Cost & Management Accounting

Part –II Management Accounting

MANAGEMENT ACCOUNTING • Management Accounting is the process within an organization that provides information used by managers in planning, implementing, & controlling the organization’s activities. • The process includes the identification, measurement, accumulation, analysis, preparation, interpretation & communication of  the information needed by management to perform its functions.

Managerial Accounting and Financial Accounting

Little Insight to Management Accounting • M.A. provides historical & estimated information on full costs & components of full costs structured by responsibility centers to support the measurement & control purpose of management accounting information; • In Mana Manage geme ment nt Accou ccount ntin ing, g, ‘COST’ is defined differently depending on the purpose; • tha thatt accou accounti nting ng numb number ers s are app appro roxi xima mati tion ons; s; • tha thatt rarely rarely the they y provi provide de exac exactly tly the info informa rmatio tion n needed needed;; • tha thatt much much more more tha than n accou accounti nting ng info informa rmatio tion n is nee needed ded in solution of a problem; & • tha thatt peop people le,, & not not num numbe bers rs,, get get thin things gs done done..

COST ESTIMATION & MANAGEMENT • COST: Resources sacrificed or forgone to achieve a specific objective. Usually measured as the monetary amount that must be paid to acquire goods & service. • COST OBJECT: Any activity or item for which a separate measurement of cost is desired. Any change made in any of the cost drivers will cause a change c hange in the total cost. • Expl.: No of units produced, No. of set-ups, No.of items distributed etc.

Flow of Manufacturing Activities Materials Activity

Production Activity

Marketing Activity

(raw materials)

(goods in process)

(finished goods)

Goods in Process

Raw Materials Beginning Inventory

Beginning Inventory

Raw Materials Used

Finished Goods Beginning Inventory

Raw Materials

Goods

Purchases

Manufactured Direct Labour Used Factory Overhead Used

inancial Reports

Raw Materials Ending Inv. (balance sheet)

Goods in Process Ending Inv. (balance sheet)

Finished Goods Ending Inv. (balance sheet)

Cost of Goods Sold (income statement)

COST SYSTEM •

A costing system accounts for costs in two basic stages – Accumulation & then assignment/ allocation.

1.

Cost Accumulation: Collection of cost data in an organized way by means of an accounting system – eg. Raw materials used, fuel consumed, labour  payment etc.

2.

Cost Al Allocation: After accumulation, cost system allocates or traces the cost to cost objects.

Cost Allocation Direct vs. Indirect Costs • Direct Costs of a cost object are related to the particular cost object & can be traced to it in an economically feasible (cost effective) way. • Eg.: Cost of can or bottle is a direct cost of  a soft drink producer. • ‘Cost Tracing’ is used to describe the assignment of direct cost to particular cost object.

Indirect Cost • Indirect costs of a cost object are related to the particular cost object but can not be traced to it in a cost effective way. • Eg.: Cost of Quality – Control personnel conducting tests on multiple soft-drink products. • ‘Cost Allocation’ is used to describe the assignment of indirect costs to particular  cost object.

Cost Allocation Service Departments Electricity

Maintenance

Factory Accounting

Stage 1 Machining Department

Assembly Department

Stage 2 Job 236

Job 237

Job 238

Elements of Cost COST

Materials

Labour

Other Expenses

Indirect Direct

Indirect

Direct

Indirect

OVERHEADS

Production or Works Overhead

Office & Administrative Overhead

Selling & Distribution Overhead

Statement of Cost Direct Material (+) Direct Labour  PRIME COST (+) Factory Overheads WORKS/FACTORY/ MANUFACTURING COST (+) Office & Administrative Overheads COST OF PRODUCTION (+)) Se (+ Sell llin ing g & Dist Distri ribu buti tion on Overheads COST OF SALES

Inventoriable Costs/ Unexpired Costs/ Manufacturing Cost

Period Costs/ Expired Costs/ Non- Manufacturing Expenses

“Factory overheads’ are not expenses – they are a re part of Inventoriable cost & will funnel into the expense stream only when the inventoriable costs are released as ‘COGS’.

Cost Classifications • Costs can be classified by:  – Relevance  – Behaviour 

Costs Classification by Relevance •

Relevant  –

If costs influence a decision

•

Costs that are applicable applicable to a particular decision. Costs that should have a bearing on which alternative a manager selects. Costs that are avoidable. avoidable.

•

Future costs that differ between alternatives.

• •

•

Irrelevant  –

If costs do not influence a decision

Costs Classification by Relevance • Sunk Costs  – All costs incurred in the past that cannot be changed by any decision made now or in the future.  – should not be considered in decisions.  – Irrelevant  – Example: You bought an automobile that cost Rs.30,000 two years ago. The Rs.30,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the Rs.30,000 cost.

Costs Classification by Relevance •

Out-of-pocket costs  –

require future outlays of cash

 –

associated with a particular decision

 –

relevant for future decisions

 –

Example: Considering the decision to take a vacation or stay at home, if you choose a vacation, you will only have travel costs (outof-pocket costs).

Costs Classification by Relevance • Opportunity Costs  – The potential benefit that is given up when one alternative is selected over another.  – Example: If you were not attending college or  university, you could be earning Rs.25,000 per  year. Your opportunity cost of attending college or university for one year is Rs.25,000.

Costs Classification by Behavior  • Cost behavior refers to  – how a cost will react to changes in the level of business activity.

• Fixed costs  – Do not change when activity changes. Remains fixed in total for a given period of time despite wide changes in the related level of  total activity or volume (within the relevant range). range).

These are period costs i.e. Lease rental, Insurance of  factory buildings etc. • Variable costs  – Change in proportion to changes in the volume of activity. These are basically product costs i.e. Direct Material Cost, Direct Labour  Costs, power, repair etc.

Variable Costs Total variable costs change when activity changes. Variable costs per unit do not change as activity increases. s o c el b ai

ti

st r

r v

a

l

at o T

n u

b ai

e p st s o c el

r

Volume of activity

a V

Volume of activity

Variable Cost Example • Consider the case of Manufacturing plant of Maruti at Gurgaon. • Assume that Maruti buys a steering wheel at Rs.3,000 for each of its Swift lxi model Vehicle • If Maruti produces 2,000 Swift-Lxi, total cost of steering wheels would be Rs.60,00,000.

Variable Costs Example Rs240 –  Rs180 – 

T o

l

at V a ri a

(0 0 ’0 0 0

Rs120 –  Rs60 – 

)

0

1

–

–

–

–

2

3

4

5

Volume (Thousands Swift cars)

Fixed Cost • Total fixed costs remain unchanged when activity changes within a relevant range. • Fixed costs per unit decline as activity increases. ti

n u r e p st s o c d e xi F

st s o c d e xi f l at o T

Volume of Activity

Volume of Activity

Fixed Costs Example Plant leasing cost is Rs.200,00,000 for its Gurgaon plant for a designated range of number of vehicles assembled during a month.

Rs400 –  Rs300 – 

l

T o ta F ix e d C

(0 0 ’0 0 0

Rs200 –  Rs100 –  –

–

)

0

1

–

2

–

3

4

Volume (Thousands of vehicles)

5

Relevant Range...  –

is a band of volume in which a specific relationship exists between cost and volume.

•

Outside the relevant range, the cost either  increases or decreases.

•

A fixed cost is fixed only within a given relevant range and a given time span.

Relevant Range

160,000 –  120,000 – 

Relevant Range

80,000 – 

ts

s

d C o

F ix e

40,000

–

0

–

–

5,000 10,000 15,000 20,000 25,000 Volume in Units

Relevant Range – Step Cost • Step-Wise Costs  – remain fixed over limited ranges of volumes but increase by a lump sum when volume increases beyond maximum amounts.  – Example: additional production production supervisors must be added when another shift is added. s ei r al a S y r o si v r e p u S

Production Volume

Mixed Cost • Semi- fixed/ Semi-variable costs  – contain a combination of fixed and variable costs.

m o C l at o T

s n e p

n oi t a

 t  s  o  c  d  e    x x   i  m   l    a a  t  o   T

Variable Sales Commissions Fixed Monthly salary

Sales

Mixed Costs Example • A mixed cost is cost is part variable and part fixed (as most of the costs are neither  perfectly fixed, nor perfectly variable). • Assume a department of a company has fixed costs of Rs.50 per month (Rs.600 per year). • There are also variable costs of Rs.3 per  hour.

Mixed Costs Example Rs2,475 –  Rs2,100 –  Variable

Rs1,350 –  T o

at

Cost

Rs600 – 

Fixed

l ts

s

C o

–

0

–

–

–

125 250 375 500 625 Volume (hours)

Cost

Estimating Cost – Volume Relationship • Several methods are used to estimate the cost volume relationship, i.e. to arrive at the total fixed cost & the unit variable cost in the equation – • TC = TFC + (UVC * X)

1. Judgment Method • Using judgment in deciding how much of cost of each item or category will vary with volume & what will be the amount of fixed cost. • Appropriate where; • Cost estimation for a situation s ituation where historical data are irrelevant viz, a proposal to introduce a new product with a new process. • The reliability of the results depends on the experience & skill of the estimator. • Also known as ‘Account-by-Accoun ‘Account-by-Accountt Method’ as the analyst considers each account in the cost structure &  judges whether the costs in that account are variable, fixed or semi-variable. semi-variable.

2. High – Low Method 1. Esti Estima mate te tot total al cost costs s at each each two two volum volume e leve levels ls,, whic which h identifies two points on the line – the upper & lower limits of the relevant range are selected for the purpose. 2. Su Subt btra ract ct tot total al cos costt at low lower er volu volume me fro from m the the hig higher her one & also subtract the corresponding lower volume from the higher. 3. Di Divi vide de the the dif diffe feren rence ce in in cost cost by by diff differ erenc ence e in vo volum lume e to arrive at the Unit Variable Cost (UVC). 4. Mult Multipl iply y eit either her of the volum volumes es by UVC UVC & subt subtra ract ct the the result from the total cost at that volume to arrive at the Fixed Cost.

3. Scatter Diagram • Make a diagram in which actual costs recorded in past periods are plotted (on the vertical axis) against the volume of levels in those periods ( on the horizontal axis). • Data on costs & volumes for each of the preceding several months may be used for the purpose. • Draw a line that best fits the observation by visual inspection of the plotted points. • The FC & TVC values are then determined by reading the values for any two points on the line and using the High-Low Method discussed previously.

Scatter diagram with High-Low Method of  Cost Estimation x x

Indire Ind irect ct 1,45 1,456 6

x

Labour  Costs

x

710

x x

Cost function =

x

Rs(23.68 + 14.92) per machine hour 

x

Rs. 46

96 Machine Hours

Varia Variable ble cost cost = Change Change in in cost cost / Change Change in in volume volume = (Rs1,456 – Rs.710) / (96 - 46) = Rs.14.92 per MH Fixed cost

= Mixed cost at hig high poin oint - variab iable cost = Rs1,456 - (96 x Rs.14.92) Rs.23.68 week

Regression Analysis Method • Regression analysis is a statistical method that measures the average amount of change in the t he dependent variable (x) that is associated with a unit change in one or more independent variable (s) • Simple linear regression - one independent independent variable • Multiple regression - more than one independent independent variable • Allows for the evaluation of the quality of the cost function  – Coefficient of determination (R-Squared) measures the goodness of fit of the line to the underlying data  – t-value measures the potential error of the estimated variables

4. Linear Regression Method of Least Square •

This approach provides two mathematical properties that are missing in all previous methods.

• •

Σy = na + b Σx…………..(1) Σxy = a Σx + b Σx2 ……..(2)

• • • • •

Where Σy = Total cost; Σx = Total Volume a= Total Fixed cost; b= Variable cost per unit; n= No. of time period Σxy = Cost, time, volume summed

Nonlinearity Cost Function Nonlinear cost function c osts versus a • a cost function in which the graph of total costs single cost driver does not form a straight line within the relevant range Time

Nonlinear  Cost Function (Learning Curve) Cumulative Total Volume

Nonlinear Cost Functions 1. Economies of Scale 2. Quantity Di Discounts 3. Step Step Cost Cost Fun Funct ctio ions ns – reso resour urce ces s incr increa ease se in in “lot-sizes,” not individual units 4. Lear Learni ning ng Curve urves s – labo laborr hou hours rs cons consum umed ed decrease as workers learn their jobs and become better at them 5. Expe Experi rien ence ce Curv Curve e – bro broad ader er appl applic icat atio ion n of  of  learning curve that includes downstream activities including marketing and distribution

Types of Learning Curves • Cumulative Average-Time Learning Model – cumulative average time per unit declines unit declines by a constant percentage each time the cumulative quantity of units produced doubles • Incremental Unit-Time Learning Model – incremental time needed to produce the last unit  declines by a constant percentage each time the cumulative quantity of units produced doubles

Data “Problems” 1. Some Some “varia “variable ble”” costs are are actua actually lly alloc allocate ated d fixed fixed costs 2. Miss Missin ing g data data poin points ts 3. Erro Errors rs in rec recor ordi ding ng dat data a poin points ts 4. Lack Lack of a homo homogen geneou eous s relatio relationsh nship ip betwe between en the dependent variable pool and cost driver  5. Colle Collectio ction n perio periods ds for for vari variabl ables es diffe differ  r  6. Relat Relation ionshi ship p betwe between en cost cost and and cost cost driver driver is unstable 7. Impact Impact of of inflat inflation ion on on data data point points s over over time time