MGT INFO All Class Lectures

1 Management Informatio

Course: Management Information The Fundamentals of Costing

Professional Stage: Knowledge Level Section # 04, Jan-Mar Session 2010

Course Conducted By: Md. AKH Hasif Sowdagar, ACMA, ACA

The Institute of Chartered Accountants of Bangladesh

n, Conducted By: Md. AKH Hasif Sowdagar, BBA, MBA (DU), ACMA, ACA

Broad-Level Course Content and Lecture Schedule:

Broad-Level Course Content

Weighting (%)

Chapter # Related Chapter Name

Lecture #

Lecture Division By

1 The fundamentals of costing 1 2 Calculating unit cost (Part 1) 2 & 3 3 Calculating unit cost (Part 2) 4 4 Marginal costing and absorption costing 5

Costing and pricing 25%

5 Pricing calculation 6 6 Budgeting 7 Budgeting and

forecasting 25% 7 Cash budgets and the cash cycle 8 & 9

MAKHHS

Muck Test 10 8 Performance management Performance

management 25% 9 Standard costing and variance analysis

10 Breakeven analysis and limiting factor analysis Management decision

making 25% 11 Investment appraisal techniques

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2M

Objectives of this Module (Management Information):

Students will be able to:

1. establish the costs associated with the production of products and provision of services and use them to determine prices.

1. select appropriate budgeting approaches and methods and prepare budgets.

1. identify key features of effective performance management systems, select

appropriate performance measures and calculate differences between actual performance and standards or budgets.

1. identify and calculate relevant data for use in management decision making.

anagement Information, Conducted By: Md. AKH Hasif Sowdagar, BBA, MBA (DU), ACMA, ACA

Lecture # 01 (Chapter-1) The Fundamentals of Costing

06 January 2010 Topic List: Chapter-1 1 What is cost accounting? 1.1 The cost accountant 1.2 Cost accounting and management accounting 1.3 Cost accounting system 1.4 Financial accounting versus cost accounting 2 Basic cost accounting concept? 2.1 Functions and departments 2.2 Cost objects 2.3 Cost units 2.4 Composite cost units 2.5 The concept of cost 2.6 Direct v indirect costs and cost objects 3 Cost classification for inventory valuation and profit measurement 3.1 Cost elements 3.2 Direct cost and prime cost 3.3 Indirect cost and overhead 3.4 Product costs and period costs 4 Cost classification for planning and decision-making 4.1 Cost behavior patterns 4.2 Fixed costs 4.3 Variable costs 4.4 Semi-variable costs (or semi-fixed costs or mixed costs) 4.5 Cost behavior and total and unit costs 4.6 Relevant range 5 Cost Classification for control 5.1 Responsibility accounting 5.2 Controllable and uncontrollable costs

The cost accountant: The cost accountant or a person having access to cost information should be able to provide the following information:

• the cost of goods produced or services provided last period; • the cost of operating a department last month; • revenue were earned last week. •

Cost Accounting: Cost Accounting identifies, defines, measures, reports and analyzes the various elements of direct and indirect costs associated with producing and marketing goods and services. Originally cost accounting dealt with ways of accumulating historical costs and of charging these costs to units of output, or to department, in order to establish inventory valuations, profits or losses and balance sheet items. So cost accounting has been extended in to planning, control and decision making.

3 Management Information, Conducted By: Md. AKH Hasif Sowdagar, BBA, MBA (DU), ACMA, ACA

Management Accounting: In today’s environment, the role of cost accounting in the provision of management information is therefore almost indistinguishable from that of management accounting, which is basically concerned with the provision of information to assist management with planning, control and decision. Cost Accounting System: Cost accounting system provides the foundations for an organization’s internal financial information system for manager. Cost accounting is concerned with providing information to assist the following:

• Establishing inventory valuations, profits or losses and balance sheet items; • Planning (the provision of forecast costs at different levels) • Control (the provision of actual and standard costs for comparison purpose) • Decision making (information about actual unit costs for pricing decisions).

Financial Accounting versus Cost Accounting: Financial accounts are usually prepared for external stakeholders e.g. shareholders, bank, customers, suppliers, customs authority and employees. Management accounts are usually prepared for internal management of an organization. Cost: An expenditure, usually of money, for the purchase of goods or services. Cost Objects: A cost object is anything for which we are trying to ascertain the cost. A cost object is a tangible input for a product manufactured/Service provided, like labor or material. For example a cloth manufacturing firm requires some amount of predetermined labor and predetermined raw material for any amount of cloth being manufactured. The cost of employing labor can be directly fixed as "per man per hour" or "per man per day", so the labor is a cost object as you can directly associate cost with it. Similarly the raw material like cotton or threads or fabric can be another cost object. Example of Cost objects includes: A unit of product (e.g. a car), A unit of service (e.g. a valet service of a car) A project (e.g. the installation of a new computer system) Cost Units: A cost unit is the basic measure of product or service for which costs are determined. Example:

Organization Cost Unit Steelworks Tonne of steel produced

Patient per day Operation Hospital Out-patient visit

Accounting firm Audit performed


Restaurent Meal served Direct versus Indirect Cost and Cost Objects: Direct costs are costs identified with a cost object. Indirect costs cannot be identified with a particular cost object. For example: if a chair is a cost object then certain costs such as materials and labour required to assemble the chair would be classed as direct costs for an individual chair. Factory rent could not be associated with an individual chair so would be classed as indirect cost of the chair. Cost Element: For the purpose of inventory valuation and profit measurement, the cost of one unit must be determined. The total cost of a cost unit of product or service is made up of the following three elements of cost:

Material Labour Other expenses (such as rent)

So cost element can be classified as direct costs or indirect costs. Direct Cost and Prime Cost: A direct cost is a cost that can be traced in full to the cost unit. Types of Direct Cost:

Direct Cost

Direct Labour Costs

Direct Material Costs

Other direct expenses

Wage paid to an employee Packing material Cost of hiring a special machine

Prime Cost: Total direct cost can be described as “Prime Cost”. Prime Cost = Total direct cost = direct material cost + direct labour cost + other direct expenses. Indirect Cost and Overhead: A cost that is incurred which can not be traced directly. Example of indirect cost: cost of supervisor’ wage on a production line, cleaning material and building insurance for a factory. These cost can not be traced directly. Total Expenditure: Material Cost = Direct material cost + Indirect material cost + + + Labour cost = Direct labour cost + Indirect labour cost + + + Expenses = Direct expenses + Indirect expenses


Total cost = Direct cost/prime cost + Indirect cost/overhead Categories of Overhead: 1. Production overhead 2. Administration overhead 3. Selling overhead 4. Distribution overhead Cost Behavior Pattern: Cost behavior pattern means grouping costs according to how they vary in relation to the level of activity. Example of level of activity:

The volume of production in a period The number of items sold The number of invoice issued The number of units of electricity consumed

A knowledge of how the cost incurred varies at different levels of activity is essential to planning and decision-making. Fixed Costs: A fixed cost is a cost that, within a relevant range of activity levels, is not affected by increases or decreases in the level of activity.

Cost

Example of Fixe

Variable Costs: A variable cost isdecreases.

6 Management Informatio

Volume output (level of activity)

d Cost: The salary of the managing director (per month or per annum) The rent of a factory building (per month or per annum) Straight line depreciation of a machine (per month or per annum)

a cost that increases or decreases as the level of activity increases or

n, Conducted By: Md. AKH Hasif Sowdagar, BBA, MBA (DU), ACMA, ACA

Cost

Volume output

Example of Variable Cost:

The cost of raw materials Direct labour cost, which are usually charged as a variable cost

even though basic wages are often fixed. Sales commission that is variable in relation to the volume or

value of sales. Semi-variable Costs (or semi-fixed costs or mixed costs): Semi-variable, semi-fixed or mixed costs that are part-fixed and part-variable and are therefore partly affected by changes in the level of activity.

Cost Variable part

Fixed part

Volume output

Example of Variable Cost: Electricity and gas bills. There is a standing basic fixed charge

plus a charge per unit of consumption. Sales representative’s salary. The sales representative may earn

a basic monthly amount plus a commission based on the value of sales made.

Cost Behavior and Total and Unit Costs: If the variable cost of producing a unit is Tk.5 per unit then it will remain at that cost per unit no matter how many units are produced (within the relevant range).


However, if the business’s fixed costs are Tk.5,000 then the fixed cost per unit will decrease the more units are produced: for example,

• one unit will have fixed costs of Tk.5,000 per units; • 2,500 units are produced the fixed cost per unit will be Tk.2; • 5,000 units are produced the fixed cost per unit will be only Tk.1.

Thus as the level of activity increases the total costs per units (fixed cost plus variable cost) will decrease. The Relevant Range: The relevant range is the range of activity levels within which assumed cost behavior patterns occur. For example, a fixed cost is only fixed for levels of activity within the relevant range, after which it could ‘step up’. Responsibility Accounting: Responsibility accounting is a system of accounting that segregates revenues and costs into areas of personal responsibility in order to monitor and assess the performance of each part of an organization. Responsibility Centre is a department of function whose performance is the direct responsibility of a specific manager. Controllable and uncontrollable Costs: A controllable cost is a cost that can be influence by management decision and action. Example: Excessive overtime, buying material by higher price by the purchasing department. An uncontrollable cost is a cost that cannot be affected by management within a given time span. Example: Increase in expenditure due to inflation.


Lecture # 02 – (Chapter-2) Calculating Unit Costs (Part I)

13 January 2010 Exam Requirement: The context of much of this chapter provides scope for a range of numerical questions. However, you should also be prepared to deal with narrative questions that examine your understanding of the implications of the techniques you are using. Main Focus of this chapter:

This chapter is related to the numerical questions. Classify costs as direct or indirect Calculate the prime cost of a cost unit Calculate the price of materials and the value of inventory using

FIFO LIFO Average Pricing Method

Topic List: Chapter-2

1 Identifying Direct and Indirect Costs for Cost Units 1.1 Direct Material Cost 1.2 Direct wages or direct labour costs 1.3 Direct expenses 1.4 Indirect costs 1.5 Direct and Indirect costs: some further points 2 Inventory Valuation 2.1 Valuing inventory in Financial Accounts 2.2 Charging units of inventory to cost of production or cost of sales 2.3 Example: Inventory Valuation 2.4 Pricing methods of Inventory Valuation 2.5 FIFO (First In First Out) 2.6 Advantages and Disadvantages of the FIFO Method 2.7 LIFO (Last In First Out)

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2.8 Advantages and Disadvantages of the LIFO Method 2.9 Cumulative Weighted Average Pricing 2.10 Advantages and Disadvantages of Cumulative Weighted Average Pricing 2.11 Periodic Weighted Average Pricing 2.12 Inventory Valuation and Profitability

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2.13 Profit Differences Direct Material Cost: Direct Material Cost is all material becoming part of the cost unit. Direct material costs are charged to the cost unit as part of the prime cost. Examples of direct material are as follows:

Components parts or other material purchased for a particular product, service, job, order or process.

Primary packing materials like carton or boxes.


Direct Wages or Direct Labour Costs: Direct wages are all wages paid for labour (either as basic or as overtime) that can be identified with the unit cost. Direct wages costs are charged to the cost unit as part of the prime cost. Examples of group of labour receiving payment as direct wage are as follows:

Workers engaged in altering the condition, confirmation or composition of the product.

Inspectors, analysts and testers specifically required for such production. Direct Expenses: Direct expenses are any expenses that are incurred on a specific cost unit other than direct material cost and direct wages. Direct expenses are charged to the product as part of the prime cost. Examples of direct expenses are as follows:

The cost of special designs, drawings or layouts of a particular job. The hire of tools or equipment for a particular job.

Indirect Costs: Indirect costs or overheads are those cost that cannot be traced in full to a specific cost unit. For Example, a garage carries out a repair job on a customer’s car. Direct and Indirect costs: some further points: Some misconceptions about direct and indirect costs:

Direct costs are not necessarily bigger in size than indirect costs. Indirect costs are not less important than direct costs. It is easy to confuse fixed and variable costs with direct and indirect

costs. Valuing inventory in Financial Accounts: For financial accounting purposes, inventories are valued at the lower of cost and net realizable cost. In practice, inventories will be valued at cost in the stores records throughout the course of an accounting period. Only when the period ends will the value of inventory in hand be reconsidered so that items with a net realizable value below heir original cost will be revalued downwards, and the inventory records altered accordingly. Charging units of inventory to cost of production or cost of sales: It is important to be able to distinguish between the way in which the physical items in inventory are actually issued and the way in which inventory is costed. In practice, a storekeeper may issue goods in the following ways:

The oldest goods first The latest goods received first Randomly Those that are earliest to reach.


Pricing methods of Inventory Valuation:

1. FIFO (First In First Out) 2. LIFO (Last In First Out) 3. Cumulative Weighted Average Pricing

FIFO (First In First Out): FIFO assumes that materials are issued out of inventory in the order in which they were delivered into inventory: issued are priced at the cost of the earliest delivery remaining in inventory. Worked Example – FIFO and LIFO:

DateQuantity (Units)

Unit Cost (Tk.)

Total Cost (Tk.)

Market value per unit on date

of transactionOpening Balance, 1 May 2009 100 2.00 200Receipt, 3 May 400 2.10 840 2.11Issue, 4 May 200 2.11Receipt, 9 May 300 2.12 636 2.15Issue, 11 May 400 2.20Receipt, 18 May 100 2.40 240 2.40Issue, 20 May 100 2.42Closing balance, 31 May 2009 200 2.45Total 1916

Solution of Worked Example - FIFO:

Date Quantity Unit Cost (Tk.)

Amount (Tk.)

Quantity Unit Cost (Tk.)

Amount (Tk.)

Quantity Unit Cost (Tk.)

Amount (Tk.)

1-May-09 100 2.00 200

3-May-09 400 2.10 840 100 2.00 200400 2.10 840500 1,040

4-May-09 100 2.00 200100 2.10 210 300 2.10 630

9-May-09 300 2.12 636 300 2.10 630300 2.12 636600 1,266

11-May-09 300 2.10 630100 2.12 212 200 2.12 424

ay-09 100 2.40 240 200 2.12 424100 2.40 240300 664

0-May-09 100 2.12 212 100 2.12 212 100 2.40 240

ay-09 200 452

Receipts Issues Inventory

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LIFO (Last In First Out): LIFO assumes that materials are issued out of inventory in the reverse order from that in which they were delivered: the most recent deliveries are issued before earlier once, and issues are priced accordingly. Solution of Worked Example - LIFO:

Date Quantity Unit Cost (Tk.)

Amount (Tk.) Quantity Unit Cost

(Tk.)Amount

(Tk.) Quantity Unit Cost (Tk.)

Amount (Tk.)

1-May-09 100 2.00 200

3-May-09 400 2.10 840 100 2.00 200400 2.10 840500 1,040

4-May-09 200 2.10 420 100 2.00 200200 2.10 420

9-May-09 300 2.12 636 100 2.00 200200 2.10 420300 2.12 636600 1,256

11-May-09 300 2.12 636 100 2.00 200100 2.10 210 100 2.10 210

ay-09 100 2.40 240 100 2.00 200100 2.10 210100 2.40 240300 650

0-May-09 100 2.40 240 100 2.00 200 100 2.10 210

ay-09 200 410

Receipts Issues Inventory

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Lecture # 03 – Chapter-2 Cont’d) Calculating Unit Costs (Part I)

20 January 2010 Cumulative Weighted Average Pricing The cumulative weighted average pricing method calculates a weighted average price for all units in inventory. Issues are priced at this average cost, and the balance of inventory remaining would have the same unit valuation. The average price is determined by dividing the total cost by the total number of units. A new weighted average price is calculated whenever a new delivery of materials is received into store. This is the key feature of cumulative weighted average pricing. The issue prices are calculated each time materials are received in stores and not when they are issued. Worked Example - Cumulative Weighted Average Pricing Using cumulative weighted average pricing, the issue costs and closing inventory of the transaction as follows:

DateReceived

Units Issued UnitsBalance

Units

Total Inventory

Value (Tk.)

Units Cost (Tk.)

Total Taka

Opening Balance, 1 May 2009 100 200 2.00May 400 840 2.10

500 1040 2.08May 200 -416 2.08 416

300 624 2.08May 300 636 2.12

600 1260 2.10May 400 -840 2.10 840

200 420 2.10May 100 240 2.40

300 660 2.20May 100 -220 2.20 220

ost of issues 1476

losing inventory value 200 440 2.20 440otal 2200 1916

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Advantages and Disadvantages of Cumulative Weighted Average Pricing: Advantages:

1. Fluctuations in price are smoothed out, making it easier to use the data for decision making.

2. It is easier to administer than FIFO and LIFO, because there is no need to identify each batch separately.

Disadvantages:

1. The resulting issue price is rarely an actual price that has been paid, and can run to several decimal points which are very much laborious.

2. Price tend to lag a little behind current market values when there is gradual inflation.

3. Materials cost does not represent actual cost price. 13 Management Information, Conducted By: Md. AKH Hasif Sowdagar, BBA, MBA (DU), ACMA, ACA

Periodic Weighted Average Pricing: The average method differs from the cumulative weighted average method. Instead of calculating a new inventory value per unit whenever a receipt occurs, a single average is calculated at the the end of the period based on all purchases for the period. This method is extremely simple to operate and can be used in process industries where each individual order is absorbed into the general cost of producing a large quantity of articles. But where each individual order is to be priced separately at each stage of completion, such as in jobbing industry, this method is unsatisfactory. Unless stated to the contrary, assume the cumulative method is required in an exam question. Worked example: Periodic Weighted Average Pricing Using periodic weighted average pricing, the issue costs and closing inventory of the transaction as follows:

Cost of opening inventory + Total cost of receipts in periodUnits in opening inventory + Total units received in period

(Tk. 200 + Tk. 1716)(100 + 800)

= Tk. 2.129 per unit

This average price is used to value all the units issued and the units in the closing inventory.

Cost of issues = 700 units x Tk. 2.129Cloing inventory value = 200 units x Tk. 2.129 Tk. 1490

Tk. 4261916

Periodic weighted average price =

Periodic weighted average price =

Inventory Valuation and Profitability: Each method of inventory valuation usually produces different figures for the value of closing inventories and the cost of material issues. A summary of the valuations based on the previous example which we have learned in the earlier is as follows:

Since material costs affect the cost of production, and the cost of production works through eventually into the cost of sales (which is also affected by the value of closing inventories), it follows that different methods of inventory valuation will provide different profit figures.

Valuation Method

Closing Inventory

Value (Tk.)

Cost of Issue (Tk.)

Total Tk.

FIFO 452 1464 1916LIFO 410 1506 1916Cumulative weighted average 440 1476 1916Periodic weighted average 426 1490 1916


Worked example: Inventory Valuation and Profitability: On 1 November 2009, DD Ltd. held 3 pink satin dress with orange sashes, designed by Freda Swoggs. There were valued at Tk. 120 each. During November 2009, 12 more of the dresses were delivered as follows:

DateDress

Received

Purchase cost per

dress (Tk.)10-Nov 4 12520-Nov 4 14025-Nov 4 150

A number of the pink satin dresses with orange sashes were sold during November as follows:

Date Dress Sold

Sales price per dress

(Tk.)14-Nov 5 20021-Nov 5 20028-Nov 1 200

Requirement: Calculate the gross profit from selling the pink satin dresses with orange sashes in November 2009, applying the following principles of inventory valuation.

a) FIFO b) LIFO c) Cumulative weighted average pricing

Calculate gross profit using the formula: Gross profit = (Sales - (opening inventory + purchase- closing inventory) BAS-2: Inventories (Paragraph 23-27): Cost Formulas: As per paragraph 23, The cost of inventories shall be assigned by using the first-in, first-out (FIFO) or weighted average cost formula. The FIFO formula assumes that the items of inventory that were purchased or produced first are sold first, and consequently the items remaining in inventory at the end of the period are those most recently purchased or produced. Under the weighted average cost formula, the cost of each item is determined from the weighted average of the cost of similar items at the beginning of a period and the cost of similar items purchased or produced during the period. The average may be calculated on a periodic basis, or as each additional shipment is received, depending upon the circumstances of the entity. Methods Used in Issuing Materials:


The various methods which are used for valuing materials issued from store can be grouped as follows: A. Cost Price Method: 1 Specific Price 2 FIFO (First In First Out) 3 LIFO (Last In First Out) 4 Base stock B. Average Price Method: 1 Simple Average 2 Weighted Average 3 Periodic Simple Average 4 Periodic Weighted Average 5 Moving Simple Average C. Average Price Method: 1 Replacement Price 2 Realizable Price D. Standard Price Method: 1 Current Standard Price 2 Basic Standard Price


Lecture # 04 – (Chapter-3) Calculating Unit Costs (Part 2)

27 January 2010 Exam Requirement: Student should be prepared to tackle narrative questions on overhead absorption as well as on the selection of the most appropriate costing method in the specific circumstances. Main Focus of this chapter:

Calculate the full cost of a cost unit using absorption costing Demonstrate an understanding of the basic principles of activity based

costing Identify the most appropriate costing method in specific circumstances Demonstrate an understanding of the general principles of target

costing, life cycle costing and just in time.

Main Study Book: 1. Management Information published by the Institute of Chartered Accountants of Bangladesh and Reference Book:

1. Managerial Accounting, By Garrison and Noreen, Edition # 9, Chapter # 7 and 8.

Chapter: 8 (Review Problem – Activity Based Costing) (Exercise # 8-4, 8-5,8-6, 8-7, 8-10) (Problem # 8-12, 8-14, 8-15, 8-16) 2. Theory and Practice of Costing, Volume One by Basu & Das, Chapter # 5

Topic List: Chapter-3 1 Absorption Costing 1.1 Calculating the absorption cost of a cost unit 1.2 Overhead Allocation 1.3 Overhead Apportionment 1.4 Overhead Absorption 1.5 Blanket Absorption rates ad departmental absorption rates 1.6 Over and under Absorption of overheads 2 Activity Based Costing 2.1 The problems with traditional absorption costing 2.2 The Activity Based Costing approach 3 Costing Methods 3.1 Specific order costing 3.2 Process (continues operation) Costing 4 Other approaches to cost management 4.1 Life cycle costing 4.2 Target costing 4.3 Just-In-Time (JIT)

Calculating the absorption cost of a cost unit: To calculate the full cost of an item using absorption costing (sometime referred to as full costing) it is necessary first to establish its direct cost or prime cost and then to add a fair share of indirect costs or overhead. 17 Management Information, Conducted By: Md. AKH Hasif Sowdagar, BBA, MBA (DU), ACMA, ACA

The full or absorption cost per unit is therefore made up as follows: Tk. Direct Materials x Direct labour x Direct expenses (if any) x Total direct cost (Prime Cost) x Share of indirect cost/overhead x Absorption (Full) Cost x There are three stages in determining the share of overhead to be attributed to a cost unit.

Overhead Allocation Overhead Apportionment Overhead Absorption

Overhead Allocation: The first stage in absorption costing is allocation. Allocation is the process by which whole cost items are charged direct to a cost centre. A cost centre acts as a collecting place for costs before they are analyzed further. Cost centre may be one of the following types:

A production Department, to which production overheads are charged. A production Service Department, to which production overheads are

charged. An Administration Department, to which administration overheads are

charged. A selling or Distribution Department, to which sales and distribution

overheads are charged. An Overhead Cost Centre, to which items of expenses which are shared

by a number of departments, such as rent and rates, heat and light and the canteen, are charged.

Worked Example: Overhead Allocation Consider the following costs of a company. Tk. Wages of the supervisor of department A 200 Wages of the supervisor of department B 150 Indirect Material consumed in department A 50 Rent of the premises shared by department A and B 300 The cost accounting system might include three cost centre. Cost Centre: 101 Department A 102 Department B 201 Rent Requirement: Compute the allocation of the above overhead cost. 18 Management Information, Conducted By: Md. AKH Hasif Sowdagar, BBA, MBA (DU), ACMA, ACA

Overhead Apportionment: The next step in absorption costing is overhead apportionment. This involves apportioning general overheads to cost centres (the first stage) and then reapportioning the costs of service cost centres to production departments (the second stage). The first stage: Apportioning General Overheads:

• The first stage of overhead apportionment is to identify all overhead costs as production department, production service department, administration or selling and distribution overhead.

• This means that the costs for heat and light, rent and so on (that is, costs

which have been allocated to general overhead cost centres) must be shared out between the other cost centres.

• Overhead costs should be shared out on a fair basis. The bases of apportionment for the most usual cases are given below:

Overhead to which the basis applies BasisRent, rates, heating and light, repairs and depreciation of buildings

Floor area occupied by each cost centre

Depreciation, insurance of equipment Cost or book value of equipmentPersonnel office, canteen, welfare, wages and cost offices, first aid

Number of employees, or labour hours worked in each cost centre

Heating, lighting (see abive) Volume of space occupied by each cost centre

Interactive Question: Bases of Apportionment The following bases of apportionment are used by a factory. A Volume of cost centre B Value of machinery in cost centre C Number of employees in cost centre D Floor areas of cost centre Compute the below table with using one of A to D of the above the bases. Production Overheads Basis

RentHeating costsInsurance of machineryCleaning costsCanteen costs

Worked Example: Overhead Apportionment: McQueen Co has incurred the following overhead cost. Tk. (‘000) Depreciation of Factory 100 Factory repairs and maintenance 60 Factory office cost (treat as production overhead) 150 Depreciation of equipment 80 Insurance of equipment 20 Heating 39 Lighting 10 Canteen 90 549


Information relating to the production and service department in the factory is as follows:

Pduction-1 Pduction-2 Service 100 Service 100Floor space (square meters) 1200 1600 800 400Volume (cubic metres) 3000 6000 2400 1600Number of employees 30 30 15 15Book value of equipment (Tk.) 30000 20000 10000 20000

Department The overhead cost Apportionment Formula:

Total overhead cost

Total value of apportionment baseX Value of apportionment base of cost

centre

Tk. 39,000 For example, Heating for

Dept. 1 = 13,000

X 3000 = Tk. 9,000

Pduction-1

Pduction-2

Service 100

Service 100

Depreciation of Factory Floor AreaFactory repairs and maintenance Floor AreaFactory office cost Number of employeesDepreciation of equipment Book valueInsurance of equipment Book valueHeating Volume 9Lighting Floor AreaCanteen Number of employeesTotal

Items of costDepartment (Tk.'000)Basis of

Apportionment

Total cost (Tk.)

Second stage: Service Cost Centre Cost Apportionment: The second stage of overhead apportionment concerns the treatment of service cost centres. The next stage in absorption costing is, therefore, to apportion the costs of service cost centres to the production cost centres. Example of possible apportionment base are as follows:

Service Cost Centre Basis of ApportionmentStores Number of materials requisitionMaintenance Hours of maintenance work

done for each cost centreProduction planning Direct labour hours worked in

each production cost centre

Overhead Absorption: Having allocated and/or apportioned all overheads, the next stage in absorption costing is to add them to, or absorb them into, the cost of production or sales.

Production overheads Administration, selling and distribution overheads


Predetermined Absorption Rate: In absorption costing, it is usual to add overheads into product costs by applying a predetermined overhead absorption rate. Calculating predetermined overhead Absorption Rate: The absorption rate is calculated by dividing the budgeted overhead by the budgeted level of activity. Selecting the appropriate Absorption Base: Management should try to establish an absorption rate that provides a reasonably accurate estimate of overhead costs for jobs, products or service Blanked Absorption Rates and Departmental Absorption Rate: A blanked or single factory overhead absorption rate is an absorption rate used throughout a factory and all jobs and units of output irrespective of the department in which they were produced. Worked Example: Absorption Rate: Over and Under Absorption of Overhead:

(a) Over Absorption means that the overheads charged to the cost of production are greater than the overheads actually incurred.

(b) Under Absorption means that insufficient overheads have been included in the cost of production.

Reasons for under/over Absorbed Overhead: The problem with Traditional Absorption Costing: The traditional absorption costing system relies on subjective judgment concerning the basis of apportionment of overheads to cost centres. The traditional absorption costing system can create a problem for management seeking to accurately identify unit costs and exert control over these costs. The Activity Based Costing Approach: Activity based costing (ABC) provides an alternative to the traditional method of absorption costing. The objective of this method is to establish a better means of relating overheads to output, it is claimed that the ABC method provides managers with a better basis for both cost control and for the analysis of profitability. Cost Drivers: For those costs that vary with production levels in the short term, ABC uses volume-related cost drivers such as labour hours or machine hours. Calculating product costs using ABC: Worked Example: Comparing ABC with Traditional Absorption Costing: 21 Management Information, Conducted By: Md. AKH Hasif Sowdagar, BBA, MBA (DU), ACMA, ACA

Specific Order Costing: Some organizations produce ‘one off’ products or services to a customer’s specific requirements, where cost unit is separately identifiable from all others. Job Costing: Job costing is appropriate where each separately identifiable cost unit or job is of relatively short duration. Contact Costing: Contact costing is appropriate where each separately identifiable cost unit is of relatively long duration. Batch Costing: Batch costing is similar to job costing except that each separately identifiable cost unit would be a batch of identical items. Process (Continue Operation) Costing: Some organizations have a continuous flow of operations and produce a large number of identical products. Life Cycle Costing: A product incurs costs over the whole of its life cycle, from the design stage through development to market launch, production and sales, and its eventual withdrawal from the market. Target Costing: Target costing works the other way round. It begins with a concept for a new product and, after considering the situation in the potential market for the product, a required selling price is determined. Just-In-Time (JIT): Just-in-time (JIT) is an approach to operations planning and control based on the idea that goods and services should be produced only when they are needed. Operational Requirement for JIT: JIT and Cost Management:


Lecture # 05 – Chapter - 4 Marginal Costing and Absorption Costing

03 February 2010 Exam Requirement: The calculation of the different profits reported under marginal costing and absorption costing is likely to be a popular examination topic. Students are also likely to be asked to reconcile the difference between the profits reported under the two systems. Main Focus of this chapter:

Calculate the profit reported under marginal costing and under absorption costing using the same basic set of data.

Reconcile the difference between the profit reported under the two systems.

Derive the marginal costing profit from data provided that is prepared using absorption costing and vice versa.

Most students are comfortable with marginal costing but have difficulty with absorption costing, particularly the under or over absorption of overhead. Narrative questions as well as numerical questions are important in this area of the syllabus. Book Reference Main Study Book: 1. Management Information published by the Institute of Chartered Accountants of Bangladesh and the Institute of Chartered Accountants of England and Wales. Reference Book:

1. Theory and Practice of Costing, Volume Two by Basu & Das.

Topic List: 1 Marginal Cost and Marginal Costing 1.1 Marginal Costing 1.2 Contribution 1.3 Conclusion

2 Marginal Costing and Absorption Costing Compared 2.1 Summarizing the differences between the two costing methods 2.2 Conclusion 2.3 Marginal Costing and Absorption Costing Compared

Marginal Costing: Marginal costing is an alternative costing system to absorption costing. With marginal costing, only variable production costs are included in the valuation of units. All fixed costs are treated as period costs and are charged in full against the sales revenue for the period. The marginal production cost per unit usually consists of the following:

Variable materials Variable labour Variable production overhead


Contribution: Contribution is an important measure in marginal costing and it is calculated as the difference between sales value and marginal cost. The term’ contribution’ is really short for ‘contribution towards fixed overheads and profit’. The contribution per unit can be calculated is follows: Per Unit (Tk.) Per Unit (Tk.) Selling Price x Variable material x Variable labour x Variable production overheads x Marginal production cost x Variable selling, distribution and administrative cost x Total Marginal Cost (x) Contribution X Worked Example: Marginal Costing: Water Ltd makes a product, the splash, which has a variable production cost of Tk. 6 per unit and a sales price of Tk. 10 per unit. At the beginning of September 2009, there was no opening inventory and production during the month was 20,000 units. Fixed cost for the month were Tk. 45,000 (production, administration, sales and distribution). There were no variable marketing costs. Requirement: Calculate the contribution and profit for September 2009, using marginal costing principle, if sales were as follows: (a) 10,000 splash (b) 15,000 splash (c) 20,000 splash Conclusions: The conclusions that may be drawn from this example are as follows:

(a) The profit per unit varies at different levels of sales. (b) The contribution per unit is constant at all level of output and sales. (c) The contribution per unit does not change.

Summarizing the differences between the two costing methods: The differences between the two costing systems can be summarized as follows:

In marginal Costing: Closing inventories are valued at marginal or variable production cost. Fixed costs are charged in full against the profit of the period in which

they are incurred. No fixed costs are included in the inventory valuation.


In Absorption Costing:

Inventories are valued at full production cost, and include a share of fixed production costs.

This means that the cost of sales in a period will include some fixed overhead incurred in a previous period (in opening inventory values) and will exclude some fixed overhead incurred in the current period which is carried forward in the closing inventory value.

Conclusions:

Marginal costing and absorption costing are different techniques for assessing profit in a period.

If there are changes in inventories during a period, marginal costing and absorption costing give different results for profit obtained.

If the opening and closing inventory levels are the same, marginal costing and absorption costing will give the same profit figure if unit costs remain constant.

In the long run, total profit for a company will be the same whether marginal costing or absorption costing is used as all inventory is sold. Different accounting conversions merely affect the profit of individual accounting periods.

Marginal Costing and Absorption Costing Compared: Advantage of Absorption Costing:

i. Fixed production costs are incurred in order to make output; it is therefore ‘fair’ to charge all output with a share of these costs.

ii. Closing inventory values, by dividing a share of fixed production overhead, will be valued on the principle required by accounting standards for the financial valuation of inventories for external

Advantage of Marginal Costing:

i. It is simple to operate. ii. There are no apportionments of fixed costs. iii. Fixed cost will be the same regardless of the volume of output. iv. Under or over absorption of overhead is avoided.


Lecture # 6 – (Chapter- 5) Pricing Calculation 10 February 2010

Exam Requirement: Pricing decisions could features as a narrative question or a calculation question. The sample paper for this syllabus featured one calculation question and one narrative question about pricing as well as a calculation question about transfer pricing. Main Focus of this chapter:

Calculate a selling price using full cost-plus pricing Calculate a selling price using marginal cost-plus pricing Demonstrate an understanding of the difference between mark-up and

margin and of the relationship between them Derive the mark up percentage that will achieve a desired return on the

investment in a product. Calculate a transfer price that will achieve profit maximization and

encourage an alignment of the goals of groups or individuals with the goals of the organization as a whole.

Book Reference Main Study Book: 1. Management Information published by the Institute of Chartered Accountants of Bangladesh and the Institute of Chartered Accountants of England and Wales.

1 Full cost-plus pricing 1.1 Cost-plus pricing 1.2 Setting full cost-plus prices 1.3 Determining the mark-up percentage 1.4 Determining the mark-up to achieve a required return on investment 1.5 Allowing for inflation when setting selling prices 1.6 Advantages and disadvantages of full cost-plus pricing

2 Marginal Cost-plus pricing 2.1 Setting marginal cost-plus prices 2.2 Advantages and disadvantages of marginal cost-plus pricing

3 Mark-ups and Margins 3.1 The difference between mark-up and margin

4 Transfer Pricing 4.1 What is transfer price? 4.2 Aims of a transfer pricing system 4.3 Practical methods of transfer pricing 4.3.1 Market price

4.3.2 A cost-plus approach to transfer pricing 4.3.3 Two part transfer price 4.3.4 Dual pricing

Cost-Plus Pricing: In practice cost is one of the most important influences on price. While in economic theory it is possible to set a sales that will maximize profit, in reality there is a lack of


precise information about cost behavior patterns and the effect of price on sales demand. This will lead some organizations to base their selling price decision on simple cost-plus rules, whereby costs are estimated and then a percentage mark-up is added in order to set the price. Setting Full Cost-Plus Pricing: The full cost may be a fully absorption production cost only, or it my include some absorbed selling, distribution and administration overhead. Therefore there are two options for calculating a full cost-plus price. Option 1: Unit sales price = Total production cost per unit + Percentage mark-up Option 2: Unit sales price = Total production cost per unit + Other Cost* per unit + Percentage mark-up *Other cost include selling, distribution and administration costs. Clearly, to achieve the same sales price, the mark-up on cost must be greater under Option1 than under Option 2 in order to recover the other costs. Worked Example: Calculating a cost-plus selling price XY Ltd has began to produce product S, for which the following cost estimates have been prepared.

Variable Costs Tk. Per unit

Variable materials 14.00 Variable labor at Tk. 12 per hour 54.00 Variable production overheads at Tk. 3 per hour 13.50 Variable production cost per unit 81.50

Fixed production overheads are budgeted to be Tk. 69,000 each period. The overhead absorption rate will be based on 17,250 budgeted direct labor hours each period. Requirement: The company wishes to add 20 percent to the full production cost in order to determine the selling price per unit for product S. Determining the mark-up percentage: A business may have an idea of the percentage profit mark-up it would like to earn, and so may decide on an average profit mark-up as a general guide for pricing decisions. This would be particularly useful for businesses that carry out a large amount of contact or jobbing work, for which individual job or contact prices must be quoted regularly to prospective customers.


However, the percentage profit mark-up does not have to be rigid and fixed. It can be varied to suit the circumstances. In particular, the percentage mark-up can be varied to suit anticipated supply and demand conditions in the market. Determining the mark-up to achieve a required return on investment: A business might calculate the mark-up percentage for a product in order to achieve a required return on the investment in the product. Worked Example: Pricing to generate a return on investment Allowing for inflation when setting selling prices: We have seen that the mark-up added to total cost must be sufficient to earn the required profit, or in the case of adding a mark-up to total production cost, the mark up must be sufficient to recover all non-production costs in addition to earning the required profit. Therefore managers must estimate costs as accurately as possible and must decide whether to include allowances for anticipated inflation. Advantages and disadvantages of full cost-plus pricing: The advantages of full cost-plus pricing are as follows:

The price is quick and easy to calculate. Pricing decisions can be delegated to more junior employees. A price in excess of full cost should ensure that an organization working

at normal capacity will cover all its costs. Price increases can be justified as costs rise.

However full cost-plus pricing does have a number of disadvantages:

It fails to recognize that since demand may be determining price, there will be a profit maximizing combination of price and demand.

It reduces incentives to control costs. It requires arbitrary absorption of overheads into product costs.

Setting Marginal Cost-Plus Prices: Marginal cost-plus pricing is a method of determining sales prices whereby a profit mark-up is added to either the marginal cost of production or the marginal cost of sales. Worked Example: Calculating a marginal cost-plus price: Advantages and disadvantages of marginal cost-plus pricing: The advantages of marginal cost-plus pricing are as follows:

It is a simple method to use. It avoids the arbitrary apportionment and absorption of fixed costs that is

necessary with absorption costing.

Disadvantages of marginal cost-plus pricing:

The full costs might not be recovered in the long term.


The difference between mark-up and margin: When sales prices are being determined on a cost-plus basis it is extremely important to be clear about whether the profit to be added to unit costs is calculated as a percentage of costs or as a percentage of selling price.

Cost-Plus Pricing

Margin Percentage Mark-up Percentage (Profit expressed as a

percentage of cost) (Profit expressed as a

percentage of sales prices)

What is Transfer Price? Transfer pricing is used when divisions of an organization need to change other divisions of the same organization for goods or services that they provide to them. For example: subsidiary A might manufacture a component that is used as part of a product made by subsidiary B of the same company. The component can also be bought on or sold to the external market. Therefore there will be two sources of revenue for subsidiary A.

External sales revenue from sales made to other organization. Internal sales revenue from the transfer prices charged for components

supplied to subsidiary B. Practical Methods of Transfer Pricing:

Practical Methods of Transfer Pricing

Two part Transfer Price

Cost-Plus Price Market Price Dual Pricing


Class Lecture # 07

Management I ledge Level) Class Test # 01 nformation (Know

Section # 04, Date: 17 February 2010 r
Total Mark-50 The Inst ladesh itute of Chartered Accountants of Bang
hapter # 1: The fundamentals of costing

1. Who are the user party of financial accounts and management accounts?

. Define “Cost Unit” with example.

3. What are the three elements of cost?

4. Define “Fixed Costs”, “Variable Cost” and “Semi-variable Cost” with example

5. Write down the components of Total Cost, Direct Cost/Prime Cost and Indire

Chapte unit cost (Part 1)

6. Write down the Advantages and Disadvantages of the FIFO Method.

. At the beginning of week 10 there were 400 units of component X held in th

On day 3 of week 10 a further 120 components were received into stores a

he only issue of component X occurred on day 4 of week 10, when 15

sing the FIFO valuation method, what was the value of the closing

8. Write down the formula of computation of “Periodic Weighted Average Pricin

hapter # 3: Calculating unit cost (Part 2)

9. How you will calculate the Absorption Cost of a product?

0. Write down the three stages in determining the share of overhead to be attri

11. The following bases of apportionment are used by a factory.

ost centre e

table with using one of A to D of the above the bases.

C

2

2

Cost/Overhead Cost. r # 2: Calculating

7

of these components had been purchased for Tk. 5.55 each in week 9 and 2purchased for Tk. 5.91 each in week 8.

cost of Tk. 5.96 each. Tissued to production. Ucomponent X at the end of week 10?

C

1

cost unit under absorption costing.

A. Volume of cost centre B. Value of machinery in cC. Number of employees in cost centrD. Floor areas of cost centre Requirement: Compute the below

Production Overheads Basis

RentHeating costsInsurance of machineryCleaning costsCanteen costs


Time: 1 Hou

2

2

2

and graph.

ct 2

2

e stores. 160

t a purchase

0 units were

inventory of

g”. 2

2

buted to a 2

2

40 had been

2+2

12. How you will calculate the predetermined overhead absorption rate? 2

Co ting (A

duct? 2

st perTk. 320, the variable labour cost per unit is Tk192 and the variable production overhead

n per unit of the electrical goods? 2

17. on Co ing”.

13. Define the four stages of calculating product cost using Activity Based s BC). 2

14. Write down the advantages of Just-In-Time (JIT) cost approach. 2

Chapter # 4: Marginal costing and absorption costing

15. How you will calculate the Marginal Cost and Contribution of a pro 16. A particular electrical goods is sold for Tk.1009.99. The variable material co unit is

cost per unit is Tk. 132. Fixed overheads per annum are Tk. 100,000 and the budgeted production level is 1,000 units. Requirement: a. What would be the contributio

What are the differences between “Marginal Costing” and “Absorpti st 2

18. The following costs card relates to one unit of Product EZ.

Costs Components Tk. Variable materials 20 Variable labor 40 Production Overheads: Variable 10 Fixed 5 Sales and distribution overheads: Variable 5 Fixed 1 0Total Cost 90

Requ

hat would be the marginal production cost of one unit of Product EZ? 2 Chapte

tween mark-up and margin? 2

nt in of its productforthcoming year Tk. 800,000 will be invested in non-current assets and working capital

What would be the mark-up percentage of full cost basis? 2 ould be the selling price of product Z? 2

21. Wh ll g prices of a product?

full cost-plus basis using a mark-up of 40 percent of full cost.

the same selling prices as s basis described? 2

23. f tran er pric g.

irement: W

r # 5: Pricing calculation

19. What are the differences be

20. XY Ltd. requires an annual return of 30% on the investme all s. In the

to produce and sell 50,000 units of product X. The full cost per unit of product Z is Tk. 100. Requirement:

a. b. What w

y you will consider “inflation” at the time of setting se in 2

22. The marginal cost per unit of a product is 70% of its full cost. Selling prices are set on a

Requirement: a. What percentage mark-up on marginal cost would produce the full cost-plu Write down the practical methods o sf in 2


Lecture # 8 – Chapter 6

Budgeting 24 February 2010

Exam Requirement:

ill be limited in scope (e.g. individual budgets). Narrative Numerical questions wquestions need to be read very carefully. Main Focus of this chapter:

Demonstrate an understanding of the e of a budgetary planning and control system

d a forecast

Pre t and balance sheet ele

s and

Book Refe

:

Objectiv Difference between a budget an Administrative process of budget preparation

pare functional budgets and the income statemenments of a master budget from data supplied.

Calculate the effect on budget outcomes of changes in specified variables.

Demonstrate an understanding of a range of budgeting approachemethods.

rence

Main Study Book1. Management Information jointly published by the Institute of Chartered

ntants of Bangladesh and the Institute of Chartered Accountants of

Reference Bo

AccouEngland and Wales. ok:

Ma

nagerial Accounting, By Garrison and Noreen, Edition # 9, Chapter # 11.

What is Bu

ric expressions prepared for the assumptions of future events, which expressed via financial statements (Profit & Loss, Balance Sheet, Cash flows

y roles. Here are some of the reasons why budgets re used:

2. Communicate ideas and plans s

sibility accounting em of control

e their performance Budgets C

ly to happen in the future, given a certain set of ircumstances. This is different from a budget, which is a quantified plan of what the

organization intends should happen in the future.

dget? Budget is the numeisStatement) and Non financial outcomes KPIs (Key Performance Indicator). Reasons for Preparing Budgets: An organization’s budget fulfills mana

1. Compel planning

3. Coordinate activitie4. Means of allocating resources 5. Authorization 6. Provide a framework for respon7. Establish a syst8. Provide a means of performance evaluation 9. Motivate employees to improv

ompared with Forecasts: A forecast is a prediction of what is likec


The budget is based on the forecast, therefore the two are connected, but they are not the same thing. Measures might be taken to ensure that budgeted targets are achieved,

us a budget forces management into decision-making and taking action. For example,

o fulfill the range of purposes for which it is prepared, a budget must be quantified. For two statements would not be particularly useful for planning and

ontrol purposes.

hesat the labour hours budget is not expressed in financial terms. It still fulfills the role of a

udget because it is quantified. Therefore a budget does not necessarily need to be

ertising’ without specifying a period over hich this amount is to be spent would render the ‘budget’ useless.

he budget committee is the coordinating body in the preparation and administration of ommittee is usually headed up by the managing director (as

hairman) who is assisted by a budget officer, who is usually the finance director or

d

Coordination and allocation of responsibility for the preparation of budgets.

Timetabling

s to the appropriate managers. budgeting process by comparing actual and budgeted results.

inimise expenditure on advertising next period."

Without quantification these are merely general statements of purpose of purpose. The following quantified budgets are more useful for planning and control.

"We plan to utilise 24,800 hours of semi-skilled labour next period.""We plan to spend Tk. 107,000 on advertising next period."

tha gap between forecast sales revenue and the sales budget could force sales promotions or an increase in advertising. Quantified Budgets: Texample, the following c

"We plan to utilise fully all the available hours of semi-skilled labour next period.""We plan to m

T e budgets provide definite plans, as well as yardstick for control purposes. Notice thbexpressed in financial terms. Of course the semi-skilled labour hours budgeted can be converted into a budget expressed in financial terms by applying a rate of pay per hour to the budgeted number of labour hours. An important feature of any quantified budget is the fact that it is time bound. Just to say, ‘We plan to spend Tk. 107,000 on advw Budget Committee: Tbudgets. The budget ccanother accountant. Every part of the organization should be represented on the committee, so there should be a representative from sales, production, marketing anso on. Functions of the Budget Committee:

Issuing of the budget manual

Provision of information to assist in the preparation of budgets. Communication of final budget Monitoring the


The Budget Period:

he budget period is the period covered by the budget, which is usually one year. be prepared and used for longer periods, for example capital

xpenditure budgets. Budgets can also be prepared for shorter periods, for example in ult

risons can be made of the actual and

udgeted results.

riods but they are not calendar months, but periods of 4, 4 and 5 eeks for each quarter of the year.

he budget manual is a collection of instructions governing the responsibilities of ures, forms and records relating to the preparation and use of

udgetary data.

a) An explanation of the objectives of the budgetary process.

c) An outline of the principal budgets and the relationship between them.

Ste

he procedures for preparing a budget will differ from organization to organization but of those followed by many organizations.

alance sheet and budgeted cash flow) is finally agreed.

), to be amended many times

s a consequence of discussions between departments, changes in market conditions

he budget for the principal budget factor must be prepared first. The principal budget ion’s activities. This factor is usually sales

emand.

ld be no sales demand for the increased output at a price that would be

THowever, budgets canean environment where technology or other factors are rapidly changing with the resthat annual budgets quickly become out of date. In the common situation where a budget is prepared for a year it will usually be dividedinto monthly control periods so that regular compab Some organizations divide the annual budget into 13 periods of four weeks. Others have 12 budget pew The Budget Manual: Tpersons and the procedb A budget manual may contain the following:

b) Organizational structure.

d) Administrative details of budget preparation. e) Procedural matters.

ps in the preparation of a Budget:

Tthe steps described below will be inactive The preparation of a budget may take weeks or months and the budget committee maymeet several times before the master budget (budgeted income statement, budgetedb Functional budgets (sales budget, production budgets, direct labour budgets and so onwhich are amalgamated into the master budget, may needaand so on during the course of budget preparation. Ideally, a master budget should be finished prior to the start of the period to which it relates. Identifying the Principal Budget Factor: Tfactor is that factor which limits an organizatd A company is usually restricted from making and selling more of its products because there wou


acceptable/profitable to the company. The principal budget factor may alternatively be s

rincipal budget factor then the production manager can only repare the production budget after the sales budget is complete.

ssuming that sales has been identified as the principal budget factor, the stages r a manufacturing business can be

ummarized as follows.

The finished goods inventory budget can be prepared at the same time. This budget decides the planned increase or decrease in finished

b.

, in effect, the sales budget in units plus (or minus) the increase (or decrease) in finished goods inventory. The production budget will be

c.

sage budget, machine usage budget and a labour budget.

d.

to decide the planned increase or decrease in the level of inventory held.

e. t are known, the purchasing department can prepare a raw materials

purchase budget in quantities and value for each type of material purchased.

f.

eir department overhead costs. Such overheads will include maintenance, stores,

g.

h. In addition, several other budgets must be prepared in order to arrive at the

on-current assets), the working capital budgets (for budgeted increases or

Prepar

unctional/department budgets include budgets for sales, production, purchases, labour n the theory of budget preparation, let us look at

machine capacity, distribution and selling resources, the availability of key raw materialor the availability of cash. Once this factor is defined then the reminder of the budgets can be prepared. For example, if sales are the pp The order of Budget Preparation: Ainvolved in the preparation of a budget fos

a. The sales budget is prepared in terms of units of product, unit selling price and total sales value.

goods inventory levels.

With the information from the sales and inventory budgets, the production budget can be prepared. This is

started in terms of units.

This leads on logically to budgeting the resources for production. This involves preparing a materials u

In addition to the material usage budget, a material inventory budget will be prepared

Once the raw materials usage requirements and the raw materials inventory budge

Similarly warehousing and distribution budgets can be prepared.

During the preparation of the sales and production budgets, the managers of the cost centres of the organization will prepare draft budgets for th

administration, selling and research and development.

From the above information a budgeted income statement can be prepared.

budgeted balance sheet. These are the capital expenditure budget (for n

decreases in the level of receivables and accounts payable as well as inventories), and a cash budget.

ing Functional Budget:

Fand administration. Having see


functional (or department) budget preparation, which is best examined by means of an example. Worked Example: Preparing a Materials Purchase Budget:

same raw materials, D nd E. One unit of S uses 3 liters of D and 4 kilograms of E. One unit of T uses 5 liters

geted sales for 2002 are 8,000 units of S and 6,000 units of T; finished goods in ventory at 1 January 2002 are 1,500 units of S and 300 units of T, and the company

t 1January nd the company plans to hold 5,000 liters and 3,500 kilograms respectively at 31

nd stores managers have suggested that a provision should be made r damages and deterioration of items held in store, as follows:

roduct T : loss of 100 units

ms

nt:

rial purchases budget for the year 2002.

osting. A standard cost is a redetermined unit cost that details the price and quantity of resources (material, labour

costs provide the basic unit rates to be used in the preparation of a umber of functional budgets. The detail standard cost also enables control to be

ances, can be analyzed in detail using the standard ost information about the price and quantity of resources that should have been used

idation of all the subsidiary budgets and normally omprises a budgeted income statement, a budgeted balance sheet and a cash budget.

ECO Co. manufactures two products, S and T, which use theaof D and 2 kilograms of E. A liter of D is expected to cost Tk. 3 and a kilogram of E Tk. 7. Budinplans to hold inventories of 600 units of each product at 31 December 2002. Inventories of raw material are 6,000 liters of D and 2,800 kilograms of E aaDecember 2002. The warehouse afo Product S : loss of 50 units PProduct D : loss of 500 litersProduct E : loss of 200 kilogra Requireme Prepare a mate The Link between Budgeting and Standard Costing: There is a link between budgeting and standard cpand so on) required for each unit of production or service. This unit cost is multiplied by the budgeted activity level to determine the budgeted total cost for each of the relevant cost elements. Thus standard nexercised over actual performance. The departures from budgets, or varicfor each unit of production or services. The Content of the Master Budget: The master budget provides a consolc Worked Example: Preparing a Budgeted Income Statement and Balance Sheet: A new business is to be started and details of budgeted transactions are as follows:


Non-current assets will be purchased for Tk. 12,000. Depreciation will be charged on a straight line basis, assuming that the assets will have a useful life

for July onwards.

and one month’s credit will be

Req

information to prepare a budgeted income statement for the six months nded 30 June and a budgeted balance sheet at that date.

ummary of all the subsidiary budgets it is likely to e of most interest to senior managers and directors who may not to be concerned with

f the budget outcomes to hanges in the budget assumptions. For example, they might like to know the answers

geted profit if sales revenue is five percent higher or lower the the budget?

than the budget? A sensitivity a alysis) might be performed to how the effect of changes such as these, and to assess the impact on critical areas

if?’ Analysis:

product. The budgeted income statement ontained in the master budget for the forthcoming year is as follows.

he directors wish to uality material is sed. This will increase material costs per unit by ten percent but sales volume will be

increased by five percent. There will be no change in the unit selling price.

of five years after which they will have no residual value. Month-end inventories will be maintained at a level sufficient to meet the forecast sales for the following month.

Forecast monthly sales are Tk. 4,000 for January to March, Tk. 5,000 for April to June and Tk. 6,000 per month

The gross profit margin is budgeted to be 20% of sales value. Two months’ credit will be allowed to customersreceived from suppliers of inventory.

Operating expenses (excluding depreciation) are budgeted to be Tk. 350 each month.

The budgeted closing cash balance as at 30 June is Tk. 16,700.

uirement: Use the above e Performing a Sensitivity Analysis: Since the master budget provides a sbthe detail of budgets outside their own areas of responsibility. Of particular interest to senior managers will be the sensitivity octo questions such as the following:

What will be the bud

What will be the total budgeted costs if direct material costs are ten percent higher or lower

nalysis (sometimes called a ‘what if?’ anssuch as cash resources. Worked Example: ‘What R Ltd manufactures and sells a singlec Particulars Tk. Tk.

Sales revenue (20,000 units) 640,000 Variable materials cost 190,000 Variable labour cost 172,000 Variable overhead 13,000 Fixed overhead 155,000

530,000 Budgeted Net Profit 110,000

T know what the budgeted profit will be if a higher qu


Assumption: The budgeted sales volume will increase to 21,000 units and, in the absence of

the contrary, we will assume there will be no changes in the total fixed verhead cost incurred and no changes in the variable labour and overhead costs per

repared the revised budgeted income statement based on the above assumption.

information to ounit. Requirement: P


Lecture # 9 – Chapter 6 (Cont’d) Budgeting

03 March 2010 Forecasting Using Historical Data:

umerous techniques have been developed for using past costs as the basis for iques range from simple arithmetic to advanced

omputer-based statistical systems. With all these techniques the important

ter are d levels of

ctivity.

linear relationship can be expressed in the form of an equation that has the general

y is the dependant variable, depending for its value on the value of x

ich the hould be multiplied to derived the value of y)

For example iftotal costs, x = level of activity, a = fixed cost and b = variable cost per unit.

he high-low method is a technique for analyzing the fixed and variable cost elements d thus predicting the cost to be incurred at any activity level

ithin the relevant range.

ecords of costs in previous periods are reviewed and the costs of the following two

he period with the highest volume of activity

The ods will be the total variable cost of t d cost is included in each total ost).

iable cost per unit may be calculated from this as (difference in total cost + ifference in activity levels).

etermined by substitution.

cost for a given activity level.

Nforecasting future values. These techncpresumption is made that the past will provide guidance to the future. The forecasting methods that we will review in this in this section of the chapbased on the assumption that a linear relationship links levels of cost ana Linear Relationships: Aform y = a + bx, where, x is the independent variable, whose value helps to determine the corresponding value of y a is a constant, a fixed amount

b is a constant, being the coefficient of x (that is, the number by whvalue of x s

there is a linear relationship between total cost and level of activity, y =

The High-Low Method: Tof a semi-variable cost anw The steps taken to prepare a forecast using the high-low method are as follows: Step 1: Rperiods are selected.

T The period with the lowest volume of activity

difference between the total cost of these two peri

he difference in activity levels (since the same fixec Step 2: The vard Step 3: The fixed cost may then be d Step 4: The linear equation y = a + bx can be used to predict the 39 Management Information, Conducted By: Md. AKH Hasif Sowdagar, BBA, MBA (DU), ACMA, ACA

Linear Regression Analysis:

inear regression analysis is a statistical technique for establishing a straight line ta. Linear regression analysis is superior to the high-

w method because it takes account of all sets of recorded data, rather than only the

remember that its use in forecasting is still based on the resumption that past events are a good guide to what will happen in the future.

orrelation between the variables.

orrelation is the degree to which one variable is related to another, i.e., the degree of ce between the variables.

he coefficient of Correlation, r

he degree of correlation between two variables can be measured using the coefficient

then the variable are uncorrelated.

he coefficient of determination, r2, is a measure of the proportion of the change in one tions in the value of the other variable.

has been argued that the participation in the budgeting process will improve budget decisions and the efforts of

dividuals to achieve their budget targets.

• Top down (imposed budget)

Imposed o :

this approach to budgeting, top management prepare a budget with little or no input d upon the employees who have to work

the budgeted figures.

Lequation to represent a set of dalohighest and lowest activity. However, even though the linear regression technique is more accurate than the high-low method, it is important top A further issue with the use of both the high-low method and linear regression analysisis that the quality or reliability of the linear equation derived will depend upon the c Correlation: Cinterdependen Measures of Correlation: T Tof correlation, r. r has a value between -1 (perfect negative correlation) and + 1 (perfect positive correlation). If r=0 The coefficient of determination, r2 Tvariable that can be explained by varia Participation in the Budgeting Process: Itmotivation and so will improve the quality ofin There are basically two ways in which a budget can be set:

• Bottom up (participatory budget)

r Top-Down Style of Budgeting

Infrom operating personnel, which is then imposeto The time when imposed budgets are effective: 40 Management Information, Conducted By: Md. AKH Hasif Sowdagar, BBA, MBA (DU), ACMA, ACA

Advantages of Imposed or Top-Down Style of Budgeting:

isadvantages of Imposed or Top-Down Style of Budgeting:

articipative or Bottom-Up Style of Budgeting:

this approach to budgeting, budget are developed by lower-level managers who then are based on the lower-level

anagers’ perceptions of what is achievable and then associated necessary resources.

isadvantages of Participative Budgets:

cremental Budgeting:

he traditional approach to budgeting is to base the forthcoming year’s budget on the fied for changes in activity levels, for example by adding an

xtra amount for estimated growth or inflation next year.

oming period.

ero based budgeting (ZBB) is an approach to budgeting that attempts to ensure that d.

repared from the very beginning or zero. Every item of

xpenditure must be justified separately to be included in the budget for the forthcoming

urces are allocated as efficiently as possible.

olling budgets are sometime called continuous budgets. They are particularly useful n is facing a period of uncertainty so that it is difficult to prepare

ccurate plans and budgets.

nd particularly with a regard to price levels, by shortcoming the period between

reparing budgets.

D P Insubmit the budgets to their superiors. The budgets m Advantages of Participative Budgets: D In Tcurrent year’s results modie This approach is known as incremental budgeting since it is concerned mainly with the increments in costs and revenues which will occur in the c Incremental budgeting is a reasonable approach if the current operations are as effective, efficient and economic as they can be. Zero Based Budgeting: Zinefficient are not conceale The principle behind ZBB is that, instead of using the current year’s results as a startingpoint, each budget should be peperiod. Increments of expenditure are compared with the expected benefits received, to ensure that reso A major disadvantage of ZBB is that it is a time-consuming task that involves a great deal of work. Rolling Budgets: Rwhen an organizatioa For example, it may be difficult to estimate the level of inflation for the forthcoming period. Rolling budgets are an attempt to prepare targets and plans that are more realistic acertain, p


Advantages of Rolling Budgets: Disadvantages of Rolling Budgets:

lternative Budget Structures:

he structure of budgets may be designed around one of a number of frameworks,

roduct based budgets are drawn up by preparing budgets for each product.

his structure is appropriate when the cost and revenue responsibilities differ for each t.

esponsibility based budget systems segregate budgeted revenues and costs into order to monitor and assess the performance of

ach part of an organization.

ctivity based budgets are based on a framework of activities, and cost drivers are used get.

A Tincluding the following: Product Based Budgets: P Tproduct, or when a single manager is responsible for all aspects of one produc Responsibility Based Budgets: Rareas of personnel responsibility ine Activity Based Budgets: Aas a basis for preparing bud Sample Question & Answer Q. Write down the two ways in which a budget can be set.

ways in which a budget can be set: • Top down (imposed budget)

Q. Exp in le of Budgeting. Ans: In t a ement prepare a budget with little or no

input from operating personnel, which is then imposed upon the employees who

Q. Ans: re developed by lower-level managers

who then submit the budgets to their superiors. The budgets are based on the then associated

Q. Ans: to budgeting is to base the forthcoming year’s budget

on the current year’s results modified for changes in activity levels, for example th or inflation next year.

Ans: There are basically two

• Bottom up (participatory budget)

la Imposed or Top-Down Styhis pproach to budgeting, top manag

have to work to the budgeted figures.

Explain Participative or Bottom-Up Style of Budgeting. In this approach to budgeting, budget a

lower-level managers’ perceptions of what is achievable andnecessary resources.

Explain Incremental budgeting approach. The traditional approach

by adding an extra amount for estimated growThis approach is known as incremental budgeting since it is concerned mainly with the increments in costs and revenues which will occur in the coming period.


Q. When Incremental budgeting is a reasonable approach? ns: Incremental budgeting is a reasonable approach if the current operations are as

effective, efficient and economic as they can be.

Ans: dgeting that attempts to ensure that inefficient are not concealed.

be prepared from the very beginning or zero. Every item of expenditure must be justified separately to be included in the

, to

as efficiently as possible.

Q. Ans: k that involves a

great deal of work.

Ans: sometime called continuous budgets. They are particularly useful when an organization is facing a period of uncertainty so that it is difficult

nd budgets. For example, it may be difficult to

Q. Ans: a number of

frameworks, including the following: Budgets

Q. ppropriate? ns: duct.

enue responsibilities differ for

product. Q. Ans: bility based budget systems segregate budgeted revenues and costs

into areas of personnel responsibility in order to monitor and assess the

Q. Ans: ork of activities, and cost drivers

are used as a basis for preparing budget.

cost driver has been established as Tk. 100. What is the budgeted cost of the ordering activity?

:

A

Q. Explain Zero Based Budgeting.

Zero based budgeting (ZBB) is an approach to bu

The principle behind ZBB is that, instead of using the current year’s results as a starting point, each budget should

budget for the forthcoming period.

Increments of expenditure are compared with the expected benefits receivedensure that resources are allocated

What is the major disadvantages of Explain Zero Based Budgeting? A major disadvantage of ZBB is that it is a time-consuming tas

Q. Explain Rolling Budgets.

Rolling budgets are

to prepare accurate plans aestimate the level of inflation for the forthcoming period.

Write down the Alternative Budget Structures. The structure of budgets may be designed around one of

1. Product Based Budgets, 2. Responsibility Based 3. Activity Based Budgets.

When Product Based Budgets is aA Product based budgets are drawn up by preparing budgets for each pro

This structure is appropriate when the cost and reveach product, or when a single manager is responsible for all aspects of one

What do you mean by the “Responsibility Based Budget”? Responsi

performance of each part of an organization.

What do you mean by the “Activity Based Budgets”? Activity based budgets are based on a framew

Q. An organization expects to place 500 orders with suppliers during the

forthcoming budget period. The rate per

Ans The budgeted cost of the ordering activity is therefore 500 x Tk. 100 = Tk. 50,000.


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