Professional Documents
Culture Documents
Course guidelines
First learn all the principles, concepts and techniques of each topic to enable you to identify problems
and solve these successfully.
Assessment & DP: Of 3 tests 2 form 50% of the year mark, and 50% from a trial examination. If the DP is
met the final exam counts 70% of the final mark and the DP 30%.
MANAGEMENT ACCOUNTING
Cost Assignment (Int.) CVP Analysis (Int. & Adv.1) Budgeting Process (Int.)
Job Costing (Int.) Relevant Costing (Int. & Standard Costing (Int. &
Adv.2) Adv.5&6)
Process Costing (Int)
Activity-Based Costing (Int. Divisional Performance
Joint & By Products (Adv 1) & Adv.3) (Adv.7)
Preliminary: Introduction, cost terms, cost assignment and job costing (Drury 1 – 4)
Chapter 1
Cost accounting: “…cost accumulation for inventory valuation, reporting and profit measurement…”
Management accounting: Providing information for internal users to facilitate management’s decision making
(figure 1.1 p9), planning, control and performance evaluation.
Overall goal: Maximise shareholder value by wealth creation (i.e. earning returns in excess of investors’ required
returns/WACC= W eKe+W dKd.
1
Emphasis on customer satisfaction brings new management approaches (total quality management {TQM},
benchmarking, value chain analysis and continuous improvement – see later Study Weeks).
Cost
4000 200
2000 100
0
0
1 2 3 4 5 6 7 8 9 10 11 12 13 1 2 3 4 5 6 7 8
Books Kilowatt
iii An enterprise pays sales commission of 4% on sales that exceed R15 000 per month,
iv An enterprise pays a basic salary of R2 000 plus 4% commission on sales that R15 000 per month,
300
2350
250 2300
Basic & Com
2250
200
Basic & Com
2200
2150
150 Series1
2100 Series1
100 2050
2000
50 1950
1900
0 1850
1 3 5 7 9 11 13 15 17 19 21 1 3 5 7 9 11 13 15 17 19 21
Sales Sales
v Monthly materials cost R10 000 for the first 400 kilograms and R20/Kg thereafter,
vi An enterprise pays a bonus of R5 for every unit produced after the first 1000 units per month,
2
30000 1200
25000 1000
20000 800
Bonus
Cost
15000 Series1 600 Series1
10000 400
5000 200
0 0
1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12
Kilograms Units
vii An enterprise pays its maintenance staff a fixed salary for maintaining 3 of its 9 machines each.
20000
15000
Salaries
10000 Series1
5000
0
1 2 3 4 5 6 7 8 9
Machines
Main purposes of product costing: Inventory valuation/profit measurement (primary focus) and decision making
(incorrectly viewed as secondary purpose) e.g. Asset depreciation forms part of full product cost for inventory
valuation, but is ignored (sunk cost) for decision making purposes (e.g. discontinue a product line).
Cost systems design: Costing systems depend on the significance of indirect costs (costly errors), the
complexity of the manufacturing environment and the cost versus benefit of the cost system.
Plant-wide vs. departmental overhead rates: Diverse product range and varying production times require multiple
departmental or cost centre/pool overhead rates (not blanket/plant wide). Thus overheads to service cost
centres→production cost centres→predetermined/normal overheard absorption rate (budgeted cost/budgeted
activity) →products/services/customers (e.g. based on machine/labour hours or ABC)
Under- and over-recovery of overheads: Actual overheads and activity differ from budget. Predetermined rate
= Budgeted cost/Budgeted activity (hours/units)
*Actual cost and actual hours/units differed from budget giving a net favourable variance of R0,015m split into:
• expense variance = Bud.cost(R4,3m)–Act.cost(R4,5m)=R0,2m Unfav.
• volume variance(VC) = (Act.–Bud.hrs/units)bud.rate=(2,1–2m)R4,3m/2m =R0,215m Favourable
• volume variance(AC) = (Std – Bud hrs/units)bud rate
When the FOAR is based on production (machine or labour) hours as opposed to product units,
production overheads are charged to WIP at the FOAR x STD hours for actual production units (not at
actual hours). See AC and VC fro example
Non-manufacturing overheads: Selling, administration and distribution costs are period costs and excluded from
stock values, but part of product cost for decision making purposes.
See Example 4.2 (p115–123) for recording of typical transactions. Exhibit 4.3 on p116 summarises the transactions.
Figure 4.1 on p133 illustrates the flow of accounting entries.
Direct and indirect (depreciation/supervision) costs are allocated to a process not separate products. Pooled cost
per output unit (e.g. kilogram or litre) =Total production cost in period/ number of full units of output in period
FIFO-cost excludes the costs of BWIP. Weighted average cost includes BWIP.
Assuming only full units: Process cost per unit (R10) = Total process cost R120000/normal or expected
output 12 000
• Normal (expected) losses – reduces normal/expected output (to 10 000)(Cost pu rises to R12) and scrap
value is deducted from total process cost to reduced cost pu,
• Abnormal (unexpected) losses are valued at normal output cost (R12 after normal losses). Arise from
inefficiencies and excluded from inventory values with costs written off separately in the income statement.
Abnormal scrap value is deducted from total abnormal losses cost.
• Abnormal (unexpected) gains are valued at normal output cost. Assume maximum production of 12 000
litres, normal losses of 2 000 litres and actual output of 11 000 litres, thus abnormal gains of 1 000 litres (11
000 – [12 000 – 2 000]). Cost per unit (R11) = Total cost less normal scrap value / Expected output =
(R120 000 – [R5x2000 normal losses]) /10000 litres)
Abnormal gain is R6 000 (R11 000 gains [1 000 litres x R11 cost per unit] less scrap value of R5 000 [1 000
x R5]).
Partially completed WIP: Convert to equivalent full units = physical units x percentage completion e.g. 2 000 units
only 60% (partially) complete equals 1 200 (2000 x 60%) equivalent full units
If raw material is added at the start of the process all WIP are full units (100% complete once in the process) in the
current period. Conversion costs (CC) are normally incurred evenly during a process and WIP units share in current
conversion costs to the extent (percentage) of their completion (say 60%) in the current period.
See the equivalent unit calculation and alternative set out (using the data in Example 5.2 on page 164) in your lecture
notes.
4
Advanced Managerial Accounting 2009
At split-off point joint products could be sold or processed further. Further processing costs (after split-off =
separable costs [attributable or traceable to a specific product]). See Figure 6.1 on page 199.
Allocating joint costs: IAS 2 (AC108.12) - Conversion costs must be allocated between joint products on a
rational and consistent basis (e.g. relevant total sales value at completion or split-off). By-products are viewed as
immaterial and valued at net realisable value (deducted from the cost of the main/joint products).
By-products: No joint production costs to split-off are allocated to by-products. Processing costs of by-products
beyond split-off are charged to them. By-product revenues or net revenues (after deducting separable costs)
should be deducted from joint process costs before allocation to joint products .
A joint process may produce material (waste) or residue that has no or a negative (i.e. disposal cost) sales value.
Waste is not included in inventory.
Left over material (scrap or off cuts) from a joint process may have minor sales value which, net of any realisation
cost, are also deducted from joint process costs.
Further processing decisions: Joint products should be processed further after split off if incremental revenues
exceed incremental/separable costs (i.e. attributable or traceable to a specific product). Further processing
decisions should incorporate capital budgeting procedures (i.e. Net present value – study week 17) when the time
5
value of money is significant and relevant qualitative aspects (e.g. customer/employee satisfaction) should also
be considered.
See the joint and by-product costing question in the study material.
QE 2009 P2Q3: Discuss, with reasons, whether or not direct labour expense is a fixed manufacturing overhead
cost.
• Variable costs are defined as cost items that vary according to different levels of activity (production in the
present scenario).
• Labour costs have traditionally being regarded as variable on the assumption that management can retrench
workers in the event that production levels decline. In practice, downsizing and retrenching workers is not a
unilateral decision and negotiations are required with unions and others before wide-scale retrenchments can be
implemented. Retrenchments and downsizing are not an everyday occurrence. To assume that labour costs are
variable because of the potential to reduce these may be inappropriate.
• Labour costs are incurred irrespective of production activity and, in the short term, labour costs are fixed in nature
provided production is within normal capacity/relevant levels.
• Overtime costs are certainly variable in nature.
• The company forecast to have excess production personnel in 2008. If this transpired it would be inaccurate to
assume production personnel was a variable cost and be misleading from a decision making perspective.
Conclusion:
• Direct labour is a fixed cost as it can only be reduced through the drastic and unusual occurrence of retrenching
labour. At worst, direct labour is a short term fixed cost.
• The wage rate would be variable, but the number of employees would be fixed.
• If there was an alternative use for employees, the labour costs would be variable.
Absorption costing
Under- and over-recovery of overheads: Actual overheads and activity differ from budget. Predetermined rate
= Budgeted cost/Budgeted activity (hours/units)
*Actual cost and actual hours/units differed from budget giving a net favourable variance of R0,015m split into:
• expense variance = Bud.cost(R4,3m)–Act.cost(R4,5m)=R0,2m Unfav.
• volume variance(VC) = (Act.–Bud.units)bud.rate=(2,1–2m)R4,3m/2m =R0,215m Favourable
• volume variance(AC) = (Std – Bud units)bud rate
When the FOAR is based on production (machine or labour) hours as opposed to product units,
production overheads are charged to WIP at the FOAR x STD hours for actual production units (not at
actual hours).
Example: From the absorption costing information given below, calculate the over/under recovery of fixed production
overheads in Department P, divided into an expenditure and volume variance:
Budgeted Actual
Annual production of product A 17 000 units 17 500 units
Annual production of product B 19 500 units 18 500 units
6
Standard machine hours per unit of A 3 hours
Standard machine hours per unit of B 2 hours
Total machine hours 90 000 hours 88 000 hours
Fixed production overheads for the year R5 490 000 R5 400 000
Fixed production overheads are recovered per machine hour.
Suggested solution:
FOAR: Budgeted FC 5 490 000 / 90 000 budgeted hrs = R61 per hour
Under recovery:
Actual FO - (Std hrs x FOAR) = R5,4m – ({17500x3}+{18500x2})61= R59 500 F
FO Expenditure variance: Budget – Actual = R5,49m – R5,4 = R90 000 F
FO Volume variance: Bud hrs - Std hrs for Act Prod)FOAR
= (90000 - [{17500x3} +{18500x2}])61 = (90000-89500)61 = R30 500 U
Or balancing amount : 90 000 – 59 500 = 30 500 U
If a variable costing system was in use above, there would be no under/over recovery of fixed production overheads
and there would be no volume variance. The fixed overhead Expenditure variance would be:
Budget – Actual = R5,49m – R5,4 = R90 000 F
Variable costing
Variable or marginal or direct costing, assigns only variable production costs to products/inventory.
The difference between the profits of these two costing systems is fixed production overheads in opening and
closing inventory.
Assume UKZN Limited manufactures and sells 66 centimetre television sets. Actual data for 20X6 was:
Opening stock 2 000 units
Sales 24 000 units
Production 26 000 units
Selling price per unit R90
Variable costs per unit: R
Direct materials 20
Direct labour 10
Direct overheads 6
Selling costs 4
Fixed costs for the year:
Production overhead – Actual R324 000 (Budgeted R300 000)
Selling costs 110 000
Administration costs 80 000
The fixed production overhead rate is based on a budgeted production volume of 25 000 units for the next year.
Suggested solution
a) Workings
FOAR: Budgeted cost/Budgeted prod units = R300 000/25000 = R12 per unit
Abs. product cost pu: Materials 20, Labour 10, Direct cost 6, Fixed prod.12 = R48
Variable product cost per unit: Materials 20, Labour 10, Direct expenses 6 = R36
Under recovery: 26000UxR12 =R312000–R324000 Actual= R12000
Absorption Variable Difference
7
R R R
Sales (24 000 @ R90) 2 160 000 2 160 000
Cost of sales 1 152 000 864 000
Opening stock (2000 @ R48) & R36VC 96 000 72 000 -24 000
Cost of production (26000 @ R48) & R36 1 248 000 936 000
Closing stock (4 000 @ R48) & R36 (192 000) (144 000) 48 000
Gross profit 1 008 000 1 296 000
Under-absorbed overheads 12 000 -
Selling overhead: Variable 24000@4+110000 Fixed 206 000 96 000
Contribution 1 200 000
Admin. R80000+Other FC(Prod. 324+Sell110+Admin80) 80 000 514 000 .
Net profit 710 000 686 000 24 000
b) Stock increased by 2 000 units and the fixed production overheads in absorption stock values increased by
R24000 (increase in absorption profit).
c) The Operations Manager’s claim is incorrect. Marginal costing profits fluctuate with sales volume only.
Absorption costing profits fluctuate with changes in both sales and production volumes, assuming that there
is no difference between budgeted and actual production volumes (no over/under recoveries of fixed production
overheads).
The format of the above income statements is important and should be used at all times.
High-Low method: Variable costing requires all costs to be divided into fixed and variable cost elements. Divide
the change in cost by the change in activity between the highest and lowest levels of activity for the variable cost
per unit. The fixed cost element is the total cost less the total variable cost.
Example: Two products with different variable overhead costs per unit, but same FO cost per unit.
Products A and B have the same fixed cost per unit within a relevant range (combined 200 units). Total overhead costs:
100 units of A and 50 units of B is R45 000
150 units of A and 50 units of B is R50 000
75 units of A is R5 750.
Required: The total fixed cost and variable cost per unit for both products A and B.
Solution
Total overhead cost for 100 units of product A and 50 units of B R45 000 or R300pu
Total overhead cost for 150 units of product A and 50 units of B R50 000 or R250pu
Total overhead cost of 50 units of A 0 units of B R 5 000 or R100pu TFO
Total overhead cost of 75 units of A R 5 750
Total variable cost of 25 units of A R 750 or R30pu VC
FOH pu =R100-R30 = R70pu
FOH for 100 A and 50 B: R70 pu x 150 (100A+50B) = R10 500
Total OH for 100 A & 50B given as R45 000
Variable cost for 100 A & 50 B 34 500
Less Variable cost for 100 A 100xR30pu 3 000
Variable cost for 50 B 31 500 /50 = R630 pu
Cost is added until inventory is in a Same criteria as for absorption costing apply,
condition and location, ready for sale or but only variable production cost is included
intended use
8
Values inventory consistently on an Values inventory on Variable production cost
absorption cost basis (including fixed basis and views fixed cost as a period cost
production cost)
Cost is actual FIFO or Weighted-average LIFO can be used to charge current cost to
cost sales for internal purposes.
Direct production costs include a Same criteria as absorption costing apply, but
systematic allocation of fixed and variable only direct variable production cost is
conversion cost at normal capacity included
Both external reports (absorption costing) and internal reports (variable costing):
• exclude abnormal waste from inventory (as discussed in process costing),
• deduct trade (not cash) discounts from the cost of materials,
• value inventory at the lower of cost or net realisable value (i.e. after cost essential for realisation/sale e.g.
commission, trade discount and delivery cost),
• can value inventory at standard product cost if it approximates actual cost.
Includes a systematic allocation of both fixed and Includes only variable production costs in inventory
variable production costs in inventory values values
Fixed production overheads are assigned to Fixed production overheads are excluded from
products by means of an FOAR inventory values and treated as a period cost
Matches sales and COS (FC & VC) and treats fixed FC creates production capacity and is a period cost
costs as a necessary product costs (not linked to specific products sold or produced)
Profits changes with sales volumes and Total contribution changes with sales and the impact
production/inventory levels (FC in stock) of decisions on profit is consistent and clear
Production cost per unit and profits changes with Reflects a consistent contribution per unit or gross
increased/decreased production output profit percentage at all levels of production output
Arbitrary allocation of fixed overheads may over- Variable overheads are more easily linked with and
/understate costs/selling prices/inventory allocated to production volumes
Is IAS reporting standard, valuing inventory at full Is useful for internal (management) decision-making
cost to its condition and location for use or sale as it clearly identifies the impact of decisions on profits
Is less costly to implement as fixed and variable Controls variable cost per unit and total fixed cost per
production costs need not be split period. Resulting benefits may justify the extra costs
Presumed to improve financial statement Losses may occur when sales volumes are low during
comparability by matching FC and revenues. out-of season periods but production/inventory levels
need to be high to meet impending seasonal demand.
Chapter 8 – Cost-Volume
Volume-Profit
Volume (assessed at level 3)
Economist’s CVP graph: Total revenue and total cost functions are curvilinear. To increase sales volume one
needs to reduce the selling price per unit. At low volume levels the total cost function rises quite steeply
because it is not efficient to operate a plant at a low volume. As the production volume rises total cost function
rises less steeply as economies of scale begin to filter through. At very high volume levels, total costs begin to
rise quite steeply again as bottlenecks develop. The model applies to all expected ranges of activity (long term).
10
BE
FC
Marginal revenue per unit is constantly declining. Profit maximising output is at the point at which marginal
revenue equals marginal cost. The economist’s model applies to all ranges of activity expected in the long
term.
Economic theory (From pricing decisions): Economic theory assumes rational enterprises prefer selling prices
that maximise profits (most return with least risk/soonest) and that prices/profits can be estimated at each
potential demand level enabling profit maximisation decisions (where marginal revenue equals marginal cost
[see economist’s revenue/cost graph]) when the optimum output is sold at the optimum price.
Some difficulties include:
• enterprises have multiple products and different demand curves,
• various factors, apart from pricing, affect demand e.g. quality, packaging, advertising and credit terms,
• marginal cost curves for individual products are complicated by joint/indirect costs.
Accountant’s cost- volume- profit model/ Break-even chart: Linear revenue and cost functions are assumed,
including a constant variable cost and selling price per unit within a relevant range.
BE
Mathematical approach to CVP analysis: NP = Px – (a + bx) or NP = SPpuX – (FC + VCpuX) (X=units sold)
Breakeven: 0 = Px – (a + bx) or FC/(P-b) or FC/Contribution pu BE at fixed profit (+FC)/Variable profit pu (-Cont.pu)
Breakeven sales value = FC/profit-volume ratio
Total sales = Breakeven sales + Safety sales
Breakeven sales x PV% = FC and Safety sales x PV% = NP
Sales units at fixed profit: (FC + NP)/(P-b) or NP = Px – (a + bx)
Sales units at variable profit: FC/(P-b-variable profit)
Selling price to achieve profit: P = [NP + (a + bx)]/x
Margin of safety: Safety Sales = Sales units – BE units; MOS% = (Sales units– BE units)/Sales units
Contribution margin/Profit-volume ratio: contribution/sales.
Contribution = sales x profit-volume ratio
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NP = sales x profit-volume ratio (contribution margin ratio) – fixed costs.
NP = Margin of safety sales x profit-volume ratio
Min sales value = (fixed costs + required contribution)/ P/V ratio
Examples:
i. Calculate the total sales value when breakeven sales value is R1 million and the safety margin is 40%.
ii. Calculate total fixed costs when the total sales value is R1,667 million, the safety margin is 40% and PV
ratio 30%.
iii. Calculate total fixed costs when the total contribution is R0,5 million and the safety margin is 20%.
iv. Calculate the total profit when total sales is R1,429 million, the breakeven sales value is 70% and the PV
ratio is 20%.
v. Calculate the contribution when breakeven sales are R420 000, the margin of safety is 30% and the
profit margin is 10%.
Solutions:
i. Safety sales = 40%. Breakeven sales = 60%. Thus BE sales of R1m/0,6 = R1,667m total sales.
ii. FC = BE sales x PV% Thus R1,667m x 0,6 = R1m BE sales x 0,3 PV% = R0,3m FC
iii. Total fixed costs = Total contribution x (1-Safety margin) thus R0,5m x (1-0,2) = R0,4 mil or NP = Cont. x
Safety margin = R0,5m x 20% = R0,1m FC = Cont. – NP = 0,5m-0,1m = 0,4m
iv. NP = Safety sales x PV% = (1,429x0,3)0,2 = R85 740.
v. Total sales = BE sales/BE% = 0,42m/0,7 = 0,6 m and NP at 10% = R0,06m NP=Safety sales x PV%
Thus 0,06m= (0,6mx0,3)PV% and 0,06/0,18 = PV% of 33,3% Contribution is R0,6m/3 = R0,2m
Profit-volume graph:
Cash breakeven
500
Costs)
Profit
0
-500 1 3 5 7 9
Breakeven
-1000
Volume (Units)
This graph measures profits/losses on the vertical axis. The lower cash breakeven may enable the enterprise to
survive in the short term in spite of operating losses (below normal breakeven but above the cash breakeven
point). Short term survival becomes a valid business strategy only if long term recovery of profitable operations and
adequate funding are feasible.
Multi-product CVP analysis: A fixed sales mix (basket of products) is assumed with a weighted average
contribution (multiply each product’s unit contribution by the number of units of that product in the sales mix).
Example: Assume two products (A and B) are sold in fixed proportions of 2A:3B, contribution per product is R15 (A)
and R25 (B) and total fixed costs R787 500. The multi-product breakeven can be calculated as follows:
Main limitation of the sensitivity analysis: Only one variable is changed at a time when, in reality, management
requires the implications of simultaneous changes in a number of variables (spreadsheet model/analysis). See
scenario analysis in later weeks.
CVP analysis applied to absorption costing: The results of decisions made using variable costing based CVP
analysis are not reflected in the absorption costing reporting system if there are changes in inventory levels.
A target profit can be added to the fixed costs in the above formula and a variable profit factor per unit
deducted from the contribution per unit.
Financial performance evaluation (QE : PV%, FC% of revenue/total cost, Operating profit % before/after
HO costs, Breakeven, Margin of safety, other ratios/component percentages.
14
Qualitative factors: Important considerations are not always expressed in monetary terms (quantified) and should
not be ignored e.g. accuracy of data or a decline in product quality/customer satisfaction/support, local or
export market, entity reputation, supplier support and quality of supplies, staff morale/health and capacity
utilisation.
Remember: When fixed costs will change in the long term as a result of a decision, they will become relevant
costs/savings. Variable costs which are identical for all alternatives are not relevant (can be ignored).
TOC is used to maximise operating profit by removing bottlenecks (limiting capacity/throughput) or maximise
(i.e. ranking) throughput contribution per bottleneck hour/usage (TC pbh):
TC pbh = (SP pu – RM pu)/Bottleneck hour pu (other costs are considered fixed in ST)
Throughput accounting (TA): Ranks products according to a Throughput Accounting Ratio (TAR) :
TAR = TC pbh/Factory OH cost ph
Factory OH cost ph = Factory OH cost / Total key resource hours
Note: TAC pu rankings = TAR ranking (both share a common denominator i.e cost per factory hour).
Traditional ranking:
Contr. per constraint i.e. bottleneck hr pu R30/0,02 R26/0,015
= R1500 = R1733 maximise B
Theory of Constraint (TOC):
TC bph = (SPpu - Direct mat cost pu)/Hrs pu R58/0,2 R30/0,15
=R2900 maximise A R2000
Throughput Accounting (TAR):
Total factory cost per bottleneck hour: [(R38x120000)+(R10x45000)]/3075 hrs = R1629,27 ph
TARatio = TC pbh/Factory OH ph R2900/1629,27 R2000/1629,27
=1,78 maximise A =1,225
The following cost estimate had been prepared for a once-off furniture order, in excess of normal budgeted production:
Note R
Direct materials:
Wood 10m2 at R50 m2 1 500
Metal fittings 2 200
Direct labour
Skilled 25 hours @ R80.00 per hour 3 2 000
Unskilled 10 hours @ R50.00 per hour 4 500
Overheads 35 hours @ R100.00 per hour 5 3 500
Design 6 1 000
7 700
Administration overhead 15% of production cost 7 1 155
15
8 855
Profit @ 20% of total cost 8 1 771
Selling price 10 26
1 The wood used for this order is in stock, cost R20per m2 (Market price is R50 per m2 and sale value is R40 per m2) and is
not regularly used.
2 Metal fittings are in stock at R200 and are regularly used in products. The replacement cost is R250.
3 Skilled labour is paid R80 per hour and must work overtime at time and a half for the above order, unless the production of
another product, that requires 2 hours of skilled labour, sells at R800 and has variable costs of R500 per unit, is reduced.
4 No further unskilled labour needs to be hired to complete the above order.
5 Overheads include electricity for machines at R8 per hour. The above order requires 35 hours of machining. Other overheads
are not directly identifiable with this job.
6 Design time represents the normal working hours spent by full time employees to design the furniture for this order.
7 20% is normally added to the production cost to cover normal administration costs.
8 Products are normally priced at cost plus 20%.
REQUIRED:
• Define ‘relevant cost’, ‘opportunity cost’ and ‘discretionary cost’, and state the usefulness of these cost classifications to
management.
• Prepare the lowest cost estimate for the above order. Give reasons for including/excluding all the given costs.
• Should the order be accepted at a total sales value of R5000? (discuss quantitative and qualitative factors).
Solution
Cost estimate: R
Need for ABC: The % indirect cost is significant and increasing. Relevant costs are required to identify
potentially unprofitable products in highly complex environments and numerous product lines on a continuous
basis. Resources are shared by many products.
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Benefits of ABC
• ABC requires a better understanding of costs and cost drivers and can be expected to enhance cost
awareness and promote control over costs. The extent of cost savings and other benefits from improved
product costing resulting from ABC may not be measurable, but their existence cannot logically be denied.
• Enterprises require more sophisticated and accurate full product/contract costs when selling prices/contract
tenders are prepared on a cost plus basis or a high proportion of overheads are independent of
production volumes and a variety of products are produced.
• ABC is flexible and can be extended to determine cost per customer and for management and produces
reliable product costs which are not ideal for short term decisions, but, in the long term, is useful for strategic
planning.
• An enterprise’s product range can be improved when new product costs are determined more accurately
and less viable products (i.e. demand and profitability) are discontinued. Low-volume products are
correctly allocated a higher proportion of costs (e.g. machine set-up and packing) while high volume
products are justifiably allocated a lower proportion of costs.
Traditionally indirect costs were assigned to production and service departments based on a few volume
based cost drivers (e.g. machine and/or direct labour hours) resulting in the under-costing of low volume
products.
ABC allocates costs to a variety of cost pools (e.g. production scheduling, machine set-up, materials handling and
materials purchases) and, using a wider variety of volume (e.g. hours, %, runs, batches and no. of orders) and
non-production volume (e.g. m2, %, kilowatts, no. of employees and value of PPE) based cost drivers, to
individual products.
Cost driver/denominator: Budgeted (problem: hides unused capacity and low demand will increase cost and SP
when a lower SP would stimulate higher sales volume) or preferred Practical capacity (does not fluctuate annually
- more consistent costing/SP). (Also unlikely theoretical capacity and IAS’s normal production level under AC/VC)
Cost driver/denominator: Budgeted capacity focuses on resource usage, hiding unused capacity. Also note that
low demand will increase cost and SP when a lower SP would stimulate higher sales volume. Practical capacity is
preferred (does not fluctuate annually - more consistent costing/SP). (Theoretical capacity is unlikely)(IAS’s
requires higher of normal or actual production level)
Unused capacity arises with committed/inflexible resources acquired in discrete (constant) amounts in advance.
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• Resource supply cannot be adjusted continually/in ST to match resource usage.
• Management decisions can change activity usage (e.g. discontinuation decisions reduce resource
usage/increase unused capacity).
ABC profitability analysis: ABC product costs are not directly suitable for decision making, but more readily
reveal potential unprofitable products. For product mix and discontinuation decisions three contribution levels
should be analysed:
• unit level contribution for each product (i.e. sales minus cost of unit level activities),
• batch level contribution (i.e. unit level contribution minus batch related costs),
• product sustaining contribution (i.e. batch level contribution minus product sustaining costs).
Two more contribution levels (after Brand sustaining expenses and product-line sustaining expenses) may be
used.
See review problem 10.26 on page 400 to compare traditional and ABC cost allocations.
Chapter 11 – Pricing Decisions (Assessed at level 3, except target based pricing [level 2]) and Profitability
Analysis [level 3])
Price setters/takers: Price setters produce highly customised products and need accurate product cost
information to set selling prices. Price takers produce standard/commoditised products (i.e. not unique or
different e.g. maize meal. milk, gold, oil and petrol) and accept/take prices set by the market and need accurate
product cost information for product profitability and product mix decisions.
The decision time horizon (short and long-term) determines the cost information that is relevant for product
pricing or output mix decisions.
For short term decisions many costs are likely to be fixed and irrelevant and only incremental costs of accepting
an order must be recovered in the selling price provided:
• spare capacity is available for all the resources used to fulfil the order – Opportunity costs,
• the order is once-off (not likely to be repeated/minimised effect on normal operations) and
• spare capacity will be released by the time that more profitable opportunities become available.
In the long-run virtually all costs are variable in nature and pricing decisions must be based on accurate full cost
information (i.e. ABC).
A price taker firm facing short- and long-run product–mix decisions: Periodic and ABC hierarchical profitability
analysis should be carried out to determine which products to sell.
Economic theory: Economic theory assumes rational enterprises prefer selling prices that maximise profits
(most return with least risk/soonest) and that prices/profits can be estimated at each potential demand level
enabling profit maximisation decisions (where marginal revenue equals marginal cost [see economist’s
revenue/cost graph]) when the optimum output is sold at the optimum price. Some difficulties include:
• enterprises have multiple products and different demand curves,
• various factors, apart from pricing, affect demand e.g. quality, packaging, advertising and credit terms,
• marginal cost curves for individual products are complicated by joint/indirect costs.
Selling prices should be maximised when demand is inelastic (vary little at varying prices).
18
Facility sustaining costs are incurred to support the organisation as a whole and may either:
• be excluded from individual products costs or
• included in product costs to be recovered in revenue/SP in the long term (cost-plus pricing), but not
reported as production costs.
Pricing non-customized products: Market leaders use estimated sales volume/ demand to set production
volumes/costs and add a profit (cost plus) to determine selling prices. As selling prices affect demand it is
necessary to set selling prices for a range of potential demands.
Cost-plus pricing: Cost normally includes direct variable costs, total direct and indirect costs (overheads) and
apportioned organisational costs. A higher CV% is required to cover costs excluded from the cost base.
Disadvantages:
• price-demand relationship is ignored,
• production volume/budget is dependent on sales demand (problem: When demand/volume is low
costs/prices increase when lower selling prices would stimulate demand/volumes),
• if actual demand falls below estimated demand a loss may result even though selling prices were set on
full costs.
Cost plus pricing is useful:
• when a wide variety of products is sold and demand curves are costly/ time consuming for unimportant
products.
• to predict the prices when industry/competitor cost structures are similar and may encourage price
stability
Cost plus selling prices are not ideal, and ignores market prices.
QE 2009 P2Q3: Identify and discuss any areas for improvement in the company’s existing pricing procedure of
generally marking up the estimated absorption manufacturing cost by 30% to determine the selling price.
Pricing procedure
• Relevant cost (hedged replacement cost of imports) should be considered for engines rather than the irrelevant
historic cost per unit of R16 500. A standard cost could be developed from budgeted cost of R15 375 or actual
cost of R17 000. Could also use the disposal value or opportunity cost if no information is available.
• Detailed supplier quotes for material components appear adequate.
• Variable costs appear to be an estimate based on the 2009 annual budget [R580 per unit]. No supporting
calculation/proper allocation was given.
• Recovery of direct labour & other fixed overheads: The recovery of 27% of material cost is conservative
compared to budget (21,9%), while the actual costs for 2009 was 20,4% of material cost. Increasing recoveries
due to increases in material costs may not be appropriate as fixed costs do not increase with changes in
production volume and material price increases. Recoveries should be based on normal production volumes and
capacity and an appropriate cost driver (activity based costing) used.
Pricing policy
• Cost plus mark up policy appears to work in the company’s case, due to its actual GP% in 2009 of 24,5%, higher
than theoretical GP% of 23,1%.
• The company should investigate the use of target costing.
• Competitors selling prices for similar products should be considered as well as the impact of increasing prices on
customer orders. Is the company strategy differentiator (price setter) or a price taker. Elasticity of demand should
be considered (price sensitivity).
Target costing is the inverse of the cost plus pricing and may be used to price non-customized products. The
required profit is deducted from the maximum market selling price to arrive at a target cost (limit). Unlike cost-
plus pricing it fully considers marketing factors.
Ignore maximin, maximax and regret criteria (pages 463 to 464) and Appendix 12.1 CVP analysis and uncertainty
(pages 470 to 474).
A probability (objective=statistical with decimal >0<1) expresses the likelihood of a particular outcome. E.g. 0,3 =
30%. The probability of a 6 with one throw of a dice: 1/6
Joint probability (all occurring/together): Assume two probable results ‘A’ and ‘B’ with probabilities of 40% and
30% respectively. Joint probability: PA x PB = 12%;
2
Getting two sixes in a row: 1/6 x 1/6 = 1/36 (1/6 ). Getting a six followed by any of 1 to 5: 1/6 x 5/6 = 5/36
Probability of either outcome occurring: PA + PB = 70%. Dice:1 or 6 in one throw = 1/6+1/6 = 2/6
20
Continuous distribution
40
Probability
30 Mean
20 σ σ 10
10
0
1 3 5 7 9 11 13 15 17
Number/Value
Measure of uncertainty = Variance (σ2) = ∑[R- ]2P) is the dispersion of possible outcomes on both sides of the
mean.
Example: Calculate the Variance (σ2) and Standard Deviation (σ) of the following sales unit distribution:
20% prob. salesR 25; 60%sales R30 and 2o% sales will be R35
Solution:
Sales Probability Probable Mean Variation Variation² Probability Variance
25 0,2 5 30 -5 25 0,2 5
30 0,6 18 30 0 0 0,6 -
35 0,2 7 30 5 25 0,2 5
Expected sales/Mean 30 ( ) Variance σ2 = 10
Standard deviation(σ) √10 = 3,1623
Risk takers prefer maximum Risk and Return. Risk neutral/indifferent investors are not as aggressive as risk
takers and will accept reasonable degrees of risk. Risk averse investors prefer the lower return of lower risk
investments.
Example: Choose between alternative investments (A and B) with the following possible outcomes (Each
economic state has a 1/3rd chance of occurring): A B
Recession 240 0
Normal 300 300
Boom 360 600
Do not use a single expected/mean sales value/volume to calculate a probable overall profit. Use all probable
sales or Si x to fist calculate a separate probable net profit (Q12.17 [c]) then apply each profit/loss’ own probability or
Pi to determine the overall/mean outcome (profit/loss) (∑[Sn x Pn])(see decision tree example below).
. .
2
Measurement of risk: Risk is expressed as σ or √σ2 (i.e. dispersion of possible outcomes = √∑[R- ] P and the
coefficient of variation(CV) (σ/R, risk per rand of return) allows the comparison of the relative risk of different
projects.
21
Z-value [z = (X-ẍ)/σ]: Z-value calculates the number of standard deviations of a value (X) from the mean (ẍ)
and indicates the chance (% probability) that a variable (i.e. sales or profit) will statistically occur or that the
variable will fall within a specified range (between two different points). According to the table a z-value of 1 (one
σ from the mean) covers 0,3413 or 34,13% of the area on one side of the mean, thus 68,26% of the total area
(both sides). Two σ’s from the mean covers some 98% of the total area.
Decision tree: The most beneficial outcome of different distributions (∑ each = 1) are chosen by backward
induction (rolled back). Study the comprehensive decision tree example on pages 466 to 468.
Tip: When unstructured/chaotic data is presented in the question, first structure/ organise the data per
category/logical sequence/patterns to highlight different options and outcomes as in Q12.22.
Example: Management can develop and market a new product or continue as is. Development costs will be about
R180 000 and the chance of success is 75%. If successful the outcome, after development cost, may be a profit as
high as R540 000 (40% chance) or as low as R100 000 (30% chance) and, if a failure, a loss of R400 000 (30%
chance). Draw a decision tree for the above.
22
Illustrative example – Decision tree Question 10 - 1
An investors wants to start either a small plant (if demand is low - 25% chance) or large plant (if demand is high –
75% chance).
Small plant (1or 2) Large plant
If demand is low (m=million) and one plant only R+3m profit R-3m (loss)
If demand is high and one plant only R+4m profit R+7m profit
Chance of competing plant if demand high 60% 0%
High demand & 2 small plants–30% chance 2 plant result R+8m profit
nd
High demand 70% chance 2 small plant result R-2m loss
No competition 55% chance two plants result R+8m profit
No competition & one expanded/new plant – 55% result R+6,5m profit
nd
No competition & 2 or new plant fail – expected result R+2,5m profit
Required: Draw a decision tree and determine the highest expected profit. Also determine the course that a
risk averse investor would prefer.
Conclusion: Choose Large plant as this choice has a value of R4,5 Million which is 0,3 Million higher than the
Small plant.
Portfolio analysis: Diversification spreads/reduces risk if investments/projects are not perfectly positively
correlated (respond differently to same circumstances) and overall variability of cash flows is reduced. One must
consider the extent to which each investment/project affects the overall risk of the entity.
23
A v era g e an n u al
s ta n d a rd d ev ia tio n (% )
N u m b e r o f sh a re s
1 10 20 30 40 10 00 in p o r tfo lio
ABB aims to authorize only resources essential to meet budgeted production and sales volumes.
ABB reverses the ABC process: Essential cost driver/activity (e.g. Process 5000 sales orders) and resource
needs (e.g. 0,5 hr per order = 2500 labour hours /1500 hrs per person pa = 2 persons). Thus cost pool (i.e.
budget) includes salary of 2 persons.
Sales and cost variances: There are two basic variances for sales, materials, labour and variable/fixed overheads:
• Price/rate/expenditure variance determined by one standard and two actuals, as follows:
(Standard – Actual Price/ rate/expenditure) x Actual Volume sold/quantity purchased/hours used
24
• Volume/quantity/usage or efficiency variance determined by one actual and two standards as follows:
(Standard cost for actual production volume – Actual Volume/quantity/usage) x Standard Price/rate/expenditure
Two exceptions (Budgeted replaces Standard) :
• The Sales volume variance is: (Budgeted less Actual sales volume) x Budgeted contr. (VC) or Contr.pu – FOAR (AC)
• Fixed overhead variances: Expenditure variance = Budgeted fixed cost less Actual fixed cost
: Volume variance(Rate per unit) = (Budgeted prod. units – Actual prod. units)FOAR per unit
: Volume variance(Rate per Hour) = (Budgeted hrs – Std hrs for actual prod)FOAR per hour
A variable standard costing system has only one fixed overhead variance, namely the fixed overhead expenditure variance.
Fixed overheads variances: FOAR per unit(only one product) produced: Budgeted FC R120000 (Actual R116000)
Budgeted production 10 000 units (Actual 9 000 units) FOAR 120000/10000 = R12 pu
Fixed production overhead control account (R’000)
Actual cost incurred 116 Absorbed (or std) cost 108
(actual Prod units x FOAR
(9 000 units x R12)
Under-absorbed cost 8
116 116
Expenditure variance: Budgeted cost – Actual cost = R120 000 – 116 000 = R 4 000 F
Volume variance: (Budgeted production – actual production)FOAR = (10 000 – 9 000)12 = R12 000 A
Total variance R 8 000 A
Fixed overheads variances: FOAR per std production hour: Budgeted hrs 30 000 for 10000 units
New FOAR: R120000/30000 = R4 per hour
Fixed production overhead control account (R’000)
Actual cost incurred 116 Absorbed (or std) cost 108
(Std hrs for Actual Prod. – Actual hrs)FOAR
(9 000 units x 3 hours x R4)
Under-absorbed cost 8
116 116
Fixed overhead capacity/efficiency variances: Fixed costs are sunk costs that do not change with production volumes or
efficiency of production. As a result separate fixed overhead capacity and efficiency variances are not considered
meaningful and are seldom calculated in practice. These variances are more meaningfully combined into a single volume
variance.
Fixed overhead capacity variance: [Budgeted machine hours – Actual machine hours] x FOARph
Fixed overhead efficiency variance: [Std machine hrs of actual output – Actual machine hours] x FOAR
FOH volume variance: [Budgeted hrs – Std hrs for Act. Output) x FOAR
Detailed volume/quantity/usage variances: When more than one product is sold as substitutes or more than one raw material
is used and material is interchangeable, the volume/quantity/usage variance may be split into separate mix and yield variances
as follows (from example 19.2, p783):
25
Budgeted Sales/Mix Standard Mix Actual Mix &
(Actual sales) Sales
X: 8 000 (40%) 8 800 (40%) 6 000Dif@SM
Y: 7 000 (35%) 7 700 (35%) 7 000 “
Z: 5 000 (25%) 5 500 (25%) 9 000 “
25 000 22 000 22 000
Quantity Mix
Variance Variance
Volume
Variance
Yield/Usage variance: Material: (Standard mix and usage for actual prod. - Standard mix for Actual usage) x Std price pu
Budgeted usage (std mix) Actual usage (std mix) Variance
X: 50% x 103 000 = 51 500 50% x 100 000 = 50 000 1500F x R7= R10 500
Y: 30% x 103 000 = 30 900 30% x 100 000 = 30 000 900F x R5= 4 500
Z: 20% x 103 000 = 20 600 20% x 100 000 = 20 000 600F x R2= 1 200
Total 103 000 100 000 as before R16 200F
When more than one type of labour (skilled, semi-skilled and unskilled) is used, separate labour mix and efficiency
variances can be calculated as demonstrated above.
Quantity Mix
Variance Variance
Volume
Variance
26
1
Budgeted mix = standard mix for budgeted volume
2
Standard mix = standard mix for actual volume
Sales quantity variance split into two further variances (if industry sales volumes are available).
• Market size variance – Keep the firm’s market share constant (say 10%). If the total market grows by 75 000 units, the
firm’s sales would increase by 10% (i.e. 7 500 units at a contribution of R14,45pu = R108 375).
• Market share variance – Keep the industry market size constant (say 275 000 units). If the firm’s market share falls by
2%, its sales decrease by 2% of the market size of 275 000 units (i.e. 5 500 units at R14,45 = R79 475).
Drury suggests (p795) that, at the beginning of the new accounting period, the above stock entries of R13500 be reversed to
restore stock values to standard.
Out-of-date standards and recording errors must be identified and excluded from variance. It serves no purpose to
investigation variances resulting from random or uncontrollable factors, as opposed to variances caused by out-of-control
operations which need to be corrected.
27
Exercise - 2009 QE P2 Q3 Labourers Electricians Total
Available production hours
Budget 294400 62560 hrs
Actual 294400 62560 hrs
QE 2009 P2Q3: Identify and describe four key business risks faced by the company.
• Adverse movements in exchange rate may erode gross margins. The majority of COS comprises imported diesel engines.
Volatile exchange rate movements will make it difficult to accurately cost orders. Management’s speculation in FEC
contracts is a major potential risk in view of the Rand’s very volatile behaviour in recent times could cause material financial
losses.
• Current capacity constraints (direct labour hours) may cause the loss of key customers and/or market share if customer
demand is not met or there are delays in filling orders.
• The current economic slowdown in SA may result in lower revenue/reduced profitability and cause liquidity or cash flow
problems.
• Lead time on the ordering of diesel engines may cause working capital problems. If demand suddenly declines, a heavy
investment in engines cannot be immediately converted into cash.
• Electricity supply may normalize in SA and reduce demand for diesel generators.
• New market entrants may emerge with better competing technologies.
ROI: Say OPBIT =A, Sales =B, NAV EOY =C, OPBIT % (A/B) =D, NAV TO(B/C) =E ROI =A/C
A/C or DxE
Residual income (is an absolute value, unlike ROI %, does not adjust for relative size of divisions)
Divisional Manager Division
29
Controllable contribution Divisional contribution
Less: Capital charge on controllable investment (Wacc x NA EOY) Less: capital charge on divisional net assets
Controllable OPBIT exclude arbitrary group interest (finance not operating cost) and HO cost allocations.
Controllable OPBIT include depreciation (controlled operating cost), normal trading exchange gain and other
charges.
ROI(%) vs RI (Amount)
ROI is better understood (compare % to inflation rate) and used by mnt/external users,
ROI can be analysed further to pinpoint problem areas e.g. GP margins and working capital management,
RI encourages goal congruent capital expenditure decisions (assess (dis)investment separate from existing returns.
RI is consistent with NPV if LT performance is emphasised (PV of RI over assets’ life = NPV).
RI charges opportunity cost of capital against operating profits (encouraged focus on shareholder value creation).
1. Divisional profit and ROI, are unlikely to lead to goal congruent (NPV consistent) investment decisions.
2. If long-term EVA is emphasised, goal congruent decisions will be made.
3. If short-term EVA is emphasised, incorrect decisions are possible unless managers’ budgets include ST EVA losses.
Comparative analysis performance measures: NB - Advantages & Disadvantages of each performance measure
Best policy: Optimum (two-part) TP for TD, RD and group? TD’s MC + lump sum (covering TD’s FC & profit). Motivates
TD and RD views lump sum as FC and optimises output/contribution based on VC, thus group goal congruent (RD’s
NMC>TD’s MC).
Dual rate transfer pricing system: TD =AC+mark-up; RD=TD’s MC; Overstates divisions’ profits - Seldom used in practice
Week 9 - Cost management and Strategic management accounting – Drury chap 21 (level 1)
Traditional Man. Acc: Cost containment focus, now cost reduction – Eliminate activity, perform it more efficiently or
redesign it (do differently) using accounting and other techniques such as:
Cost reduction (profit improvement) techniques: Tear-down analysis and Value and functional analyses
Life Cycle Cost (LCC): Research & Development, Design, Pilot/Main production, After-sales service/Warranties
Example 2008 SQ2: Company has just completed the product planning and design of a new product at a total cost of
R1 000 000. Manufacturing and sales is about to commence and future demand is:
Months Monthly demand
(units)
1-10 200
11-20 500
21-30 750
31-70 1 000
71-80 800
81-90 600
Thereafter nil
Unit selling prices for the new product are expected to decline as the number of units sold increases as follows:
Unit selling price Unit variable cost
R R
31
First 2 000 units 100 50
Next 5 000 units 80 40
Next 7 500 units 70 30
Next 40 000 units 60 25
Next 14 000 units 40 30
Fixed costs during months 1 to 90 will be R900 000. Post sales service and abandonment will be R300 000.
You are required to
a. calculate the expected total contribution from the new product during each of the product’s:
i. introductory phase ii. growth phase iii. maturity phase iv. decline phase
b. Also calculate the life cycle profit/loss of the new product.
c. Should manufacturing and sales commence?
32
Target costing: Find customer (target) price - target profit margin = target product cost
Kaizen costing focuses on the production process cost (not product cost). Seeks to empower employees.
Activity-based management (ABM): Analyses entity by business activities (e.g. ordering cost not just telephone cost) -
Knowing activity costs stimulates competitive actions and identifies non-value adding activities (adds cost not value).
Business process re-engineering (BPR): Group linked activities/ operations in a co-ordinated manner to reduce costs,
simplify activities/operations and improve product quality and customer satisfaction.
Tear-down analysis or Reverse Engineering: Identify product improvement or cost reduction opportunities by dismantling
competitor’s product’s functionality, design, processes and cost component.
Total quality management (TQM): Strives to promote continuous improvement (ultimately - zero-defects) in
products/service quality by performing tasks once (right first time) and so reduce waste, inspections, reworking, scrap and
warranty repairs. Uses non-financial measures and statistical quality control tools to improve quality (standards) and reduce
internal/external failure costs.
The value chain: Linked set of value-creating activities from supplier to customer to be more efficiently/cost effective than
competitors by using customer focus on each link.
Strategic planning: Endeavours to analyse an enterprise’s historical and expected internal and external environments for 5 to
10 years and to establish financial and management objectives i.e.
• L/term vision (size, reputation, financial strength and niche or uniqueness),
33
• medium and short term plans/mission (i.e. values, corporate culture, attitude towards risk and change, market segment and
products/services,
It also determines and controls human, physical, operational and financial resource needs with the objective of developing
distinctive and innovative policies, plans and actions which are sustainable over a long period, to generate superior
performance or competitive advantage and create shareholder wealth.
SMA assesses external competition and own competitive status to gain competitive advantage by exploiting value chain links
and adopt performance measures aligned with entity strategy.
Benchmarking: Improve key activities/processes to world-class best practices. (Virgin/Richard Branson and Formula 1)
Environmental cost management: An environmental cost report (like quality cost report above) can be used.
The balanced scorecard (Porter): Incorporates both financial (typically ROI, RI, EVA, Revenue↑, Cost↓ and asset
utilization) and three new non-financial performance perspectives, namely:
• The customer perspective: Generic measures include Market share, Customer retention/ loyalty/ acquisition/satisfaction
/profitability
• The internal business perspective: Critical processes the entity must excel at include: % sales from new products, New
products, Product development and break-even time, process cycle time, Quality, Post-sales service.
• The learning and growth perspective: Focuses on infrastructure needed to create long-term growth and improvement,
including Employee capabilities, Information system capabilities and Motivation, empowerment and alignment.
Week 10 COST ESTIMATION & BEHAVIOUR (Drury Chapters 24 & 26) (Quantitative methods)
Level 1: Scatter graphs & Linear regression, Level 3: High-low method, learning curve. IGNORE: Multiple regression analysis
& Simplex method
QE 2009 P2Q3: Discuss, with reasons, whether or not direct labour expense is a fixed manufacturing overhead
cost.
• Variable costs are defined as cost items that vary according to different levels of activity (production in the
present scenario).
• Labour costs have traditionally being regarded as variable on the assumption that management can retrench
34
workers in the event that production levels decline. In practice, downsizing and retrenching workers is not a
unilateral decision and negotiations are required with unions and others before wide-scale retrenchments can be
implemented. Retrenchments and downsizing are not an everyday occurrence. To assume that labour costs are
variable because of the potential to reduce these may be inappropriate.
• Labour costs are incurred irrespective of production activity and, in the short term, labour costs are fixed in
nature provided production is within normal capacity/relevant levels.
• Overtime costs are certainly variable in nature.
• The company forecast to have excess production personnel in 2008. If this transpired it would be inaccurate to
assume production personnel was a variable cost and be misleading from a decision making perspective.
Conclusion:
• Direct labour is a fixed cost as it can only be reduced through the drastic and unusual occurrence of retrenching
labour. At worst, direct labour is a short term fixed cost.
• The wage rate would be variable, but the number of employees would be fixed.
• If there was an alternative use for employees, the labour costs would be variable.
Engineering methods: Observe physical quantities required for activity→cost estimate - Expensive
Inspection of accounts method: Man. & accountant inspect & classify cost accounts as fixed, var, semi-variable
Graphical or scatter graph method: Plot past observations on graph and draw a line of best fit
High – low method: Reliance on two extreme observations to determine normal cost behaviour
Solution:Total overhead cost for 100 units of product A and 50 units of B R45 000 or R300pu
Total overhead cost for 150 units of product A and 50 units of B R50 000 or R250pu
Total overhead cost of 50 units of A 0 units of B R 5 000 or R100pu TFO }
Total overhead cost of 75 units of A R 5 750 }FOH R70pu
Total variable cost of 25 units of A R 750 or R30pu VOH }
FOH for 100 A and 50 B: R70 pu x 150 (100A+50B) = R10 500
Total OH for 100 A & 50B given as R45 000
Variable cost for 100 A & 50 B 34 500
Less Variable cost for 100 A 100xR30pu 3 000
Variable cost for 50 B 31 500/50 = R630 pu
Regression equation/cost function (Y=a+bx): Measures past cause-and-effect relationship or correlation between dependent
variable (total cost=Y) and independent variable (i.e. cost drivers/activity =b). Simple regression y = a + bx (Ignore Multiple
regression). Cost functions must be economically plausible/sensible e.g. Total labour cost is function of labour hrs not OT hrs
Regression analysis assumptions:
• circumstances underlying the cost/volume sample will remain the same in future,
• current (inflation adjusted) cost meaningfully predict future costs and
• unexplained errors (y-y1) (i.e. observed cost (y) - regression line (y1) are normally distributed above/below the line.
35
The total cost (y) formula (y = a + bx) is derived from the
opposite accountant’s Cost-Volume-Profit graph:
4 Coef. of Determination (r2) or Goodness of Fit expresses the explained [Σ(y1- ỹ)2/n] variations as a % of the total [Σ(y-
ỹ)2/n] deviations from the mean. Thus:
Coef. of Determination or r2 = [Σ(y1- ỹ)2/n] / [Σ(y- ỹ)2/n] (deviations above and below line -Minimum 0,3 0r 30%)
Coef. of Correlation or r = √r2 (deviations on one side of regression line)
2
A r of 0,8 means 80% of the deviations in Y (cost) result from changes in volume (x). Thus a strong correlation exists
between total cost/activity. The remaining deviations (20%) are random variation of cost from other (omitted) variables.
Step 5: Standard error (Se) of the estimate (y) determines the extent (absolute value) of dispersion of unexplained deviations
around the regression line. If Se is R4 and estimate(y) is R100, possible estimates range from R96 to R104. ‘n-2’ equals the
number of observations less a statistical degree of freedom of 2 for the number of variables (a & b), thus:
Se = √(∑[y-y1]2)/(n-2) Per p1060 Se = R201,25 and T-tables (p1063) at 10 (12 observations – 2) for a 90% (,05)
confident estimate require an estimate range of 1,812Se or ±R380,97 [R210,25Se x 1,812) (Assuming a normally distribution).
Step 6: A significant relationship between volume [x] and total cost [y]) exists when a deviation in variable cost [b] per unit
is greater than 2 standard errors from zero (i.e. b/Sb > 2), where Sb = Se/√(Σ[x2 - Σx]) or Sb = Se/√ [∑(x- )2]
Note: Simultaneous, Se and Sb equations will be given and questions will likely require an interpretation of given statistics.
Total estimated hours/cost (y) at natural doubling points (2, 4, 8, 16 etc): y= axbd where
y = total cumulative hours (including the learning effect) or total cum. Cost (if ‘a’ is labour cost for 1st run)
a = hours for 1st batch/run/product (or labour cost for 1st run)
x = total number of runs/batches/units
b = learning percentage (e.g. 90% displayed as 0,9)
d = number of natural doubling points
Example: Calculate the cumulative hours (y) for the first 4 batches (x), thus 2 doubling points (d) when the first batch took 300
hours (a) at a learning percentage of 80% (0,8)(b).
Solution: y = axbd and y = 300 x 4 x 0,82 = 768 hours
Example: The first production run produced 700 units and required 100 labour hours at a cost of R40 per hour. The second batch
of 700 units required only 70 hours as a normal learning curve effect occurred. To date the company produced 5 600 units.
Calculate the labour costs for the 5 600 units produced.
Solution: Learning percentage: 100h/ax =(100 x 170)/(100x2) = 85% Production runs 5 600/700 = 8
Production doubled at 2, 4 & 8 (3 times) Total labour hours(y) = axbd = 100(8)(0,85)3 = 491,3 x R 40 = R19 652
Solution using logarithms: Log y = log a + Log x (b)
where b = log learning % / log 2 Thus b = log 0,85/log 2 = -0,070581/0,30103 = -0,234465
Thus log y = log100 + (log 8)(-0,2345) = 2 + 0,90309(-0,2345) = 1,788225 (log y) Anti-log is 61,41 avg time x 8 runs = 491,3 hours
Learning percentage at non-doubling point: Use simultaneous equations at different cumulative average times.
Example: It took 135 days to build 3 aircrafts and 231 days to build 7 aircrafts. Determine the learning percentage.
Solution: Cumulative average times: 135/3=45 days and 231/7=33 days
log y = log a{1st unit} + b.log x {#runs/units} Thus log45 = log a + b.log 3 and log33 = log a + b.log7
Thus 1,653212514 = log a + b.0,47712154 (1)
And 1,51851394 = log a + b.0,84509804 (2)
(1)-(2) 0,134698573 = 0 + b.-0,367976785 Thus b = 0,1347/-0,36798 = -0,366052 and b = log%/log2
Thus log % = b.log2 and log% = -0,366052 x 0,30103 = -0,110192259 and anti-log = 0,7759% (learning percentage)
Review the section on “estimating incremented hours and incremental cost” on page 1053 which is self explanatory.
Week 11 - Linear programming Chap 26 (Level 3: Linear programming, sensitivity and shadow prices).
LP assumptions: Linearity, Divisibility of products and resources, all alternatives are included in the model and FC stay constant.
1st test for limiting factors - use sales demand
Single constraint – maximise product with highest contr. pu (e.g. bottleneck hour)
Multiple constraints may favour same product/use (same strategy as above) – draw graph for visual & maximise contribution
Constraints favour diff. prod./uses – use LP (Note LP assumptions)
LP steps: Formulate the problem algebraically, specify the objective function (max. contribution) (e.g. 14Y+16Z),
Formulate input constraints (e.g.Mat: 8Y+4Z ≤3440; Lab: 6Y+8Z≤2880; Mach. capacity: 4Y+6Z≤2760; Min./Max. Sales : 0
≤Y≤420 and Z≤0). Zero sales prevents solutions with negative sales qty.
Solve Y and Z with simultaneous equations (P1114 solved mat (8Y+ 4Z ≤3440) and lab (6Y+8Z≤2880) to 400Y and 60Z
Labour constraint 6Y + 8Z ≤ 2,880 (When Z = 0, Y = 480; When Y = 0, Z =360)
Machine capacity constraint 4Y + 6Z ≤ 2,760 (When Z = 0, Y = 690; when y = 0, Z = 460)
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Opportunity cost: Scarce resources have opportunity cost (i.e. shadow price) See Easy method and Drury p1110)
Easier method: Objective function: 14Y + 16Z Mat.: 8Y + 4Z ≤ 3440 Lab: 6Y + 8Z ≤ 2880
Contribution Y: 8M + 6L = 14 Contribution Z: 4M+8L=16 x2: 8M +16L = 32 Difference 0 +10L = 18
Thus L=R1,80 and M=R0,40 shadow prices
Entity can ↑labour rate by a max. of R1,80 and ↑mat price by a max. of 40c to ↑3440 lab hrs and ↑2880 mat units.
Shadow prices Drury: Mat.8Y+4Z ≤3441 & Lab. 6Y+8Z≤2880 →Y=400,2 & Z=59,85 MC is 40c [2,8 (,2Yx14)-2,4(,15Zx16)]
Similarly: 8Y+4Z ≤3440 & 6Y+8Z≤2881 →Y=399,9 & Z=60,2 MC is R1,80 [R3,2(,2Zx16)-1,4(,1Yx14)]
Simplex method: This non-graphical method for>two products is not part of the syllabus and may be ignored.
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