cost. Only when inventory is consumed costs apply. Therefore, for Management Accounting the major focus is 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. <?page no="50"?> After we listed items of no relevance for Management Accounting, we rework our Bookkeeping entries in order to meet the (so far) lower requirements. <?page no="51"?> DR Cash/ Bank.................... 400,000.00 GBP CR Issued Capital............... 400,000.00 GBP DR Cash/ Bank.................... 200,000.00 GBP CR Interest Bearing Liabilities 200,000.00 GBP DR Interest..................... 6,000.00 GBP DR Interest Bearing Liabilities. 20,000.00 GBP CR Cash/ Bank.................... 26,000.00 GBP DR P, P, E saws................. 150,000.00 GBP DR VAT.......................... 30,000.00 GBP CR Cash/ Bank.................... 180,000.00 GBP DR Depreciation Production Dep.. 30,000.00 GBP CR P, P, E saws................. 30,000.00 GBP DR Rent......................... 90,000.00 GBP CR Cash/ Bank.................... 90,000.00 GBP DR Purchase..................... 600,000.00 GBP DR VAT.......................... 120,000.00 GBP CR Cash/ Bank.................... 720,000.00 GBP <?page no="52"?> 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 DR Purchase..................... 600,000.00 GBP DR VAT.......................... 120,000.00 GBP CR Accounts Payables............ 720,000.00 GBP DR Purchase..................... 66,001.00 GBP DR VAT.......................... 13,200.20 GBP CR Cash/ Bank.................... 79,201.20 GBP DR Purchase..................... 256,500.00 GBP DR VAT.......................... 51,300.00 GBP CR Cash/ Bank.................... 307,800.00 GBP DR Purchase..................... 1,237,500.00 GBP DR VAT.......................... 247,500.00 GBP CR Cash/ Bank.................... 1,485,000.00 GBP DR Purchase..................... 20,000.00 GBP DR VAT.......................... 4,000.00 GBP CR Cash/ Bank.................... 24,000.00 GBP <?page no="53"?> DR Labour....................... 2,000,000.00 GBP CR Cash/ Bank.................... 2,000,000.00 GBP DR Cash/ Bank.................... 6,062,280.00 GBP CR VAT.......................... 1,010,380.00 GBP CR Revenue...................... 5,051,900.00 GBP 400,000.00 26,000.00 400,000.00 200,000.00 180,000.00 6,062,280.00 90,000.00 720,000.00 270,000.00 79,201.20 307,800.00 1,485,000.00 2,000,000.00 24,000.00 20,000.00 200,000.00 6,000.00 Figure 4.2: Management Accounting accounts <?page no="54"?> 150,000.00 30,000.00 30,000.00 1,010,380.00 120,000.00 90,000.00 120,000.00 13,200.20 51,300.00 247,500.00 4,000.00 30,000.00 90,000.00 600,000.00 270,000.00 450,000.00 720,000.00 600,000.00 66,001.00 256,500.00 1,237,500.00 20,000.00 2,000,000.00 5,051,900.00 Figure 4.2: Management Accounting accounts (continued) Ad (C2): Management Accounting Basic Features <?page no="55"?> 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 can be either prepared for budgeted or actual amounts and it frequently is for monthly Accounting periods. DR Raw Materials (alu).......... 600,000.00 GBP CR Purchase..................... 600,000.00 GBP <?page no="56"?> DR Raw Materials (hin).......... 450,000.00 GBP CR Purchase..................... 450,000.00 GBP DR Raw Materials (pan).......... 600,000.00 GBP CR Purchase..................... 600,000.00 GBP DR Raw Materials (slb).......... 66,001.00 GBP CR Purchase..................... 66,001.00 GBP DR Raw Materials (str).......... 256,500.00 GBP CR Purchase..................... 256,500.00 GBP DR Raw Materials (fst).......... 1,237,500.00 GBP CR Purchase..................... 1,237,500.00 GBP 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 which gives a 1 : n relationship per cost category. It requires cost allocations. Direct costs are debited to the WIPaccounts whereas indirect costs are overheads. Most common direct costs are direct materials and direct labour. Overhead costs are costs that apply for more than one product. They cannot be traced to a single product but are assigned to cost centres and are later allocated to products based on <?page no="57"?> cost rates. Another term for overheads is indirect costs. Examples for overheads are labour for the supervisor, factory rent, security service, material procurement costs etc. 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. Work-in-process and work-inprogress is used interchangeably in literature. We mostly say WIP. 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 <?page no="58"?> 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 account are closed-off directly to the Profit and Loss account. As the nonmanufacturing overheads skip the production cost centres the costs cannot be allocated to products. They fall under period costs. 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 DR MOH Account.................. 15,000.00 GBP CR Raw Materials (scr).......... 15,000.00 GBP DR MOH Account.................. 90,000.00 GBP CR Rent......................... 90,000.00 GBP DR MOH Account.................. 30,000.00 GBP CR Depreciation................. 30,000.00 GBP <?page no="59"?> 400,000.00 26,000.00 400,000.00 200,000.00 180,000.00 6,062,280.00 90,000.00 720,000.00 270,000.00 79,201.20 307,800.00 1,485,000.00 2,000,000.00 24,000.00 20,000.00 200,000.00 6,000.00 150,000.00 30,000.00 30,000.00 1,010,380.00 120,000.00 120,000.00 150,000.00 150,000.00 90,000.00 120,000.00 120,000.00 13,200.20 51,300.00 247,500.00 4,000.00 30,000.00 30,000.00 90,000.00 90,000.00 600,000.00 600,000.00 270,000.00 450,000.00 450,000.00 720,000.00 600,000.00 600,000.00 66,001.00 66,001.00 256,500.00 256,500.00 1,237,500.00 1,237,500.00 20,000.00 20,000.00 Figure 4.3: Manufacturing Accounting’s accounts after 1 st allocation <?page no="60"?> 2,000,000.00 1,200,000.00 5,051,900.00 800,000.00 2,000,000.00 2,000,000.00 600,000.00 400,000.00 450,000.00 300,000.00 120,000.00 90,000.00 80,000.00 60,000.00 600,000.00 600,000.00 450,000.00 450,000.00 80,000.00 60,000.00 600,000.00 500,000.00 66,001.00 50,770.00 100,000.00 15,231.00 600,000.00 600,000.00 66,001.00 66,001.00 100,000.00 15,231.00 256,500.00 190,000.00 1,237,500.00 1,000,000.00 57,000.00 200,000.00 9,500.00 37,500.00 256,500.00 256,500.00 1,237,500.00 1,237,500.00 9,500.00 37,500.00 20,000.00 15,000.00 1,200,000.00 5,000.00 15,000.00 20,000.00 20,000.00 90,000.00 5,000.00 30,000.00 400,000.00 120,000.00 300,000.00 90,000.00 500,000.00 50,770.00 190,000.00 57,000.00 1,000,000.00 200,000.00 800,000.00 Figure 4.3: Manufacturing Accounting’s accounts after 1 st allocation (continued) <?page no="61"?> 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 thereafter. As the cost rates are often budgeted data, they come as budgeted costs divided by the planned output. Actual data are likely to differ from the predetermined overhead allocation rate which results in overand under-applied overheads. This means 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 in order to assign the overheads to the Accounting period they occurred in. 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 <?page no="62"?> 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 Figure 4.4: Cost of manufacturing report <?page no="63"?> The sales department needs to know for pricing products and services. DR FG Inventory Window .......... 3,302,500.00 GBP CR WIP Account Window ........... 3,302,500.00 GBP DR FG Inventory Door............ 940,270.00 GBP CR WIP Account Door............. 940,270.00 GBP A Cost of Goods Sold account records the unit costs of manufacturing times the amount for goods sold during the Accounting period as costs. Also, goods produced in previous Accounting periods can be released from stock and become cost of goods sold of the actual Accounting period. 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 <?page no="64"?> Figure 4.5: Cost of goods sold report 400,000.00 26,000.00 400,000.00 200,000.00 180,000.00 6,062,280.00 90,000.00 720,000.00 270,000.00 79,201.20 307,800.00 1,485,000.00 2,000,000.00 24,000.00 1,480,278.80 6,662,280.00 6,662,280.00 1,480,278.80 Figure 4.6: Management Accounting’s accounts <?page no="65"?> 20,000.00 200,000.00 6,000.00 6,000.00 180,000.00 200,000.00 200,000.00 180,000.00 150,000.00 30,000.00 30,000.00 1,010,380.00 120,000.00 120,000.00 150,000.00 150,000.00 90,000.00 120,000.00 120,000.00 13,200.20 51,300.00 247,500.00 4,000.00 334,379.80 1,010,380.00 1,010,380.00 334,379.80 30,000.00 30,000.00 90,000.00 90,000.00 600,000.00 600,000.00 270,000.00 450,000.00 450,000.00 990,000.00 720,000.00 600,000.00 600,000.00 990,000.00 990,000.00 66,001.00 66,001.00 990,000.00 256,500.00 256,500.00 1,237,500.00 1,237,500.00 20,000.00 20,000.00 3,230,001.00 3,230,001.00 2,000,000.00 1,200,000.00 5,051,900.00 5,051,900.00 800,000.00 2,000,000.00 2,000,000.00 Figure 4.6: Management Accounting’s accounts (continued) <?page no="66"?> 600,000.00 400,000.00 450,000.00 300,000.00 120,000.00 90,000.00 80,000.00 60,000.00 600,000.00 600,000.00 450,000.00 450,000.00 80,000.00 60,000.00 600,000.00 500,000.00 66,001.00 50,770.00 100,000.00 15,231.00 600,000.00 600,000.00 66,001.00 66,001.00 100,000.00 15,231.00 256,500.00 190,000.00 1,237,500.00 1,000,000.00 57,000.00 200,000.00 9,500.00 37,500.00 256,500.00 256,500.00 1,237,500.00 1,237,500.00 9,500.00 37,500.00 20,000.00 15,000.00 1,200,000.00 800,000.00 5,000.00 15,000.00 400,000.00 20,000.00 20,000.00 90,000.00 112,500.00 5,000.00 30,000.00 22,500.00 1,335,000.00 1,335,000.00 400,000.00 3,302,500.00 120,000.00 940,270.00 300,000.00 90,000.00 500,000.00 50,770.00 190,000.00 57,000.00 1,000,000.00 200,000.00 800,000.00 400,000.00 112,500.00 22,500.00 3,302,500.00 3,302,500.00 940,270.00 940,270.00 800,000.00 800,000.00 3,089,819.00 3,910,674.71 820,855.71 3,910,674.71 3,910,674.71 Figure 4.6: Management Accounting’s accounts (continued) <?page no="67"?> 3,302,500.00 3,089,819.00 940,270.00 820,855.71 212,681.00 119,414.29 3,302,500.00 3,302,500.00 940,270.00 940,270.00 212,681.00 119,414.29 3,910,674.71 5,051,900.00 800,000.00 6,000.00 335,225.29 5,051,900.00 5,051,900.00 335,225.29 Figure 4.6: Management Accounting’s accounts (continued) 5,051,900 (3,910,675) 1,141,225 (800,000) (6,000) 335,225 Figure 4.7: Profitability Analysis <?page no="68"?> 120,000 400,000 335,225 639,326 180,000 1,324,380 1,480,279 2,239,605 2,239,605 Figure 4.8: Pro forma balance sheet based on Management Accounting data <?page no="69"?> 2,575 2,575 2,830 2,830 480 480 530 530 2,317,500 2,317,500 2,830,000 2,830,000 768,000 768,000 901,000 901,000 3,088,555 3,088,555 3,734,360 3,734,360 Figure 4.9: Revenue plan <?page no="70"?> 200,000 6,000 20,000 180,000 180,000 5,400 20,000 160,000 160,000 4,800 20,000 140,000 Figure 4.10: Interest and pay-off schedule 1,735,550 1,735,550 1,698,000 1,698,000 460,320 460,320 518,340 518,340 400,000 400,000 400,000 400,000 2,700 2,700 2,400 2,400 2,598,570 2,598,570 2,618,740 2,618,740 Figure 4.11: Cost plan <?page no="71"?> 3,088,555 3,088,555 3,734,360 3,734,360 (2,598,570) (2,598,570) (2,618,740) (2,618,740) 489,985 489,985 1,115,620 1,115,620 979,970 2,231,240 (293,991) (669,372) 685,979 1,561,868 685,979 1,561,868 Figure 4.12: Profitability plan <?page no="72"?> 120,000 90,000 60,000 639,326 639,326 639,326 1,145,899 2,035,301 3,982,550 1,905,225 2,764,628 4,681,877 400,000 400,000 400,000 234,658 920,637 2,482,505 180,000 160,000 140,000 990,000 990,000 990,000 100,568 293,991 669,372 1,905,225 2,764,628 4,681,877 Figure 4.13: Budgeted balance sheet (annual) <?page no="73"?> 2,575 2,575 2,830 2,830 480 480 530 530 2,317,500 2,317,500 2,830,000 2,830,000 768,000 768,000 901,000 901,000 3,088,555 3,088,555 3,734,360 3,734,360 1,735,550 1,735,550 1,698,000 1,698,000 460,320 460,320 518,340 518,340 400,000 400,000 400,000 400,000 2,700 2,700 2,400 2,400 2,598,570 2,598,570 2,618,740 2,618,740 3,088,555 3,088,555 3,734,360 3,734,360 (2,598,570) (2,598,570) (2,618,740) (2,618,740) 489,985 489,985 1,115,620 1,115,620 979,970 2,231,240 (293,991) (669,372) 685,979 1,561,868 685,979 1,561,868 n/ a 90,000 n/ a 60,000 n/ a 639,326 n/ a 639,326 n/ a 2,035,301 n/ a 3,982,550 n/ a 2,764,628 n/ a 4,681,877 n/ a 400,000 n/ a 400,000 n/ a 920,637 n/ a 2,482,505 n/ a 160,000 n/ a 140,000 n/ a 990,000 n/ a 990,000 n/ a 293,991 n/ a 669,372 n/ a 2,764,628 n/ a 4,681,877 Figure 4.14: Business plan for PENOR PLC <?page no="74"?> 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, 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 along the cost of sales format. The business plan is prepared as a result of 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 support of managers. Mostly it is used to answer the basic questions in business: ‘What does the product/ service cost? ’, ‘Is the business successful/ profitable? ’, How much are future costs? ’, ‘Does the company generate cash? ’ and: ‘Are there substantial deviations from the budget? ’. Working Definitions: 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 amount for 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 in order 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="75"?> 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. 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: 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 amount 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. Solutions: 1-3; 2-3; 3-4; 4-1; 5-2. <?page no="76"?> What is in the Chapter? The chapter (5) Characteristics of Management Accounting and Major Differences to Financial Accounting explains Management Accounting in general, not based on a case as in the previous chapters. It shows and explains the differences to Financial Accounting. Learning Objectives: In this chapter, you learn the main characteristics of Management Accounting and compare them to Financial Accounting We cover the basics of Management Accounting and introduce its technical terms. After studying the chapter, you will gain a sound knowledge of Management Accounting and its concepts. You’ll know the technical terms and their meaning. The aspects below will be discussed as the main differences between Management Accounting and Financial Accounting. - Management Accounting includes 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 about allocations. - Management Accounting is shortterm: mostly for periods less than one fiscal year. - Management Accounting’s focus is on deviations. - Management Accounting reports to managers. Management Accounting Includes Planning/ Budgeting Financial Accounting is about reporting to owners and the authorities. It informs 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 approved budgets. An approved cost plan is the budget. A budget is the same as a business plan. It contains at least the approved revenue planning, cost planning, profit planning and liquidity planning. Budgets are in the details. In contrast to the business plan which is related to the whole company, a budget is mostly linked to cost centres. The detail level determines the quality of cost information but also causes Accounting workload to increase. Management Accountants calculate profit and cash flows figures based on planned business operations, as derived from production quantities. Frequently, the budget does not come out <?page no="77"?> straight. It is more a kind of loop process that also includes negotiations between the involved departments and requires coordination and compromising. Do not understand a budget or a business plan as forecast but as planning of future economic activities. The amount of what is to be planned in the future is a product/ service mix decision which is supported by Marketing Research. The process of preparing a budget often results in numerous plan versions before the cost plan is decided on and 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 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. It is a forum where future operations of the company are discussed in detail. The investors want to understand the economic outcome of future activities and their own benefits thereof. In non-Accounting terms, a budget is often regarded as a kind of allowance. This is not its meaning in Accounting. A budget shows the costs which are planned in order to produce a quantity of goods/ services to achieve a certain profit. Companies strive to plan costs as low as possible in order to be able to compete with other participants on the market. Hence, a good cost plan is one which meets the company’s performance goals at lowest costs. Therefore, a manager shall not overspend what has been budgeted. In order to keep costs at bay, actual costs are compared to budgets, which we refer to as monitoring. Checking cost deviations helps a company to achieve its financial goals. We cover monitoring in chapter (15). Management Accounting is not Required by Law In contrast to Financial Accounting, Management Accounting does not follow legal rules. Management Accounting is a discipline of Business and Management focussing on the support of managers with Accounting data. Its aim is to provide managers with useful information to control the business and to make the best decisions in the interest of the entire company. 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. fall under internal sources and must strictly remain undisclosed. They are not intended for company comparisons (except in case of benchmarking) but for controlling and making decision. The quality of Management Accounting calculations depends on the information needs of managers. It can even happen that a company budgets their processes on a highly aggregated level, e.g. based on entire product groups instead of single goods/ services. <?page no="78"?> 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 business. As a result, costs must be related to business operations. Management Accounting is based on cost information, e.g., for cost planning and monitoring and the profit and product calculation. In most cases, costs equal expenses. However, there are a few cases where costs are not expenses and where expenses are no costs. An airline can support a soccer team and records payments for sponsoring. As the soccer team is no aviation operation the support is not a cost. As Management Accounting focusses on operating activities, an expense that is not considered as costs is ignored for controlling. Expenses which do not fall under costs are disclosed on the income statement as other comprehensive expenses in Financial Accounting. In those cases, the income statement likely shows a different profit compared to Management Accounting data. On the other hand, there are costs which are no expenses, when no payment takes place. E.g., a B&B hotel’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 financial statements in order to increase profit. With no payment recorded this is legit. 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 for calculated costs are interest, if the company lends from its owners, calculated rent, if the company resides in buildings that belong to its owners and does not pay them rent, calculated labour if the owner works ‘for free’ in her/ his own business etc. In order to make the distinction between costs and expenses as easy as possible, in this textbook we assume expenses equal costs if not stated otherwise. <?page no="79"?> Management Accounting Works on a Different Details Level The level of precision differs between Financial Accounting and Management Accounting. Financial Accounting reports on company level but follows the regulations of recording business activities by Bookkeeping entries. In contrast, Management Accountants plan costs on aggregated levels. Management Accounting is About Allocations Decisions in a company are made by managers who in general are responsible for divisions, departments, cost centres or products. As a result, Management Accounting information must follow the objects decisions are made for. To create cost data linked to objects single or multiple cost allocations are required. We describe in chapter (13/ 14) the general cost flow through a Management Accounting system. In general, costs are allocated first to cost centres, thereafter to products. 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 difficult and often not precise. As a manager is responsible for the cost in her/ his cost centre, we call her/ him the cost centre responsible. Managers strive to meet the cost plans in the budget 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 low deviations from budget. Next, we describe how to allocate costs to cost centres. Allocations require a measurement for dividing costs. In general, allocations mean to divide something (costs) and assign portions thereof to objects, such as cost centres. <?page no="80"?> Cost allocations are subject to chapter (16). Management Accounting is for Periods Less than a Fiscal Year Management Accountants provide information for business control. In order to make decisions about (re-)directing resources and costs, the relevant data should preferably be provided on short notice. For this reason, Management Accountants plan and monitor costs for periods less than a year. Very commonly, monthly cost information is generated and reported. This gives for managers the chance for taking early corrective actions, once monitoring reveals that business 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 with regard to importance and understood. Recording cost monthly is an important precondition in order to provide appropriate information for cost control. Another argument for on time data availability is calculation. In order to fix selling prices, a company must know the cost of manufacturing. A company cannot wait until the Accounting period (year) is up for determination of the cost for its production/ service. Management Accounting’s Focus is on Deviations A main reason for running a Management Accounting system is to detect deviations. A deviation means that costs differ from budget. Before we discuss deviations, we consider the following: Budgeting strives to plan and decide on business activities that lead to a profitable performance. In general firms pursue profit, cash flow per se and return maximisation for its investors. An approved budget is based on the lowest doable costs for production or service rendering. A detailed cost plan shows for every cost centre budgeted cost, mostly per cost category. Assume all costs in the company would equal their budget. Then, the company will become as profitable as budgeted. Any <?page no="81"?> deviation causes an under-achievement of financial goals because every relevant deviation in costs will reduce profits and must be addressed. As the cost consumption is under responsibility of a cost centre manager, they want to compare actual costs to budget on a monthly basis. Management Accounting has to provide appropriate reports in order to support cost monitoring. Detected deviations are checked with regard to their relevance and in case of significance, the deviations are analysed to find reasons and measures to control or compensate costs. One of the major requirements for Management Accounting is the ability to frequently provide managers with deviation reports. Monitoring is succeeded by variance analysis of costs. 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 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. Managerial Accounting is mostly driven by requirements. Reports are based on the results of a detailed information requirements study. Managers are interviewed in order to find out what information they need and what the information should look like. In Management Accounting the term cockpit is very common. The Accountant provides all relevant information about the business to facilitate the managers piloting the company. The format of reports is based on the knowledge and understanding of Accounting by recipients. Note that not every manager holds a degree in Accounting. Hence, Management Accounting information is to be made easily accessible and easy to understand. In some cases, reporting information is not sufficient as more detailed data are required. The in-depth analysis in cost data is called drill-down and is add-on to monthly standard reports. The latter one will be called an exceptional reporting. 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. In particular, if the tax attorney is representing clients in court or at the revenue service she/ he must hold a degree as <?page no="82"?> Steuerberater (StB) and Wirtschafts prüfer (WP). In many other countries, postgrad uate studies are required for Mana gement 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. Summary: - Management Accounting comprises planning. - Management Accounting is not required by law. - Management Accounting is based on costs instead of expenses. - Management Accounting works on a different details level. - Management Accounting is about allocations. - Management Accounting is shortterm: mostly for periods less than a fiscal year. - Management Accounting’s focus is on deviations. - Management Accounting reports. - How to become an Accountant. 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 same as a budget. 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. Question Bank: (1) In Managerial Accounting … 1. … budgeting is required in order 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. <?page no="83"?> (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. Solutions: 1-4; 2-2; 3-3; 4-1; 5-3. <?page no="85"?> Section (2): Accounting for General Management <?page no="86"?> What is in the Chapter? This section starts with the planning of the company’s operations by chapter (6) Cost Planning / Business Plan. The case study in chapter 6 KIRSTENBOSCH (Pty) Ltd. is about a fast food business. We show 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 case study McTOY GmbH, we cover a more complex case for a production firm. McTOY GmbH produces different kind of goods (toys) and we study the budgeting process for multiple products and changing prices during these periods. A third business plan SCHLUCHMAN is prepared in order to demonstrate changes in the legal form of a company. SCHLUCHMAN is a case study linked to Hospitality Management; it is a caterer business case. Learning Objectives: Planning is one of the most important features in Management Accounting. In this chapter, you learn performance and cost planning for business. After studying this chapter, you understand the planning concept of Managerial Accounting. You should be able to prepare a business plan for an entire company and clearly understand the difference between profitability and liquidity planning: Profitability is based on revenue and costs - liquidity on payments. To plan the operations of a business, we must anticipate and decide on its activities in the upcoming Accounting periods. In Managerial Accounting, the term budgeting for the preparation of a business plan is common. A budget is an approved plan. The core element of a business plan is cost and profit planning. It requires performance information, given as the output of cost centres which can be derived from the amount of goods and services produced. For a cost plan, different combinations of resource deployment can apply. Management Accounting combines many resources. Often departments compete in regard of the allocation of resources. In a real business, single departments prepare their cost plans and the Management Accountant’s task is the coordination of the partial plans towards a master budget. We here focus on easy company structures and discuss business planning for small case studies in order to teach you budgeting. For the preparation of a business plan, we schedule future activities and determine their effects on costs and revenue. We prepare internal financial statements, like profitability, liquidity and budgeted balance sheets. A common structure for a business plan is to divide the business plan in: (1) Revenue plan. (2) Cost plan. (3) Profit plan. (4) Liquidity plan and/ or cash flow statement. (5) Budgeted balance sheet. <?page no="87"?> We follow the latter approach and next study the company KIRSTEN BOSCH (Pty) Ltd. Date Sheet for KIRSTENBOSCH (Pty) Ltd. <?page no="88"?> Ad (1 KB ): Revenue Plan 27 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. Figure 6.1: KIRSTENBOSCH (Pty) Ltd.’s revenue plan Ad (2 KB ): Cost Plan KIRSTENBOSCH (Pty) Ltd.’s cost plan is the next one to prepare. 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 level for an Accounting period. <?page no="89"?> Figure 6.2: KIRSTENBOSCH (Pty) Ltd.’s interest and pay-off schedule We are marking the interest column for budgeting. Figure 6.3: KIRSTENBOSCH (Pty) Ltd.’s cost plan Ad (3 KB ): Profit Plan A profit plan is a schedule where planned and budgeted costs are deducted from the revenues for an Accounting period. The profit plan is referred to as the profitability analysis by Management Accountants. As income taxes depend on the profit for the period, tax expenses are disclosed on the profit plan, too. The appropriation of profits is also subject to the profit planning and is shown at the bottom line of the profit plan. <?page no="90"?> Figure 6.4: KIRSTENBOSCH (Pty) Ltd.’s profitability plan Ad (4 KB ): Liquidity Plan So far, we only considered profitability values. Profitability values determine profit. They are revenues and costs/ expenses. Besides of profit maximisation, companies strive to generate cash. A positive cash flow is the increase of cash/ bank. A cash flow results from payments or money transfers. As higher the cash flow is, as higher becomes the probability for a company to stay solvent. Profitability amounts can differ from payments. E.g., a company that pays for an investment creates a cash outflow in the first Accounting period which is no cost. In the next following Accounting periods, the company depreciates the asset gives it costs 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 amount of the Cash/ Bank account, adds cash inflows and deducts cash outflows for a future Accounting period. The bottom line on the liquidity plan discloses the balance of the Cash/ Bank account. It is also called liquidity. <?page no="91"?> Figure 6.5: KIRSTENBOSCH (Pty) Ltd.’s liquidity plan <?page no="92"?> Companies strive to guarantee the liquidity to be positive, but try to keep it as low as possible. Cash reserves are not deployed in form of investments and do not contribute to a company’s return. Therefore, we keep the liquidity as low as possible but must guarantee it stays positive. 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 amends 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 towards a bankruptcy. Ad (5 KB ): Budgeted Balance Sheet In order to analyse a business future financial position, companies prepare a budgeted balance sheet. A budgeted balance sheet is a pro-forma statement of financial position at a future balance sheet date. The budgeted balance sheet is prepared for the last day of the period covered by the business plan. The budgeted balance sheet does not have to follow IFRS requirements. 28 <?page no="93"?> Figure 6.6: KIRSTENBOSCH (Pty) Ltd.’s pro-forma balance sheet Ad (4 KB ): Cash Flow Statement We discuss liquidity again, however, this time from a more Financial Accounting point of view as a future cash flow statement. A planned cash flow statement is a list of future operating cash flows, investing cash flows and financial cash flows. The list is on cash flow group level mostly. Many companies ascertain the operating cash flow by reconciliation of the net operating <?page no="94"?> profit with the operating cash flow. You’ll understand that it means less Accounting work. The cash flow statement contains similar data as the liquidity plan. In contrast, the structure of cash flows is based on its triggers: operating activities, investing activities and financial activities. Figure 6.7: KIRSTENBOSCH (Pty) Ltd.’s statement of cash flows <?page no="95"?> How it is Done (Business Plan) (1) Determine the amount of goods/ services that are intended to be sold. (2) Determine net selling prices by Marketing Research. (3) Calculate the revenue by multiplying sales amounts × 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. Deduct income tax expenses from earnings before taxes by multiplying the earnings before taxes × total tax rate (in the text book always 30 %). (8) Consider the appropriation of earnings after taxes as either (a) profit carried forward, (b) dividend or (c) reserves. Follow the policy of the company’s appropriation of profits. (9) Prepare a liquidity plan by direct method or reconciliation of profits with operating cash flows. (10) Deduct cash outflows from opening cash/ bank item and from cash inflows to 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 in order to access business. (13) If the result of the business plan is unsatisfying change the business concept and rework from step (1) onwards. After studying a business plan for a service provider, we take it a step further. A business plan for a production firm is more complicated, because it considers materials that cause inventory movements. We present the case study McTOY GmbH, which is a German toy manufacturer. <?page no="96"?> Ad (1 McT ): Revenue Plan 29 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="97"?> Before we cover the business plan, we show the data sheet for McToy GmbH. Data Sheet for McToy GmbH Ad (2 McT ): Cost Plan <?page no="98"?> Figure 6.10: McTOY GmbH’s cost plan (partial) A routing is a document in a production firm that tells how much time a production step on which machine group takes to get processed. Figure 6.11: McTOY GmbH’s routing information (1) <?page no="99"?> Figure 6.12: McTOY GmbH’s routing information (2) Figure 6.13: McTOY GmbH’s cost plan (partial) <?page no="100"?> Figure 6.14: McTOY GmbH’s bank loan <?page no="101"?> Figure 6.15: McTOY GmbH’s aggregated cost plan Ad (3 McT ): Profit Plan <?page no="102"?> Figure 6.16: McTOY GmbH’s profit plan Ad (4 McT ): Liquidity Plan <?page no="103"?> Figure 6.17: McTOY GmbH’s liquidity plan <?page no="104"?> Ad (5 McT ): Budgeted Balance Sheet Figure 6.18: McTOY GmbH’s budgeted balance sheet <?page no="105"?> The third business plan is about a company that changes its legal form. Therefore, it is more complex and relevant for study legal aspects, too. The case study SCHLUCHMAN is linked to Hospitality Management. The owner Mr Schluchman starts a privately-owned company and later transfers it into a privately-owned limited company in the legal form of a German GmbH after two years. We prepare a business plan for 4 years. Find below the data sheet for SCHLUCHMAN: Date Sheet for SCHLUCHMAN <?page no="106"?> Data Sheet for MOBILE TARTE FLAMBEE GmbH <?page no="108"?> Ad (1 Sch ): Revenue Plan 45,000 45,000 200,000 237,500 64,800 64,800 240,000 285,000 109,800 109,800 440,000 522,500 Figure 6.19: Mr Schluchman’s/ MOBILE TARTE FLAMBEE GmbH’s revenue plan Ad (2 Sch ): Cost Plan <?page no="109"?> 750 750 2,500 2,500 750 750 60 40 240 160 120 120 120 400 500 5,000 5,000 5,100 5,100 2,160 2,160 8,000 9,500 24,060 24,060 91,133 106,758 14,400 14,400 144,000 171,000 2,400 40,000 45,000 48,950 46,530 292,243 341,268 Figure 6.20: Mr Schluchman’s / MOBILE TARTE FLAMBEE GmbH’s cost plan <?page no="110"?> Ad (3 Sch ): Profit Plan <?page no="111"?> 109,800 109,800 440,000 522,500 (48,950) (46,530) (290,943) (339,968) 60,850 63,270 149,057 182,532 0 0 (44,717) (54,760) 60,850 63,270 104,340 127,772 52,170 63,886 52,170 63,886 65,668 63,264 13,267 12,305 Figure 6.21: Mr Schluchman’s / MOBILE TARTE FLAMBEE GmbH’s profitability plan <?page no="112"?> Ad (4 Sch ): Liquidity Plan 10,000 9,651 40,000 243,800 109,800 109,800 440,000 522,500 88,000 104,500 (88,000) (21,200) 0 (11,200) (1,500) 0 (1,500) (6,000) 2,000 (60) (40) (240) (160) (500) (500) (2,000) (2,000) (120) (360) 0 (1,440) (360) 240 (2,190) (2,160) (9,750) (11,400) 1,625 (19,272) (24,066) (107,950) (126,550) 17,992 (14,400) (14,400) (144,000) (171,000) (2,400) 0 0 0 (40,000) (45,000) (52,170) (48,267) (47,305) (44,717) 9,651 30,980 243,800 351,300 Figure 6.22: Mr Schluchman’s / MOBILE TARTE FLAMBEE GmbH’s liquidity plan <?page no="114"?> Ad (5 Sch ): Budgeted Balance Sheet 2,250 1,500 7,500 5,000 750 0 240 120 800 600 0 16,200 11,200 6,100 1,000 30 30 125 125 30 30 125 125 21,857 23,052 9,651 30,980 243,800 351,300 28,401 43,860 281,057 381,202 10,000 10,000 40,000 40,000 52,170 116,056 12,583 28,548 0 0 88,000 104,500 1,000 500 4,000 2,000 52,170 63,886 4,818 4,812 44,717 54,760 28,401 43,860 281,057 381,202 Figure 6.23: Mr Schluchman’s / MOBILE TARTE FLAMBEE GmbH’s balance sheet <?page no="115"?> Summary: Companies plan their operations for the next upcoming Accounting periods and disclose the results on 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 cases. 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 amount 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 tells how much time a production step on which machine group takes to get processed. 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. <?page no="116"?> (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. Solutions: 1-2; 2-4; 3-2; 4-3; 5-1. <?page no="117"?> What is in the Chapter? In this chapter (7) Cost Concepts, Cost Behaviour and Cost Separation, we study behaviour of costs. This means we try to understand whether costs change with the performance or they whether they stay constant. We strive to determine what drives costs in order to predict them for different outputs. The output of a company is the quantity of goods it produces or services it renders. The performance of cost centres depends proportionally from the output a company produces. In order to keep Accounting simple, we only study the reaction of costs to the performance. Behavioural Accounting is important for cost planning based on the future operations of a business. 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 case study DANNING (Pty) Ltd. which is a law firm in Australia. Learning Objectives: In this chapter, you learn the basic concepts to plan costs on output/ performance figures. We distinguish proportional and fixed costs. Proportional costs change with the performance in a cost centre. For budgeting, we need to know if and whether they do, how costs change with the performance. From studying cost behaviour, Management Accountants know what drives proportional costs or which costs are fixed. Knowing the cost functions ‘cost over performance’ we understand what costs are to be expected for a specific quantity of goods or services. After studying this chapter, you 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. We teach you the most common methods for cost function determination. You will be able to apply the methods and know their strengths and weak points and can estimate the effort for their application. We distinguish between fixed and variable costs. Variable costs depend on the output of the business whereas fixed costs remain unchanged no matter how much the output is. 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 farther below. Costs represent a consumption of resources and are linked to business operations. E.g., materials only count as a cost, when 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 = 2,190.00 EUR as illustrated by Figure 6.21. The difference to the extent of: 2,190 - 2,160 = 30.00 EUR comes <?page no="118"?> 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. 33 For the sake of correct terminology, we introduce common cost concepts in 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. Ad (1): 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. The first one (direct materials) is firstly recorded in the Raw Materials Inventory account and contains all materials bought from suppliers. Raw materials can be dough for a pizza restaurant or a full headlight component for a car manufacturer. When 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. They are added to the cost of a cost centre (MOH-account). Direct labour is labour costs that is assigned straight to the product/ service. Some manufacturers call direct labour ‘touch labour’ in order 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. Ad (2): 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 associated with production of goods or service rendering but, e.g., with selling, administration (SG&A). In Accounting, nonmanufacturing costs shall not be 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 these costs as period costs. In Management Accounting, two further technical terms are frequently in use: prime costs and costs of conversion. Prime costs are direct materials and direct labour. The costs of conversion contain direct labour and manufacturing overheads. The latter one represents <?page no="119"?> the costs necessary to convert the materials into the finished product but no 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. Ad (3): Product vs. Period Costs The classification in product and period costs is based on the disclosure of costs on the 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, the product costs are deferred to later Accounting periods when they get sold. This means, the cost consideration on the income statement is delayed until goods are sold. We say product costs are ‘parked’ in inventory until sales takes place. In contrast, period costs are linked to the Accounting period they occur in. Period costs cannot be assigned to inventory as they elapse after the Accounting period. No cost parking is possible. 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 nonmanufacturing costs, like for administration, sales, Accounting etc. Data Sheet for STAFFORD (Pty) Ltd. We study the Bookkeeping entries below: <?page no="120"?> DR Cash/ Bank.................... 1,000,000.00 ZAR CR Issued Capital............... 1,000,000.00 ZAR DR Raw Materials Inventory...... 800,000.00 ZAR CR Cash/ Bank.................... 800,000.00 ZAR DR Labour....................... 1,900,000.00 ZAR CR Cash/ Bank.................... 1,900,000.00 ZAR DR P, P, E Account.............. 4,000,000.00 ZAR CR Cash/ Bank.................... 4,000,000.00 ZAR DR Depreciation................. 500,000.00 ZAR CR Acc. Depr.................... 500,000.00 ZAR DR Cash/ Bank.................... 8,500,000.00 ZAR CR Revenue...................... 8,500,000.00 ZAR 1,000,000.00 800,000.00 1,000,000.00 8,500,000.00 1,900,000.00 4,000,000.00 Figure 7.1: STAFFORD (Pty) Ltd.’s accounts <?page no="121"?> 800,000.00 1,900,000.00 4,000,000.00 8,500,000.00 500,000.00 500,000.00 Figure 7.1: STAFFORD (Pty) Ltd.’s accounts (continued) 1,000,000.00 800,000.00 1,000,000.00 1,000,000.00 8,500,000.00 1,900,000.00 1,000,000.00 4,000,000.00 2,800,000.00 9,500,000.00 9,500,000.00 2,800,000.00 800,000.00 640,000.00 1,900,000.00 1,600,000.00 160,000.00 220,000.00 800,000.00 800,000.00 80,000.00 160,000.00 1,900,000.00 1,900,000.00 Figure 7.2: STAFFORD (Pty) Ltd.’s accounts <?page no="122"?> 4,000,000.00 4,000,000.00 8,500,000.00 8,500,000.00 4,000,000.00 500,000.00 500,000.00 500,000.00 500,000.00 500,000.00 640,000.00 2,960,000.00 220,000.00 720,000.00 1,600,000.00 500,000.00 720,000.00 720,000.00 720,000.00 2,960,000.00 2,960,000.00 2,960,000.00 2,312,500.00 2,312,500.00 2,312,500.00 647,500.00 2,960,000.00 2,960,000.00 647,500.00 2,312,500.00 8,500,000.00 80,000.00 80,000.00 80,000.00 6,107,500.00 8,500,000.00 8,500,000.00 1,832,250.00 6,107,500.00 4,275,250.00 6,107,500.00 6,107,500.00 1,832,250.00 1,832,250.00 4,275,250.00 4,275,250.00 1,832,250.00 4,275,250.00 Figure 7.2: STAFFORD (Pty) Ltd.’s accounts (continued) <?page no="123"?> Figure 7.3: STAFFORD (Pty) Ltd.’s income statement <?page no="124"?> Figure 7.4: STAFFORD (Pty) Ltd.’s balance sheet Ad (4): 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 the output. Variable cost change with the output of a company. We acknowledge: Proportional costs depend directly on the output. In order to understand the dependencies, 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 amount of dash boards installed. Also, assembling costs depend proportionally on the assembling time. Hence, we classify assembling costs as 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, depreciation stays constant. Further cost behavioural patterns are step-fixed costs. Those are costs that <?page no="125"?> 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 of 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 to find out, 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 in companies. Hence, your effort for separating costs can become very intense. There are more efficient ways for cost separation. All methods start from the total 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. <?page no="126"?> Figure 7.5: DANNING (Pty) Ltd.’s cost volume records Ad (a): High-low Method 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. Ad (b): Scatter Graph The scatter graph is based on a graphic diagram of the cost over factor observations and requires to manually draw a line in the diagram that way that most observation marks are on or close to the line. <?page no="127"?> Figure 7.6: DANNING (Pty) Ltd.’s Cost Separation by scatter graph method Ad (c): Regression Method The regression method calculates the function’s parameter based on all plotted observations mathematically. It determines a function by minimising the difference between the square deviations and the function line that way that all observations are on the calculated cost function or closest thereto. <?page no="128"?> The cost formula to be determined comes with the common structure as: C (TS) = PC × TS + FC (with: C = total costs, TS = tax statements, PC = proportional costs, FC = fixed costs) The first equation for the Cost Separation is based on i rectangles, which have an area of: TS i × C i , with i = 1 … 4 for 4 monthly observations. i i i i i i i TS PC TS FC TS C (with: C = total costs, TS = tax statements, PC = proportional costs, FC = fixed costs) The second equation is based on the cost amounts only. There are 4 costamounts C i . We want to divide costs in a proportional and a fixed portion. i i i i TS PC FC C For a convenient calculation, we determine a few sums used in the equations. 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. Figure 7.7: Workings for regression analysis <?page no="129"?> 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 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 (2) n i n i i i X a b n Y 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 most likely selling price based on the observations from in the past. <?page no="130"?> 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 call it ‘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 the 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) 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="131"?> 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 which is the opposite leg of the angle divided by its adjacent leg. Figure 7.9: Calculation of the slope of Y(X) By the next step we study the 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="132"?> Figure 7.10: Areas A and C for the function Y(X) The area A got the size: b × X 1 . With regard to 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 equals 1. This will be the case if: = 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 is less than 45° the tangent “squeezes” the area. E.g., if = 30° a becomes: a = tan 30° = 0.57. As a result, the square area is multiplied by the factor 57%. This will squeeze the square and the area C becomes a flat rectangle. This applies for the area C in Figure 7.10. In all cases where the angle exceeds 45°, e.g. if = 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="133"?> 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 × (X 12 + X 22 ) We now study the equation (2) for 2 observations as well: (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 Yamounts represent the costs for the monthly observations Y 1 and Y 2 . On the right-hand side, there are two summands. The first one represents the portion of Y-amounts that does not depend on Y. Therefore, the first summand got the height of: 2 × b. The second summand is the amount of (Y 1 - b) and (Y 2 - b) that depends proportionally on X i . <?page no="134"?> Figure 7.12: Function Y(X) = a × X +b The slope of the function Y(X) is a and can be calculated as a = tan = (Y 1 - b) / X 1 . Check Figure 7.12. The same applies for the second mark on the function that represents the second observation: a = tan = (Y 2 - b) / X 2 . If the slope of the function is positive the contribution for the second observation to the Y-amount will be higher than for the first one because Y i - b = a × X i = tan × X i . The equation below is valid: Y 1 + Y 2 = 2 × b + tan × (X 1 + X 2 ) The simple regression method is an instrument widely applied in Management Accounting in order to separate costs for cost functions that depend linear from a reference unit. Ad (5): Differential/ Sunk/ Opportunity Costs Most of the management problems are linked to decisions which is why costs should be calculated for alternatives in order to support decision making. Differential costs are the costs for one 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. had to hire an additional attorney for the next tax statement TS to be prepared, step fixed costs would apply. Differential costs are based on incremental costs. The increase or decrease <?page no="135"?> 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 drops, 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. 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. 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. 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 by reference units. Fixed costs do not depend on the output. Cost separation is a method to ascertain the amount of proportional costs and fixed costs in a business, 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 under neglect of 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. <?page no="136"?> 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 amount 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 parameter based on all plotted observations mathematically. It determines a function by minimising the difference between the square deviations and the function line that way that all observations are on the calculated cost function or closest thereto. Scatter Graph: The scatter graph is based on a graphic diagram of the cost over factor observations and requires to manually draw a line in the diagram that way that most observation 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. 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 / 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. <?page no="137"?> 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, highlow-method, 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. Solutions: 1-3; 2-3; 3-2; 4-1; 5-2. <?page no="138"?> What is in the Chapter? The chapter (8) Cost Volume Profit Analysis (CVP-Analysis) discusses how many products a business must produce and sell in order to breakeven. To break even indicates a scenario where revenue meets costs. E.g., a passenger flight’s certain load factor that tells the airline how many passengers on board make the flight earn zero profit. The airlines strive to exceed that threshold load factor operating their flights profitably. We demonstrate that the CVP-analysis is a more powerful tool than only to determine the critical quantity of products to break-even. It is widely used to decide about the launch of new products or changes in the service/ product mix. 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 when factors are unknown but can be assumed to be normally distributed around an estimated value. Learning Objectives: After studying this chapter, you understand that cost volume profit analysis requires a cost separation as discussed in the previous chapter (7) because cost behaviour is essential. You further understand how a CVP-Analysis helps managers to find the right level of activities. 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 where profitability begins. You also can apply the CVP-Analysis to determine what happens if changes in the business concept are made by running a what-if analysis. Another outcome of this chapter is that you’ll understand the calculation of probabilities for profit. The CVP-analysis is also known as break-even analysis. When a company starts its operations, at first fixed costs apply, e.g. depreciation on its investments. A business without investments is found very seldom. Think about a taxi company. It must first buy a car. Without investing, the company must lease the car which means, someone else (the lesser) covers fixed costs and charges the taxi company rent. Acquisitions of machinery lead to fixed costs for depreciation. The first unit of products must cover the fixed costs. Only after the business produces/ sells a quantity of goods or services to cover its fixed costs, revenue exceeds costs and the company earns a profit. We say, the company breakseven to indicate where revenue starts to exceed costs. <?page no="139"?> Management Accountants strive to find the right product/ service quantities in order to make the company profitable. No company 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. Next, we study the profit after breaking-even to understand what happens once the company exceeds the breakeven quantity. The following assumptions apply to study a CVP-analysis: (1) The selling prices per unit are constant. In particular, no discounts apply, no ‘buy 10 - get one free’. (2) The unit cost function is constant. This means variable costs do not change as a result of good/ service quantities. A cost separation must be possible. Furthermore, jump costs do not exist, which implies there are no step-fixed costs as the existing resources allow the production of all goods/ services considered. (3) Companies that are selling different goods must sell a constant mix of <?page no="140"?> goods. This requires that the goods ratio is constant, like ‘for 3 oranges sell 2 bananas’. 36 (4) There are no changes in inventories of finished goods. Production equals sales. No goods are added to stock 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 quantity where the revenue curve intersects the cost curve. 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) <?page no="141"?> Figure 8.1: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (1) Figure 8.2: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (2) <?page no="142"?> The break-even point in a CVP analysis is the quantity of goods or the activity level where the company earns a zero profit. Figure 8.3: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (3) What is the use of a CVP analysis for managers? Obviously, it is to know the break-even quantity. However, most companies operate beyond that point. Even when a company cannot predict the quantity of its products, it cannot deny the service when 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. However, in the case of DEERFIELD TOURS (Pty) Ltd. this kind of escape route is provided by the contract. A CVP-Analysis also supports managers making decisions with regard to adjusting the business concept and to predict whether or not changes result in profit improvements for the company. We continue studying DEERFIELD TOURS (Pty) Ltd. Now, we analyse possible changes in the business model: <?page no="143"?> Figure 8.4: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (base case) Figure 8.5: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (internet) <?page no="144"?> Figure 8.6: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (bungee jumping) <?page no="145"?> Figure 8.7: DEERFIELD TOURS (Pty) Ltd.’s Calculation of the adjusted net selling price 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 particular variables. Being no simulation means that no random figures apply. 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 major question for budgeting stays: How does DEERFIELD TOURS (Pty) Ltd. know, what happens to the quantity of customers, in response of product parameter changes? The answer is: They don’t know. However, the experience will proof what Marketing research estimates. We therefore study probabilities and distributions to predict customers’ decisions based on experiences in the past. We refer the DEERFIELD TOURS (Pty) Ltd. case again: <?page no="146"?> Figure 8.8: Observations <?page no="147"?> 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 to 0 and the standard deviation equals to 1. Tables for standard normal distributions give us the probability for each value. You find a table for the normal standard distribution in Figure 8.10. Figure 8.9: DEERFIELD TOURS (Pty) Ltd.’s break-even point (internet campaign) <?page no="149"?> Figure 8.10: Standard normal distribution table 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. In order to determine a break-even ‘point’ with a certain combination of products (product mix), Accountants assume a fixed ratio for the products sold. This narrows the solutions to one. A ratio between products gives for a certain quantity 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 traveller-ratio, see below. Data Sheet for KL tour <?page no="150"?> Figure 8.11: DEERFIELD TOURS (Pty) Ltd. 2-product statement <?page no="151"?> Figure 8.12: DEERFIELD TOURS (Pty) Ltd.’s 2-product statement (2) If the MS-Excel spreadsheet for the contribution income statement is wellstructured if we can calculate by the goal seek function. Figure 8.13: Goal seek function break-even point calculation <?page no="152"?> Figure 8.14: DEERFIELD TOURS 2-product statement (3) Summary: The cost volume profit analysis calculates profits for different product/ service/ activity levels. Frequently, the CVP analysis is applied in order to determine the break-even point. This is the output quantity where the company does not earn a profit (zeroprofit). A viable use of the CVP analysis is to study alterations of the business plan and test for the most profitable alternative. We recommend running CVP analysis on a spreadsheet program such as MS-Excel. Working Definitions: Break-Even Point: The break-even point in a CVP analysis is the goods quantity 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 particular variables. 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. (2) A company produces goods at proportional costs of 125.00 EUR/ u. The non-manufacturing <?page no="153"?> 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 in order 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 in order 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. Solutions: 1-2; 2-4; 3-3; 4-1; 5-1. <?page no="154"?> What is in the Chapter? The chapter (9) Degree of Operating Leverage (DOL) covers a concept for decision making with regard to fixed assets. Investments reduce the flexibility of a business due to lower liquidation options. They move the breakeven point towards higher outputs and in over-capacity situations, the fixed costs are divided to fewer products. The degree of operating leverage DOL is a factor that indicates how much profit or cash flow change in response of changes in revenues (outputs). Investments work as a leverage. As more a company invests as more profit increases due to higher sales quantities. But caution! The leverage works both ways, lower quantities of goods/ services make profits decrease. We study the DOL with the case study of DEERFIELD TOURS (Pty) Ltd. Later we introduce the new case study of the production firm. EMS KAYAK GmbH produces kayaks. 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, 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 with regard to investments. Managers strive to understand, how a business responds to changes. E.g., they need to know how much profit changes per 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 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: Output A,B = Output B / Output A - 1. <?page no="155"?> (4) Determine the percentage of changes in profit. The percentage increase/ decrease is: EBIT A,B = EBIT B / EBIT A - 1. (5) Calculate the Degree of Operating Leverage. It equals to: DOL A,B = EBIT A,B / Output A,B We start our considerations with the example from the previous chapter, DEERFIELD TOURS (Pty) Ltd. Figure 9.1: DEERFIELD TOURS (Pty) Ltd. break-even point Data Sheet for DEERFIELD TOURS (Pty) Ltd. 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 less 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="156"?> Figure 9.2: DEERFIELD TOURS (Pty) Ltd.’s/ profit calculation (1 additional traveller) Figure 9.3: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (11 travellers) <?page no="157"?> 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 Companies with a high DOL will experience high changes in profit when the sales quantities 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. Ad (1): DOL-Degression Effect The DOL depends on the absolute output quantity. As the profit equals to zero at the break-even point and we measure changes by percentage, profit changes close to the break-even point are relatively high. Ad (2): Fixed Costs The degree of operating leverage depends on fixed costs. Hence, it becomes a trade-off between enjoying the leverage to maximise profits and decreasing flexibility by making investments. Managers who change cost structures towards fixed costs, must tolerate a loss in flexibility. To understand the concept better, we study a new case where a company can adjust its fixed costs. This way, the company can enjoy the effects of high DOL when certain about selling beyond break-even. <?page no="158"?> We also study the impact of outputs on changes in operating cash flows. 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 deployable over a period of 5 years. Hence, it is committed to its cost structure for the upcoming Accounting periods. In preparation of DOL studies, we set up 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 <?page no="159"?> Figure 9.4: EMS KAYAK GmbH’s profit and cash flow Calculation (1) The Accounting break-even point is based on the output amount which makes the company earn a profit of zero. Figure 9.5: EMS KAYAK GmbH’s Accounting break-even point (2a) <?page no="160"?> The cash break-even point is based on the output quantity that makes the operating cash flow become zero. The cash break-even point only matters in Accounting periods when EMS KAYAK GmbH manufactures kayaks and receives returns from operations. Figure 9.6: EMS KAYAK GmbH’s profit and cash flow Calculation (2b) <?page no="161"?> Figure 9.7: EMS KAYAK GmbH’s cash break-even point (2b) We study the cash break-even point in cases, when a company needs to know, whether a project contributes to cash flows. We check the financial break-even point. It is relevant for investment decisions. The question is: how many goods/ services are to be produced/ rendered, in order 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 quantity where the net present value is zero. <?page no="162"?> Figure 9.8: EMS KAYAK GmbH’s financial break-even point (2c) Figure 9.9: EMS KAYAK GmbH’s financial break-even point (2c) After we checked the break-even points, we can study the degree of operating leverage DOL for alternative outputs. <?page no="163"?> Figure 9.10: EMS KAYAK GmbH’s profit and cash flow calculation (3) Figure 9.11: EMS KAYAK GmbH’s profit and cash flow calculation (4) <?page no="164"?> Figure 9.12: EMS KAYAK GmbH’s profit and cash flow calculation (5) <?page no="165"?> Figure 9.13: EMS KAYAK GmbH’s profit and cash flow calculation (6) Figure 9.14: EMS KAYAK GmbH’s profit and cash flow calculation (7) <?page no="166"?> 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 at 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 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 with less products. 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 calculate the effects properly. In order to determine the variable costs that can be added to an existing production scenario we study EMS KAYAK GmbH again at the breakeven point as depicted by Figure 9.5. <?page no="167"?> Figure 9.16: EMS KAYAK GmbH’s profit and cash flow plan for the farming out case We discussed break-even point shifting in order 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, machinery invested in 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. <?page no="168"?> Figure 9.17: EMS KAYAK GmbH’s break-even point Below, 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 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 reacts <?page no="169"?> to sales reductions by DOL × profit decreases. Working Definitions: Accounting Break-Even Point: The Accounting break-even point is based on the output amount which makes the company earn a profit of zero. Cash Break-even Point: The financial break-even point is based on the output quantity 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 the output quantity 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. 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. CF / EBIT. 2. CF / sales. 3. CF / proceeds. 4. sales / 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. <?page no="170"?> Solutions: 1-2; 2-4; 3-2; 4-1; 5-4. <?page no="171"?> What is in the Chapter? The chapter (10) Performance Measurement covers the measurement of output based on the case study VANHUIZEN BV which is a car windows tinting service. Performance is the major factor for a business to be successful and achieve its profit, return, cash 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. Learning Objectives: In this chapter, you learn different concepts of performance valuation. You learn the technical terms and performance ratios and get to know how to apply them. We analyse the impacts of different concepts for performance figures on managers’ decisions. Due to efficiency, it is required to monitor performance ratios regularly and to allocate resources to where their best performance is expected to be achieved. After this chapter, you know performance ratios and develop an awareness of how performance monitoring in your division works. Performance measurement refers to the achievements of an organisational unit, e.g. of a cost centre. We observe divisions and calculate which ones works best. For better understanding, we apply the case study VANHUIZEN BV 40 . <?page no="172"?> Data Sheet for VANHUIZEN BV: 832,000 832,000 (312,000) (5,000) (156,000) (40,000) (100,000) (40,000) 179,000 Figure 10.1: Profitability analysis for the GELDERN branch <?page no="173"?> 1,456,000 1,456,000 (546,000) (8,000) (273,000) (40,000) (200,000) (60,000) 329,000 Figure 10.2: Profitability analysis for the PIETERBUREN branch <?page no="174"?> Ad (a): Short-run (Variable) Contribution Margin Ad (b): Controllable Contribution Margin Ad (c): Divisional Contribution Margin Ad (d): Divisional Net Profit <?page no="175"?> 832,000 1,456,000 (468,000) (819,000) 364,000 637,000 (45,000) (48,000) 319,000 589,000 (140,000) (260,000) 179,000 329,000 (200,000) (200,000) (21,000) 129,000 Figure 10.3: Performance figures for VANHUIZEN BV <?page no="176"?> 832,000 1,456,000 (468,000) (819,000) 364,000 637,000 (45,000) (48,000) 319,000 589,000 (140,000) (260,000) 179,000 329,000 (200,000) (200,000) (21,000) 129,000 108,000 (32,400) 75,600 Figure 10.4: Profit calculation VANHUIZEN BV We discuss below: (1a) Return on investment. (1b) Return on equity. (2) Residual income. (3) Economic value added EVA TM . Ad (1a): Return on Investment The return on investment shows the profit as percentage of the invested funds. The consideration of assets helps to compare companies or divisions of different sizes. <?page no="177"?> Another disadvantage results from the denominator of the return on investment ratio. The denominator either is the initial investment (cost of acquisition) or the carrying amount of assets. In case the initial investment amount applies, managers are motivated to reinvest continuously, as new investments do not have an impact on their performance ratio. 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 enjoys riding a brand-new taxi car with low costs for maintenance. In case the carrying amount applies for the denominator of the return of investment figure, the taxi driver can reduce the rides after a few years, because the performance increases due to 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. If the taxi driver is driven by the idea to keep his return on investment on a constant level, she/ he 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 him/ her a ROI 3,half = 10,000 / (50,000 - 30,000) = 50.00 %/ a, same as in the first year. We study this effect with VANHUIZEN BV: <?page no="178"?> Ad (1b): Return on Equity The problem with regard to the denominator of the return on investment figure can be remedied by comparing returns on equity. However, this method does not apply for divisions, as there is no acceptable way in Accounting of how to allocate portions of equity to divisions. The return on equity shows the profit after taxation as percentage of the book value of the company. The return on equity gives the owners a performance ratio which is based on their investment. The owners hold the total of equity which includes reserves and retained earnings as well as the share capital. Hence, their input is the total book value of the company. The outcome of the company is the profit after taxes. It can be declared as a dividend to the shareholders. The application of the return on equity can be 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 the capital costs, a higher level of debts results in an increase of the return on equity. We look at VANHUIZEN BV again. <?page no="179"?> 832,000 1,456,000 (468,000) (819,000) 364,000 637,000 (45,000) (48,000) 319,000 589,000 (140,000) (260,000) 179,000 329,000 (211,000) (211,000) (32,000) 118,000 86,000 (25,800) 60,200 Figure 10.5: VANHUIZEN BV’s performance report (alternative capital structure) Capital structure theory has first been published by Modigliani and Miller and is therefore referred to as ‘MM theory’. The leverage effect is based on the capital structure and makes the return on equity a weak performance ratio if companies are compared with different capital structures. For divisional comparisons, the return on equity requires an allocation of equity to divisions which only can be done by valuebased allocations, e.g. along divisions’ asset. An alternative to the return on equity is the Earnings per share ratio. It is based on IAS 33 and divides the earnings available for distribution to ordinary shareholders by the number of ordinary shares outstanding. Note, treasury shares do not receive dividends. 41 For the earnings calculation, the profit after taxation is adjusted with regard to required payments, e.g. preference dividends, and to additions to legal reserves (in Germany for companies in the legal form of an AG), and hence not available for distributions to shareholders. The earnings are divided by the amount of <?page no="180"?> outstanding ordinary shares to compute the EPS figure. The earnings per share ratio gives the highest possible dividend that can be declared to the ordinary shareholders. By multiplying the EPS figure by the number of shares, the earnings per book value of the company are calculated. This is very close to a return on equity ratio except of the fact that it is related to only ordinary shareholders. Even as the EPS ratio is widely in use, it suffers from the capital structure impact as well as the return on equity. The only difference to a return on equity ratio lays in the adjustments. Furthermore, the allocation of company values to divisions can only be made by inaccurate allocations. Ad (2): Residual Income: The residual income is the profit or profit contribution after deduction of allocated capital costs. The residual income is calculated here as the controllable contribution margin less the cost of capital. It gives an absolute figure measured in EUR. Ad (3): Economic Value Added (EVA™) The economic value added EVA TM expresses how much the company increases in value by deducting the 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 divide once-off costs, such as for Marketing campaigns or product development costs, over the years the company benefits therefrom. The costs of capital are the weighted average costs of capital. Weighted Average Costs of Capital are the costs when different interest rates and opportunity costs for equity are considered proportionally to their portions of financing the business. <?page no="181"?> 832,000 1,456,000 (468,000) (819,000) 364,000 637,000 (45,000) (48,000) 319,000 589,000 (140,000) (260,000) 179,000 329,000 (146,750) (146,750) 32,250 182,250 214,500 (64,350) 150,150 Figure 10.6: VANHUIZEN BV’s performance clear of interest/ coupon <?page no="182"?> Summary: For performance measurement, we studied different steps of contribution margin calculation in order to determine the right performance measure for decisions. Situations for performance measurement can be the assessment of managers or decisions about resource allocations, mostly investment decisions. We introduced most common performance ratios: Return on investment, residual income and economic value added EVA TM . Working Definitions: Earnings per Share: EPS is based on IAS 33 and divides the earnings available for distribution to ordinary shareholders by the number of ordinary shares outstanding. Economic Value Added EVA TM : The economic value added EVA TM expresses how much the company increases in value by deducting the capital costs based on the WACC calculation from the net operating profit after taxes. 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 <?page no="183"?> for equity are considered proportionally to their portions of financing the business. 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. 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. Solutions: 1-1; 2-1; 3-1; 4-3; 5-2. <?page no="184"?> What is in the Chapter? In Chapter (11) Accounting for Mergers and Acquisitions we demonstrate how acquisitions and mergers are prepared and how to determine a 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 company. 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 take-over by LOS POLLOS ASADOS (Pty) Ltd., based in Johannesburg. Learning Objectives: In this chapter, you learn which Accounting information support a merger with or an acquisition of another company. In particular, you get to know about 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. Mergers and Acquisitions (M&As) can be strategically motivated, e.g. to increase the economics of scale or the 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 has been found already and the purchase price is known. We only 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 a company appraiser. The structure of the 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. Under (5) we discuss different scenarios: An acquisition by a company leading to group Accounting, a merger with another company and a cross border acquisition. Ad (1): General Description of OHIO FRIED CHICKEN <?page no="185"?> Ad (2): Reading the ‘Financials’ <?page no="186"?> Figure 11.1: ‘Financials’ provided by OHIO FRIED CHICKEN’s owner <?page no="188"?> Figure 11.2: OHIO FRIED CHICKEN’s refined data sheet <?page no="189"?> Figure 11.3: OHIO FRIED CHICKEN’s weekly calculation of cash profit <?page no="190"?> Figure 11.4: OHIO FRIED CHICKEN’s monthly operating cash flows Ad (3): Business Valuation <?page no="191"?> 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 book value calculation is the discounted cash flow method. The discounted cash flow method determines the value of a business as the total of the present value of all free cash flows. In order to determine the present values, payments must be discounted based on the rate of interest on the capital market. The discounted cash flows consider the total of all future discounted cash flow as value of the company. It tells us how much the owner benefits from the restaurant by considering 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. Assuming the free cash flow always is paid to the proprietors, its total indicates the return to the proprietors. We must discount future payments in order to consider the time value of money. In case we discount all free cash flows over the lifetime of the company and add them up, we arrive at the value of the business based on discounted free cash flows. The present value (PV) of a constant payment A over T periods is: T T i i i A PV (with: PV = present value, A = annual payment, i = annual rate of interest, T = number of periods.) <?page no="192"?> i A PV (with: PV = present value, A = annuity, i = rate of interest) Ad (4): Investment Appraisal <?page no="193"?> Figure 11.5: OHIO FRIED CHICKEN’s payments discounted by 4.75% 44 Figure 11.6: Calculation of the internal rate of return <?page no="194"?> Ad (5): Financial Statements Ad 5(a): Private Purchase 25,000 33,947 8,947 0 33,947 33,947 Figure 11.7: OHIO FRIED CHICKEN’s balance sheet <?page no="195"?> 1,797,000 1,797,000 (1,086,000) (88,000) (25,000) (245,000) 353,000 353,000 Figure 11.8: Budgeted income statement for OHIO FRIED CHICKEN 0 386,947 8,947 378,000 386,947 386,947 Figure 11.9: OHIO FRIED CHICKEN’s budgeted balance sheet [ZAR] <?page no="196"?> Ad 5(b): Acquisition by a Company 25,000 35,000 8,947 1,053 35,000 35,000 Figure 11.10: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet <?page no="197"?> 400,000 400,000 400,000 400,000 Figure 11.11: AYAM GORENG Sdn. Bhd.’s opening balance sheet 400,000 298,333 101,667 400,000 400,000 Figure 11.12: AYAM GORENG Sdn. Bhd.’s balance sheet after acquisition <?page no="198"?> 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. <?page no="199"?> 8,333 11,667 2,982 351 11,667 11,667 Figure 11.13: OHIO FRIED CHICKEN (Pty) Ltd.’s adjusted balance sheet An aggregated balance sheet is an interim balance sheet in preparation of consolidated financial statements the items of which contains the sums of all group member’s balance sheet items. We can say, the balance sheets are added per item. 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. <?page no="200"?> 400,000 11,667 411,667 (11,667) 400,000 (400,000) (11,667) (411,667) 11,667 (400,000) Figure 11.14: Consolidation worksheet [MYR] <?page no="201"?> 8,333 400,000 286,667 0 2,982 102,018 400,000 400,000 Figure 11.15: AYAM GORENG Sdn. Bhd. consolidated balance sheet 1,797,000 1,797,000 (1,086,000) (88,000) (25,000) (245,000) 353,000 353,000 (105,900) 247,100 Figure 11.16: OHIO FRIED CHICKEN (Pty) Ltd.’s budgeted income statement <?page no="202"?> 0 35,000 247,100 8,947 379,053 105,900 388,000 388,000 Figure 11.17: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet 0 11,667 82,367 2,982 126,351 35,300 129,333 129,333 Figure 11.18: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet <?page no="203"?> 400,000 129,333 529,333 (11,666) 517,667 (400,000) (129,333) (529,333) 11,667 (517,667) Figure 11.19: Consolidation worksheet in MYR 0 400,000 286,667 82,367 0 2,982 228,018 35,300 517,667 517,667 Figure 11.20: AYAM GORENG holding’s balance sheet as at 31.12.2015 <?page no="204"?> Ad 5(c): Merger In case two (or more) companies merge, the companies cease to exist as separate entities and form one new legal entity. The new company prepares one set of single 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. For this, the purchase method applies. Hence, all items are to be recognised at fair values. A goodwill might exist too. With regard to 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 fast food restaurant chain, based in Johannesburg. 4,000,000 1,000,000 6,500,000 0 2,000,000 1,000,000 2,500,000 0 8,500,000 8,500,000 Figure 11.21: LOS POLLOS ASADOS (Pty) Ltd.’s balance sheet <?page no="205"?> 4,025,000 1,000,000 6,500,000 (860,000) 2,008,947 1,000,000 1,606,053 0 7,640,000 7,640,000 Figure 11.22: LOS POLLOS ASADOS (Pty) Ltd.’s balance sheet after taking-over 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. <?page no="206"?> 4,025,000 1,000,000 6,500,000 (625) 2,008,947 1,000,000 2,465,428 0 8,499,375 8,499,375 Figure 11.23: LOS POLLOS ASADOS (Pty) Ltd.’s balance sheet after take-over <?page no="207"?> Ad (6): Financial Statement Analysis 25,000 35,000 8,947 1,053 35,000 35,000 Figure 11.24: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet <?page no="208"?> 1,797,000 1,797,000 (1,086,000) (88,000) (25,000) (245,000) 353,000 353,000 (105,900) 247,100 Figure 11.25: OHIO FRIED CHICKEN (Pty) Ltd.’s income statement 0 35,000 247,100 8,947 379,053 105,900 388,000 388,000 Figure 11.26: OHIO FRIED CHICKEN (Pty) Ltd.’s balance sheet <?page no="209"?> 12,500 35,000 123,550 8,947 190,053 52,950 211,500 211,500 Figure 11.27: Average balance sheet for OHIO FRIED CHICKEN (Pty) Ltd. Ad (6): Risk Analysis Ad 6(A): Reputation Risk <?page no="210"?> Ad 6(B): Food Price Increase Risk Ad 6(C): Staff Fluctuation Risk Ad 6(D): Competitor Risk <?page no="211"?> Ad 6(E): Asset Structure Risk In order to explain the situation of low asset amounts, we compare OHIO FRIED CHICKEN (Pty) Ltd. to a property investment in Port Elizabeth, South Africa. Assume, an investor buys for a similar amount as paid for OHIO FRIED CHICKEN a 1 bedroom, kitchen, 1 bathroom apartment and invests 900,000.00 ZAR with the intention to rent it out. If the tenant falls behind with paying rent, the landlord can evict the property and is still left with the apartment worth 900,000.00 ZAR. Hence, the investment in property is less risky than the purchase of a fast food restaurant with low 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. In case new requirements are implemented the owner of the restaurant has to face further costs for certificates and examinations. Other risks result from unions with regard to minimum salaries, employee participation in decision-making etc. Ad 6(G): Currency Exchange Risk The following exhibit shows the 2 years-changes of the South African Rand against the Euro. In case the ZAR depreciates to the target currency, the EUR 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%. <?page no="212"?> Figure 11.28: Long-term currency exchange rate ZAR-EUR (OFX.com) In order 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 amount of 9,000.00 ZAR is calculated cost for property management and repairs. The EUR-amount of the rental profit is: 99,000 / 14 = 7,071.43 EUR/ a. The return on investment in ZAR equals: 99,000 / 1,000,000 = 9.9%. Now we look at January 2016. The profit is still 99,000.00 ZAR but it is now to be converted to a EUR amount 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. Hence, the investment payment is: 1,000,000 / 14 = 71,428.57 EUR. The investor calculates his return on investments based on the current EURamounts. It gives him a return to the extent of: 5,500 / 71,428.57 = 7.7%. The return dropped by: 2.2% / 9.9% = 22.22%. Summary: Mergers and Acquisitions require strategic and Accounting due diligence on the target firm’s side. With regard to 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 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. <?page no="213"?> Working Definitions: Aggregated Balance Sheet: An aggregated balance sheet is an interim balance sheet in preparation of 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 total of the present value of all free cash flows. Free Cash Flow: The free cash flow is the operating cash flow plus the investing cash flow. 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. 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. 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 amount 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) <?page no="214"?> 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 intergroup investments. 2. The effective rate of interest. 3. The discount rate to apply in order to calculate a zero present value. 4. Calculated and artificial dividend costs. Solutions: 1-3; 2-3; 3-4; 4-2; 5-3. <?page no="215"?> What is in the Chapter? In chapter (12) Risk Valuation we cover risks for companies. A risk is an uncertain outcome of a factor that affects profit and/ or cash flow. For risks the probability and probability density function must be known. In order to combine multiple risks, we prepare a risk simulation based on the Mathematical concept of a MonteCarloSimulation. In this chapter we study the case of ROCKS PLC., in order 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’s selling on sun glasses and umbrellas depends on the weather, which is to be seen as one single risk. The next case of the consultancy NAMGURO Ltd. covers a multiple risk situation and teaches 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.’s Accounting insolvency. Leaning Objectives: Risk Valuation and Risk Management are subject to Management Accounting. The aim is to determine how risky a business can become for the investors. The highest damage is to completely lose the invested funds. In this chapter we aim to 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. In this chapter, we teach you 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. The knowledge helps you to understand how risk management software solutions work. You will be able to calculate the probability for bankruptcy based on Accounting insolvency and/ or illiquidity. You also understand the risk management ratio value at risk (VaR) and its parameters. A business must be closed-down by legal requirements once its losses make the debts exceed the assets. Then equity becomes negative. In a limited company, owners cannot be held reliable for such a loss as their responsibility is limited to equity. As a consequence, creditors will lose all or part of the funds they are lending the company. For creditors’ protection, a company must file for bankruptcy once too deep in debts (Accounting insolvency) or when payment obligations cannot be fulfilled (illiquidity). In order 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="216"?> 2,500 10,000 2,000 3,000 8,000 4,500 15,000 15,000 Figure 12.1: ROCKS PLC’s balance sheet If ROCKS PLC earns a loss that exceeds 12,000.00 GBP it must file for bankruptcy. In order to keep the case study simple, we assume the following Bookkeeping entry in order to recap a loss of 13,000.00 GBP: 47 DR P&L-Account.................. 13,000.00 GBP CR Accounts Payables............ 13,000.00 GBP The loss makes ROCK PLC’s equity to become negative. Study the balance sheet below in Figure 12.2. 2,500 10,000 2,000 (13,000) 3,000 8,000 13,000 4,500 15,000 15,000 Figure 12.2: ROCKS PLC.’s balance sheet <?page no="217"?> Why is the situation depicted in Figure 12.2 so bad? The answer lays in an assumed liquidation. ROCKS PLC sells all assets at fair values which add up to 15,000.00 GBP. This is the sum of assets on the balance sheet’s asset side. Next, ROCKS PLC retires its debts. We ignore transaction costs and prepayment penalties. ROCKS PLC pays: 3,000 + 13,000 = 16,000.00 GBP. As the funds from the liquidation are only able to cover 15,000.00 GBP of debts ROCKS PLC is unable to settle all its debts. We assume, ROCKS PLC. pays a total amount of 15,000.00 GBP to creditors but still is left with payables to the extent of: 16,000 - 15,000 = 1,000.00 GBP. Now, the owners of ROCKS PLC file for bankruptcy and are held liable to the extent of the company’s equity which was 12,000.00 GBP and is eaten by the loss. Hence, the owners lost 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 lose a portion of 1,000.00 GBP they lent ROCKS PLC as the loans become uncollectable. 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 takes over the business to make sure that all creditors are equally and fairly treated with regard to the liquidations. Another reason for bankruptcy is illiquidity which means the company cannot fulfil its payment obligations. This is caused by debts and negative cash flows. An insolvency takes place once the company has no or negative Cash/ Bank account balance and has no chance for positive cash flows, nor from operating activities nor from lending money from creditors. Both, either Accounting insolvency and/ or illiquidity require the management to file for bankruptcy at the local court house. We next study how to avoid bankruptcies. Mostly, negative and dangerous developments are foreseeable. We call a threat for a company to go insolvent a risk. A risk is an event by which something happens differently as foreseen or expected. Risks analysed in business are risks that can lead to a company’s bankruptcy. Risks are a plan/ forecast deviation. In Business and Management, we do not classify risks in good or bad. Any deviation becomes relevant. 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 events by the technical term risk, even as a deviation to the better exam result is considered a chance based on common understanding. We refer to this concept as symmetrical risk definition which is the precondition for risk simulations. Valuation of risks and Risk Management aims to control risks of a company. It also calculates the probability for bankruptcy. <?page no="218"?> Taking risks is normal business. With regard to Risk Management, a company will ask 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 won’t exceed its 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 won’t 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 foreseen or estimated amount. We apply the symmetric definition of risk. In case a risk cannot be calculated by a probability (unknown probability) it will be referred to as an uncertainty. In order to handle risks, risk valuations are needed. A risk valuation determines the monetary value of risks. The value of a risk is determined by the damage caused by the risk and the risk’s probability (%). The product of probability and damage gives the expected value of a risk. V(risk) = D × P (with: V = value, D = damage, P = probability [%].) For instance, a risk that inventory is stolen is its damage, e.g. 1,000.00 EUR, times the probability of theft which is 2 %. Hence, the risk’s value is: 1,000 × 2% = 20.00 EUR. Risk management is about the identification, calculation and controlling of risks taken by shareholders and creditors. The risk of these parties losing their funds depends on the volatility of the business's profits and cash flows. A company applying effective Risk Management helps to avoid risks. Risk Management can be seen as a service for the funds providing parties of the company. In general, companies take more than one risk at a time. In order to calculate the resulting entire risk for the shareholders and creditors, companies have to combine their risks. As risks can depend mutually on each other, risks can either have compound or compensating effects. One way of risk combination is by pairing risks and to examine their mutual impacts. A company taking 10 single risks that depend on each other has than to consider (10 - 1)! = 362,880 risk combinations. For that reason, an examination of risk dependencies in detail is theoretically possible but not applicable for Risk Management in a company. The effort is too high for the gained information. <?page no="219"?> 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 of a company. The name MonteCarloSimulation refers to gambling in Monaco. The comparison to gambling is often made in Mathematics as it is assumed that a dice has 6 equal sides - each number has the same probability of appearance. We say, diced numbers between 1 and 6 are equally distributed. An equal distribution is a distribution where every number has the same probability to appear. In order to explain risk simulation, we study events and their probabilities. Every risk depends on an event. The occurrence of an event is measured by probabilities and disclosed as a percentage. To deepen our understanding of risks, we refer to the case study WEATHERMAN. See below its data sheet. Data Sheet for WEATHERMAN <?page no="220"?> Figure 12.3: Random figure generator on a calculator (Casio) The generator gives us figures between 0 and 1, such as 0.84. We multiply these random figures by 100 in order to get figures between 0 and 99. As a result, every figure's probability to be drawn is 1%. 48 Figure 12.4 WEATHERMAN’s profit simulation <?page no="221"?> Figure 12.5: WEATHERMAN’s profit MS-Excel simulation In the real business world, there are multiple risks with all having an impact on profit and/ or cash flows. For Risk Management, we have to identify the risks and study what they depend on. Separate risks are simulated separately! In case a company takes 3 risks, it is required to set up 3 risk simulations which are based on mutually independent events and single random figures. Data Sheet for NAMGURO Ltd. <?page no="222"?> Figure 12.6: NAMGURO Ltd.’s statement of comprehensive income <?page no="223"?> Figure 12.7: Results of NAMGURO Ltd.‘s profit simulation In business, the distribution of profits is often assumed to be normally distributed without being proven in terms or Mathematics. 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 profit is. The equation of the normal distribution is: <?page no="224"?> (with: = mean, = standard deviation, f = probability, x = (here profit), e = Euler’s number) The probability (here: f) only depends on constant amounts and on the mean and the standard deviation . In other words: once we know the mean and the standard deviation of a distribution we can calculate and draw a normal distribution. A normal distribution gives us the value at risk. The value at risk is the minimum profit that is achieved by 95 % of all cases. This is the profit amount at the right border of the first 5 % interval under the distribution curve. In order to deal with a normal distribution, 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 text books of Mathematics and Statistic. See below the table for the right section of the standard normal distribution. The figures represent probabilities. As the normal distribution is symmetrical, the maximum amount is 50 %. There is no need for describing the left portion of the distribution. <?page no="225"?> Figure 12.8: Probabilities for the standard normal distribution The transformation equation from a normal distribution towards a standard normal distribution is: x x z (with: z = z-amount, = mean, = standard deviation, x = x-amount) We apply the standard normal distribution for NAMGURO Ltd. in order to calculate the value at risk with regard to the profit: <?page no="226"?> The value at risk based on a 5% quartile is the profit that is exceeded by a probability of 95 % of the distribution. The calculation is as follows: we read the z-amount for a probability of 45 % from the table for a normal distribution and retransform it to the x-value that represents profit. The value at risk is a common risk management figure applied in business and management. We must evaluate the risks for OHIO FRIED CHICKEN (Pty) Ltd., as we discussed in chapter (11). Based on the past data we already prepared a budgeted income statement as below in Figure 12.9. <?page no="227"?> 1,797,000 1,797,000 (1,086,000) (88,000) (25,000) (245,000) 353,000 353,000 (105,900) 247,100 Figure 12.9: Budgeted income statement for 20Y5 x x z (with: z = z-amount, = mean, = standard deviation) <?page no="228"?> Figure 12.10: Risk simulation (MonteCarloSimulation) <?page no="229"?> Figure 12.11: Profit and loss simulation <?page no="230"?> Summary: For management of a company, risks must be identified and valuated, which gives the value at risk or a Mathematically calculated probability for bankruptcy. A bankruptcy applies in case of an Accounting insolvency of illiquidity. The case study ROCKS PLC shows the bankruptcy situation from the Accounting point of view. The case study WEATHERMAN made the basics of risk simulation understood. The case study NAMGURO Ltd. demonstrated the combination of risks by a MonteCarloSimulation approach. We applied the MonteCarloSimulation on the case OHIO FRIED CHICKEN (Pty) Ltd. as well and applied one risk that gives us a normal distribution whereas the other risks are equally distributed. We also calculated the probability for bankruptcy. 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 of a company. Risk: A risk is 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 minimum profit that is achieved by 95 % of all cases. Standard Normal Distribution: A standard normal distribution is a special normal distribution where the mean is 0 and the standard deviation is 1. 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? 1. 50,000.00 EUR. 2. 39,000.00 EUR. <?page no="231"?> 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. Solutions: 1-3; 2-2; 3-4; 4-2; 5-3. <?page no="233"?> Section (3): Cost Accounting <?page no="234"?> What is in the Chapter? We start-off the Cost Accounting section at chapter (13) Structure of Cost Accounting Systems which provides an overview of cost Accounting features. 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 is called calculation. We also prepare a profitability analysis. The chapter shows the structure step by step along the cost flow. The entire chapter follows the case study GIULIO’s PIZZA&PASTA Ristorante. Learning Objectives: Management Accounting systems are the internal portion of Accounting. They provide managers with relevant Accounting information that matches their information needs. In this chapter, we teach you the structure of and the cost flow within Management Accounting systems. After studying this chapter, you can describe the major features of a Management Accounting system and you can recognise parts of the Management Accounting systems when you see them in a company. You also gain knowledge of how business processes in Accounting and understand the features of software solutions for cost Accounting. A Management Accounting system contains four major components: (1) Cost category Accounting. (2) Cost centre Accounting. (3) Calculation. (4) Profitability analysis. See Figure 13.1 in order to study the Cost Accounting components and their links in between. <?page no="235"?> Figure 13.1: Management Accounting system We explain the structure following the data flow in Figure 13.1. The cost Accounting system is an absorption costing, meaning we work without cost separation in this chapter and consider full costs. 49 Cost Accounting is almost always based on Financial Accounting’s Bookkeeping records. You can see a 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 revenue enter the Management Accounting system. The data transfer is no cost Accounting step. The data do not flow from one system towards the next one. There are merely two Accounting systems working based on identical data. 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 … its debit entry in the Cost account is used for cost Accounting. 50 The cash/ bank item is of minor interest for cost Accounting. For teaching purpose, it is easier to think of data flows which originate in Financial Accounting and flow into Cost Accounting system. Therefore, we describe a cost Accounting system as if data were flowing from one box into the next one. <?page no="236"?> Revenues are transferred to the Management Accounting system as well as costs. In the box for the Financial Accounting system you see a reference to the general ledger. Subordinated accounts, such as data from the purchase ledger, do not matter. Below, we discuss the boxes disclosed in Figure 13.1. Ad (1): Cost Category Accounting The first box is cost category Accounting. A cost category is a certain group of costs, such as rent. The inputs for the cost category Accounting are expenses which are assumed to be congruent to costs. The output are different cost categories and divided in direct costs and overheads. In cost category Accounting, expenses are checked regarding their cost relevance and divided in direct costs and overheads. The classification depends on the interrelationship with products (= 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. For a marginal cost Accounting system, a cost separation takes place in cost category Accounting. We follow the cost flow of overheads into cost centre Accounting. The other cost flow of direct costs towards calculation is discussed under (3a). Ad (2): Cost Centre Accounting In order to support efficient control a company is organised by organisational units. Management Accounting divides a company into numerous cost centres. Often, a company runs 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 exists. Accountants must be able to allocate costs directly to cost centres. Straight means without making allocations. E.g. room costs can easily be traced to a building where the cost centre is located in. If the building hosts more cost centres the building costs must be allocated to single cost centres by square metres. Cost centre Accounting covers all steps that takes place inside of a cost centre. It is required to completely allocate overheads from cost category Accounting to cost centres and to calculate the cost rates. If actual and budgeted cost data are available in a cost centre monitoring is possible. It is covered by chapter (15) in this text book. Cost variances are calculated and reported to cost centre managers as efficiency report. See chapter (17) for Reporting. An efficiency report shows where and how much budgeted costs and actual costs differ. Any cost deviation indicates inefficiently operating activities. Next, we cover cost rates: Cost centre Accounting determines 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. time, volume, KWh etc. A cost rate tells how much costs are spent for one reference unit’s amount of output. Cost rates are frequently calculated based on budgeted costs, called predetermined overhead allocation rates POR. Cost rates <?page no="237"?> apply for the allocation of overheads to products. 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 supports internal cost allocations. Internal cost allocation means that a receiving cost centre covers the provider’s costs for its service. Internal cost allocations are measured by reference units, too. In Accounting, the sequence is to first calculate internal cost allocations and thereafter to determine the cost rates for the calculation of products. Internal cost allocations are covered by chapter (16). Check 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. When the overhead application is at full costs the arrow from the cost centres to profitability analysis is only for overor under-applied overheads. Ad (3): Calculation A Calculation determines the unit costs per good manufactured or services rendered. Unit costs contain direct costs, like direct labour or materials, multiplied by the quantity of resources consumed - like cost per wheel × 4 for a car. The quantities are derived from the bill of materials and routings. Unit costs also contain portions of applied overheads. The overhead application is determined by multiplying cost centre rates with a usage factor. Let us assume, the Volkswagen Golf dash board assembly cost rate equals to 150.00 EUR/ h and the assembling time for one dash board takes 10 min., then the costs allocated to the car are: 10 × 150/ 60 = 25.00 EUR. The sum of all direct costs and overhead allocations results in the product/ service costs. In case we divide these total costs by the batch size or monthly output we calculate unit costs. Ad (4): Profitability Analysis The last step in Cost Accounting, the profitability analysis, is similar to the profit and loss calculation in Financial Accounting. It can be based on the nature of expense method or the cost of sales format. The only difference in comparison to Financial Accounting is that cost Accounting is based on costs and Financial Accounting’s income statement on expenses. The profitability analysis simply follows the equation: revenue less product costs and less other non-manufacturing expenses results in profit. A profitability analysis can be prepared for the entire company or for sections thereof - whatever is useful for managers to control the business better. In contrast to Financial Accounting, expenses for taxation and Finance, such as interest, are not subject to Management Accounting. Management Accountants only calculate the profitability analysis ‘down to’ the earnings before taxes EBT or even stop at earnings before interest and taxes EBIT. The result of the profitability analysis are single product margins and absolute profit. <?page no="238"?> 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. For the sake of simplification, assume the restaurant is in private ownership. We discuss a Management 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 case study for marginal costing. Here comes the cost Accounting on full cost basis: Data Sheet for GIULIO’s PIZZA&PASTA RISTORANTE <?page no="239"?> Figure 13.2: GIULIO’s PIZZA&PASTA Ristorante’s BOM Overheads are indirect costs which cannot be traced to a certain product or service. For Management Accounting, we ignore VAT. All costs are net amounts. <?page no="240"?> In Management Accounting, budgeting starts with performance planning. Starting budgeting procedures from the output is referred to as reverse budgeting. Consider the profitability analysis box in Figure 13.1 as starting point. Figure 13.3: GIULIO’S PIZZA&PASTA RISTORANTE’s direct costs based on products <?page no="241"?> Ad (1): Cost Category Accounting <?page no="242"?> Figure 13.4: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (1) Ad (3a): Calculation Unit costs are costs based on one unit of the product. <?page no="243"?> Figure 13.5: GIULIO’S PIZZA&PASTA RISTORANTE’s direct costs Ad (2): Cost Centre Accounting Kitchen <?page no="244"?> Restaurant/ Order Management Delivery <?page no="245"?> Figure 13.6: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (2) The cost rate is costs of a cost centre divided by its output related reference unit. <?page no="246"?> Figure 13.7: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (3) Ad (3b): Calculation DR WIP Pizza.................... 50,000.00 EUR DR WIP Lasagne.................. 25,000.00 EUR CR Purchase (2) ................ 75,000.00 EUR DR WIP Pizza.................... 30,000.00 EUR DR WIP Lasagne.................. 20,000.00 EUR DR WIP Cannelloni............... 10,000.00 EUR CR Purchase (4)................. 60,000.00 EUR Cost tracing is the assignment to Work-in-Process accounts without calculation. <?page no="247"?> 40,000.00 10,000.00 50,000.00 25,000.00 75,000.00 16,000.00 30,000.00 195,000.00 20,000.00 71,000.00 195,000.00 195,000.00 71,000.00 71,000.00 195,000.00 71,000.00 5,000.00 24,000.00 24,000.00 10,000.00 24,000.00 7,200.00 10,000.00 32,200.00 32,200.00 32,200.00 32,300.00 Figure 13.8: GIULIO’S PIZZA&PASTA RISTORANTE’s manufacturing accounts (1) 3,600.00 33,600.00 360.00 3,000.00 48,000.00 4,000.00 15,000.00 2,000.00 12,000.00 Figure 13.9: GIULIO’S PIZZA&PASTA RISTORANTE’s manufacturing accounts (2) <?page no="248"?> DR WIP Kitchen.................. 9,000.00 EUR DR WIP Restaurant/ OM............ 27,000.00 EUR CR Rent......................... 36,000.00 EUR 3,600.00 33,600.00 360.00 3,000.00 48,000.00 27,000.00 63,600.00 4,000.00 63,600.00 63,600.00 9,000.00 64,960.00 63,600.00 64,960.00 64,960.00 64,960.00 15,000.00 36,000.00 9,000.00 2,000.00 27,000.00 12,000.00 29,000.00 36,000.00 36,000.00 29,000.00 29,000.00 29,000.00 Figure 13.10: GIULIO’S PIZZA&PASTA RISTORANTE’s manufacturing accounts (3) Pizza DR WIP Pizza.................... 46,400.00 EUR CR MOH Kitchen.................. 46,400.00 EUR DR WIP Pizza.................... 34,500.00 EUR CR MOH Restaurant/ OM............ 34,500.00 EUR <?page no="249"?> Lasagne DR WIP Lasagne .................. 12,373.33 EUR CR MOH Kitchen .................. 12,373.33 EUR DR WIP Lasagne .................. 13,800.00 EUR CR MOH Restaurant/ OM ............ 13,800.00 EUR Cannelloni DR WIP Cannelloni............... 6,186.67 EUR CR MOH Kitchen .................. 6,186.67 EUR DR WIP Cannelloni............... 6,900.00 EUR CR MOH Restaurant/ OM ............ 6,900.00 EUR Chianti DR WIP Chianti.................. 8,280.00 EUR CR MOH Restaurant/ OM ............ 8,280.00 EUR <?page no="250"?> 40,000.00 10,000.00 50,000.00 25,000.00 75,000.00 16,000.00 30,000.00 195,000.00 20,000.00 71,000.00 195,000.00 195,000.00 71,000.00 71,000.00 195,000.00 71,000.00 46,400.00 12,373.33 34,500.00 275,900.00 13,800.00 97,173.33 275,900.00 275,900.00 97,173.33 97,173.33 275,900.00 97,173.33 5,000.00 24,000.00 24,000.00 10,000.00 24,000.00 7,200.00 8,280.00 32,280.00 10,000.00 32,200.00 32,280.00 32,280.00 32,200.00 32,200.00 32,280.00 32,200.00 6,186.67 6,900.00 45,286.67 45,286.67 45,286.67 45,286.67 3,600.00 33,600.00 360.00 3,000.00 48,000.00 27,000.00 63,600.00 4,000.00 63,600.00 63,600.00 9,000.00 64,960.00 63,600.00 34,500.00 64,960.00 64,960.00 13,800.00 64,960.00 46,400.00 6,900.00 12,373.33 8,280.00 6,186.67 120.00 64,960.00 64,960.00 63,600.00 63,600.00 120.00 15,000.00 36,000.00 9,000.00 2,000.00 27,000.00 12,000.00 29,000.00 36,000.00 36,000.00 29,000.00 29,000.00 29,000.00 Figure 13.11: GIULIO’S PIZZA&PASTA RISTORANTE’s manufacturing accounts (4) <?page no="251"?> Figure 13.12: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (4) Ad (4): Profitability Analysis A cost of sales format is based on the cost of manufacturing allocated to the sold goods/ services. The costs of sales are deducted from revenue to calculate the 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. 53 As the cost of sales contain fixed costs we shall not refer to this margin as contribution margin. <?page no="252"?> Figure 13.13: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (5) <?page no="253"?> How it is Done (Cost Accounting) (1) Copy expenses from the Financial Accounting systems to the Management Accounting system. (2) Check expenses for cost characteristics. Check further whether or not 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 in a marginal cost Accounting systems. In an Absorption Cost Accounting system pass step (5) and go straight to step (6). (6) In case non-manufacturing overheads, such as Marketing and Distribution costs, apply add them to common (non-production-linked) cost centre accounts that are closed-off to the Profitability Analysis later. (7) In case of (mutually) cost centre support run a cost allocation as in chapter (16) of this text book. (8) Calculate cost rates by dividing (final) costs of cost centres by their output. (9) Apply overheads based on cost rates and 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. 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="254"?> rates. The profitability analysis calculates the net operating profit of the business. 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. Question Bank: (1) In an absorption cost Accounting system, the arrow from cost centre Accounting to calculation represents… 1. … proportional cost rates. 2. … full cost rates. 3. … applied overheads based on proportional costs. 4. … applied overheads based on full costs. (2) In an absorption cost Accounting system, a cost centre plans 5,000.00 EUR/ m labour costs. Depreciation is 1,000.00 EUR/ m. The cost centres output is planned to be 100 units. The cost centre records an output of 110 units. How much are applied overheads? 1. 6,500.00 EUR. 2. 6,600.00 EUR. 3. 6,000.00 EUR. 4. 5,000.00 EUR. (3) In Managerial Accounting … 1. … proportional overheads are assigned to the profitability analysis and fixed overheads are assigned to products. 2. … direct costs and overheads are allocated to the profitability analysis. 3. … direct costs are assigned to cost centres and overheads are allocated to products 4. … direct costs are assigned to products and overheads are allocated to cost centres. (4) A company records 26,000.00 EUR labour costs in cost centres, 10,000.00 EUR depreciation and 45,000.00 EUR materials. The planned output is 1,000 units and the actual output is 900 units. The revenue per unit is amounting to 150.00 EUR/ u. How much is the profit per unit if an absorption costing applies? 1. 60.00 EUR/ u. 2. 65.00 EUR/ u. 3. 69.00 EUR/ u. 4. 64.00 EUR/ u. (5) In a production firm, the predetermined overhead allocation rate is 5,500 EUR/ 100 h and based on an absorption costing. The actual overheads are amounting to 5,800.00 EUR and the output is 95 h. Which statement is correct? 1. There are over-applied overheads of 575.00 EUR. 2. There are under-applied overheads of 575.00 EUR. 3. There are over-applied overheads of 275.00 EUR. 4. There are under-applied overheads of 275.00 EUR. <?page no="255"?> Solutions: 1-4; 2-2; 3-4; 4-1; 5-2. <?page no="256"?> What is in the Chapter? The chapter (14) Flexible Budgeting/ Marginal Cost Accounting covers the same case 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 marginal cost Accounting systems that start with a cost separation and apply only proportional overheads for the cost rates. All fixed costs are allocated to the Profit and Loss account. You can study the outcomes 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 an absorption costing. Learning Objectives: In this chapter, we focus on flexible budgeting. You learn how to apply a marginal cost Accounting system and will notice that only proportional overheads are assigned to cost rates and products. As no fixed costs are considered cost rates are not biased by allocated fixed costs and thus remain constant. You will understand that the application of only 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 ability to discuss the advantage of marginal costing system over full cost Accounting. You further can argue the problems of full cost Accounting systems when products are added to stock and released therefrom for sales in periods later than production. Here are two technical terms we use in this chapter interchangeable: Absorption costing considers all costs and this is a full cost Accounting system. In contrast, a marginal cost Accounting system requires a cost separation. Only proportional costs apply for the calculation of cost rates and the product calculation. As proportional product costs represent incremental costs, we call this marginal cost Accounting. It allows to prepare a budget for different outputs, called a flexible budgeting. We refer to the same restaurant example as in the preceding chapter. Now, we distinguish proportional (variable) and fixed costs. Flexible Budgeting almost always starts with mixed cost functions. They consist of a fixed cost portion and proportional costs. For flexible budgeting, we separate costs. Planned cost at (any) output level are referred to as standard costs. Standard costs are a linear cost function depending on the output. The point on the cost function which represents the cost for the budgeted output is referred to as planned costs. After approval by management we refer thereto as budgeted costs. We saw already in chapter (13) how cost Accounting allocates costs. Costs are classified in cost categories and then allocated to cost centres and <?page no="257"?> products. Only proportional costs should be allocated to cost centres and products. Next, we study cost allocation principles. We cover the three most important principles for cost allocations starting by 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 when goods are manufactured or services are rendered. They do not apply when 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 is paying. Alternative cost allocation principles are the average principle and the carrying capacity principle. Once you follow the average principle all costs are divided to all objects on average. You apply this principle when you have dinner with your friends and decide to share the bill equally. The carrying capacity principle is based on the idea to charge 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 bill, the cost allocation principle of the carrying capacity applies for the family dinner. In a sophisticated Management Accounting system, the cost-by-cause principle is the preferred one. It guarantees most exact 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 assignments apply. When we assign direct costs, we say we trace them to cost objects. When we assign overheads, we refer to allocating. Proportional overheads are allocated to cost objects by the cost-by-cause principle. Fixed overheads are not caused by the cost objects and therefore, shall not be allocated to products. We add them to the Profit and Loss account. In flexible budgeting we never allocate fixed costs to cost centres or products. At low output levels this would overcharge products with costs and gives management distorted cost information. We next apply flexible budgeting for GIULIO’s PIZZA&PASTA RISTO RANTE. This leads to a better Management Accounting system as studied in chapter (13). We separate overheads (Direct costs are always proportional.). Thereafter, we apply cost centre Accounting, calculation and profitability analysis. Marginal cost Accounting allows us to plan profit for different outputs, here: dishes+wines. Look at the end of this chapter where we disclose some output scenarios and calculated profits therefor (Figure 14.3). With regard to our case study, all direct costs remain the same as in the previous chapter (13), as separating overheads has no impact on direct costs. Below, we repeat the figures: <?page no="258"?> For the overheads, we change the case study: Artificial overheads can be allocated to products by the cost-bycause principle. However, they won’t, because the effort for correct calculations is not justified by its outcome, which is the accurate cost information. Hence, we transfer these costs to profit or loss. Stand-by costs are costs, which occur, when a company provides resources, without consideration of their use. 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 determining the cost function for the Kitchen: <?page no="259"?> C kitchen (X) = PC kitchen × X + FC kitchen . Kitchen Restaurant/ Order Management Delivery The Management Accounting system design for GIULIO’s PIZZA&PAS TA RISTORANTE looks as depicted in Figure 14.1. <?page no="260"?> 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: Pizza <?page no="261"?> Lasagne Cannelloni Chianti The difference between revenue and proportional costs is called the contribution margin. The budgeted contribution margin can be displayed as per unit, too. This supports product mix decisions. <?page no="262"?> Figure 14.2: GIULIO’s PIZZA&PASTA RISTORANTE’s Management Accounting system The advantage of flexible budgeting is a more realistic cost planning depending on the output. The profit can be calculated by a formula with the structure as below: m j n i i j j j FC X CM X P (with: j = index for the product/ service, j = 1 … m, i = index for the cost centre, i = 1 … m, P = profit, CM = contribution margin, X j = amount of products, FC i = fixed costs) <?page no="263"?> Figure 14.3: GIULIO’s PIZZA&PASTA RISTORANTE’s profit planning Flexible budgeting allows accurate profit calculations based on different product/ service levels. Managers can vary the product mix and output level for checking consequences on the profit. The impact of flexible Budgeting becomes more important for companies that store finished goods or releases manufactured goods from stock for sale. When adding 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 product costs. No deferral of fixed costs distorts profit and loss. We discuss the case study LOGA (Pty) Ltd., which is a record label. Data Sheet for LOGA (Pty) Ltd. <?page no="264"?> As we will demonstrate by LOGA (Pty) Ltd., a production firm applying a full cost Accounting system, makes mistakes with regard to the profit calculation, by adding finished goods to stock. In a full cost Accounting system, finished goods put on stock, contain fixed costs. The fixed costs assigned to the finished goods count for profit calculation only in periods when the goods are released from stock and sold. As a consequence, the profit is too high in 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 are 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. Ad (1): Absorption Costing <?page no="265"?> Figure 14.4: LOGA (Pty) Ltd.’s profitability analysis based on absorption costing Ad (2): Marginal Costing <?page no="266"?> Figure 14.5: LOGA (Pty) Ltd.’s profitability analysis based on marginal costing <?page no="267"?> Summary: A flexible budgeting is a budgeting based on product outputs. For unit cost calculations and for profitability analysis it is strongly recommended to only consider only proportional costs. This way, the cost allocation is based on the cost-by-cause principle and provides managers with fair and unbiased information. For supporting budgeting and decision making, the Accountant can predict costs correctly. A marginal cost Accounting system provides correct cost information for the 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 cost-by-cause principle at a 1 : 1 relationship whereas fixed costs allocations are based on the average principle. Working Definitions: Artificial Overheads: Artificial overheads can be allocated to products by the cost-by-cause principle. However, they won’t, because the effort to calculate correctly is not justified by its outcome. 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. 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 output is 200 units/ a of product A and 400 units/ a of product B. Depreciation is amounting to 10,000.00 EUR/ a. How much is the profit if the product amounts are 400 units/ a of product A and 200 units/ a of product B? 1. 45,000.00 EUR/ a. 2. 42,000.00 EUR/ a. 3. 35,000.00 EUR/ a. 4. 32,000.00 EUR/ a. <?page no="268"?> (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 underapplied 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. Solutions: 1-3; 2-4; 3-3; 4-2; 5-1. <?page no="269"?> What is in the Chapter? The next following chapter (15) Cost Monitoring is strictly based on flexible cost Accounting and introduces to monitoring. The case study CROX TON Ltd. is about a laptop display manufacturer and we study its cost deviations at planned output level in April 20X6, at a lower level in May 20X6 and at a higher level in June 20X6. Cost deviations, such as consumption and volume variances, are calculated and explained. We also introduce efficiency reports. Learning Objectives: Cost monitoring is for checking the efficiency of cost centres, processes or products. We compare actual costs to the budgets. Any deviation is considered being an inefficiency. Other technical terms for monitoring are targetperformance checking or variance analysis. A company performs well once it meets its budget. This way, the company works on schedule and is likely to reach its profitability objectives. Preferably, regular efficiency checks are made in all cost centres. Every cost centre has a manager who is responsible for its cost consumption. Management Accounting reports to them a detailed efficiency report that discloses actual costs, the budgeted amounts and deviations. We develop an efficiency report as displayed by Figure 15.3 and Figure 15.5 at the chapter’s end. Cost deviations are divided in volume and consumption variances. By their received proficiency report, managers see whether they stay within their cost limits. In this chapter, we teach 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 about responsibilities for certain cost variances. For the following considerations, we apply a marginal cost Accounting system. The costs of a cost centre are budgeted based on proportional and fixed costs. Once the cost centre is in operation, actual costs can be recorded and compared to budget. You might ask yourself, why not planning costs rather generously, as by doing so the actual costs meet the budget easily? Any add-on towards budgeted costs would work as safety cushion and protects managers against cost variances. 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 too. 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 is very straight forward. The actual costs should match the budget. A difference in costs is an indicator for a negative deviation, <?page no="270"?> which can be caused by rework, wrong resource application, delays etc. The variance analysis that succeeds monitoring is about the investigation of cost deviations. Cost comparisons become more complicated, once costs are recorded at different volume/ output levels. We discuss the case of CROXTON. See the data sheet for the case study below: Data Sheet for CROXTON Ltd. 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 input variable. It is the planned and recorded performance of a cost centre, e.g., how many units are produced. Cost Accountants measure volume in reference units which depend on the output. In case cost centres support each other, further performance is required. Then, the performance in a cost centre contains output plus performance provided other cost centres with. You will learn further details in the next chapter (16). For monitoring, always both, the volume and the cost, matter. In case other cost centres are charged for internal support, monitoring considers costs where they occur. This means that cost checking takes place before internal cost allocations are calculated inside of the providing cost centre. <?page no="271"?> Figure 15.1: CROXTON Ltd.’s cost variance in April 20X6 <?page no="272"?> Figure 15.2: CROXTON Ltd.’s variance in May 20X6 The consumption variance is the difference between actual costs and standard costs based on the actual volume. The consumption variance is caused by resource deviations. The cost centre manager is held responsible for consumption variances. A second variance relevant for Managerial Accounting is the volume variance v. The volume variance is the difference between standard costs at actual volume and total planned cost rates times actual volume. The volume difference actually is a cost difference caused by changes in volume. It can be observed in the Manufacturing Overheads account. It shows on the debit side actual costs to the extent of 151,000.00 EUR. On the credit side we see the amount added to the Finished Inventory account based on the predetermined overhead allocation rate. It gives: 10,000 × 160,000 / 12,000 = 133,333.33 EUR. Hence the overheads are under-applied to the extent of: 151,000 - 133,333.33 = 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 = 16,666.67 EUR. The application of overheads is frequently based on a predetermined <?page no="273"?> 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, the Accountant multiplies the actual performance by the POR-rate. Thus, the applied overheads are represented by the line which goes from the point (0/ 0) to the budgeted cost mark, in the case of CROXTON Ltd at (12,000/ 160,000). This line is dotted in Figure 15.2. Hence, the volume difference results in either overor underabsorbed overheads. For better understanding consider the dotted line as the ‘refunded costs line’. The cost centre is discharged for its costs when ‘selling’ the goods to finished goods inventory. In contrast, differences should never be added to products but are added to the Cost of Sales account which later on is closed-off to the Profit and Loss account. This way, deviations do not increase inventory valuations but count for profit or loss. In general, only the consumption variance c counts for the assessment of performance in cost centres. We say, in case the consumption variance is close to zero, the cost centre works efficiently. <?page no="274"?> Figure 15.3: CROXTON Ltd.’s cost efficiency report May 20X6 We next study a situation where the output exceeds the budgeted performance. <?page no="275"?> Some managers are tempted to cook their efficiency reports, e.g., in order to earn incentives based on the cost centre performance. They try to increase budgeted costs to make themselves look good with low cost deviations. This problem is serious in business and is subject to principle-agent theory. Figure 15.4: CROXTON Ltd.’s variance in June 20X6 <?page no="276"?> Figure 15.5: CROXTON Ltd.’s cost efficiency report June 20X6 Summary: A cost centre efficiency report gives information about the performance of a cost centre. The cost centre works well, if the consumption variance stays low. A negative consumption variance indicates a poor level of budgeting quality because mismanagement tolerances are granted. The volume difference is caused by other 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 is supposed to budget and record costs based on a marginal cost Accounting system. 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 times actual volume. 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. <?page no="277"?> 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. Solutions: 1-3; 2-4; 3-4; 4-1; 5-2. <?page no="278"?> What is in the Chapter? Costs do not get 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 gives a loop in the cost flow. Those cost allocations are subject to chapter (16) Cost Allocations. We study the transportation business CLYDBANK Ltd. for cost allocations among its cost centres ‘City Logistics’, ‘Long Distance Logistics’, ‘Support’ and ‘Storage’. We discuss cost allocations based on one-directional exchanges with CLYDBANK Ltd. and with TUSCAN (Pty) Ltd. Later in the chapter we cover a higher sophisticated case study HEISFELD Ltd. for mutual exchanges calculated by equation method and iteration method. Learning Objectives: Management Accounting allocates costs to objects. In this chapter, we focus on cost assignments and allocations. We demonstrate 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. 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. Overhead applications fall under cost allocations, too. In contrast, a cost assignment by tracing does not require mathematical operations but is a 1 : 1 relationship between the cost object and its costs. In a Management Accounting process as discussed in chapter (13/ 14) cost allocations apply at 3 stages: 1 st allocation Overheads are derived from expense accounts in Financial Accounting, such as labour, materials etc., and assigned to cost centres. If more than one cost centre is charged with the costs, allocations apply in order to divide, e.g. room costs to different departments based on their square metres. 2 nd allocation When mutual performance support structures apply, costs are transferred from one cost centre (sender) to another one (receiver) in order to refund the provider for the performance delivered. 3 rd allocation Costs are transferred from cost centres to products by cost rates. This is also called an overhead application. This last allocation discharges the cost centres and charges the final cost objects goods manufactured or services rendered. Cost allocations apply in full cost Accounting systems as well as for marginal cost Accounting. In case of marginal cost allocations, only proportional costs are considered for allocations whereas all fixed costs are closedoff to the Profit and Loss account. <?page no="279"?> We study a simple (because one-directional) cost allocation process for CLYDBANK Ltd. Figure 16.1: CLYDBANK Ltd.’s cost centre characteristics <?page no="280"?> 4,120,000.00 555,000.00 282,000.00 120,000.00 Figure 16.2: CLYDBANK Ltd.’s accounts 1 st Allocation How it is done (Cost Allocation) (1) Determine the amount of the base figures of the cost objects the costs are to be assigned to. (2) Write the figures as an a : b : c ratio. If possible, divide the a-, band c-amounts by a constant figure (cancellation). (3) Calculate the percentages of the cost objects by dividing the base figure of one cost object by the sum of all base figures: a / (a + b + c) (4) Multiply the total costs with the percentages. <?page no="281"?> DR MOH CC 03.................... 2,000.00 EUR CR Insurance ................... 2,000.00 EUR 4,120,000.00 920,000.00 555,000.00 135,000.00 2,250,000.00 330,000.00 350,000.00 30,000.00 600,000.00 60,000.00 4,120,000.00 4,120,000.00 555,000.00 555,000.00 282,000.00 80,000.00 120,000.00 27,600.00 150,000.00 60,000.00 2,000.00 8,400.00 50,000.00 24,000.00 282,000.00 282,000.00 120,000.00 120,000.00 920,000.00 2,250,000.00 135,000.00 330,000.00 80,000.00 150,000.00 27,600.00 1,162,600.00 60,000.00 2,790,000.00 1,162,600.00 1,162,600.00 2,790,000.00 2,790,000.00 1,162,600.00 2,790,000.00 Figure 16.3: CLYDBANK Ltd.’s accounts <?page no="282"?> 350,000.00 600,000.00 30,000.00 60,000.00 2,000.00 50,000.00 8,400.00 390,400.00 24,000.00 734,000.00 390,400.00 390,400.00 734,000.00 734,000.00 390,400.00 734,000.00 Figure 16.3: CLYDBANK Ltd.’s accounts (continued) Figure 16.4: CLYDBANK Ltd.’s cost allocations to cost centres 2 nd Allocation The second degree cost allocations reflect the performance exchanges between cost centres. In case one cost centre supports another one, the receiving cost centre reimburses the delivering cost centre. The exchanges are recorded by Bookkeeping entries. The sender cost centre is reimbursed by a credit entry and the receiving cost centres are charged for the costs by debit <?page no="283"?> entries for costs. This way, cost flows follow the path of performance. When a cost centre delivers its entire performance to other cost centres it becomes 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 centres by cost allocations. DR MOH CC 01.................... 78,080.00 EUR CR MOH CC 03.................... 78,080.00 EUR DR MOH CC 02.................... 273,280.00 EUR CR MOH CC 03.................... 273,280.00 EUR DR MOH CC 04.................... 39,040.00 EUR CR MOH CC 03.................... 39,040.00 EUR <?page no="284"?> 920,000.00 2,250,000.00 135,000.00 330,000.00 80,000.00 150,000.00 27,600.00 1,162,600.00 60,000.00 2,790,000.00 1,162,600.00 1,162,600.00 2,790,000.00 2,790,000.00 1,162,600.00 2,790,000.00 78,080.00 1,240,680.00 273,280.00 3,063,280.00 1,240,680.00 1,240,680.00 3,063,280.00 3,063,280.00 1,240,680.00 3,063,280.00 350,000.00 600,000.00 30,000.00 60,000.00 2,000.00 50,000.00 8,400.00 390,400.00 24,000.00 734,000.00 390,400.00 390,400.00 734,000.00 734,000.00 390,400.00 78,080.00 734,000.00 273,280.00 39,040.00 773,040.00 39,040.00 773,040.00 773,040.00 390,400.00 390,400.00 773,040.00 Figure 16.5: CLYDBANK Ltd.’s accounts after internal cost allocations <?page no="285"?> Figure 16.6: CLYDBANK Ltd.’s spreadsheet with internal cost allocations 3 rd Allocation The last cost allocation is for product calculation. We call it 3 rd degree overhead allocation. In Manufacturing Accounting this is referred to as application of overheads. Products are charged by cost centres for performance received. 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. In contrast to output cost centres, auxiliary cost centres do not contribute directly to the production of goods or to service rendering. As a result, no output related reference unit for auxiliary cost centres applies. The table indicates this by ‘n/ a’ (not applicable) in the cost rate cell. 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. <?page no="286"?> Figure 16.7 discloses the cost rates per cost centre as result of the cost allocation process. 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 with regard to the internal cost allocations before we study more complex, mutual, cost allocations. Check Figure 16.7 when reading the explanations below: Primary costs are costs of a cost centre that are assigned directly. Once costs are assigned by 2 nd degree allocations, further costs are added to the total costs in the cost centre. Total costs are primary costs plus all costs assigned to the cost centre by internal cost allocation (2 nd degree allocation). <?page no="287"?> 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 - the Accountant records a credit entry (discharging) for the costs covered - all remaining costs are final costs. Final costs are primary costs plus secondary costs less discharged costs from internal cost allocations (2 nd degree allocation). Internal cost allocations (2 nd degree allocation) is more difficult, when 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. Ad (1): Equation Method The equation method is based on the idea that all costs are charged and discharged simultaneously. There are two equations for every cost centre, one for the total costs TC i and another one for final costs FC j . The index for the cost centres is i and j. i stands for the receiving cost centre and j for the provider. The total number of cost centres is n. (i = 1 … n; j = 1 … n). PC i stands for the primary costs of a cost centre. The factor ij is the portion of the providing cost centre’s (j) performance, received by cost centre i. If cost centre A supports cost centre B to an extent of 35 % of its performance, BA = 35%. n j j ij i i TC PC TC n i ij j j TC FC (with: TC = total costs, PC = primary costs, = percentage of allocation, FC = final costs, i, j = index for cost centres) In order to study internal cost allocations by the equation method, we study the case of TUSCAN (Pty) Ltd. <?page no="288"?> We now look at another case study HEISFELD Ltd., which got more cost centres than TUSCAN (Pty) Ltd. <?page no="290"?> Figure 16.8: HEISFELD Ltd.’s performance structure <?page no="291"?> Figure 16.9: HEISFELD Ltd.’s primary costs <?page no="292"?> 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 . 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 rather simple as only 6 exchange relationships take place between 4 cost centres. However, with full mutual exchanges there would be 12 exchanges between 4 cost centres which can make our equation solving more extensive. 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. Ad (2): Iteration Method The reason for the application of the iteration method is that computers, on which we run the cost allocation routines, are not good at solving equations. However, a computer is good at computing, that is why it is called a computer. Next, we present a cost allocation method based on computing instead of equation solving. It is called iteration, derived from the Latin word ire (= to walk). It works similarly to the equation method, but the cost allocations are made step by step. This means we start the cost calculation of <?page no="293"?> total costs by the primary costs and add secondary costs stepwise. 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 compute, as more accurate the costs will become. In order to perform the iteration process efficiently, we prepare an MS- Excel spreadsheet. It is shown in Figure 16.10 and the following Figures for the HEISFELD Ltd. case. JA = 10/ 148 = 6.76% WJ = 100/ 200 = 50% WA = 100/ 148 = 67.57% WC = 50/ 950 = 5.26% CA = 38/ 148 = 25.68%. JC = 400/ 950 = 42.11%. Figure 16.10: HEISFELD Ltd.’s cost centre support structure <?page no="294"?> 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 any more. 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. <?page no="295"?> Figure 16.11: HEISFELD Ltd.’s iteration process <?page no="297"?> Figure 16.12: HEISFELD Ltd.’s iteration process based on proportional costs <?page no="298"?> 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 in order to calculate the percentage of performance exchange AB . How it is Done (Cost Allocations) (1) Calculate the total costs as the sum of primary costs and costs for receiving support from other cost centres. In a marginal cost Accounting system, only proportional costs apply. (2) 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: 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) Solve the equation system to 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 of total costs that are for support of other cost centres in order to get the final costs FC j . (6) Divide final costs FC by the output of the cost centres to calculate the cost rates. No cost rates for auxiliary cost centres apply. <?page no="299"?> Summary: Management Accounting systems apply multiple cost allocations in order to determine costs for particular cost objects. There is a 1 st degree allocation required in order to assign overheads to cost centres. The 2 nd degree cost allocation is to consider the performance exchange between cost centres. Mutual support relationships require an equation method or can be calculated by iteration. The 3 rd degree cost allocation is based on cost centre cost rates. The allocation charges products with costs and discharges the cost centres where the product has been manufactured or the service been rendered. 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 in order to cross-check cost allocation results (in an Accounting exam). 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 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. 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. XY = 20 %. 2. YX = 20 %. 3. XY = 25 %. 4. YX = 25 %. (3) A company divides 34,000.00 EUR by head count. The cost centres A, B, C, D got 23 / 45 / 62 / 40 employees. How much costs are allocated to cost centre C? 1. 6,200.00 EUR. 2. 21,080.00 EUR. 3. 12,400.00 EUR. 4. 8,000.00 EUR. <?page no="300"?> (4) A cost centre in a production firm receives insurance costs from an insurance cost centre. The insurance will cover damages at the 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. Solutions: 1-3; 2-2; 3-3; 4-2; 5-1. <?page no="301"?> What is in the Chapter? As cost information is needed to control the business, budgets, calculations, monitoring results, profitability checks etc. must be brought to the operating manager’s attention. This is studied by this chapter (17) Reporting on Manufacturing Accounting. We cover the case study LEBUHRAYA Ltd. a production firm for wine bottles. You’ll see its Bookkeeping records and how to develop a report as statement of cost of goods sold and a profitability analysis. Learning Objectives: The role of Management Accountants within a company can be described as internal consultant. Accountants support managers by data. They calculate appropriate cost information, like cost and ratios, for controlling the business. Commonly, information is brought to managers’ attention in form of reports. For the reporting quality, their form matters. Reports can be calculations linked to cost objects, business graphics to display the data history or a figures structure, like timeline or pie diagrams, or ratios, such as return figures or market shares. We teach in this chapter the development of a manufacturing report for a production firm. After studying this chapter, you understand how reports are prepared and how to read them. You can apply reporting in other business situations than here discussed. Within a company, a lot of information about costs is available. It results from budgeting and recording of actual business activities. The latter one comes from Bookkeeping records. One of the major problems is to filter available data in order to provide useful controlling information. Furthermore, Management Accountants prepare management information based on allocations towards cost objects, by providing comparisons and by calculating ratios, such as for performance and liquidity. The field of reporting is wide and depends on the managers need for support and personal preferences. In literature, reporting is always compared to a cockpit. The situation in aviation is very similar and the Management Accountants job within a company is to ‘design the cockpit’. Reporting is the subject that deals with the 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 design a cockpit that shows all data used during flight. In an electronic cockpit the most important information is displayed as one screen that combines an attitude indicator for the pitch and the bank angle (artificial horizon), the direction indicator for the heading flown, the true airspeed indicator and the altimeter together with the vertical speed indicator (sink/ climb rate). Based on that information, a pilot can fly (at least straight and level). However, during flights a pilot runs further <?page no="302"?> checks which required more information, like fuel levels, engine temperature/ pressure checks, power settings etc. The cockpit display must cover these further information needs, too. Next, we demonstrate only two examples for a report linked to manufacturing. We could say, we only build one cockpit instrument - not the entire cockpit. The reporting skills taught are generic. The subject of this chapter is manufacturing reporting. We prepare two reports: - COS report. - Profitability statement. We study the case of LEBUHRAYA Ltd. See below its data sheet. We derive the reporting information from its Bookkeeping records and design the reports. Data Sheet for LEBUHRAYA Ltd. 20,000.00 5,000.00 Figure 17.1: LEBUHRAYA Ltd.’s opening amounts <?page no="303"?> DR Purchase..................... 100,000.00 EUR CR Cash/ Bank.................... 100,000.00 EUR DR Inventory.................... 100,000.00 EUR CR Purchase..................... 100,000.00 EUR DR Labour....................... 200,000.00 EUR CR Cash/ Bank.................... 200,000.00 EUR DR Depreciation ................. 80,000.00 EUR CR Acc. Depr.................... 80,000.00 EUR DR WIP Account.................. 55,000.00 EUR CR Inventory Account............ 55,000.00 EUR DR MOH Account.................. 50,000.00 EUR CR Inventory Account............ 50,000.00 EUR DR WIP Account.................. 180,000.00 EUR CR Labour....................... 180,000.00 EUR DR MOH Account.................. 20,000.00 EUR CR Labour....................... 20,000.00 EUR <?page no="304"?> DR MOH Account.................. 80,000.00 EUR CR Depreciation................. 80,000.00 EUR DR WIP Account.................. 150,000.00 EUR CR MOH Account.................. 150,000.00 EUR DR Finished Goods Inventory..... 300,000.00 EUR CR WIP Account.................. 300,000.00 EUR DR Cash/ Bank.................... 225,000.00 EUR CR Revenue...................... 225,000.00 EUR DR COS Account.................. 150,000.00 EUR CR FG Inventory................. 150,000.00 EUR DR Administration............... 50,000.00 EUR CR Cash/ Bank.................... 50,000.00 EUR DR Marketing.................... 10,000.00 EUR CR Cash/ Bank.................... 10,000.00 EUR <?page no="305"?> 20,000.00 55,000.00 5,000.00 300,000.00 100,000.00 50,000.00 55,000.00 15,000.00 180,000.00 120,000.00 120,000.00 150,000.00 90,000.00 15,000.00 390,000.00 390,000.00 90,000.00 100,000.00 100,000.00 ... 100,000.00 225,000.00 200,000.00 50,000.00 10,000.00 200,000.00 180,000.00 80,000.00 80,000.00 20,000.00 200,000.00 200,000.00 300,000.00 150,000.00 225,000.00 225,000.00 150,000.00 300,000.00 300,000.00 150,000.00 150,000.00 150,000.00 50,000.00 50,000.00 Figure 17.2: LEBUHRAYA Ltd.’s accounts <?page no="306"?> 10,000.00 10,000.00 150,000.00 225,000.00 50,000.00 10,000.00 15,000.00 225,000.00 225,000.00 15,000.00 Figure 17.2: LEBUHRAYA Ltd.’s accounts (continued) <?page no="307"?> Figure 17.3: LEBUHRAYA Ltd.’s statement of COS Ad (1): Calculation of Materials <?page no="308"?> Ad (2): Calculation of Labour Ad (3): Application of Overheads Ad (4): Adjustments <?page no="309"?> Figure 17.4: LEBUHRAYA Ltd.’s profitability analysis Summary: Management Accountants provide information by reports. The reports contain calculations, ratios and/ or comparisons, which are useful for managers to make decisions. Reports are prepared on monthly and annual basis. Besides of standard reports, Management Accountants provide exceptional reports too. Often business graphics, such as charts and pie diagrams are added to the reports. Question Bank: (1) A report discloses purchases at 10,000.00 EUR, an opening value of raw materials at 2,500.00 EUR, a closing stock of raw materials of 1,000.00 EUR and indirect materials of 4,000.00 EUR to be allocated by the application of overheads. How much is the total of direct materials? 1. 10,000.00 EUR. 2. 12,500.00 EUR. 3. 11,500.00 EUR. 4. 7,500.00 EUR. (2) What 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. <?page no="310"?> (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) What 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. Solutions: 1-4; 2-2; 3-4; 4-2; 5-1. <?page no="311"?> What is in the Chapter? Manufacturing Accounting is subject of the next chapter (18) Job Order Costing and (19) Process Costing. In manufacturing Accounting, we calculate the unit costs per product are calculated. In chapter (18) we study MAHKOTA (Pty) Ltd. case study, a production firm for cell phone pouches. The company produces 2 distinguishable types of goods by 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 with consideration of closing stocks. Learning Objectives: Manufacturing Accounting is relevant for Financial Accounting (inventory valuation) as well as for Management Accounting (calculation). You observed already job order costing in chapter (4) with regard to the product calculation for PENOR PLC’s doors and windows. In this chapter (18) you learn the job order costing method that is based on internal job orders. After studying this chapter, you understand calculation and the account structure applicable for calculations in a production environment. Calculations provide the unit cost of manufacturing for goods or services. Manufacturers control production based on internal job orders and assign direct and overheads thereto. At the end of production - when goods are finished and added to stock - the total costs of the job order (batch costs) are divided by the goods quantity (lot size) which gives the unit costs of manufacturing. A job order is an internal order for production of goods or parts thereof. A job order is represented by a Job Order account or its reconciliation account: Work-in-Process account. Overheads in a department (cost centre) are first collected in MOHaccounts and thereafter allocated to products based on performance outputs (overhead application). The overhead allocation is based on a predetermined overhead allocation rate. The application of overheads is shown as an arrow from cost centre Accounting to calculation in Figure 13.1. A company that applies a marginal cost Accounting system, will only apply proportional costs. In contrast, production firms applying absorption costing apply full overheads. Hence, the predetermined overhead allocation rate is based on either proportional costs or full costs. Applying overheads by predetermined allocation rates, likely results in differences between actual overheads and applied overheads. This results in a deviation of manufacturing overheads. A <?page no="312"?> debit balanced Manufacturing Overheads account indicates under-applied overheads - a credit balanced Manufacturing Overheads account indicates over-applied overheads. Manufacturing Overheads accounts are closed-off to the Cost of Sales account. Deviations are considered as profit or loss. 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 certain products. (4) Prepare Manufacturing Overhead accounts per cost centre. Plan cost rates for cost centres by dividing budgeted overheads by planned output of the cost centre. (5) Assign direct costs, such as direct labour and direct materials, to the job orders. Make debit entries in the applicable Job Order account. (6) Add manufacturing overheads to the applicable Manufacturing Overhead account. (7) Apply overheads based on the predetermined overhead allocation rate per job order. Calculate the amount for the transferred manufacturing overheads by multiplying the actual job order quantity by the predetermined overhead allocation rate. Make debit entries in the applicable Job Order accounts and credit the Manufacturing Overhead account. (8) Once a job order is finished, goods are transferred to the Finished Goods Inventory account. Make a debit entry in the Finished Goods Inventory account and credit the amount to the Job Order account. For unit cost calculation, divide the total costs of the finished goods by the lot size of the job order. (9) Balance-off the Job Order accounts. Use the Workin-Process account as summary account. Its balance is to be disclosed as inventory of work-in-process on the balance sheet. (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. <?page no="313"?> (13) Add all non-manufacturing costs to the Profit and Loss account. (14) Calculate profit. We introduce the first case study for a Job Order Costing system: the manufacturer, MAHKOTA (Pty) Ltd. Data Sheet for MAHKOTA (Pty) Ltd. DR Cash/ Bank.................... 50,000.00 AUD CR Issued Capital............... 50,000.00 AUD DR Cash/ Bank.................... 300,000.00 AUD CR Interest Bear. Liabilities... 300,000.00 AUD DR Interest..................... 10,500.00 AUD CR Cash/ Bank.................... 10,500.00 AUD <?page no="314"?> DR P, P, E Account.............. 200,000.00 AUD CR Cash/ Bank.................... 200,000.00 AUD DR Depreciation................. 40,000.00 AUD CR Acc. Depr. .................. 40,000.00 AUD DR Purchase..................... 120,000.00 AUD CR Cash/ Bank.................... 120,000.00 AUD DR Inventories.................. 120,000.00 AUD CR Purchase..................... 120,000.00 AUD DR WIP Pouch-A.................. 12,000.00 AUD CR Inventory.................... 12,000.00 AUD DR WIP Pouch-B.................. 17,000.00 AUD CR Inventory.................... 17,000.00 AUD <?page no="315"?> DR MOH Account.................. 74,000.00 AUD CR Inventory.................... 74,000.00 AUD DR MOH Account.................. 40,000.00 AUD CR Depreciation ................. 40,000.00 AUD DR Labour....................... 300,000.00 AUD CR Cash/ Bank.................... 300,000.00 AUD DR Administration............... 94,000.00 AUD CR Labour....................... 94,000.00 AUD DR MOH Account.................. 206,000.00 AUD CR Labour....................... 206,000.00 AUD DR WIP Pouch-A .................. 158,000.00 AUD CR MOH Account.................. 158,000.00 AUD DR WIP Pouch-B .................. 158,000.00 AUD CR MOH Account.................. 158,000.00 AUD <?page no="316"?> DR COS Account.................. 4,000.00 AUD CR MOH Account.................. 4,000.00 AUD DR FG Inventory A............... 110,500.00 AUD CR WIP Pouch-A.................. 110,500.00 AUD DR FG Inventory B............... 78,750.00 AUD CR WIP Pouch-B.................. 78,750.00 AUD DR COS Account.................. 88,400.00 AUD CR FG Inv A..................... 88,400.00 AUD DR COS Account.................. 51,187.50 AUD CR FG Inv B..................... 51,187.50 AUD DR Cash/ Bank.................... 208,000.00 AUD CR Revenue...................... 208,000.00 AUD <?page no="317"?> DR Cash/ Bank.................... 163,800.00 AUD CR Revenue...................... 163,800.00 AUD 50,000.00 10,500.00 50,000.00 50,000.00 300,000.00 200,000.00 50,000.00 208,000.00 120,000.00 163,800.00 300,000.00 91,300.00 721,800.00 721,800.00 91,300.00 300,000.00 300,000.00 10,500.00 10,500.00 300,000.00 200,000.00 200,000.00 40,000.00 40,000.00 200,000.00 40,000.00 40,000.00 120,000.00 120,000.00 40,000.00 120,000.00 12,000.00 74,000.00 158,000.00 17,000.00 40,000.00 158,000.00 74,000.00 206,000.00 4,000.00 17,000.00 320,000.00 320,000.00 120,000.00 120,000.00 4,000.00 4,000.00 17,000.00 Figure 18.1: MAHKOTA (Pty) Ltd.’s accounts <?page no="318"?> 12,000.00 110,500.00 17,000.00 78,750.00 158,000.00 59,500.00 158,000.00 96,250.00 170,000.00 170,000.00 175,000.00 175,000.00 59,500.00 96,250.00 300,000.00 94,000.00 94,000.00 94,000.00 206,000.00 300,000.00 300,000.00 4,000.00 143,587.50 110,500.00 88,400.00 88,400.00 22,100.00 51,187.50 110,500.00 110,500.00 143,587.50 143,587.50 22,100.00 78,750.00 51,187.50 371,800.00 208,000.00 27,562.50 163,800.00 78,750.00 78,750.00 371,800.00 371,800.00 27,562.50 143,587.50 371,800.00 123,712.50 123,712.50 94,000.00 123,712.50 10,500.00 123,712.50 371,800.00 371,800.00 123,712.50 123,712.50 Figure 18.1: MAHKOTA (Pty) Ltd.’s accounts (continued) <?page no="319"?> Figure 18.2: MAHKOTA (Pty) Ltd.’s profitability analysis Figure 18.3: MAHKOTA (Pty) Ltd.’s pro-forma balance sheet So far, we studied the structure of a job order costing system. We discuss below a more complicated case but follow the same structure. We demonstrate a company with more products <?page no="320"?> and more cost centres. We also show the effect of goods stored in inventory. The company WEIXDORF Ltd. produces 3 different types (banana, lemon, strawberry) of ice cream in 2 cost centres: Production and Filling. Data Sheet for WEIXDORF Ltd. DR Cash/ Bank.................... 50,000.00 EUR CR Issued capital............... 50,000.00 EUR DR Cash/ Bank.................... 50,000.00 EUR CR Interest Bear. Liabilities... 50,000.00 EUR <?page no="321"?> DR Interest Bear. Liabilities... 2,000.00 EUR CR Cash/ Bank.................... 1,000.00 EUR CR Accounts Payables A/ P ........ 1,000.00 EUR DR Interest..................... 1,250.00 EUR CR Cash/ Bank.................... 1,250.00 EUR DR P, P, P Account.............. 20,000.00 EUR DR VAT.......................... 4,000.00 EUR CR Cash/ Bank.................... 24,000.00 EUR DR P, P, E Account.............. 14,500.00 EUR DR VAT.......................... 2,900.00 EUR CR Cash/ Bank.................... 17,400.00 EUR DR Depreciation ................. 5,000.00 EUR CR Acc. Depr. .................. 5,000.00 EUR DR Depreciation ................. 2,900.00 EUR CR Acc. Depr.................... 2,900.00 EUR DR Purchase..................... 43,200.00 EUR DR VAT.......................... 8,640.00 EUR CR Cash/ Bank.................... 51,840.00 EUR <?page no="322"?> DR Purchase..................... 84,000.00 EUR DR VAT.......................... 16,800.00 EUR CR Cash/ Bank.................... 100,800.00 EUR DR Purchase..................... 24,000.00 EUR DR VAT.......................... 4,800.00 EUR CR Cash/ Bank.................... 28,800.00 EUR DR Labour....................... 270,000.00 EUR CR Cash/ Bank.................... 270,000.00 EUR DR Administration............... 70,000.00 EUR CR Labour....................... 70,000.00 EUR DR 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 <?page no="323"?> 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 DR Raw Materials Container...... 43,200.00 EUR CR Purchase..................... 43,200.00 EUR DR Raw Materials Milk........... 84,000.00 EUR CR Purchase..................... 84,000.00 EUR DR Raw Materials Fruits......... 24,000.00 EUR CR Purchase..................... 24,000.00 EUR <?page no="324"?> DR WIP Banana................... 13,200.00 EUR CR Raw Materials Containers..... 13,200.00 EUR DR WIP Lemon.................... 15,000.00 EUR CR Raw Materials Containers..... 15,000.00 EUR DR WIP Strawberry............... 15,000.00 EUR CR Raw Materials Containers..... 15,000.00 EUR DR WIP Banana................... 25,666.67 EUR CR Raw Materials Milk........... 25,666.67 EUR DR WIP Lemon.................... 29,166.67 EUR CR Raw Materials Milk........... 29,166.67 EUR DR WIP Strawberry............... 29,166.67 EUR CR Raw Materials Milk........... 29,166.67 EUR DR WIP Banana .................. 7,333.33 EUR CR Raw Materials Fruits......... 7,333.33 EUR DR WIP Lemon.................... 8,333.33 EUR CR Raw Materials Fruits......... 8,333.33 EUR DR WIP Strawberry............... 8,333.33 EUR CR Raw Materials Fruits......... 8,333.33 EUR <?page no="325"?> 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 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 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 <?page no="326"?> DR Cash/ Bank.................... 695,058.00 EUR CR VAT.......................... 115,843.00 EUR CR Revenue...................... 579,215.00 EUR DR Cost of Goods Sold........... 108,145.00 EUR CR FG Inventory Banana.......... 108,145.00 EUR DR Cost of Goods Sold........... 119,663.70 EUR CR FG Inventory Lemon........... 119,663.70 EUR DR Cost of Goods Sold........... 125,750.00 EUR CR FG Inventory Strawberry...... 125,750.00 EUR 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 <?page no="327"?> 20,000.00 20,000.00 5,000.00 5,000.00 20,000.00 20,000.00 5,000.00 5,000.00 20,000.00 5,000.00 4,000.00 115,843.00 5,000.00 5,000.00 2,900.00 2,900.00 2,900.00 8,640.00 7,900.00 7,900.00 16,800.00 4,800.00 2,475.00 76,228.00 115,843.00 115,843.00 76,228.00 43,200.00 43,200.00 579,215.00 579,215.00 84,000.00 84,000.00 579,215.00 579,215.00 24,000.00 24,000.00 151,200.00 151,200.00 Figure 18.4: WEIXDORF Ltd.’s accounts 43,200.00 43,200.00 579,215.00 579,215.00 84,000.00 84,000.00 579,215.00 579,215.00 24,000.00 24,000.00 151,200.00 151,200.00 <?page no="328"?> 270,000.00 70,000.00 70,000.00 70,000.00 150,000.00 50,000.00 270,000.00 270,000.00 70,000.00 70,000.00 14,500.00 14,500.00 2,900.00 2,900.00 14,500.00 14,500.00 2,900.00 2,900.00 14,500.00 2,900.00 150,000.00 47,520.00 50,000.00 16,940.00 5,000.00 54,000.00 2,900.00 19,250.00 7,173.91 54,000.00 5,201.09 19,250.00 6,653.91 2,661.09 162,173.91 162,173.91 58,101.09 58,101.09 12,375.00 5,201.09 43,200.00 13,200.00 7,173.91 15,000.00 15,000.00 12,375.00 12,375.00 43,200.00 43,200.00 84,000.00 25,666.67 24,000.00 7,333.33 29,166.67 8,333.33 29,166.67 8,333.33 84,000.00 84,000.00 24,000.00 24,000.00 13,200.00 110,660.00 15,000.00 125,750.00 25,666.67 29,166.67 7,333.33 8,333.33 47,520.00 54,000.00 16,940.00 19,250.00 110,660.00 110,660.00 125,750.00 125,750.00 Figure 18.4: WEIXDORF Ltd.’s accounts (continued) <?page no="329"?> 15,000.00 125,750.00 6,653.91 362,873.70 29,166.67 2,661.09 8,333.33 108,145.00 54,000.00 119,663.70 19,250.00 125,750.00 125,750.00 125,750.00 362,873.70 362,873.70 110,660.00 108,145.00 125,750.00 119,663.70 1,886.25 4,564.73 628.75 1,521.57 110,660.00 110,660.00 125,750.00 125,750.00 628.75 1,521.57 125,750.00 125,750.00 1,886.25 6,450.97 4,564.73 125,750.00 125,750.00 6,450.98 6,450.97 362,873.70 579,215.00 97,048.23 97,048.23 6,450.97 97,048.23 97,048.23 70,000.00 97,048.23 1,250.00 138,640.33 579,215.00 579,215.00 41,592.10 138,640.33 97,048.23 41,592.10 41,592.10 138,640.33 138,640.33 41,592.10 1,000.00 1,000.00 1,000.00 Figure 18.4: WEIXDORF Ltd.’s accounts (continued) <?page no="330"?> Figure 18.5: WEIXDORF Ltd.’s income statement Figure 18.6: WEIXDORF Ltd.’s balance sheet Summary: A job order costing system calculates products in a manufacturing company. The job order costing system is based on Work-in-Process WIP-accounts and Manufacturing Overheads MOHaccounts. The allocation of overheads charges the cost objects with their portion of overheads caused by usage of production facilities in the cost centre(s). It results in a debit entry in the Work-in-Process WIP-account(s) and a credit entry in the Manufacturing Overheads MOH-account(s). The <?page no="331"?> overhead allocation is based on predetermined overhead allocation rates POR. A difference between overheads and applied overheads is closed-off to the Cost of Sales account and changes the operational profit for the period. Working Definitions: Job Order: A job order is an internal order for production of goods or parts thereof. Predetermined Overhead Allocation Rate: A predetermined overhead allocation rate (POR) is a cost rate for charging products with cost centre overheads that is based on budgeted overheads and budgeted cost centre outputs. 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. 4. For other income. Solutions: 1-1; 2-3; 3-4; 4-2; 5-3. <?page no="332"?> What is in the Chapter? In chapter (19) we study process costing which applies for production line manufacturing. The purpose of process costing is the same as of job order costing. As the products follow an identical sequence of production steps, a process costing is a simplification. It only applies 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. Learning Objectives: In this chapter (19) you learn alternative calculations applicable for line production. You study the account structure and the cost flow. You will see how along the flow of goods through a production line their unit costs increase. After studying this chapter, you understand and can apply a process costing system. You also can calculate goods produced in a production line when finished as well as when still under production. You can distinguish a job order costing system from a process costing system. In particular, you learn how to calculate goods not yet finished based on equivalent units and can consider opening stock in production with regard to different cost categories at different percentages of completion for calculation. Process Costing follows a multiplestep calculation. With every step of production, the cost of manufacturing increase. Every department allocates its total costs to 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 step by step. The last production step results in the total unit costs of manufacturing. After completion, the goods are added to Finished Goods Inventory accounts. Process Costing systems apply only when manufacturing is organised along a straight sequence of production steps, such as in industries, where raw materials are converted into homogeneous products. Examples are brick production, paper production or breweries. You also can apply process costing for service providers who have a constant workflow, like a revenue service or a doctor’s clinic. It is required that a continuous flow of goods/ documents exists. Units are often indistinguishable. Costs are allocated on a monthly basis to goods produced during that period of time. Although there is a continues flow of units, the best way to capture the idea of a process costing system is thinking about an assembling line, where a batch of units goes from one production step to the next one. That batch leaves a step of production after completion and is transferred to the next one. <?page no="333"?> In a process costing system, the Workin-Process account is linked to cost centres. Overheads are added to the Work-in-Process accounts and then allocated to the units of production. The cost allocation to the departments is the same as in a Job Order Costing system. Costs are debited the WIPaccounts. A Manufacturing Overheads account can be skipped as overheads are added straight to the WIP-account. 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 products. The costs are carried forward to the next cost centre. This discharges the previous cost centre and adds the costs to the next following cost centre along the line of production. After the costs of the last production step are allocated, the costs of the products are added to finished goods inventories by closing-off the last WIP-account. 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. (5a) If the products are finished within a production step, divide the total costs of the Work-in-Process account by the quantity of products completed therein. (5b) If the products are not finished completely within a production step, transform the product quantity to equivalent units. Calculate the equivalent unit as percentage of completion × amount of unfinished goods. For finished goods, the equivalent unit per product is 1. Divide the costs of the current production step by the amount of equivalent units. The costs of previous production steps are allocated to the products by the product quantity (not by equivalent units! ) Not completed goods are not transferred to the next production step and show as the balancing figure (debit balanced) of the Work-in-Process account. Completed products are transferred to the next Work-in-Process account. <?page no="334"?> (6) Transfer completed (with regard to the production step) goods to the Work-in-Process account that represents the next following production step. Product values are quantities × unit costs. (7) Once the goods are finished with regard to all production steps, transfer them to the Finished Goods Inventory account. Make a debit entry in the Finished Goods Inventory account and credit the amount to the Work-in-Process account. For unit cost calculation, divide the total costs of the finished goods by the quantity of finished goods during the Accounting period. (8) Once goods are sold, add them to the Cost of Goods Sold COS account and reduce the finished goods inventories by a credit entry in the Finished Goods Inventory account. (9) Record the revenue. (10) Add all non-manufacturing costs to the Profit and Loss account. (11) Debit the cost of sales to the Profit and Loss account. (12) Calculate the profit. 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 shoe calculation. Data Sheet for EDEWECHT (Pty) Ltd. <?page no="335"?> 160,000.00 160,000.00 160,000.00 540,000.00 120,000.00 ... 160,000.00 120,000.00 540,000.00 Figure 19.1: EDEWECHT (Pty) Ltd.’s accounts 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 <?page no="336"?> 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 160,000.00 160,000.00 160,000.00 160,000.00 540,000.00 90,000.00 120,000.00 120,000.00 450,000.00 540,000.00 540,000.00 ... 160,000.00 120,000.00 540,000.00 40,000.00 80,000.00 30,000.00 30,000.00 270,000.00 90,000.00 340,000.00 200,000.00 40,000.00 30,000.00 90,000.00 120,000.00 280,000.00 Figure 19.2: EDEWECHT (Pty) Ltd.’s accounts <?page no="337"?> DR WIP CC-002................... 340,000.00 EUR CR WIP CC-001................... 340,000.00 EUR DR WIP CC-003................... 540,000.00 EUR CR WIP CC-002................... 540,000.00 EUR 40,000.00 340,000.00 80,000.00 540,000.00 30,000.00 30,000.00 270,000.00 90,000.00 340,000.00 340,000.00 540,000.00 Figure 19.3: EDEWECHT (Pty) Ltd.’s WIP-accounts <?page no="338"?> 40,000.00 30,000.00 90,000.00 120,000.00 540,000.00 820,000.00 Figure 19.3: EDEWECHT (Pty) Ltd.’s WIP-accounts (continued) 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. Next, we study what happens, if a production company does not complete a production step. In a process costing system uncompleted products are represented by equivalent units. An equivalent unit is the quantity of goods calculated as amount × percentage of completion. Equivalent units apply in order 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 divide the costs to all products. If all products are completed to a certain percentage, we do the same. Only in cases when some products are completed and some are not, we allocate costs by an equivalent unit. 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. <?page no="339"?> Below, we apply the concept of cost allocation based on equivalent units for EDEWECHT (Pty) Ltd.: DR FG Inventory................. 790,115.00 EUR CR WIP CC-003................... 790,115.00 EUR DR Cash/ Bank.................... 1,400,000.00 EUR CR Revenue...................... 1,400,000.00 EUR DR Cost of Sales................ 665,360.00 EUR CR FG Inventory................. 665,360.00 EUR <?page no="340"?> 160,000.00 160,000.00 160,000.00 160,000.00 540,000.00 90,000.00 120,000.00 120,000.00 450,000.00 540,000.00 540,000.00 ... 160,000.00 120,000.00 1,400,000.00 540,000.00 40,000.00 340,000.00 80,000.00 540,000.00 30,000.00 30,000.00 270,000.00 90,000.00 340,000.00 340,000.00 540,000.00 40,000.00 790,115.00 790,115.00 665,360.00 30,000.00 124,755.00 90,000.00 790,115.00 790,115.00 120,000.00 124,755.00 540,000.00 29,885.00 820,000.00 820,000.00 29,885.00 1,400,000.00 1,400,000.00 665,360.00 665,360.00 665,360.00 1,400,000.00 734,640.00 1,400,000.00 1,400,000.00 734,640.00 Figure 19.4: EDEWECHT (Pty) Ltd.’s accounts <?page no="341"?> 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 quantity 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. Working Definition: Equivalent Unit: An equivalent unit is the quantity of goods calculated as amount × percentage of completion. 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 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? <?page no="342"?> 1. 0. 2. 3. 3. 4. 4. 5. Solutions: 1-1; 2-4; 3-3; 4-2, 5-2. <?page no="343"?> What is in the Chapter? Besides of product calculation and profitability analysis, fixed cost management is an important feature of Management Accounting. We cover this subject by two alternatives methods in the next following chapters. Chapter (20) Multi-Level Contribution Margin Accounting shows how a hotel chain allocates fixed costs to different houses by the case study FLINDERS Ltd. We study how to assign fixed costs to different levels of aggregation. Learning Objectives: Management of fixed costs is important, as fixed costs nowadays dominate the cost mix. A marginal cost Accounting system excludes fixed costs from cost rates because they do not matter for day-to-day decisions. Hence, companies must manage their fixed costs extra. You learn how to structure fixed costs and how to allocate them to cost centre levels. The allocations of fixed costs follow dependencies and responsibilities. After studying this chapter, you understand the problem of fixed cost allocations for decision making and you can run a multi-level contribution margin Accounting system. In a multi-level contribution margin Accounting system, the profitability analysis works along different levels of allocations. At first, the calculation starts with single products. For profit calculation, variable costs of the products are deducted from revenues which gives the contribution margin CM1. Thereafter fixed costs for products are deducted if the fixed costs apply only for the specific products. We call that the contribution margin CM2. Next, product groups are formed and fixed costs that apply for the groups of products are deducted to determine the contribution margin CM3. Besides, product groups, plants or distribution channels are used to define groups of cost objects. The process is continued up to the last contribution margin which is the profit of the company By this approach, matches of fixed costs to cost objects are identified and allow a fixed cost management that avoids cost allocations based on the average principle. If costs cannot be allocated to certain cost objects, they get carried on to the next lower level of cost allocations. The last level is the entire company. Multi-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. This guarantees the allocation of costs by the cost-by-cause principle. These allocations provide Marketing with valuable cost information and support product mix and distribution channel decisions. We study multi-level Contribution Margin Accounting with a case study from Hospitality Management. Below <?page no="344"?> we discuss a hotel chain that runs hotels in Berlin and Amsterdam. Find below the data sheet for FLINDERS Ltd. Data Sheet for FLINDERS Ltd. Figure 20.1: FLINDERS Ltd.’s sales information for 7/ 20X6 <?page no="345"?> The purpose of contribution margin Accounting is to assign fixed costs to cost objects in order to understand, what happens, in case the cost objects change or are given up. We study the FLINDERS Ltd.’s hotel case more in the details. <?page no="346"?> Figure 20.2: FLINDERS Ltd.’s multi-level CMA Contribution margin Accounting does not apportion costs that result from shared resources (no allocations apply). By contribution margin Accounting, managers can study the overheads assigned to particular cost objects and to groups thereof in order to make decisions on different levels of aggregation. Summary: 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 the fixed costs are for, which gives them valuable information for fixed cost management and product decisions. <?page no="347"?> 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 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. Solutions: 1-4; 2-3; 3-4; 4-2; 5-1. <?page no="348"?> What is in the Chapter? In chapter (21) Activity Based Costing, you learn a modern Controlling approach based on business process chains. We’ll introduce the concept of an activity based costing system (ABC) for the airliner TORQUAY Ltd. and focus on their fixed costs for Ticketing, Re-scheduling and Advertising departments. In order to point out the conceptual differences, we compare the costs allocations made to those of 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). Learning Objectives: Activity based costing (ABC) became a popular Management Accounting instrument over the last decades. It is linked to the concepts of business reengineering. Both systems work on business activities and process chains. ABC assigns costs to business processes, which are sequences of business activities that in general cross departmental borders. One important aspect about Activity Based Costing is, that costs are allocated via cost drivers. A cost driver is a factor that determines the utilisation of resources represented by fixed costs. A cost driver looks like a reference unit but the difference is that the cost driver does not cause costs. It divides costs for the utilisation of resources already standingby. ABC allocates portions of fixed costs to business activities. ABC is no alternative concept to a marginal cost Accounting system. It only applies when no direct fixed cost management is possible. Allocations along cost drivers are based on the average principle which makes the cost rates become dividers. We recommend the application of ABC for business process reengineering. 62 In no case, an ABC system should apply for product calculations as fixed costs are allocated by average principle to cost objects. Neither do we endorse software applying ABC for product calculations. The allocation principle endangers a company because it leads to volatile unit costs. The average principle means that in a hotel the only guest must cover all costs. This is not a good idea for unit cost calculation and pricing! After this short academic appraisal of ABC, we refer to what you should lean in this chapter: Below, we introduce an Activity Based Costing system and demonstrate its cost allocations. After studying this chapter, you understand ABC and can discuss concepts of Activity Based Costing in comparison to traditional (cost centre based) Accounting systems. You will be able to design an Activity Based Costing system on your <?page no="349"?> own. You gain an awareness of the application of ABC and will understand its high potential for the design and management of business processes. The main reason for the introduction of ABC are today’s cost structures. Many overheads are almost completely fixed costs. This development is caused by how companies work and what kind of resources they apply. More and more, machinery replaces direct work. Product costs contain less direct work but more maintenance, depreciation and supervision. The application of a marginal cost Accounting system with a percentage of variable costs down to 2 …5 % of the total costs, becomes less helpful for management support. Management Accountants strive to look for factors that influence costs. They need to know in order to make changes in costs. Most costs are driven by activities. In a traditional marginal cost Accounting system, costs are assigned and allocated based on the cost-by-cause principle. The question is: Is production the reason for the cost? The answer allows only to allocate proportional costs to goods. In contrast, an Activity Based Costing system assigns costs to activities based on the average allocation principle. E.g., in Procurement costs for order management are classified as fixed costs. No costs in the procurement division depend on the quantity of finished goods. The order quantity is identified 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. In contrast to a reference unit, cost drivers do not depend proportionally on the output. Fixed costs are not changed by cost drivers but the management makes decisions about the allocation of resources to, e.g. the Procurement division, based on the CD ‘orders’. An Activity Based Costing system assigns costs to cost centres similar to a traditional Cost Accounting system. A traditional Cost Accounting system is in the best case a combination of a marginal cost Accounting and a contribution margin Accounting. Unlike a traditional Cost-Accounting system, there is no internal cost allocation in an Activity Based Costing system. Costs of the cost centre are structured along their dependency on cost drivers and allocated to cost pools. A cost pool is a portion of costs which depends on the same cost driver. The allocation of costs to cost pools is often based on the time spent in a cost centre for that particular activity. All costs allocated to cost pools are divided by the activity amount, in order to determine the activity cost rate. The currency of the activity cost rate is, e.g., EUR/ CD. In literature, the term activity cost rate is replaced by process cost rate PCR. In terms of the calculation steps, an ABC system is similar to a traditional cost Accounting system. 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. <?page no="350"?> We look at an example from the university to make the concept understood. A ‘How is is done’ section is following. Think about costs in a professors’ department. The 1 st degree cost allocation assigns salary, office costs and computer costs to the cost centre. This one is followed by an allocation to cost pools. The 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 tell the Accountant, that teaching and class preparation takes 60 % of the workload, 30 % is for research and 10 % is spent on administration tasks. 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 have to attend. Based on the interview data, the cost pool Teaching receives 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 amounts. 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 a process cost rate 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 an Accounting class requires to determine the weekly hours. This is the 3 rd cost allocation. A class taught 4 lessons per week during one year costs: 4 × 1,500 = 6,000.00 EUR. An ABC system assigns fixed costs that can be allocated by cost drivers, to cost pools. In the cost pools, process cost rates for activities are calculated. For process calculation, the activities included therein need to be calculated by PCR times usage factor. A business process is a sequence of activities in order to serve a product or service. 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 run in cost centres. (3) Identify cost drivers for activities. <?page no="351"?> (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 the managers responsible for cost centres. In the interviews, the workload per cost pool is determined. Use percentages provided by the experts or time measurement in order to calculate a cost allocation ratio between cost pools. Allocate costs based on the ratios. (6) Measure/ plan the activity amounts and express them in cost driver units. (7) Divide the costs per cost pool by the cost driver amounts in order to calculate the process cost rate PCR. The unit of the process cost rate is EUR/ CDamount. (8) Measure/ plan the cost driver amount per product. Call that cost driver amount the utility factor of an activity. (9) Aggregate activities to business processes based on the business process models. (10) Calculate goods/ services that apply the activities/ business process by multiplying the process cost rates × utility factor. (11) Add the process costs of business processes along the activities therein. Data Sheet for TORQUAY Ltd. <?page no="352"?> Figure 21.1: TORQUAY Ltd.’s revenue Traditional Cost-Accounting System <?page no="353"?> 1,100,000.00 322,494.02 720,000.00 3,000,000.00 5,897,505.98 600,000.00 2,000,000.00 322,494.02 1,642,494.02 120,000.00 1,642,494.02 1,642,494.02 6,220,000.00 6,220,000.00 1,642,494.02 1,380,000.00 2,100,000.00 5,897,505.98 9,377,505.98 9,377,505.98 9,377,505.98 9,377,505.98 Figure 21.2: TORQUAY Ltd.’s accounts Figure 21.3: TORQUAY Ltd.’s calculation based on a traditional cost Accounting system Activity Based Costing (partial) <?page no="354"?> To implement ABC only in certain areas is common in Accounting. The cost allocations along a marginal cost Accounting system in many departments are quite effective and do not need an additional ABC. Only in departments, where managers do not find sufficient direct costs but good cost drivers, an Activity Based Costing system is promising. Figure 21.4: TORQUAY Ltd.’s ABC cost centre Sales Office <?page no="355"?> Figure 21.5: TORQUAY Ltd.’s route calculation on a partial ABC system Caution! Activity Based Costing provides cost rates for activities, which make you think, more activities will lead to higher costs and less activity runs will reduce costs. This is not the case. As the cost rates of an activity only contain allocated fixed costs, a change of processes does not change costs. For cost management based on ABC, costs must be changed by decisions, followed by a new ABC- Calculation. Activity Based Management (ABM) is a management process based on Activity Based Costing information. In Activity Based Management, cost decisions come first. After making a decision about costs, cost pooling, calculation of process cost rates for activities and business process calculation follow. This procedure is different to marginal cost Accounting systems. In a marginal cost Accounting system, the manager has <?page no="356"?> to change the business process, like avoiding double work, re-runs of activities etc. Costs, then change automatically according to the volume. Double volume causes double costs. In contrast, with ABM, business process runs and cost occurrences are not interrelated. If the manager ceteris paribus halves the process runs, but does not make any cost adjustments, the cost rate per process will double. An increase of process runs reduces the process cost rate. Process cost rates merely reflect capacity loading 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, which are about amendments made to the business model. 1 st Scenario: Figure 21.6: TORQUAY Ltd.’s alternative activity analysis <?page no="357"?> Figure 21.7: TORQUAY Ltd.’s alternative Profitability Analysis 2 nd Scenario: Figure 21.8: TORQUAY Ltd.’s process cost rates, 2 nd amendment <?page no="358"?> Figure 21.9: TORQUAY Ltd.’s profitability analysis, 2 nd amendment <?page no="359"?> 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 along an 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. 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 in order 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 CDamount. Question Bank: (1) What is the difference between a cost driver and a reference unit? 1. A reference unit depends proportional on the output. 2. None. 3. A cost driver is more accurate as it refers to activities. 4. A cost driver measures the cost of a cost pool in compliance with the cost-by-cause principle. (2) In a cost pool, there are labour costs at 5,000.00 EUR and Depreciation to the extent of 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. <?page no="360"?> 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="361"?> 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 CM Contribution Margin CMA Contribution Margin Accounting <?page no="362"?> 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 PC Delta Proportional Costs Dep Department Depr, Dpr Depreciation 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 fst 90°-Fastener FUE Fuel costs <?page no="363"?> 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 MOF Manufacturing Overheads account for the Filling department MOI Memorandum of Incorporation <?page no="364"?> 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 Managment OTH Other Costs out Outsourcing P Probability P Profit P out Profit for outsourcing screnario pan Pane P&L Profit and Loss PC Proportional costs 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 R/ E Retained Earnings Res, RES Reserves <?page no="365"?> 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 slb Slab 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 WP Wirtschaftsprüfer, auditor Wst Waste <?page no="366"?> ZAR South African Rand Standard deviation Mean <?page no="372"?> 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., Berkau, K.S. [2018]: Basics of Accounting. 5th edition, Munich. Berkau, C. [2019]: Financial State ments, 4th edition Munich. Berkau, C. [1994]: Vernetztes Prozeß kostenmanagement. Wiesbaden. Britzelmaier, B. [2017]: Controlling - Grunlagen, Praxis, Handlungsfelder. 2. Aufl., Hallbergmoos. Correia, C. et al. [2007]: Financial Management. 6 th edition, Cape Town. Drury, C. [2017]: Management and Cost Accounting. 10 th edition, Florence KY. Flynn, D.; Kornhof, C. [2016]: Fundamental Accounting. 7 th edition. Cape Town. Garrison, R.H.; Noreen, E.W.; Brewer, P.C. [2020]: Managerial Accounting. 17 th edition. Boston MA. Grunwald, G.; Hempelmann, B. [2016]: Angewandte Marketinganalyse, Praxisbezogene Konzepte und Me thoden zur betrieblichen Entschei dungsunterstützung. Berlin, et. al. Datar, S.M.; Rajan, M.V. [2017]: Horngren’s Cost Accounting, 16 th Edition. New York, NJ. Kieso, D.E.; Weigandt, J.J.; Warfield, T.D. [2014]: Intermediate Accounting - IFRS Edition. 2 nd edition, Hoboken NJ. Kilger, W.; Pampel, J.R.; Vikas, K. [2012]: Flexible Plankostenrechnung und Deckungsbeitragsrechnung. 13. Aufl., Wiesbaden. Lubbe, I.; Modack, G.; Watson, A. [2011]: Accounting: GAAP Principles. 3 rd edition, Cape Town. Needles, B.E.; Powers, M: [2013] Financial Accounting. 12 th Edition, Boston, MA. Megginson, W.L.; Smart, S.B., Lucey, B.M. [2008]: Introduction to Corporate Finance. London. van Rensburg, M.[2016]: Cost and Management Accounting. 3 rd edition. Pretoria. Sangster, A. [2018]: Wood’s Business Accounting 1. 14 th edition, Harlow et al. Sangster, A. [2018]: Wood’s Business Accounting 2. 14 th edition. Harlow et al. Scheer, A.-W. [2002]: ARIS - Vom Geschäftsprozess zum Anwendungs system. 4. Aufl., Berlin et al. <?page no="373"?> Schneeloch, D.; Meyering, S.; Patek, G. [2017]: Betriebswirtschaftliche Steuerlehre, Band 1: Grundlagen der Besteuerung, Ertragsteuern. 7. Aufl., München. Schneeloch, D.; Meyering, S.; Patek, G.: [2017]: Betriebswirtschaftliche Steuerlehre, Band 2: Steuerliche Gewinnermittlung. 7. Aufl., Mün chen. <?page no="374"?> Carsten Berkau 6th Edition Management Accounting 6th Edition Be r ka u Management Accounting Management Accounting is written for students in international Business Management study programs. It covers the widely applied syllabus of Cost Accounting and Management Accounting at universities on bachelor’s and master’s level. The book is based on more than 20 years’ academic teaching experience in Germany and at international universities in South Africa, Malaysia, China, the Netherlands and South Korea. In this text book, the application of methods and instruments comes first. Management Accounting follows a case study based approach. All cases are taken from previous exam papers and explained in detail. The text book starts with a case study of a manufacturing company and compares Financial Accounting to Management Accounting. It covers two point of views: (1) a General Management view, with aspects of business planning, cost-volume-profit analysis, degree of operating leverage, mergers and cross-border acquisitions and risk valuation. (2) a Cost Accounting view with Management Accounting systems, flexible budgeting, cost allocations, performance measurement and monitoring, reporting, calculation, manufacturing accounting (job order and process costing), activity based costing and multi-level contribution margin Accounting. On the UVK website, numerous exam tasks and complete solutions thereto are available in English. www.uvk.de ISBN 978-3-7398-3028-5 Auch als E-Book 53028_Umschlag.indd 1 53028_Umschlag.indd 1 24.03.2020 13: 26: 46 24.03.2020 13: 26: 46