Department of Accounting Science and Finance

DEPARTMENT OF ACCOUNTING SCIENCE AND FINANCE

COST AND MANAGEMENT ACCOUNTING II(CUAC 203) NOTES

BSCAC 2.1 2015

COMPILED BY MUGUTI E(MR)

CHINHOYI UNIVERSITY OF TECHNOLOGY

accounting science and finance department

 P. Bag 7724, CHINHOYI, ZIMBABWE

 +263 67 22203-5 ext 216

 +263 67 28957

Website:

E-mail: ,

The Chairperson’s Office

COURSE OUTLINE 2015(Revised)

COURSE LECTURER: E.MUGUTI (MR.)

General Information

Office: Prefab Block 1 Office 6

E-mail: , .

+263775712712

1.0Course Title and Code

Cost and Management Accounting II – CUAC 203

2.0Time Allocation

4 hours per week and 1 hour will be reserved for tutorials

3.0Rationale

This course develops further the costing concepts and methods introduced in Cost and Management Accounting 1(CUAC 104) and also introduce contemporary approaches in arriving at the cost of products produced or services rendered. In addition, the course discusses applications of techniques in the analysis of relevant data to provide information for managerial planning, control, divisional performance evaluation and decision making.

4.0Purpose

4.1 To provide an understanding on how organisations accumulate, assign and analyse cost and revenue data for use within the organisation and its practical applications thereof.

4.2 To provide an understanding on how organizations use managerial information in planning, controlling, decision making and divisional performance evaluation, and to enable students to apply management accounting techniques in providing such information.

5 Main Capabilities

By the end of the course, students should be able to:

5.1Apply the concept of Activity Based Costing (ABC) in product costing and profitability analysis and distinguish it from the traditional absorption costing approach.

5.2 Compile the master budget from the functional, operating budgets and other given information and use the concept of flexible budgeting in managerial control.

5.3 Explain the concept of relevant costs and revenues and apply this concept in tactical short-term decisions such as (i) make or buy decisions (ii) dropping a product, department or business unit (iii) profitability analysis (iv) acceptance/rejection of a special order and (v) limiting factor analysis

5.4 Apply the linear programming model in solving problems with more than one limiting factor

5.5Use various techniques in capital investment decisions including accounting rate of return, payback; discounted payback, discounted cash flow techniques, and adjust for the effect of inflation and taxation.

5.6 Compute the profitability index and use it in capital rationing situations

5.7 Incorporate motivational, behavioural and ethical issues in managerial planning, control and decision making.

5.8 Analyse management accounting information and use performance measures such as Return on Capital Employed (ROCE), Residual Income (RI), Economic Value Added (EVA) and Cash Flow Return on Investment (CFROI) in divisional performance evaluation and management control.

5.9 Critically evaluate each costing technique, method and approach used in the analysis of cost information for managerial control, decision making and performance evaluation.

6 Method of Instruction

Each section of the course outline will be thoroughly demonstrated in the lecture, with comprehensive examples articulated to the students. The following methods among others will be used:

6.1 Lectures

6.2 Demonstrations

6.3Group discussions

6.4Tests

7 Students Assessments

7.1 Coursework comprises of at least two (2) tests and one (1) assignment, which constitute 30% weight of the final mark. Questions in the tests will cover all the pertinent aspects of the course covered up to the time of the test, and will serve as mock exams, in preparation for the final exam.

7.2 Final exam constitute 70% of the final mark and will examine all the pertinent aspect of the course.

7.3 The final mark will be a summation of course work and the exam mark.

7.4 The students will evaluate the course online on their student portals

7.5 The range of marks attained by the student will be classified as follows:

Degree Class / Range of Marks / Description
1 / 75% - 100% / Distinction
2.1 / 65% - 74% / Pass
2.2 / 60% - 64% / Pass
3 / 50% - 59% / Pass
F / 0% - 49% / Fail

8Course Content

8.1 Activity Based Costing (ABC)

Changes in cost composition and impact of the Activity-based costing (ABC) method

Treatment of costs are under Activity-Based Costing(ABC)

Designing an Activity-Based Costing(ABC) system

The mechanics of ABC

Comparison of traditional and ABC product costs

Advantages and limitations of ABC

ABC in the service industry

8.2 Intermediate Budgeting and Budgetary Control

8.2.1 Master Budget

Budgeted Cash Flow Statement (Cash Budget)

Budgeted Income Statement

Budgeted Statement of Financial Position

8.2.2 Flexible Budgeting

Preparation of fixed budgets

Preparation of flexible budgets

Separation of fixed and variable costs using the high-low method.

Budgetary control statements under both the fixed and flexible budgets

The appropriateness of fixed and flexible budgets in different circumstances

8.3 Short-term Tactical Decision Making

8.3.1 Relevant costs and Decision Making

The concept of relevant costs and revenues for decision making

Make or buy decisions

Dropping a segment, department or a business unit

Profitability analysis

Acceptance/rejection of a special order

Limiting factor analysis

8.3.2Linear programming

Formulating a linear programming model with objective function, variables and constraints

Solving a linear programming problem using (i) graphical method (ii) simultaneous equations method and (iii) simplex method

Shadow prices

Slack and surplus

8.4Investment Appraisal

8.4.1 The capital budgeting process and the role of investment appraisal

8.4.2 Capital investment appraisal techniques

Accounting rate of return

Payback

Discounted payback

Net present value

Internal rate of return

8.4.3Profitability Index and capital rationing

8.4.4Effect of inflation and taxation in capital investment appraisal

8.4.5Ethical and non-financial issues in long-term decision-making

8.4 Divisional Performance Evaluation

8.4.1Responsibility centres:

Cost centre, Revenue centre, Profit centre, Investment centre

8.4.2 Measures of performance:

Profit, Return On Capital Employed(ROCE), Residual Income(RI), Economic Value Added(EVA) and Cash Flow Return on Investment(CFROI)

Course Text(s) Recommended Reading

1. Drury C (2008) Management and Cost Accounting, 7th Edition, Cengage Learning, London.

2. Horngren, C.T. etal Cost Accounting – A managerial Emphasis, 13th Edition, Prentice Hall Inc, New Jersey.

3. Lucey T (2006) Costing, 7th Edition, DP Publications.

4. Lucey T (2006) Management Accounting, 5th Edition, DP Publications

5. Vigario F (2007) Managerial Accounting, 4th Edition, LexisNexis, Durban, South Africa.

6. CPA Australia/CIMA/ACCA modules.

7. Articles from professional journals.

1. ACTIVITY BASED COSTING

OBJECTIVES

By the end of this topic, the student should be able to;

1. Explain the shortcomings of traditional overhead absorption/allocation methods.

2. Describe and explain the Activity Based Costing (ABC) approach to overhead absorption and how it overcomes the limitations of the traditional methods.

3. Compute products costs using ABC approach and compare the costs with those calculated under the traditional methods.

4. Comment on the reasons for the differences in costs between ABC and traditional methods.

1.0 INTRODUCTION

The cost of a product or service is information that is quite often required by management for various purposes, for example, stock valuation, profit measurement or decision making.
Cost is simply the aggregate of all the expenses incurred in bringing a product to its present condition and location,
Some expenses are directly traceable to the cost object (direct costs), while some are not (indirect costs or overheads).
The problem remains that production overhead, which is not directly traceable, should form part of the production cost of a product.
The process of allocating production overheads to cost units/cost objects is known as overhead absorption.
There are two approaches to overhead absorption; (i) traditional approach (ii) Activity Based Costing (ABC) approach.

1.1 TRADITIONAL COST ALLOCATION METHODS

Apportions the total production overheads based on production volume.
Common absorption bases are number of units, machine hours and direct labour hours.

Under this approach, an organisation can use either a (i) plant-wide allocation method or a (ii) departmental allocation method.
The plant-wide allocation method uses the entire plant/organisation as a cost pool.
Therefore one overhead absorption rate is calculated for the whole plant/organisation.
Simple organizations having only a few departments and not much variety in activities in different departments might justify using the plant-wide method.
The department allocation method uses separate cost pools for each department.
Therefore a separate overhead absorption rate for each department is established.
The overheads in each department are then allocated to cost units using the calculated overhead absorption rates.

Activity 1

A company produces two products; Ordinary Product and Premium Product. Production data is as given below:

Budget / Ordinary Product / Premium Product
Units produced / 20 000 / 2 000
Costs per unit / $ / $
Material / 10 / 12
Labour / 5 hrs @ $12 per hour / 60 / 6 hrs @ $12 per hour / 72
Variable Overhead / 5 hrs @ $1 per hour / 5 / 6 hrs @ $1 per hour / 8
Budgeted fixed production overheads / $224 000

Required

Calculate the total full production cost and the production cost per unit of each product using labour hours to absorb overheads.

The major drawback of the traditional approach to overhead absorption is that overhead is absorbed into product cost on the basis of production volume (measured generally in machine hours, labour hours, etc) regardless of the fact that most of the overhead expenses may not have been the result of that production volume.
This, therefore, results in inaccurate allotment of overhead cost with a consequent effect on product pricing and profitability or profit measurement.
The modern approach called Activity Based Costing (ABC) challenges this traditional approach by arguing that in these days of technological advancement, different factors do influence the overhead expense.
These factors are called cost drivers.
ABC attempts to find a causal relationship between overhead and the cost driver.
A cost driver is, therefore, any factor which causes a change in the cost of an activity.

1.2 ACTIVITY BASED COSTING (ABC)

Challenges the traditional approach but takes into consideration the real factors that cause overhead to vary with production.
This is because, it is believed that, what is regarded as overheads is now accounting for significant proportion of total cost and a more accurate method of apportionment is therefore, required.
Using this approach would require a different way of classifying overhead cost, and the use of Cost Drivers.
Activity-based costing (ABC) rest on this premise: Products require activities; activities consume resources and acquisition of resources causes costs.
ABC therefore, assigns costs first to activities, then to the products based on each product’s use of activities.

1.2.1 Steps in ABC

Activity-based costing requires accountants to follow four steps.

1. Identify the activities that consume resources and assign costs to those activities

Activity: an event, task, or unit of work with a specified purpose,
e.g. designing products, setting up machines, operating machines, procuring materials etc. are some of the activities in a manufacturing organisation.
Activities can be classified into 4 categories namely; unit level activities, batch level activities, product level activities, and facility level activities.

(a)Unit level activities.

The costs of these activities are stronglycorrelated to the number of units produced.
For example, the use of indirect materials/consumables tends to increase in proportion to the number of units produced. Another example is; the inspection or testing of every item produced

(b)Batch level activities.

The costs of these activities are driven by the number of batches of units produced.
Examples of this are:

Material ordering – where an order is placed for every batch of production.
Machine set-up costs – where machines need resetting between each different batch of production.
Inspection of products – where the first item in every batch is inspected rather that every item.

(c)Product level activities.

The costs of these activities (often once only activities) are drivenby the creation of a new product line and its maintenance,
For example, designing the product, producing parts specifications and keeping technical drawings of products upto date. Advertising costs fall into this category if individual products are advertisedrather than the company’s name.

(d)Facility level activities.

These costs are not related to a particular product line; insteadthey are related to maintaining the buildings and facilities.
Examples are the maintenanceof buildings, plant security, business rates,production manager’s salary and advertising to promote the whole organisation.

The first and last categories above are the same as those in traditional absorption costingand so if an organisation’s costs are mainly made up of these two categories ABC willnot improve the overhead analysis greatly.
But if the organisation’s costs fall mainly in thesecond and third categories an ABC analysis will provide a different and more accurateanalysis.

2. Identify the cost driver(s) associated with each activity.

A cost driver is a factor that causes,or ‘‘drives,’’ an activity’s costs.
For the activity ‘‘purchasing materials,’’ the cost driver could be ‘‘number of orders.’’(Each activity could have multiple cost drivers.)
How do managers decide which cost driver to use? The primary criterion for selecting a costdriver is causal relation. Choose a cost driver that causes the cost.

Activity 2

Match the following costs with their appropriate cost drivers and also identify volume based and non volume based cost drivers:

COSTS COST DRIVERS

1. Depreciation A. No. of set ups

2. Indirect labour cost B. No. of purchases

3. Machine set up cost C. No. of product design

4. Order placing cost D. No. of inspections

5. Inspection cost E. Machine hours

6. Design cost F. Direct labour hours

3. Compute a cost driver rate for each cost driver.

Cost driver rate=Indirect cost or Overheads for each activity/Cost driver volume

4. Assign costs to products using the cost driver rate

Multiply the cost driver rate by the volume of cost driversconsumed by the product.
For example, the cost per purchase order times the number oforders required for Product X for the month of December would measure the cost of thepurchasing activity for Product X for December.

1.2.2 Activity Analysis

ABC starts with activity analysis.
An activity is a unit of work, a task or an event, it involves action words, for example, purchasing raw materials, setting up machinery, machining and inspecting finished goods.
Activity Analysis has 4 steps;

1. Chart, from start to finish, the activities used to complete the product or service.

2. Classify activities as value-added or non–value-added.

3. Eliminate non–value-added activities.

4. Continuously improve and reevaluate the efficiency of value-added activities or replace them with more efficient activities.

Activity analysis provides a systematic way for organizations to evaluate the processes that they use to produce goods and services for their customers.
Such an analysis can identify and eliminate activities that add costs but not value to the product.
Non–value-added costs are costs of activities that the company can eliminate without reducing product quality, performance, or value.
The following activities are candidates for elimination because they do not add value to the product; (i) storage of materials, (ii) moving items and (iii) waiting for work.
The traditional method of cost allocation is criticized as being too simplistic and inaccurate; the dinner example
There is the trade-off that accountants and managers face: the less expensive, less accurate, traditional method versus the more expensive, more accurate, activity analysis.
Managers must make a cost-benefit call whether the added benefits of activity-based information justify the additional costs of obtaining that information.
Cost pools are groups of costs.

Activity 3

Continuing from data in Activity 2 above, the following additional information is provided;

1. The examination of the fixed overheads of $224,000 shows that they consist of:

Machine set-up costs 90,000

Material handling costs 92,000

Packaging costs (manual) 42,000

Total 224,000

2. Activity Levels are as follows;

ProductOrdinary Premium

Number of set ups 1020

Number of material movements400 00060 000

Required

(a)Calculate the total full production cost and the production cost per unit using ABC principles

(b) Compare the cost per unit under the Traditional approach and ABC approach and comment on why there are differences.

Activity 3

Two products X and Y are made using similar equipment and methods.

The data for last period are:

X Y

Units produced 6,000 8,000

Labour hours per unit 1 2

Machine hours per unit 4 2

Set-ups in period 15 45

Orders handled in the period 12 60

Overheads for period $

Relating to production set-ups 89,500

Relating to order handling 15,000

Relating to machine activity 27,500

Required:

Calculate the overheads to be absorbed per unit of each product basedon:

(a) Conventional absorption costing using a labour absorption rate

(b) An ABC approach using suitable cost drivers.

(c) Compare the overhead cost per unit in (a) and (b) above and comment on why ABC is considered to be superior to the traditional approach.

END OF TOPIC NOTES

2. INTERMEDIATE BUDGETING AND BUDGETARY CONTROL

OBJECTIVES

After studying this topic, the student should be able to:

1. Compile master budgets (Statement of Comprehensive Income, Statement of Financial Position and Budgeted Cash Flow Statement (Cash budget)

2. Explain the importance of preparing cash budgets

3. Explain and prepare fixed, flexible and flexed budgets and justify the circumstances under which each type of budget is appropriate.

4. Prepare budgetary control operating statements under both fixed and flexed budgets and suggest reasons for the causes of variances.

1.1 MASTER BUDGET

This is the summary of all the operating and financial budgets and it consists of a Budgeted Income Statement, a Budgeted Statement of Financial Position and a Budgeted Cash flow statement.
The master budget is, therefore, an overall budget.

1.11 Cash Budget