MANAGEMENT ACCOUNTING ( PAPER 4)

ACTIVITY BASED COSTING

Product costing requires an accurate measurement of the resources consumed to

manufacture a product. If a product is undercharged it may result into a loss to the
business. Contrary to that if a customer is overcharged, there are ample chances
that the business may not be able to compete and lose a customer.

The conventional absorption costing method absorbs support overheads simply

on production volume measured in terms of labour hours worked or number of units
produced. In case the proportion of support overheads is quite low in total cost of a
product and the manufacturing process is labour intensive, as a result, the direct
costs would have been much higher than indirect costs and it may have an
insignificant impact on realistic product pricing.

However, the modern manufacturing process has become more machine intensive
and as a result the proportion of production overheads have increased as compared
to direct costs, therefore it is important that an accurate estimate is made for the
production overheads per unit.

The activity based costing (ABC) adopts more realistic approach to charge
production overheads to determine the product cost. It charges overheads on the
basis of benefits received from a particular overheads. It considers the relationship
between the overheads costs and the activity which causes incurring of such costs,
known as cost drivers.

The examples of transactions-based cost drivers are given below:

Support department (Cost centre) Possible cost driver

1. Production scheduling Number of production runs
2. Set-up costs Number of machine set-ups
3. Store department Number of store requisitions
4. Purchasing department Number of purchase orders
5. Finished goods handling Number of orders delivered
6. Canteen Number of employees
7. Power generation Number of kilo-watts consumed
Steps to calculate cost of production using ABC

There are following five basic steps:

1. Classify production overheads into activities according to how they are driven.
2. Identify the cost driver for each activity, which causes these activities to incur the
costs.
3. Calculate an overheads absorption rate (OAR) for each activity.
4. Absorb the activity costs into the product based on the benefits received by the
production process.
5. Calculate the total cost of the product.

Uses of Activity Based Costing

1. It is used to calculate a more accurate and realistic cost of a product.

2. It is used in an organisation where production overheads form a significant
portion of total cost of production.
3. It gives a better insight to consider what factors drive overheads costs.
4. It recognises that all overhead costs are not related to production and sales
volume.
5. It is used to control overhead costs by managing cost drivers.
6. It is used to apply on all the overhead costs not only the production overheads.
7. It is used just as easily as it is used in product costing.

Limitations of Activity Based Costing

1. It has limited benefit if the overhead costs are a small proportion of the total costs.
2. The choice of both activities and cost drivers might be inappropriate.
3. It is more complex method of calculating the cost of a product.
• Delay capital expenditure for a later period
• Delay payment of dividends
• Search for short term borrowings
• Issue shares
• Control expenses
• Encourage debtors to pay earlier
• Sell Surplus fixed assets
• Negotiate better credit terms with suppliers

What is Flexible Budget and Fixed Budget? ( Done with Standard Costing)

A flexible budget is a budget which is designed to change in accordance with the

LEVEL OF ACTIVITY actually produced. The budget is designed to change

appropriately with such fluctuation in units. Main purpose of this is to take effect

of VOLUME away from the budget so that we can compare it with actual
performance.
A fixed budget, the budget remains unchanged irrespective of the level of activity
actually attained. The fixed budget is prepared based only on one level of output.
Fixed budget approach helps to ensure that each department within the organization
always knows exactly how much they have to spend at the

beginning of the period and how much is remaining at any given point during the
budgetary period as the target is pre-set this may increase motivation
 Standard Costing
Standard cost is the amount the firm thinks a product or the operation of the process for a
period of time should cost, based upon certain assumed conditions. The technique of using
standard cost for the purpose of cost control is known as standard costing. It is a system of
cost accounting which is designed to find out how much should be the cost of a product
under the existing conditions. The actual cost can be calculated only when the production is
undertaken. The pre-determined cost is compared with the actual cost and a VARIANCE
between the two is calculated. This enables the management to take necessary corrective
measures.

Advantages:

• * Helps in prepration of budgets.

• * Activities which are responsible for variances are highlighted
• * Varianaces allow management by exception to be practiced. Management by
exception means that everybody is given a target to be aceivhed and management
need not supervice each and everything. The responsiblities are fixed and everybody
tries to achieve his/her targets.
• * As Standard cost is already calculated it helps in preparation of estimates for the
cost of new products and quoatations for orders.
• * Motivation increases as it a taget of effeciency .
• * Standards provide a benchmark against which actual cost can be compared.
• * Managers of deparment with favourable varainces can be rewarded.
• * Increases workers participation.

Disadvantages:

• * There is cost involved in establshing and mantaing a standard costing system

• * There be may be reluctance from workforce to establish the system
• * Results in increase in admin work
• Can de motivate ( if standards are not met constantly)

TYPES OF STANDARDS:

Standard here means expectation from your workforce.

Basic Standards: These allow for a low level of effeciency . Workforce is not expected to
be very good and low standards are kept which will allow for wastage. Basic standards are
set at the intial time the company has started, as the workforce gets more trained the
company will move towards more strict standards.

Attainable Standards: These are relatively more strict than the basic standards but do
allow for some wastage and recognizes that not all hours worked are productive.

Ideal Standards: are standards that can only be met under ideal conditions. They allow for
no wastage or no idle time .
 wastage and recognizes that not all hours worked are productive.

Ideal Standards:

are standards that can only be met under ideal conditions. They allow for no
wastage or no idle time .

Causes Of Variances.

Direct Material Usage Varaince

Favorable Unfavorable (adverse)

Better Quality Material Poor Quality
Efficient Workers Ineffecient Workers
Better Machinery Poor Machinery/More spoilage/ Theft of
material
Direct Material Price Variance

Favorable Unfavorable (Adverse)

Fall in Price (Deflation) Inflation
Supplier charging lower price due to less Supplier charging higher price due to shortage
demand of material
Use of different type of material Use of different type of material
Buying in bulk (trade discount) Buying less (loss of discount)
Favourable change in currency ( in case of Unfavorable change is currency ( in case of
imported material) imported material)

Direct Labor Effeciency Varaince

Use of higher or lower skilled labor

Poor or good machinery

Poor or good working methods

Poor or good morale

Poor or good quality control / Training

Direct Labor Rate Variance (opposite for unfavorable variances)

Use of higher lower skilled labor

Wage inflation

Minimum Wage requirement by government

Overtime Conditions

Sales Price Variance Sales Volume Varaince

Change in price for bulk cosumers Change in marketing strategy

Price redution (summer sale) Change in consumer taste

Price increse ( new models) Competition within the sector

What is the link between Material usage and Labor Effeciency Varaince?

These varainces generally go in same direction , if one is favourable other one is

also favourable ( not every time but generally) . The reason behind this is that if we
use better quality material it wil give a favourable usage varaince , now since better
quality material has less spoilage and is much easier to handle this will also save on
Wage inflation

Minimum Wage requirement by government

Overtime Conditions

Sales Price Variance Sales Volume Varaince

Change in price for bulk cosumers Change in marketing strategy

Price redution (summer sale) Change in consumer taste

Price increse ( new models) Competition within the sector

What is the link between Material usage and Labor Effeciency Varaince?

These varainces generally go in same direction , if one is favourable other one is

also favourable ( not every time but generally) . The reason behind this is that if we
use better quality material it wil give a favourable usage varaince , now since better
quality material has less spoilage and is much easier to handle this will also save on
the time consumed by labor ( hence a reduction in actual labor hours worked) which
will lead to a favourable labor effeciency varaince. The opposite Is also true if we use
relatively poor quality material.
INVESTMENT APPRAISAL
Investment appraisal is a process of evaluating whether it is worthwhile to invest your funds
in a project. The projects can be of different nature and can be in both; the private and the
public sector. They can range from acquiring a new non-current
asset , replacement of an existing asset, introducing a new product, buying an already
established business or even buying a new player (for a sports club).

Different Accounting techniques are used to evaluate these projects. While evaluating any
project, an investor will look for profitability, liquidity and feasibility of the project. Good
companies should also take the social implications of the project into account e.g. external
costs like pollution.
Most commonly used techniques include Accounting Rate of Return (ARR), Payback Period,
Discounted Payback Period, Net present Value and the Internal Rate of Return. ARR and
payback period are non-discounted methods while others are discounted techniques. By
discounting we mean, taking the “time value of money” into account. The investment has to
be made today but returns are coming in the future. Future cash flows are discounted to
present day values so that they can be compared with the initial outlay on a realistic basis.
To understand this consider the following example
Assuming the interest rate is 10%. And I owe you $11000 but I will pay you in twelve months’
time. You should be willing to accept $10000 from me today because you can put that
$10000 in the bank and after 12 months, it will automatically grow up to $11000 (including
the interest). So we can say that the present value of receiving $11000 in one year’s time is
$10000. Or simply the real worth of $11000 coming in 12months are equal to $10000 today.
As we know money coming in the future won’t be worth the same in today’s terms, so we
reduce the size of the cash-flow according to the discount factor (which will always be
available in CIE exam, may be not in my tests). Question might give you full discount factor
table with different percentages remember the discount factor you have to use should be the
cost of capital of the company.

So what the hell is Cost of Capital?

While explaining you concept of discounting in class I must have referred to cost of capital
being the inflation rate or sometimes the interest rate. But it is actually the rate at which the
company can borrow funds from debt and shareholders. For E.g. If a project is financed
through borrowing money from a bank loan at 8%, the cost of capital for this project will be
8%. If it is partially financed by loan and shareholders then an average percentage should be
used (will be discussed in class during later chapters).
What is the difference between Profit and Net Cash-flow?
Technically profit and cash-flow are very different concepts. When we calculate profit we
subtract all expenses (cash and non-cash) from our revenue (which can be on cash or
credit). Non-cash expenses might include depreciation and other provisions. Cash-flow is
calculated by simply subtracting all cash paid from total cash received. It’s helpful to
remember that while doing this chapter, we are making a lot of basic assumptions. Firstly
there are no credit sales; no other provisions except straight line depreciation and all
expenses are paid on time (no Owings or prepayments). If we consider this then the only
difference between profit and cash-flow is the depreciation of asset, and in the last year
Scrap value. While calculating profits we don’t take scrap value into account (because profit
is only calculated from revenue) but in cash- flow calculation we got to include it. Following
equation summarizes this concept
Profit = Cashflow – depreciation –Scrap Value (last year)

Note: ARR is the only method which takes profit into account. All other methods are either
based on Cash-flows or Discounted Cash-flows

KEYPOINTS TO REMEMBER

• While solving any question, you have to take the incremental approach.

A lot of questions will give data in such a way that you can calculate
revenue/expenses without project and revenue/expenses with project. In this
situation always take the increase in values because we can associate that
directly to the project. Existing profits and cash flows are ignored as being
irrelevant because they will continue whether the new project is undertaken or
not.

• Sunk Cost consists of expenditure that has already been incurred before the
new project has been considered. While appraising the new project this
should be ignored.
• Some projects do not increase cash flows but reduce operating expenses
(Savings). While evaluating such projects we have to evaluate how much
money will be saved against the cost of the project. Savings are treated as
cash inflows.
• If a project requires an increase in working capital this should be treated as a
cash outflow at the start of the project and as a cash inflow in the last year of
the project.
• Unless stated in the question we assume that the initial cost will have to be
paid in year 0 (which means start of the project). All other cash flows are
assumed to occur at the end of the particular year. For example it is assumed
that all revenue of first year is received at the end of the first year. (Similarly
operating payments are also treated in the same way). That Is why we write
sales of first year as year 1

( which means after 12 months)

• But if the question states that a particular operating expense is paid at

the start of the year this would have a significant impact on our cashflows. If
like let’s say rent has to be paid at the start of the year then first years rent will
nd
be paid in year 0 and 2 years rent will be paid in year 1.
ADVANTAGES AND DISADVANTAGES OF ALL METHODS

Out of all the methods the best and most commonly used (and the criteria to decide an
investment) is the net present value method. If NPV is positive the project should always be
accepted unless there is another project with a higher NPV and funds are limited.

1. ACCOUNTINGRATEOFRETURN/AVERAGERATEOFRETURN (ARR)

ADVANTAGES

1. Focuses on Profitability
2. Management can compare the expected profitability with the present return

on capital employed of the existing business

3. Easy and simple to calculate and understand

DISADVANTAGES

1. It is based on profit which is subjective. Deprecation is a management

decisions and can be manipulated

2. Average Profit is not earned in any of the year

3. The time value of money is ignored
4. Ignores the risk factor as it doesn’t tell when the initial cost will be recovered

( ignores liquidity )

5. There is no common method to calculate average investment

2. PAYBACKPERIOD

ADVANTAGES

1. Based on Cash flows which is more accurate profits

2. Evaluates risk and it focuses on liquidity
3. Easy and Simple to calculate

DISADVANTAGES

1. The time value of money is ignored

2. Ignores cashflow occurring after the payback period is achieved

3. Ignores the timing of cashflow( two projects can have same payback but

with different timings of cashflow and can hence effect the liquidity)
3. NET PRESENT VALUE

ADVANTAGES

1. Considers time value of money

2. Based on cash flows
3. Consider all the cashflows of the project
4. It can directly be linked with shareholders wealth. A positive NPV of $50000

means the wealth of company will increase by $50000

DISADVANTAGES

1. Difficulty in estimating the discounting rate ( Cost of capital)

2. More complicated and doesn’t give a return in % form.

4. INTERNAL RATE OF RETURN (IRR)

ADVANTAGES

1. Considers time value of money

2. Based on cashflows
3. Indicates a return in % form.

DISADVANTAGES

1. More complicated than other methods

2. Ignores the size of investment
3. Is only estimated because we need spreadsheet to determine it accurately
4. Multiple IRR problem

How to compare two projects?

A lot of examination questions are designed in a way that we first have to evaluate two or
more projects using different investment appraisal techniques. The projects are usually
similar in nature and then based on our appraisal we have to eventually recommend which
project the company should go for. As discussed above the rule is to maximize the net
present value.
How to compare two projects?
A lot of examination questions are designed in a way that we first have to evaluate
two or more projects using different investment appraisal techniques. The projects
are usually similar in nature and then based on our appraisal we have to eventually
recommend which project the company should go for. As discussed above the rule is
to maximize the net present value.
Following Example should be helpful:
Two projects X and Y have the following results after appraisal.
Project X (Cost Project Y (Cost
$100000) $100000)
Accounting Rate of Return 23% 26%
Payback Period 2 years 8 months 3 years
Net Present Value $23000 $28000

From the above figures it can be seen that Project Y should be selected as it is
relatively more financially sound and feasible due to a higher NPV. NPV of $28000
indicates the amount earned after recovering the original cost and also catering for
time value of money. In simple words company’s wealth will increase by $28000 in
real terms if they invest in project Y as compared to Project X which only brings in
$23000.
However Project X is relatively more liquid, as the investment is recovered 4 months
earlier than Project Y. This means that risk involved is relatively less for Project X. If
the company will be really short of liquid funds in the future and is a risk-averse
company then they might consider Project X but since the difference is not that
significant, I think Project Y is still better.
Project Y is also more profitable than Project X according to ARR. This indicates only
an average during the life of the two projects we will earn more profits if we choose
project Y. ARR is not a very important determinant of choosing a project due to its
several disadvantages.
The company should also consider social implications of both the project. Will it
cause pollution? Will it create more jobs? Etc.
To conclude based on the numbers available. I would advise the company to invest
in Project Y

NOTE:
· Usually when doing comparison projects are of similar nature, life and
similar investment cost. If size of the investment is different than
deciding purely on NPV will not be correct. You can use the following if
size of the investment is really different.

Calculate a ratio (known as profitability index)

NPV/ Initial Cost
The project giving highest answer should be most beneficial.
· Usually all the methods (Payback/ARR/NPV) will suggest that one
project is superior to the other so it will be really easy to write about it.
(Unlike in the example above where Project X has a better payback).

Standard Costing
Standard cost is the amount the firm thinks a product or the operation of the process
for a period of time should cost, based upon certain assumed conditions. The
technique of using standard cost for the purpose of cost control is known as standard
costing. It is a system of cost accounting which is designed to find out how much
should be the cost of a product under the existing conditions. The actual cost can be
calculated only when the production is undertaken. The pre-determined cost is
compared with the actual cost and a VARIANCE between the two is calculated. This