Chapter 10 MARGINAL COSTING AND ABSORPTION ：10章边际成本法和吸收

Chapter 10 MARGINAL COSTING AND ABSORPTION ：10章边际成本法和吸收 Chapter 10 MARGINAL COSTING AND ABSORPTION COSTING This chapter explains and compares the concepts of absorption costing and marginal costing. The chapter covers syllabus areas 6 (a) and (b). CONTENTS 1 The concept of contribution 2 Absorption costing and marginal costing 3 Reconciliation of profits under absorption costing and marginal costing 4 Absorption costing v marginal costing 5 Profit and contribution 6 Break-even point and margin of safety 7 The contribution to sales ratio 8 The assumptions and limitations of break-even analysis 9 Limiting factor analysis LEARNING OUTCOMES On completion of this chapter the student should be able to: • explain and illustrate the concept of contribution • calculate and utilise contribution per unit, per $ of sales and per unit of limiting factor • explain and calculate the break-even point and the margin of safety • analyse the effect on break-even point and margin of safety of changes in selling price and cost • describe the assumptions, uses and limitations of marginal costing and break-even analysis • prepare, and explain the nature and purpose of, profit statements in absorption and marginal costing formats. 139 PAPER 2 : INFORMATION FOR MANAGEMENT CONTROL 1 THE CONCEPT OF CONTRIBUTION 1.1 FIXED AND VARIABLE COSTS In previous chapters a distinction was drawn between fixed costs and variable costs. If all costs of a business (fixed and variable) are deducted from sales revenue, the remaining amount is known as profit. 1.2 CONTRIBUTION If only the variable costs of the business are deducted from sales revenue, the resulting figure is known as contribution. Definition Contribution is sales value less variable costs. Contribution can be calculated on a per unit basis or alternatively on a total basis. Example A company makes and sells a single product. Details of this product are as follows: Per unit Selling price $20 Direct materials $6 Direct labour $3 Variable overhead $4 Fixed overhead $20,000 per month The fixed overhead is absorbed on the basis of expected production of 20,000 units per month. If actual production and sales are 20,000 units in a month calculate the contribution per unit, the total contribution for the month and the total profit for the month. Solution Contribution per unit Selling price 20 Less: variable costs Direct materials 6 Direct labour 3 Variable overhead 4 13 Contribution per unit 7 140 MARGINAL COSTING AND ABSORPTION COSTING : CHAPTER Total contribution and | profit $ $ Sales (20,000 x $20) 400,000 Variable costs: Direct materials (20,000 x $6) 120,000 Direct labour (20,000 x $3) 60,000 Variable overhead ($20,000 x$4) 80,000 260,000 Contribution 140,000 Fixed overheads 20,000 Total profit 120,000 Alternatively this could be calculated as follows: Total contribution = Sales units x Contribution per unit (20,000 x $7) = $140,000 Less fixed costs $20,000 Profit $120,000 2 ABSORPTION COSTING AND MARGINAL COSTING 2.1 INTRODUCTION In earlier chapters the idea of absorbing production overheads into the cost of units c production was considered in some detail. The overheads that were included in the cost of the cost units were both variable production overheads and fixed production overheads. 2.2 ABSORPTION COSTING Definition Absorption costing is a cost accounting system that charges both fixed and variable production overheads to cost units. Under an absorption costing system each unit of inventory, whether it has been sold and charged as cost of sales or is unsold and included in closing inventory, is valued at full production cost. This includes both fixed and variable production overheads. 2.3 MARGINAL COSTING AS AN ALTERNATIVE TO ABSORPTION COSTING Definition Marginal costing is an accounting system in which variable costs are charged to cost units and fixed costs are not absorbed into cost units bul written off in the income statement for the period to which they relate. We saw in an earlier chapter that this involves classifying fixed production overheads as period costs and not as product costs. In a marginal costing system all cost units are valued at variable production cost only. Therefore when the cost of sales is deducted from the sales revenue the result is contribution. KAPLAN PUBLISHING PAPER 2 : INFORMATION FOR MANAGEMENT CONTROL Example Company A produces a single product with the following budget: Selling price $10 per unit $3 per unit Direct materials $2 per unit Direct wages $1 per unit Variable production overhead $10,000 per month. Fixed production overheads The fixed production overhead absorption rate is based on a production level of 5,000 units per month. Prepare the operating statement for the month under marginal costing principles, if 4,800 units were produced and sold. Assume that costs were as budget, and that there is no opening inventory and that there are no non-production costs. Solution $ 48,000 Sales (4,800 x $10) 28,800 Variable costs (4,800 x $6) (W1) 19,200 Contribution 10,000 Fixed costs 9,200 Profit (W1) Variable costs = Materials ($3) + Wages ($2) + Variable overheads ($1) = $6 per unit. 2.4 MARGINAL COSTING AND INVENTORY VALUATION Under marginal costing inventory is valued at variable production cost. This is in contrast to absorption costing where fixed production overhead costs are also included in inventory valuations using the predetermined absorption rate. The following example illustrates the effects of the different inventory valuations on profit. Example Suppose that in the previous example production was in fact 6,000 units i.e. 4,800 units sold and 1,200 units left in closing inventory. Prepare profit statements for the month using both absorption costing and marginal costing principles. 142 MARGINAL COSTING AND ABSORPTION COSTING : CHAPTER 10 Solution Absorption costing With absorption costing the predetermined overhead absorption rate will be $10,000/5,000 units = $2 per unit. Therefore the full production cost per unit for the absorption costing statement = $6 variable cost + $2 fixed production overheads = $8 per unit. A further problem occurs because the actual level of production (6,000 units) is greater than the level of production used in calculating the overhead absorption rate (5,000 units). This leads to a situation of over-absorbed fixed production overheads, which means that more production overhead will have been absorbed into the cost of production than has been incurred during the period. This over-absorbed overhead is added back to the profit at the end of the operating statement in order to determine the absorption costing operating profit for the period. The over-absorbed fixed production overhead is calculated as follows. $ 12,Fixed production overhead absorbed (6,000 units x $2) 000 Fixed production overhead incurred 10.000 Over-absorbed fixed production overhead 2.000 $ $ 48 Sales ,000 Cost of sales: Production (6,000 x $8) 48,000 38,400 Closing inventory (1,200 x $8) 9,600 9,600 Over-absorbed fixed overhead (see working above) 2,000 Profit 11,600 In this example there was an over absorption of fixed production overhead when absorption costing principles were used. If the actual production level had been lower than the budgeted level then there would have been an under absorption. This amount would have been deducted at the end of the statement to deduce the profit for the period. Conclusion Using absorption costing principles, the cost of production is valued at full production cost which includes a share of the fixed production overhead. This may mean that there is an under or over absorption of production overhead. KAPLAN PUBLISHING PAPER 2 : INFORMATION FOR MANAGEMENT CONTROL Marginal costing $ 48,0 Sales 00 Variable costs: 36,000 Production costs (6,000 x $6) 7,200 Closing inventory (1,200 x $6) 28,800 19,200 10,000 Fixed costs 9,200 Profit Using marginal costing principles, the cost of sales is valued at variable production cost only. The fixed production costs are written off as they are incurred as a period cost in the income statement. Therefore there is no absorption of fixed production overheads and consequently no under- or over-absorption. If inventory levels increase or decrease in a period the two methods report different figures for profit. RECONCILIATION OF PROFITS UNDER ABSORPTION COSTING AND MARGINAL COSTING 3.1 INTRODUCTION As we saw in the previous example, if inventory levels increase or decrease in a period, there will be a difference in the amount of profit reported under absorption costing and marginal costing. 3.2 INVENTORY VALUATION The only difference between absorption costing and marginal costing is the way in which inventory is valued. Under absorption costing a share of the fixed production overhead is included in the inventory valuation whereas under marginal costing only the variable production overheads are included in the inventory valuation and all fixed production overhead is charged to the income statement. It is this different treatment of fixed production overhead that causes the difference in reported profit between the two costing systems. 3.3 CHANGES IN INVENTORY LEVELS If inventory levels increase then the profit under absorption costing will be higher than under marginal costing. This is because some of the fixed production overhead is carried forward in the absorption costing inventory valuation instead of being charged against the profits for the period. If inventory levels fall in a period then the profit under marginal costing will be higher than under absorption costing. This is because some of the fixed production overhead brought forward in inventory is charged against the absorption costing profit when inventory levels fall. 144 MARGINAL COSTING AND ABSORPTION COSTING : CH; Example In the previous example a difference in profit arose between the absorption o profit of $11,600 and the marginal costing profit of $9,200. Reconcile this difference in profits. Solution Reconciliation Absorption costing profit 11,600 Increase in inventory level 1,200 units x $2 (fixed production overhead carried forward in inventory 2400 valuation) Marginal costing profit 9200 Conclusion The difference between absorption costing profit and marginal c profit will always be caused by changes in inventory levels and production overhead absorbed into those increasing or decrease number of units. If inventory levels increase the absorption cost will be higher and if inventory levels fall, then the marginal costing will be higher. 4 ABSORPTION COSTING v MARGINAL COSTING 4.1 ARGUMENTS FOR ABSORPTION COSTING Absorption costing is a widely used costing method. Defenders of the absorption principle out that: (a) it is necessary to include fixed production overhead in inventory value financial statements; routine cost accounting using absorption costing inventory values which include a share of fixed production overhead (b) for a small jobbing business, overhead absorption is the only practice obtaining job costs for estimating and profit analysis (c) analysis of under-/over- absorbed overhead is useful for identifying inefficient of production resources. 4.2 ARGUMENTS AGAINST ABSORPTION COSTING Preparation of routine operating statements using absorption costing is considered less informative than using marginal costing: (a) Profit per unit is a misleading figure: in the example the operating margin of $2 per unit arises production overhead per unit is based on 5000 If another activity level were used, the profit margin per unit would though the fixed production overhead cost was the same amount (b) Build-up or run-down of inventory of finished goods can distort comparison operating statements and obscure the effect of increasing or sales. (c) Comparison between products can be misleading because of the effect of arbitrary apportionment fixed cost PAPER 2 : INFORMATION FOR MANAGEMENT CONTROL ACTIVITY 1 A company sells a product for $10 per unit, and incurs $4 per unit of variable costs in its manufacture. The fixed production costs are $900 per year and are absorbed on the basis of the normal production volume of 250 units per year. The results for the last four years were as follows: 2nd year units 3rd year Total 1st year 4th year units units units units Opening inventory 200 300 300 - Production 300 250 200 200 950 300 450 500 500 950 Closing inventory 200 300 300 200 200 Sales 150 200 100 300 750 $ 1,0$ 1,5$ 2,0$ 3,0$ 7,5 00 00 Sales value 00 00 00 Calculate the profit each year under both absorption costing and marginal costing. For a suggested answer, see the 'Answers' section at the end of the book. 5 PROFIT AND CONTRIBUTION 5.1 INTRODUCTION Calculations of both profit and contribution will provide managers with useful information. However each serves different purposes. 5.2 PROFIT INFORMATION A business must make a profit in order to survive. It must ensure that in the long run all of its costs are covered. Therefore information regarding the profit that a business has made will be of great importance to management. 5.3 CONTRIBUTION INFORMATION Contribution is sales value less variable costs. Therefore it is effectively a fund out of which firstly fixed costs are covered and then a profit is made. It is argued that contribution provides more useful information than profit particularly for decision-making purposes. Contribution will vary directly with the level of activity as long as sales price and variable costs are constant per unit. Therefore if decisions are to be made about activity or production levels then contribution per unit will be more relevant, because the absorption costing profit per unit changes every time the activity level changes. 146 MARGINAL COSTING AND ABSORPTION COSTING : CHAPTER 10 To determine the profitability of individual products the fixed overheads of the organisation must be apportioned in some way to each product. This apportionment is arbitrary. Therefore, when comparing products it can be argued that the contribution of each product rather than the profit will give more useful information as there is no arbitrary apportionment involved. Conclusion Profit information is important to management as the business must be profitable in the long run. However for most management decision purposes contribution will be more useful. BREAK-EVEN POINT AND MARGIN OF SAFETY 6.1 BREAK-EVEN POINT The break-even point is the point at which a business generates sufficient sales to just cover the costs incurred, i.e. at which it makes no profit or loss. It can be expressed in a variety of ways, the most common being the total sales value required to cover costs or in terms of specifying how many units need to be sold to break even. The break-even equation is usually expressed as: Fixed costs Break-even point = Contribution per unit In order to determine the number of units to be sold to break even you need to know the fixed costs and the contribution per unit. For example, if the fixed costs were $50,000 and the selling price and variable cost of a unit were $10 and $8 respectively, then the break-even point would be achieved at: $50,000 = 25,000 units $(10-8) At 25,000 units all costs are covered so sales above that level will earn profits for the business. It is useful for management to know at what level of sales profits will be earned, but this approach can only be applied easily in situations where one product is sold. It can be used to assess whether changes to costs and selling prices will significantly impact the number of units to be sold before making a profit. It can also be used to determine by how much a selling price needs to be altered when further costs are incurred if the business wishes to break even. 6.2 MARGIN OF SAFETY The margin of safety measures the amount by which expected or budgeted sales exceed the level required to break even. For example, in the above case, if the total number of units which can be sold is 27,000 units then the margin of safety is: 27,000 - 25,000 = 2,000 units KAPLAN PUBLISHING PAPER 2 : INFORMATION FOR MANAGEMENT CONTROL Expressed as a percentage the safety margin is: Margin of safety _ 2,000 pected sales 27,000 In this case the margin of safety is quite small and the sales volume cannot be allowed to fall by more than 7.4 per cent before the business will start to make losses. ACTIVITY 2 The fixed costs of a business are $252,000. It produces units which have a variable cost of $21 per unit and the units can be sold for $30 each. What number of units need to be sold to break even? If budgeted sales are 32,000 units what is the margin of safety? If the selling price was reduced to $29 per unit, how will this affect the margin of safety? For a suggested answer, see the 'Answers' section at the end of the book. 7 THE CONTRIBUTION TO SALES RATIO An assumption made in break-even analysis is that the ratio between the contribution and the sales value of a product or mix of products remains constant. This constant ratio is called the contribution to sales ratio (C/S ratio) and is usually expressed as a percentage. Contribution in Contribution to sales ratio (C/S ratio) = $ Sales in $ Note: The term profit to volume (or P/V) ratio is sometimes used instead of contribution to sales ratio. Profit to volume is an inaccurate description, however, and should not be used. 7.1 ESTIMATING THE BUDGETED PROFIT The C/S ratio can be used to estimate the budgeted profit for a period, given estimates for sales revenue and fixed costs. Example A business sells a range of products, and has estimated that the average C/S ratio on its sales is 40%. Annual fixed costs are expected to be $350,000. Budgeted sales are $1,050,000. The budgeted profit is: $ 420,000 Budgeted contribution (40% x $1,050,000) 350,000 Budgeted fixed costs 70,000 Budgeted profit 148 MARGINAL COSTING AND ABSORPTION COSTING : CHAPTER 10 7.2 CALCULATING THE BREAK-EVEN POINT AND MARGIN OF SAFETY The C/S ratio can be used to calculate the break-even point, expressed in terms of sales revenue. At the break-even point, total contribution = fixed costs, and the break-even point in sales revenue is: Fixed costs C/S ratio Example A retail store incurs fixed costs of $60,000 each month. It sells its goods at a gross profit of 50% of purchase cost. The purchase cost of goods are its only variable costs. Required: (a) Calculate the break-even value of sales each month. (b) If budgeted monthly sales are $200,000, calculate the margin of safety. Solution 7o 100 Purchase cost (variable costs) 50 Gross profit 150 Sales price C/S ratio = 50/150 = 0.333 or 33.33% $60,000 Break-even value of sales = ------------ 0.3333 = $180,000 per month If budgeted sales are $200,000 per month, the margin of safety is ($200,000 -$180,000) = $20,000. This is 10% of budgeted sales. KAPLAN PUBLISHING PAPER 2 : INFORMATION FOR MANAGEMENT CONTROL ACTIVITY 3 has the following budget for period 1: Door Total Shutter Hinges handles handles 2,000 1,000 400 600 Fylindales Fabrication Sales value $ 3,000 $ 35,$ 30,000 $ 2,4Sales units Variable costs 1,700 400 20,000 00 23,000 1,300 Contribution 10,000 1,100 1,300 12,400 Fixed costs 5,000 Profit 7,400 Required: Calculate the break-even point in sales revenue. State the assumptions on which your estimates are based. For a suggested answer, see the 'Answers' section at the end of the book. 8 THE ASSUMPTIONS AND LIMITATIONS OF BREAK-EVEN ANALYSIS The limitations of the practical application of break-even analysis arise due to the assumptions which underlie the analysis. • The selling price per unit is assumed to be constant irrespective of the number of units to be sold. However in practice it is likely to be necessary to reduce the selling price in order to achieve higher sales volumes. • The fixed costs are assumed to be constant in total. In practice there is likely to be a step in the fixed costs at some point as activity levels increase. • The variable cost per unit is assumed to be constant irrespective of the number of units produced. In practice there is likely to be a change in cost behaviour patterns over a range of outputs, for example if bonuses or overtime premiums need to be paid in order to achieve higher production volumes. • The analysis is applicable only to a single product, or to a constant mix of multiple products, which is probably an unlikely situation to arise in practice. • The model takes no account of any uncertainty underlying the forecasts of the variables. 150 MARGINAL COSTING AND ABSORPTION COSTING : CHAPTER 10 9 LIMITING FACTOR ANALYSIS A limiting factor is any factor which limits the activities of an organisation and stops it from expanding indefinitely. Often the limiting factor will be sales volume because the organisation cannot sell all that it is able to produce. However, especially in the short term, a factor of production may be a limiting factor. For example the number of labour hours may be restricted or material availability may be limited in a future period. 9.1 IDENTIFYING THE LIMITING FACTOR It is important to identify the limiting factor so that the optimum use can be made of it in the organisation's activities. Example X Ltd makes a single product which requires $5 of materials and 2 hours of labour. There are only 80 hours labour available each week and the maximum amount of material available each week is $500. Solution It can be said that the supply of both labour hours and materials are limited and that therefore they are both scarce resources. However, there is more to this problem than meets the eye. The maximum production within these constraints can be shown to be: 100 units Materials: $500/$5 40 units Labour hours: 80 hours/2 hours Thus the shortage of labour hours is the limiting factor- the scarcity of the materials does not limit production. In the context of the decision in this example the materials are not a scarce resource. 9.2 OPTIMISING THE USE OF THE LIMITING FACTOR If we assume that the objective is to maximise profits, then only those costs and revenues that vary according to the decision are considered; since fixed costs do not, they are irrelevant and may be ignored. This leaves revenue and variable costs to consider. Sales revenue less variable cost is contribution. Thus, to maximise profit we maximise contribution, and the decision rule is to maximise the contribution per unit of limiting factor. 9.3 MULTIPLE PRODUCT SITUATIONS When more than one product or service is provided from the same pool of resources, profit is maximised by making the best use of the resources available. Example Z Ltd makes two products which both use the same type of materials and grades of labour, but in different quantities as shown by the table below. Product A Product B Labour hours/unit 3 4 Material/unit $20 $15 KAPLAN PUBLISHING PAPER 2 : INFORMATION FOR MANAGEMENT CONTROL During each week the maximum number of labour hours available is limited to 600; and the value of material available is limited to $6,000. Each unit of product A made and sold earns a contribution of $5 and product B earns a contribution of $6 per unit. The demand for these products is unlimited. Advise Z Ltd which product they should make. Solution 1 Determine the scarce resource Each resource restricts production as follows: Labour hours 600/3 = 200 units of A, or 600/4 = 150 units of B Materials $6,000/$20 = 300 units of A, or $6,000/$15 = 400 units of B It can be seen that whichever product is chosen the production is limited by the shortage of labour hours, thus this is the limiting factor or scarce resource. 2 Calculate each product's contribution per unit of the scarce resource consumed by its manufacture Product A contribution per labour hour = $5/3 hours = $1.67 per hour Product B contribution per labour hour = $6/4 hours = $1.50 per hour Thus Z Ltd maximises its contribution by making and selling product A. Total contribution is maximised by concentrating on that product which yields the highest contribution per unit of limiting factor. Example X Ltd makes three products, A, B and C, for which relevant details are as follows: Product A Product B Product C Machine hours required to produce one unit 10 12 14 $ $ $ Direct materials @ $5 per 70 (14 kg) 90 60 (12 kg) 60 50 (10 kg) 30 kg Direct wages @ $7.50 per (12 hours) 30 (8 hours) 30 (4 hours) 30 hour Variable overheads 150 110 Total variable costs 190 200 150 Selling price 250 Contribution 60 50 40 Sales demand for the period is limited as follows: Product A 4,000 Product B 6,000 Product C 6,000 152 MARGINAL COSTING AND ABSORPTION COSTING : CHAPT As a matter of company policy it has been decided that a minimum of 1,000 units Product A should be produced. The supply of materials in the period is unlimited, machine hours are limited to 200,000 and direct labour hours to 50,000. How many units of each product should be produced in order to maximise profitat Solution First determine which is the limiting factor. We are told that there are unlimited supplies of materials, but both machine hours and labour hours are restricted in availability. Ideally, the company would like to produce enough of each product to satisfy total sales demand. However, this would require the following amounts of scarce resources to be available: Sales potential Total labour Total machine units hours hours Product A 4,000 40,000 48,000 Product B 6,000 72,000 48,000 Product C 6,000 84,000 24,000 120,000 196,000 Hours available 200,000 50,000 Thus, sufficient machine hours are available to produce everything we require, but labour hours are a limiting factor. Our production plan must be based on gaining the fullest possible benefit from the scarce resource. To do so, we calculate contribution per labour hour for each product: $60 12 Product A = $5.00 $50 Product B = $6.25 $40 Product C = $10.00 Product C earns $10 in contribution for every scarce labour hour used, whereas Product B earns only $6.25 and Product A only $5.00. Thus, production should be concentrated on C, up to the maximum available sales, then B, and finally A. However, a minimum of 1,000 units of A must be produced. Taking these factors into account, the production schedule is as follows: LabouUnits Cumulative produced r hours labour hours Limiting factor Product A 1,000 12,000 12,000 Policy to produce 1,000 units Product C 6,000 24,000 36,000 Sales demand Labour hours Product B 1,750 14,000 50,000 KAPLAN PUBLISHING ACTIVITY 4 A Ltd makes two products, X and Y. Both products use the same machine and the same raw material which are limited to 200 hours and $500 per week respectively. Individual product details are as follows: Product X Product Y Machine hours/unit 5 2.5 Materials/unit $10 $5 Contribution/unit $20 $15 Identify the limiting factor. For a suggested answer, see the 'Answers' section at the end of the book. ACTIVITY 5 Using the data in the activity above, recommend which product A Ltd should make and sell (assuming that demand is unlimited). For a suggested answer, see the 'Answers' section at the end of the book. CONCLUSION Contribution is an important concept in decision making and can be used in a variety of techniques to help determine which products should be produced to maximise profits. KEY TERMS Contribution - sales value less variable costs. Absorption costing - a cost accounting system that charges both fixed and variable production costs to cost units. Marginal costing - a cost accounting system in which only variable costs are charged to units and fixed costs are charged to the income statement in the period to which they relate. Break-even point - the point at which a business generates sufficient revenue to just cover its costs, i.e. makes no profit or loss. Margin of safety - the amount by which expected or budgeted sales exceeds the level required to break even. Contribution to sales ratio - the ratio between the contribution and the sales revenue, which is assumed to be constant and is usually expressed as a percentage. Limiting factor - a factor which limits the activities of an organisation and stops it expanding indefinitely. 154 KAPLAN PUBLISHING MARGINAL COSTING AND ABSORPTION COSTING : CHAPTER 10 SELF TEST QUESTIONS Paragraph 1 Explain the term contribution. 1.2 2 Explain what absorption costing and marginal costing methods are. 2.2, 2.3 3 How is closing inventory valued in a marginal costing system? 2.4 4 In what circumstances would there be a difference between the profit reported under absorption costing and the profit reported under marginal costing? 3.2 5 If closing inventory is greater than opening inventory will absorption costing profit or marginal costing profit be higher? 3.3 6 What is the formula for calculating the number of units to be sold to break even? 6.1 7 What is the margin of safety and how is it calculated? 6.2 8 State the formula which uses the contribution to sales ratio to calculate the break-even point in terms of sales revenue. 7.2 9 What are the limitations of break-even analysis? 8 10 What is the decision rule when seeking to optimise the use of a limiting factor? 9.2 KAPLAN PUBLISHING PAPER 2 : INFORMATION FOR MANAGEMENT CONTROL EXAM-STYLE QUESTIONS 1When preparing an operating statement based on absorption costing principles, inventory valuation comprises which of the following costs? A Direct labour and material costs only B Prime cost plus variable and fixed production overhead C Prime cost plus variable production overhead D Total cost 2 company's product sells for $10 per unit. Results of the latest period are as follows: Sales $104,000 Variable costs $31,200 Fixed costs $59,500 Whalevel of sales is required to break even each period? t A 5,950 units B 7,250 units C 8,500 units D 10,400 units Using the data from question 2, if the selling price is reduced to $8 per unit, what level of sales is now required to break even each period (to the nearest unit)? A 6,800 units B 7,438 units C 10,200 units D 11,900 units Complete the following definition: Contribution is 156 MARGINAL COSTING AND ABSORPTION COSTING : CHAPTER 10 The following are assumptions made in break-even analysis: True False (a) The selling price is constant per unit. ........... ......... (b) The organisation sells a single product or multiple products in a constant ratio. ........... ........... (c) The total variable cost is constant however many units are produced. ................................. X Ltd makes two products, A and B. Both products use the same machine and the same labour which are limited to 100 hours and 50 hours per week respectively. Individual product details are as follows: Product A Product B Machine hours/unit 10 5 Labour hours/unit 6 5 Contribution/unit $20 $18 Which product should X Ltd make and sell and what is the maximum contribution that can be earned ? For suggested answers, see the 'Answers' section at the end of the boo Chapter 11 BASIC BUDGETING This chapter introduces the function of budgetary control. The chapter covers syllabus areas 5 (a) (iii) and (b) (i). CONTENTS 1 Introduction to budgeting 2 Standard costs 3 An example of a sales budget and its use for management control 4 Flexible budgets LEARNING OUTCOMES On completion of this chapter the student should be able to: • explain the forecasting/budgeting process and the concept of feedforward and feedback control • calculate material requirements, making allowance for sales and product/material inventory changes (N.B. control levels and EOQ are excluded) • explain the concept of flexible budgets. PAPER 2 : INFORMATION FOR MANAGEMENT CONTROL 1 INTRODUCTION TO BUDGETING 1.1 THE NATURE OF BUDGETS Budgets are plans set in financial and quantitative terms for either the whole of a business or for the various parts of a business for a specified period of time in the future. Budgets are prepared within the framework of objectives and policies that have been determined by senior management. 1.2 FUNCTIONS OF BUDGETARY CONTROL Essentially the budgetary control process consists of two distinct elements: (i) Planning This involves the setting of the various budgets for the appropriate future period. Managers at various levels in an organisation should be involved in the budgetary planning stage for their area of responsibility. The budgets for the different divisions of an organisation need to be coordinated to ensure that they are all complementary and in line with overall company objectives and policies -feedback is essential. (ii) Control Once the budgets have been set and agreed for the future period, the formal element of budgetary control is ready to start. This control involves comparing the plan in the form of the original budget with the actual results achieved for the period under consideration. Any significant differences between the budgeted and the actual results should be reported to appropriate management so that action can be taken if necessary. Again, appropriate feedback is an essential component of the budgeting control process. Feedback control is action taken by a manager in response to recorded differences between the budget and actual performance. The action may be taken to correct deviations or to revise the budget if appropriate. If current forecasts show that the future expected results are different from the budgeted outcome then managers may take action now to bring expected results more into line with the budget. This type of corrective action, taken in advance to prevent or reduce expected deviations from budgeted performance, is called feedforward control. 1.3 PREPARING THE BUDGET In order for the budgets for the different areas of an organisation, and in particular the different cost centres, to be complementary then there are a number of steps that must be taken in the budget preparation. 1.4 PRINCIPAL BUDGET FACTOR Definition A principal budget factor is the factor that limits the activity level for the organisation as a whole. The first step is to determine the limiting factor for the organisation that is known as the principal budget factor. Usually this will be the expected demand for sales as this will be the factor that determines the activity level for the organisation as a whole. However it is entirely possible that availability of raw materials or labour might be the limiting factor. 160 1 INTRODUCTION TO BUDGETING 1.1 THE NATURE OF BUDGETS Budgets are plans set in financial and quantitative terms for either the whole of a business or for the various parts of a business for a specified period of time in the future. Budgets are prepared within the framework of objectives and policies that have been determined by senior management. 1.2 FUNCTIONS OF BUDGETARY CONTROL Essentially the budgetary control process consists of two distinct elements: (i) Planning This involves the setting of the various budgets for the appropriate future period. Managers at various levels in an organisation should be involved in the budgetary planning stage for their area of responsibility. The budgets for the different divisions of an organisation need to be coordinated to ensure that they are all complementary and in line with overall company objectives and policies -feedback is essential. (ii) Control Once the budgets have been set and agreed for the future period, the formal element of budgetary control is ready to start. This control involves comparing the plan in the form of the original budget with the actual results achieved for the period under consideration. Any significant differences between the budgeted and the actual results should be reported to appropriate management so that action can be taken if necessary. Again, appropriate feedback is an essential component of the budgeting control process. Feedback control is action taken by a manager in response to recorded differences between the budget and actual performance. The action may be taken to correct deviations or to revise the budget if appropriate. If current forecasts show that the future expected results are different from the budgeted outcome then managers may take action now to bring expected results more into line with the budget. This type of corrective action, taken in advance to prevent or reduce expected deviations from budgeted performance, is called feedforward control. 1.3 PREPARING THE BUDGET In order for the budgets for the different areas of an organisation, and in particular the different cost centres, to be complementary then there are a number of steps that must be taken in the budget preparation. 1.4 PRINCIPAL BUDGET FACTOR Definition A principal budget factor is the factor that limits the activity level for the organisation as a whole. The first step is to determine the limiting factor for the organisation that is known as the principal budget factor. Usually this will be the expected demand for sales as this will be the factor that determines the activity level for the organisation as a whole. However it is entirely possible that availability of raw materials or labour might be the limiting factor. 160 BASIC BUDGETING : CHAPTER 11 Assuming the sales are the principal budget factor then the sales budget must be prepared first. This will consist of the number of each type of product that it is anticipated will be sold and the price at which they are to be sold. 1.5 PRODUCTION BUDGET Once the budgeted sales have been determined in units in the sales budget then the number of units that need to be produced in the period can be determined and this is known as the production budget. The production budget will be determined by adjusting the budgeted sales volume for the budgeted change in inventory of finished goods: Budgeted production = Budgeted sales plus Budgeted closing finished goods inventory less Budgeted opening finished goods inventory. 1.6 RAW MATERIALS Once the number of units that are to be made is known from the production budget then the quantity of raw materials needed can be determined. The expected price of the raw materials is then applied to the quantity budgeted to be used in production to determine the raw materials usage budget. The raw materials purchases budget is then determined as follows: Budgeted raw materials purchases = Budgeted raw materials usage plus Budgeted closing inventory of raw materials less Budgeted opening inventory of raw materials. Example - calculating material requirements Budgeted sales of product C for next period are 4,500 units. Each unit of product C requires 4 kg of raw material. Details of budgeted inventory requirements are as follows: Opening inventory Closing inventory Raw materials 4,200 kg 4,600 kg Product C 1 100 units 800 units Solution Production budget - product C Units Sales requirement 4,500 Closing inventory 800 5,300 Opening inventory 1,100 Budgeted production 4,200 Raw materials purchases budget Kg Production requirements (4,200 x 4 kg) 16,800 Closing inventory 4,600 21,400 Opening inventory 4,200 17,200 Budgeted purchases KAPLAN PUBLISHING PAPER 2 : INFORMATION FOR MANAGEMENT CONTROL 1.7 LABOUR BUDGET Once it has been determined how many units are to be produced, then it will be possible to determine the number of labour hours needed in order to make the products. The rate of pay for each grade of labour can then be applied to produce the labour cost budget. 1.8 EXPENSE BUDGETS Finally budgets will be set for production expenses, selling expenses and administration expenses based upon the level of activity that has been set in the production and sales budgets. 1.9 MASTER BUDGET Once all of these subsidiary budgets have been set then they will often all be brought together in a master budget. This will normally consist of a budgeted income statement, budgeted balance sheet (statement of financial position) and a cash flow budget. 2 STANDARD COSTS 2.1 STANDARDS Definition Standards are predetermined measurable quantities set in defined conditions. A standard can be set for any activity. Suppose that a journey of 100 miles normally takes two hours. Then it could be said that the standard journey time was two hours. Equally it could be said that the standard speed on the journey was 50 miles per hour. 2.2 STANDARD COST Definition A standard cost is the cost expected for a single unit of output for a future period of time. The total standard cost of a product is built up from an assessment of the expected or standard value of each of the cost elements involved in making the product. The unit standard costs provide the basic building blocks for determining the absolute money values in the budgets. 3 AN EXAMPLE OF A SALES BUDGET AND ITS USE FOR MANAGEMENT CONTROL Budgetary control is a process whereby actual results are compared to budgeted Definition figures and any significant differences must be investigated to discover the cause. Example Tennis Skill Ltd has four main sales areas. Its cumulative sales for the five months ended 31 May 20X3 and actual sales for June were: 5 months June Total Sales area 31 May 20X3 20X3 $ $ $ Scotland and North 24,100 3,200 27,300 Midlands 12,900 1,700 14,600 South East 14,200 4,100 18,300 South West 19,100 2,300 21,400 70,300 11,300 81,600 162 BASIC BUDGETING : CHAPTER 11 Its planned level of sales, i.e. the budget for six months ended June 20X3 was: $ Scotland and North 25,000 15,000 Midlands South East South West 17,500 20,100 A sales management report using this information would show as follows: 77,600 Area Budget Actual Variance *F/(A) $ $ $ Scotland and North 25,000 27,300 2,300 F Midlands 15,000 14,600 400 (A) South East 17,500 18,300 800 F South West 20,100 21,400 1,300 F 81,600 77,600 4,000 F Definition Variance is the difference between the budget and actual performance. F = favourable. In this case, where sales exceed budget there is a favourable variance. If costs are lower than budget this also results in a favourable variance. (A)= adverse, where sales are lower than budget or costs are higher than budget. Management can see how each responsibility centre has performed by looking at management reports which show variances. This example illustrates the two elements of planning and control. The budget is the planned or target performance; the variance is an aid to management in the process of control. ACTIVITY 1 Using the information in the example above, calculate the following: (i) for each sales area, the percentage value of sales in excess of, or below, the budget (ii) for the business as a whole, the percentage value of sales in excess of the budget. For a suggeste PAPER 2 : INFORMATION FOR MANAGEMENT CONTROL FLEXIBLE BUDGETS The simple budgeting process described above is the preparation of a fixed budget. A fixed budget assumes a level of costs and revenues for a specific level of activity. This might be appropriate in the short term or if a large amount of the costs are fixed in nature. If the nature of the costs is predominantly variable then quite small changes in the level of activity could destroy any meaningful comparison between the budgeted and actual costs. It would be difficult therefore to determine whether or not the business was operating efficiently. Consider a decorating department run by the local council for its housing stock. A fixed budget might look like this: June 20X3 $ Labour 40,000 Materials 8,000 Other costs 2,000 50,000 Expected number of houses to decorate: 20 If the actual result for the month was: Jun20X3 $ e Labour 39000 Materials 9, 000 , Other costs 2, 200 50200 , Number of houses decorated: 21 Is this better or worse than budgeted? The department has incurred higher costs than expected but has decorated more houses than budgeted. At first sight this looks good. However it would be useful to give a target budget based on the level of activity achieved. To do this we need to know which costs are fixed and which are variable. We would expect the budget cost allowance for variable costs to increase since more houses were decorated than expected in the original fixed budget. Continuing this example, suppose that the budgeted fixed costs were identified as follows: Other costs $200 Labour costs $30,000 All other costs are variable in proportion to the number of houses decorated. BASIC BUDGETING : CHAPTER 11 In this case the target budget cost allowance would be prepared as follows: June 20X3 Variable costs per house $ Labour $((40,000 - 30,000)/20) 500 Materials $8,000/20 400 Other costs $((2,000 - 200)/20) 90 990 and therefore the target budget for 21 houses would be: variable Fixed Budget Actual cost cost June 20X3 cost Variance $ $ $ $ $ Labour 10,500 30,000 40,500 39,000 1,500 F Materials 8,400 — 8,400 9,000 600 A Other costs 1,890 200 2,090 2,200 110A 790 F 20,790 30,200 50,990 50,200 The department has therefore performed even better when the actual results are compared with a realistic budget for 21 houses. This type of target budget is a flexible budget where the focus of the budget is in terms of the activity variables achieved, i.e. in the case above for 21 houses. This approach can be used for a business or a department where the variable element of the costs is proportionately high and where the units produced are not necessarily in the control of the manager for whom the budget is prepared. CONCLUSION The function of budgetary control comprises the elements of planning and control. Planning is the setting of realistic achievable targets, and control is the reporting and managerial action, resulting from the identification of variances for income and each element of cost. KEY TERMS Principal budget factor - the factor that limits the activity level for the organisation as a whole. Budgetary control - a process whereby actual results are compared to budgeted figures and any significant differences must be investigated to discover the cause. Feedback control - action taken by a manager in response to recorded differences between the budget and actual performance. Feedforward control - action taken by a manager to reduce or remove differences between projected results and the budgeted outcome. Standards - predetermined measurable quantities set in defined conditions. Standard cost - the cost expected for a single unit of output for a future period of time. Fixed budget - a budget that assumes a level of costs and revenues for a specific level of activity. Flexible budget - a budget that flexes the budgeted level of costs and revenues according to the level of activity actually achieved. SELF TEST QUESTIONS Paragraph 1 What is a budget? 1.1 2 What is the difference between feedback control and feedforward control? 1.2 3 What is a principal budget factor? 1.4 4 State the formula for deriving the budgeted production volume from the budgeted sales volume. 1.5 5 State the formula for deriving the budgeted raw materials purchases from the raw materials usage budget. 1.6 6 What is the connection between unit standard costs and the absolute budget values? 2.2 7 Explain the difference between a fixed budget and a flexible budget. 4 166 BASIC BUDGETING : CHAPTER 11 EXAM-STYLE QUESTIONS The following budgeted and actual costs were recorded last period. Direct material Budget Actual $ $ Direct labour Fixed production overhead 24,000 22,400 12,800 11,900 Total production costs 18,700 15,600 55,500 49,900 Actual sales volume was 90% of the budgeted level. Using a flexible budget comparison, what was the total production cost variance for the period? A $50 Favourable B $1,920 Favourable C $3,200 Favourable D $5,600 Favourable G Limited manufactures product H and budgeted sales for next period are 2,400 units. Each unit of product H requires 2 kg of material M. Inventory levels at the beginning of the period are budgeted to be as follows: Product H 440 units Material M 740 kg Inventory levels are budgeted to increase by 20% by the end of next period. The budgeted purchases of material M for next period are: A 4,476 kg B 4,940 kg C 4,976 kg D 5,124 kg The total budget for X Ltd was $125,000 to produce 10,000 units. If fixed costs are 20% of the total budget, the flexed budget for 8,000 units would be: A $125,000 B $105,000 C $100,000 D $80,000 KAPLAN PUBLISHING 2 : INFORMATION FOR MANAGEMENT CONTROL 4 Complete the following definition: A principal budget factor is........................................................................................................... 5 State whether the following are true or false: True False (a) Feedback control compares the difference between targets and projected results. ...................... (b) The calculation of variances between actual results and a budget target is an example of feedforward control. ........................ (c) A fixed budget gives the same cost allowance for each month of the year. ........................ 6 To calculate a material purchases budget the following formula applies: Production budget + Opening inventory of raw materials - Closing inventory of raw materials This statement is true/false (delete the incorrect words). For suggested answers, see the 'Answers' section at the end of the book. Chapter 12 COMPARISON OF INFORMATION AND PERFORMANCE INDICATORS In this chapter we will be dealing with comparisons of current actual costs with information from different sources. The chapter covers syllabus areas 5 (a) and (b), and 6(b). CONTENTS 1 Purpose of making comparisons 2 Comparisons frequently used 3 Current and previous period 4 Current period and budget 5 Sales 6 Productivity measures 7 Performance measures appropriate to responsibility centres LEARNING OUTCOMES On completion of this chapter the student should be able to: • explain the purpose of making comparisons • identify relevant bases for comparison; previous period data, corresponding period data, forecast/budget data • use appropriate income and expenditure data for comparison • describe and apply performance measures appropriate to cost, profit and investment centres (cost/profit per unit/% of sales; efficiency, capacity utilisation and production volume ratios; ROCE/RI, asset turnover). KAPLAN PUBLISHING PAPER 2 : INFORMATION FOR MANAGEMENT CONTROL 1 PURPOSE OF MAKING COMPARISONS The purpose of management information is to help management: • make decisions about the future of the business and about the day-to-day running of the business • plan the strategy of the business and its operations • control the operations, costs and income of the business. Without comparisons management will not know whether it is achieving its targets, whether it is improving, how it compares with this time last year and how it compares with its competitors. Comparisons and their analysis are one of the ways in which management can identify whether control action is needed. 2 COMPARISONS FREQUENTLY USED 2.1 PREVIOUS PERIODS In some cases you will be required to compare current costs and income to the same costs and income from previous periods in order to determine any significant differences. Comparisons with the results for previous periods will help to identify any trends in the company's costs and income. The previous period's costs and income will have been summarised in management cost reports and you need to be able to find these reports in your organisation's filing system. 2.2 CORRESPONDING PERIODS Although comparison with previous periods can help to identify trends it can be misleading if the company's activity is subject to seasonal fluctuations. Think about a company in the UK that sells ice creams. The following results show the sales revenue generated during the latest two quarters. $000 98 July to September 20X5 29 October to December 20X5 This comparison shows an apparently alarming reduction in sales between the two quarters. However the sales of ice cream in this situation will be subject to seasonal fluctuation therefore this comparison is not particularly effective. Either the effect of the seasonal variation should be removed from the data, or a comparison should be made with a corresponding period to obtain more useful information. A comparison with the results for the corresponding periods in the preceding year might be as follows: 20X4 20X5 % $000 $000 increase 75 98 31 July to September 22 29 32 October to December Now managers can see that there has been a significant increase in sales revenue when a comparison is made between corresponding periods. 170 COMPARISON OF INFORMATION AND PERFORMANCE INDICATORS : CHAPTER 12 2.3 FORECAST DATA We saw in the last chapter how current forecasts might be compared with the budgeted results for the forthcoming period in a system of feed forward control. If the comparison shows that the future expected results are different from the budgeted outcome then managers may take action now to bring expected results more into line with the budget. 2.4 BUDGET DATA You may also be required to compare current costs and income to the amounts that were budgeted for this period. Again you will need to be able to find the relevant budgets in the organisation's filing system. In making a budgetary control comparison it will be important to take account of the possible impact of activity levels. If activity levels fluctuate and a significant proportion of costs are variable then it will be necessary to use a system of flexible budgets, as we saw in the last chapter. 2.5 STANDARD COSTS Finally you may have to compare costs for this period with the standard costs that have been set in order to determine if there are any variances. You will therefore need to know where to find the relevant standard cost information. 2.6 CURRENT PERIOD COSTS In most cases you will be comparing current costs and income. These figures will have to be extracted from the relevant cost and income ledger accounts. 3 CURRENT AND PREVIOUS PERIOD The first example of comparison of information that will be considered is comparison of the current period's costs to the costs of the previous period. Example You have been asked to prepare a comparison of the wage cost for each cost centre for the month of May and the month of June. The gross wages account from the costing ledger is given for both May and June. In May 22,500 units were produced but in June only 18,000. Sales were the same quantity in both May and June. May Gross wages cost control account Cr Dr $ 51$ ,000 WIP control account Sales cost 31,500 Cost ledger control account centre Administration cost centre 7,500 12,000 51,000 51,000 KAPLAN PUBLISHING PAPER 2 : INFORMATION FOR MANAGEMENT CONTROL June Gross wages cost control account Cr Dr $ $ 46,300 26,500 Cost ledger control account WIP control account Sales cost centre Administration cost centre 8,200 11,600 46,300 46,300 You also discover from the payroll records that one weekly paid employee was on holiday for two weeks in June with no holiday pay. The gross pay of this employee is $250 per week. This employee was working in the administration cost centre. Prepare a schedule showing any significant differences in the wage costs for each cost centre for May and June. Solution Differences May May Flexed June F/(A) Activity level 22,500 18,000 units units Production labour $31,500 ($31,500x18,000/22,500) $25,200 $26,500 $1,300 (A) Sales labour $7,500 — $8,200 $700 (A) Administration labour $12,000 $11,500 $11,600 $100 (A) *F = favourable, (A) = adverse Tutorial note: The sales labour cost is not flexed for comparison purposes because the sales level was the same in May and June. The administration labour cost is assumed to be fixed in relation to the level of activity, but for a valid comparison the May cost of $12,000 is 'flexed' or adjusted by removing the $500 of cost of the employee who was on unpaid holiday leave in June. 4 CURRENT PERIOD AND BUDGET Now we will look at a comparison of actual current costs with the figures that were budgeted for the current period. For this activity you will again need to remember how to calculate a budget cost allowance in a flexible budgeting system. Variable costs are expected to change with the level of activity but fixed costs are expected to remain the same even if activity levels do vary. Example Shown below is last month's expense costs and activity, both budget and actual, for department 7 in a manufacturing company: Month's budget Month's actual 8,000 8,400 Production (units) $ Fixed expenses: 6,750 6,400 Rent 3,250 3,315 Maintenance 10,000 9,715 172 COMPARISON OF INFORMATION AND PERFORMANCE INDICATORS : CHAPTER 12 Variable expenses: Power 17,600 20,140 Machine repairs 6,000 5,960 Packaging 4,400 4,480 Total expenses $38,000 $40,295 Draw up a schedule highlighting any variances both in the totals for fixed and variable expenses and for each category of expense within the totals. Solution Fixed expenses: Flexed Variance Actual Budget $ 6,750 budget $ F/(A)* $ $ Rent 3,250 6,750 350 F 6,400 Maintenance 3,250 65 (A) 3,315 10,000 10,000 9,715 285 F Variable expenses: 17,600 18,480 20,140 1,660 (A) 6,000 6,300 5,960 340 F Power Machine 4,400 4,620 4,480 140 F repairs Packaging 28,000 29,400 30,580 1,180 (A) *F = favourable, (A) = adverse Tutorial note: Fixed expenses are not flexed as they would not be expected to change despite the fact that actual production is 400 units more than budgeted production. Variable expenses have been flexed to reflect that the activity level was 8,400 units rather than the budgeted figure of 8,000 units. Power $17,600x8,400/8,000 = $18,480 Machine repairs $6,000 x 8,400/8,000 = $6,300 Packaging $4,400 x 8,400/8,000 = $4,620 SALES So far in this chapter we have only considered the comparison of costs to previous periods and budgeted figures. The same type of comparison can be made for sales income. Example The sales figures for your organisation's two products, X and Y, are given below for May and June. May June Product X Product Y Product X Product Y 2,000 3,500 2,400 3,300 Units $5.40 $3.80 Price per unit $5.00 $4.10 KAPLAN PUBLISHING PAPER 2 : INFORMATION FOR MANAGEMENT CONTROL Prepare a schedule showing changes in units and total income from sales between May and June. Solution May June Difference F/(A) Product X 2,000 2,400 400 F units $10,800 $12,000 $1,200 F value Product Y units 3,300 3,500 200 (A) value $13,530 $13,300 $230 F Total $24,100 value $25,530 $1,430 F * F = favourable; (A) = adverse 6 PRODUCTIVITY MEASURES 6.1 INTRODUCTION In this chapter we will examine a variety of performance indicators. Performance indicators provide information to management as to how the business is operating. There is a huge range of such indicators, made up of financial information, non-financial information or a mixture of the two. 6.2 WHAT IS A PRODUCTIVITY MEASURE? A productivity measure relates the goods or services produced to the resources used to produce them. The most productive or efficient operation produces the maximum output from given resource inputs or alternatively, uses the minimum inputs for any given quantity or quality of output. 6.3 PRODUCTION AND PRODUCTIVITY It is important to be able to distinguish between production and productivity. Production is the quantity of goods or services that are produced. Productivity is a measure of how efficiently those goods or services have been produced. Production levels are reasonably straightforward for management to control as they can be increased by working more hours or taking on more employees, or decreased by cutting overtime or laying off employees. Production levels can also be increased by increasing productivity and vice versa. Productivity however, is perhaps more difficult for management to control as it can only be increased by producing more goods or services with a given set of resources, or alternatively, reaching set production targets using less resources. 6.4 PRODUCTIVITY RATIOS Productivity is often analysed using three labour control ratios: • production volume or activity ratio • capacity utilisation ratio • efficiency or productivity ratio. 174 COMPARISON OF INFORMATION AND PERFORMANCE INDICATORS : CHAPTER 12 Example The budgeted output for a period is 2,000 units and the budgeted time for the production of these units is 200 hours. The actual output in the period is 2,300 units and the actual time worked by the labour force is 180 hours. Calculate the production volume, capacity utilisation and efficiency ratios. 6.5 PRODUCTION VOLUME RATIO Definition The production volume ratio assesses the overall production. Over 100% indicates that overall production is above planned levels and below 100% indicates a shortfall compared to plans. The production volume ratio is calculated as: Actual output measured in standard hours x100% Budgeted production hours A standard hour is calculated as: Budgeted output x100% Budgeted production hours 2,000 units Solution - production volume ratio 200 hours 10 units 2,300 units 10 Standard hour = units 230230 standard hours x Actual output measured in standard hours = 100% 200 115% This shows that production is 15% higher than the Production volume ratio = planned production levels. 6.6 CAPACITY UTILISATION RATIO Definition The capacity utilisation ratio indicates worker capacity, in terms of the hours of working time that have been possible in a period. The capacity utilisation ratio is calculated as: _ Actual hours worked Annn/ Capacity utilisation ratio = ---------------------------- x 100% Budgeted hours KAPLAN PUBLISHING PAPER 2 : INFORMATION FOR MANAGEMENT CONTROL Solution - capacity utilisation ratio 180hoursCapacity utilisation ratio = = 90% 200 hours Therefore this organisation had only 90% of the budgeted labour hours for production. 6.7 EFFICIENCY RATIO Definition The efficiency ratio is an indicator of productivity with the benchmark being 100%. The efficiency ratio is calculated as follows: Actual output measured in standard hours Actual production hours The efficiency ratio is often referred to as the productivity ratio. Solution - efficiency ratio 230 x100% Efficiency ratio = 180 This can be proved. The workers were expected to produce 10 units per hour, the 127.78% standard hour. Therefore, in the 180 hours worked it would be expected that 1,800 units would be produced. In fact 2,300 units were produced. This is 27.78% more than anticipated (500/1,800). 6.8 RATIO RELATIONSHIPS The three ratios calculated above can be summarised diagrammatically as follows: Production volume ratio 115% Equals Capacity ?, 127.78% Efficiency ratio utilisation ratio Conclusion Note the difference between production and productivity. Production is output in terms of units e.g. 1,000 units per month. Productivity is this output expressed relative to a vital resource e.g. 10 cars per employee per year or 12 tons of steel per employee per month. The efficiency or productivity ratio measures the productivity of the labour force in comparison to 100%. If the productivity ratio is higher than 100% then this indicates higher than anticipated productivity and if it is lower than 100%, lower than anticipated productivity. 176 COMPARISON OF INFORMATION AND PERFORMANCE INDICATORS : CHAPTER 12 ACTIVITY 1 The following data was recorded last period for production department B: Budgeted labour hours 2,700 Number of units of product X produced 370 Number of units of product Y produced 420 Standard hours to produce one unit of X 3 Standard hours to produce one unit of Y 4 Actual labour hours worked 3,110 Calculate the following labour ratios and explain their meaning: • production volume ratio • capacity utilisation ratio • efficiency ratio. Fora suggested answer, see the 'Answers' section at the end of the book. 7 PERFORMANCE MEASURES APPROPRIATE TO RESPONSIBILITY CENTRES We have already seen that the different types of responsibility centre are cost centres, profit centres and investment centres. The manager responsible for the performance of each of these types of centre will be able to exercise control over different aspects of the centre's operations. It is important that a performance measure used to monitor the performance of the centre is appropriate to the type of centre, in that it monitors aspects of the centre's performance over which the manager can exercise some control. 7.1 MEASURING COST CENTRE PERFORMANCE The manager of a cost centre is able to control only the costs incurred in the centre. In this context is important to distinguish between controllable costs and non-controllable costs. A controllable cost is one over which a particular manager can exercise some influence, for example the cost of direct labour in a production cost centre is usually controllable by the manager of that cost centre. A non-controllable cost is one which cannot be influenced by a particular manager. For example the rent of the whole factory would not be controllable by the manager of a production cost centre. It would not be fair and it could cause motivation problems if the manager was held responsible for this cost over which he is not able to exercise any control. Note that a cost which is non-controllable for one manager will be classified as controllable for another manager. For example the factory rent will be non-controllable for the manager of a particular production cost centre but the rent is likely to be classified as a controllable cost for the general manager who has overall responsibility for the whole factory. KAPLAN PUBLISHING PAPER 2 : INFORMATION FOR MANAGEMENT CONTROL A cost centre manager can be monitored according to costs incurred and according to the resources utilised. For example the productivity ratios considered earlier in this chapter would be appropriate for monitoring the efficiency of a production cost centre. The absolute amount of cost incurred in a cost centre might be a useful control measure but if output can be measured then cost per unit might be more informative. Example: cost per unit Department A incurred the following labour costs and produced the following output in the latest two periods: Period 1 Period 2 $96,800 $99,700 Labour costs 9,920 Units produced 9,500 Calculate the labour cost per unit in each period and comment on the result. Solution Period 1 labour cost per unit = $96,800/9,500 = $10.19 Period 2 labour cost per unit = $99,700/9,920 = $10.05 Although the total labour cost incurred in department A increased in period 2, the output also increased but by proportionately more. Therefore the labour cost per unit reduced in period 2 compared with period 1. 7.2 MEASURING PROFIT CENTRE PERFORMANCE The manager of a profit centre has control over the revenues earned as well as the costs incurred, therefore performance measures based on profit would be more appropriate. The following example will demonstrate a range of performance measures that might be used to monitor a profit centre's performance. Example: monitoring profit centre performance Department A achieved the following results in the latest periods. Period 5 Period 6 Units produced 2,300 2,600 $ $ Sales value of output 27,600 31,400 18,400 21,820 Direct costs 5,300 3,950 Overheads 23,700 25,770 3,900 5,630 Profit Comment on Department A's performance. 178 COMPARISON OF INFORMATION AND PERFORMANCE INDICATORS : CHAPTER 12 Solution Profit margin The profit margin calculates the profit achieved as a percentage of sales value. Profit Profit margin x 100% Sales 3,900 /27,600 Period 5 x 100%= 14.1% Period 6 5,630 /31,400 x 100%= 17.9% The profit margin has improved, indicating that more profit has been earned per $1 of sales revenue generated. Cost to sales ratio Looking at the ratios of costs incurred to sales value achieved can help to provide more information for cost control to improve profitability. Direct cost 100% Direct cost percentage Sales 18,400 x 100%= 66.7% Period 5 Period 6 27,600 21,820 x 100%= 69.5% 31,400 OverneadsOverhead cost percentage = xSales Period 5 5,300 /27,600 x 100%= 19.2% Period 6 3,950 / 31,400 x 100%= 12.6% Control of overhead costs was good but profitability would have been improved if the direct cost percentage had been maintained at period 5 levels. Profit per unit The profit per unit can only be calculated if all units produced are identical Otherwise it would be necessary to express the output in terms of standard hours produced. Profit per unit: Period 5 $3,900 $1.70 2,300 $5,630 $2.17 2,600 Period 6 KAPLAN PUBLISHING PAPER 2 : INFORMATION FOR MANAGEMENT CONTROL Improvement in the profit margin has led to a substantial increase in the profit earned per unit sold. 7.3 MEASURING INVESTMENT CENTRE PERFORMANCE Since the manager of an investment centre has control over costs and revenues and over the level of investment in the centre, the most appropriate performance measure will be one that relates the profit earned to the level of investment in the centre. The most important measures that you need to know about are return on capital employed, residual income and asset turnover. Return on capital employed (ROCE) ROCE is also referred to as Return on Investment (ROI). There are several ways of measuring ROCE/ROI but the profit figure normally used is the profit before interest and tax. Profit before interest and tax ROCE = --------------------------------------- x 100% Capital employed Capital employed is a sum of non-current (fixed) assets and net current assets. Although it is better to base the calculation on average capital employed during the year, the calculation is often based on year-end capital employed. Example: calculating ROCE Division X achieved the following results for the latest two periods. COMPARISON OF INFORMATION AND PERFORMANCE INDICATORS : CHAPTER 12 Example: calculating residual income (Rl) Using the data from the ROCE example above, and assuming a notional interest charge of 12% each period, the residual income is calculated as follows. Period 1 residual income = $55,800 - ($329,000 x 12%) = $16,320 Period 2 residual income = $67,200 - ($373,300 x 12%) = $22,404 A positive Rl was earned in both periods, because the ROCE was greater than the 12% notional interest cost. Rl was greatly improved in period 2 because a higher return was earned on a greater amount of capital invested in the division. Controllable and non-controllable items When measuring the ROCE or Rl of an investment centre it is important to monitor performance based on only the controllable items. Only controllable revenues and costs should be attributed to the investment centre, and only those capital employed items over which the centre manager can exercise control must be included. For example, if the manager has discretion over the level of inventory held, then inventory values must be included in the capital employed figure. However, if the investment centre manager does not have control over the company's credit policy, then receivables should be excluded from the capital employed figure. Asset turnover ratio The asset turnover ratio measures how efficiently the assets of an organisation are used to generate revenue. Revenue Asset turnover ratio = Capital employed Example: calculating asset turnover The following data relates to company A and company B. Company A Company B $ $ Revenue 800,000 600,000 Capital employed 400,000 400,000 800,000 Asset turnover company A = ----------------------------------------------------- = 2 400,000 D600,000 Asset turnover company B = ----------- = 1.5 400,000 Asset turnover is expressed as 'x times'. Therefore, the asset turnover for company A shows that capital employed ($400,000) generates 2 times its value in revenue ($800,000). Company B has the same capital employed ($800,000), but only generates 1.5 times the value of these assets in revenue ($600,000). PAPER 2 : INFORMATION FOR MANAGEMENT CONTROL 7.4 THE LINK BETWEEN PROFIT MARGIN, ASSET TURNOVER AND ROCE The return on capital employed can also be calculated using known results for profit margin and asset turnover as follows: ROCE = Profit margin x Asset turnover Similarly, if only ROCE and asset turnover are known, the profit margin can be calculated by rearranging the equation above: ROCE ROCE Profit margin = or Asset turnover = Asset turnover Profit margin ACTIVITY 2 The following results are available for divisions A and B. Profit Division A Capital $ employed Revenue 160,050 Division B 15,800 106,700 $ 252,00 0 27,300 210,00 0 Calculate the following for each division and comment on the results: (a) ROCE (b) residual income, using a notional interest rate of 11% per period (c) asset turnover ratio. For a suggested answer, see the 'Answers' section at the end of the book. CONCLUSION Management compare data to produce useful information for planning, control and decision-making purposes. KEY TERMS Productivity measure - relates the goods or services produced to the resources used to produce them. The most productive or efficient operation produces the maximum output from given resource inputs or, alternatively, uses the minimum inputs for any given quantity or quality of output. Actual output measured in standard hours x100% Production volume ratio = Budgeted production hours _ Actual hours worked *nnn/ Capacity utilisation ratio = ------------------------------- x 100% Budgeted hours ActualEfficiency ratio = output measured in standard hours Actual production hours 182 COMPARISON OF INFORMATION AND PERFORMANCE INDICATORS •* Resource utilisation - a measure of how an organisation uses its inputs or resource* Residual income - surplus profit after charging a notional interest charge for use a' net assets (or capital) employed. ROCE - return on capital employed. It measures the profit earned as a percentage of 9m capital employed. Asset turnover - a measure of how efficiently the assets of an organisation are used to generate revenue. SELF TEST QUESTIONS 3 Wh at is the 1 What is a productivity measure? ROCE 2 What does the capacity utilisation ratio measure? ratio? 4 How is residual income calculated? Paragraph 5 What does the asset turnover ratio measure? 6.2 6.6 7.3 7.3 7.3 EXAM-STYLE QUESTIONS Which of the following performance measures would not be suitable for a cost centre? A Direct cost per employee B Profit margin C Overhead cost per machine hour D Productivity ratio The following results are available for Division Y: Profit before interest and tax 185 000 Capital employed 1,540 000 The cost of capital is 10%. The ROCE for Division Y is: A $18,500 B 12% C $31,000 D 10% INFORMATION FOR MANAGEMENT CONTROL State whether the following are true or false. True False (a) A production volume ratio of 110% means that overall production is 10% higher than planned levels. ........................... (b) A capacity utilisation ratio of 95% means that actual hours of production are 5% less than planned. ........................... (c) An efficiency ratio of 105% means that 5% more units were produced than planned. ........................... Delete the incorrect words in the following statement: Residual income is a performance measure most suited to a cost/profit/investment centre. List three performance measures that would be suitable for a cost centre. 1 ................... 2 3 For suggested answers, see the 'Answers' section at the end of the book. 184 KAPLAN PUBLISHING CHAPTER 10 ACTIVITY 1 Absorption costing Yeari Year 2 Year 3 Year 4 Total $ $ $ $ $ Sales 1.000 1,500 2,000 3,000 7,500 Opening inventory @ $7.60 — 1,520 2,280 2,280 6,080 Variable costs of production @ $4 1,200 1,000 800 800 3,800 Fixed costs 91,080 900 720 720 3,420 @??=$3.60 250 2,280 3,420 3,800 3,800 13,300 Closing inventory ($4 + $3.60) $7.60 1,520 2,280 2,280 1,520 7,600 Cost of sales (760) (1,140) (1,520) (2,280) (5,700 (Under)/over- absorption (W) 180 Nil (180) (180) (180 1,620 300 540 420 360 Net profit KAPLAN PUBLISHING Period 2 Period 1 $ $ and tax 55,800 67,200 Profit before interest 329,000 373,300 Capital employed Period 1 ROCE = 55,800 x 100% = 17.0% 329,000 Period 2 ROCE = 67,200 x 100% = 18.0% 373,300 The division's performance improved in period 2 compared with period 1 becau; more profit was earned per $1 of capital invested in the division. Residual income (Rl) Alternatively a residual income approach could be used where the profit is mea as the surplus available after deducting a notional figure for interest on the cap employed in the investment centre. Residual income (Rl) = Investment centre profit - Notional interest on capital employed in centre 180 179 1 168 KAPLAN PUBLISHING