FIA MA1 2013 notes

FIA – MA1 Management Information For exams in 2013

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Notes

ExPress Notes FIA MA1 Management Information

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Contents

About ExPress Notes 3

1. The nature and purpose of cost and management accounting

7

2. Source documents and coding 14

3. Cost classification and measurement 17

4. Recording costs 24

5. Providing information 34

6. The spreadsheet system 42



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Chapter 1

The Nature and Purpose of Cost and Management Information

KEY KNOWLEDGE Business organisation and accounting systems

The business organisation and its structure Taken in its most general sense, an organization is a social arrangement which aims for collective goals; in the case of a business, this usually involves the maximization of wealth of the shareholders (owners) of the business. An organisation controls its own performance and is distinct from its environment. Benefits of an organisation include:

• shared expertise • pooling of resources



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Policies, procedures and best practices A policies and procedures manual contains a description of the practices and rules governing an organisation’s operations. In setting standards for the performance of work, it ensures consistency across the organisation. Additional benefits of such a manual, normally distributed to all employees, include the mitgation of risk to the business (and to staff) as well as compliance with external regulatory rquirements. By setting standards with reference to “best practices” – i.e. the best that the industry can demonstrate at any given moment -- the organisation is recognizing that it can only survive by doing at least as well as its competitors. Effective control over transactions Effective control over transactions means that they are initiated, executed and recorded according to pre-set policies and procedures, so that the organisation is not exposed to an unacceptable level of risk of loss. Controls exist to prevent and detect errors and fraud; for example, internal controls are processes put in place by management to help prevent things from going wrong. It is management’s responsibility for having an adequate internal control policy in place. Double-entry book-keeping Double-entry bookkeeping involves the recording of transactions in such a way that two entries are recorded, one called a debit and the other a credit. Debits mean Credits mean An increase in assets A decrease in assets A decrease in liabilities An increase in liabilities In this system, debits must equal credits.



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Ledgers and prime entry records All accounting transactions are recorded in a document called a General Ledgers.

Books of prime entry are the bridge between the raw data (e.g. receipt for cash purchase of some building materials) and the accounting system. They may be written up by the accountant, or by a semi-trained member of staff within the client’s business.

The most commonly used books of original entry are:

Book of original entry:

Used to record data on: Data typically used to feed:

Cash in book Cash received into the business bank account.

All sorts of things! Anything that may generate cash for the business.

Cash payments book

Cash paid from the business bank account. All sorts of things! Anything that results in cash being paid out of the business.

Petty cash book Cash in and out of the balance of cash held in notes and coins by the business (normally small). This is often controlled using the imprest system (see later).

Typically, small expenses (eg Friday cakes for staff!) and sundry income.

Sales day book Sales on credit. Note that sales immediately settled in cash will be recorded in either the cash book (if paid directly into the bank account) or petty cash book (if received in notes and coins).

Sales revenue.

Purchases day book

Purchases of inventory for resale on credit. Note that purchases settled immediately in cash will be recorded immediately in the cash payments book or petty cash book.

Purchases of inventory for resale.

Journal book Anything not covered by any of the other books of original entry.

Often, this is the book maintained by the accountant, in which “period 13” adjustments like depreciation and bad debts are recorded.

Books of original entry may be recorded in paper form, or using a spreadsheet.



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Integrated and interlocking accounting systems An integrated system is one in which the cost and financial accounts are maintained in the same books; In an interlocking system, cost and financial accounts are kept separately (so that a reconciliation of the two must be made) Computerised accounting systems Computerised systems are common and can be cheap. They still require rigorous systems for data capture at the point when transactions happen, as the maxim “garbage in, garbage out” very much applies! Input to a computerised system will not look like a book of original entry, but will require the same data. Software may be more user friendly, for example asking “how much cash was spent?” and “what was this for?”, whilst then offering a drop down menu of choices. The software will still prepare records using the same methodology as the manual recording systems above.

Advantages of using a computerised system include:

• Back ups can be made easily • Makes producing periodic frequent accounts much less laborious than a manual

system • Can be user-friendly • Analyses sales taxes more easily than manual systems (see later) • Can be used to quickly produce lots of reports such as VAT returns and interim

management accounts.

Disadvantages of a computerised system include:

• Cost • May not be tailored very well to the business own needs • Still requires effective data capture and maintenance of the underlying records.



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KEY KNOWLEDGE Management information

The purpose of management information

Planning: has to do with the formulation of objectives within the organization, both in the short- and long-term;

Decision-making: refers to conclusions drawn once all relevant information has been analysed. Implementation of decisions taken (i.e. the decision to take action) follows;

Control: Post-implementation, actual results are analysed in order to determine whether planning and decisions taken need to be revised or to implement corrective actions.

The control step acts as a feedback loop into the previous processes. Remember, look at theses systems dynamically: we learn from experience and need to take corrective steps and to improve processes continuously!

An important focus of management accounting is suggested by its original name, cost accounting. Knowing the costs of individual products is vital to running a business!

Comparison of cost and management accounting with external financial reporting

Principal differences between financial accounting and management accounting:

It particular, it should be noted that management accounting is:

• Aimed at internal users (as opposed to financial accounting, which is aimed at external stakeholders)



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• Focused on present and future performance (as opposed to financial accounting, which reports past performance)

• Not required by law and not regulated by accounting frameworks (as opposed to financial accounting, which is a legal requirement and is regulated by accounting frameworks)

• Focused on specific areas or activities (as opposed to financial accounting, which provides a holistic view of company’s performance)

• Employs non-financial indicators as well financial, while financial accounting uses only financial measures.

Since the management accounting system is based on (or derived from) a company’s financial accounting system, the two are usually combined (or integrated) for reasons of cost and efficiency, i.e. to avoid duplications. Distinction between data and information

Management information systems convert raw data (facts and figures) into meaningful information which can then be used by management for a variety of analyses and ultimately decisions regarding the business. Good quality information enhances the quality of decision- making. Features of useful management information.[K]

Using a well known mnemonic, information should be ACCURATE:

Accurate Complete Cost-beneficial Understandable Relevant Adaptable Timely Easy to use

Sources and categories of information: Financial and Non-financial

In addition to financial information which can be extracted from the financial accounting records, managers rely for their decision-making on a host of information that is derived



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from non-financial sources. These can range from industry data (overall size, market shares of different competitors) to customer opinions about the products and services offered.

Internal examples of non-financial information

Non-financial information can embrace a host of operational statistics which are relevant to managerial decision-making: examples include the rate of staff turnover; the time it takes to cook a hamburger (in a restaurant business); the rate of defects in a production process; the set-up time necessary between different production batch runs; or measurements of service/product quality.

Limitations of cost and management accounting information

The key to management accounting is to measure the “right” things, i.e. activities and processes that are relevant to the success of the business. Due to limitations of staff and time, it is necessary to identify and prioritize what is to be measured. Not all companies are successful in doing this and therefore squander resources measuring the wrong things! The role of information technology

Information technology has had a dramatic and far-reaching impact on the structure and conduct of business. IT has also been frequently poorly employed at great cost to companies. When implemented well, IT has made it possible for companies to exploit the benefits of increased accuracy of information and faster decision-making. Suitable formats for the presentation of management information according to purpose

Managerial accounting is a free-style form of accounting in which format and structure of information are not prescribed externally, but conform to the requirements of the users (management and staff).



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Chapter 2

Source Documents and Coding

KEY KNOWLEDGE Source documents

When a business transaction happens, it is essential that the source data is captured immediately. This does not necessarily mean immediately writing up the books, but it does involve some record being made of the transaction happening.

Materials The ordering, receiving and issuing of materials from inventory must be controlled according to procedures and documented at all stages with forms appropriate to the purpose.

The controls and procedures are designed to monitor inventory movements so as to minimise discrepancies and losses and theft.

Every company which buys, processes and sells materials will have established procedures for ordering, receiving and issuing (such materials) which are generically similar. Some may have highly automated systems in place, while others record the steps manually.



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The key documents one should be familiar with are: Purchase requisition form: This is an internal form that provides the authorization for materials to be ordered from a supplier (external). Purchase order (PO): The buyer issues a PO to the seller, indicating the

• Description • Quantity • Price

of the product ordered. The PO is a legal offer. Its acceptance by the seller creates a contractual commercial relationship for the intended transaction. Goods Received Note (GRN): This is completed by the buyer upon delivery to verify whether the order has been properly fulfilled. It will contain:

• Order No. • Description • Quantity ordered • Quantity delivered

Materials issuance (or requisition) form: This is the form necessary to authorize the release of materials from inventory into the production process at the company. Labor Labor is evidenced by work contracts. The payroll function is responsible for ensuring prompt payment of salaries and wages to employees. Documents relating to the recording of sales Sales order Records an order from a customer Goods despatched note Records that an order from a customer has been sent out Invoice A request for payment by a supplier

http://en.wikipedia.org/wiki/Vendor_(supply_chain)�

http://en.wikipedia.org/wiki/Contract�



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Credit note Acknowledgement from a supplier that the customer has overpaid and is entitled either to a refund or free goods/ services in the future Debit note To cancel a credit note that previously existed, eg if goods were ordered, paid for and then returned there would initially be a credit note. The refund made would be accompanied with a debit note Remittance advice Normally included with an invoice. A document that is included with the payment (eg if paid by cheque) with details that will allow the recipient of the funds to match the payment to the customer’s account Receipt Issued by the supplier for goods, to acknowledge payment of a debt

KEY KNOWLEDGE Coding system

Transactions in a business are more easily processed by use of a coding system. This involves assigning to a particular transation a code, i.e. a kind of symbolic label, which identifies the nature of the transaction in a systematic and unambiguous way. In doing so, this allows transactions to be grouped together in information systems, processed, added up and analyzed in a manner that permits checking and reconciliation (against original records).

The characteristics of a coding system shares some of the features of good information: it must be standardized, logical, objective, brief (i.e. capable of being summarized), verifiable, comprehensive and yet flexible (allowing development to cover all relevant situations in a relevant manner).

There are different methods by which data can be coded; these include: • sequential, • hierarchical, • block, • faceted, and • mnemonic



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Chapter 3

Cost Classification and Measurement

KEY KNOWLEDGE Cost Classification

There are a variety of ways in which one can classify costs:

Production vs. Non-Production

Production costs: These are costs (both direct and indirect, also variable and fixed) which relate to the production of goods; this is also referred to as manufacturing or factory cost. It is these costs, accumulated, which provide the value at which goods are placed in inventory (prior to sale) and form the “cost of goods” value when sold.



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Non-production costs: These are expenses that are incurred independent of production and include administrative, selling, distribution and finance costs. These costs can have the character of “period” costs, as they relate to the period of time in which they occur.

Direct vs. Indirect

Direct costs: are costs that can be directly attributable to a product.

Indirect costs: these are costs that cannot be directly attributable to a product.

Fixed vs. variable

Fixed costs: are costs that remain constant regardless of the volume of production. A variety of indirect costs are fixed.

Variable costs: vary in proportion with the volume produced. Direct costs are by their nature variable in behaviour.

Other types of costs

Mixed costs: these are costs that contain a fixed and a variable element.

Step costs: costs that remain fixed within a defined range of production, but at a certain level of output increase in a significant way to a new (fixed) level.

Direct and indirect labour Direct labour refers to work which is directly involved in the manufacture of a product. Indirect labour (e.g. the supervisor’s salary, or that of a security guard) forms part of overhead costs. It is important to note that the basic pay portion of direct labour costs is included in the prime cost of a product. Overtime premiums, bonuses, employers’ contributions, sick pay and idle time costs relating to direct workers are all accounted for as overheads (indirect costs). One exception: Overtime performed as a result of a client request is recorded as a direct labour cost. Profit statements in Absorption and Marginal costing

Example



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Below is data on a manufacturing company. Selling price (per unit): 120 Cost card (per unit): Direct materials 45 Direct labour 18 Variable production O/Hs Total variable costs 72

9

There is a variable selling cost of $2 per unit Year 1 Year 2 (units) (units) Budget (normal) production 1,100 1,100 Actual Production 1,000 1,100 Actual Sales 950 1,150 Actual fixed production O/Hs $16,500 $16,500 Actual SGA costs $ 7,000 $ 7,000

Based on the above data, a profit and loss statement for the Years 1 and 2 is prepared.

Assume that the beginning inventory is zero.

Profit/Loss (Marginal costing)

Year 1 Year 2 $ $ Sales (950/1,150 units) 114,000 138,000 Less: Variable cost of sales Opening inventory 0 3,600 Production costs:

o Variable (1,000 x $72) 72,000 (1,100 X $72) 79,200 Less: closing inventory (50 x $72) (3,600) (68,400) (82,800)

0



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Less: Variable selling costs (950 x $2) (1,150 x $2)

(1,900)

(2,300)

Contribution 43,700 52,900 Less: Fixed production O/Hs (16,500) (16,500) Less: SGA costs (7,000)

(7,000)

Profit 20,200 29,400

Inventory is valued at variable production costs.

Absorption Costing

This method argues that focusing on marginal costs is potentially misleading in the longer run because fixed production costs have also to be covered. Accounting conventions require that fixed production costs be reflected in each unit produced.

Revised cost card (Absorption costing)

Cost card (per unit): Direct materials 45 Direct labour 18 Variable production O/Hs 9 Fixed production O/Hs Total production costs 87

15

Year 1 Year 2 Profit/Loss (Absorption costing) $ $

Sales (950/1,150 units) 114,000 138,000 Less: Variable cost of sales Opening inventory 0 4,350 Production costs:

o Variable (1,000 x $72) 72,000 (1,100 X $72) 79,200



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o Fixed

(1,000 x $15) 15,000 (1,100 X $15) 16,500

Less: closing inventory (50 x $87) (4,350) 0 Over/(under) absorption 1,500 0

(84,150)

Gross Profit 29,850 37,950 (100,050)

Less: Variable selling costs (950 x $2) 1,900 (1,150 x $2) 2,300 Less: SGA costs 7,000 (8,900) 7,000 Profit 20,950 28,650

(9,300)

Inventory is valued at the full production costs.

KEY KNOWLEDGE Summary of Absorption and Marginal costing systems

Summary of Absorption costing and Marginal costing formats

Absorption Costing Marginal Costing

Revenue

Less: Cost of Sales

Variable/Fixed Variable production/ production costs non-production costs Gross profit Contribution

Less: Expenses



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Variable/Fixed Fixed production/ non-production costs non-production costs Net Profit

Reconciliation of the two methods

The different profit figures calculated under Absorption costing and Marginal costing can be reconciled thus:

The difference in profit = Net change in inventory (no. of units) X the fixed cost per unit

It follows that:

• If the level of inventory increases in a given period, then profits (for that period) under the Absorption costing system will be greater than under Marginal costing; and

• If the level of inventory decreases, then profits under the Absorption costing system will be smaller than under Marginal costing

• If the inventory level does not change, then the profit calculated under both methods will be equal.

KEY KNOWLEDGE Cost concepts and terms

Cost units: The units are the discreet items to be measured, such as packs of nails (batches) or a student.

Cost centres: Responsible for current expenses only

Revenue centres: Responsible for revenues, but not current expenses other than marketing expenses

Profit centres: Responsible for revenues and current expenses

Investment centres: Responsible for revenues, current expenses and capital expenditure

In order to competently manage his/her area of responsibility, a manager needs to have relevant information (and authority) pertaining to their job function.



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Performance measures Different measures of performance apply to the types of centre: Cost centres: Controlling costs in absolute (monetary) terms or in relation to overall business volumes achieved (revenue);

Revenue centres: Sales targets achieved (on a risk-adjusted basis);

Profit centres: Profits achieved; Profit margins (and in the case of banks, for example, profitability on a risk-adjusted basis);

Investment centres: Return on Capital Employed (ROCE); Residual Income (RI); Asset turnover (in relation to sales)



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Chapter 4

Recording Costs

KEY KNOWLEDGE Accounting for materials

Material costs can be broken down into

• Raw materials • Semi-finished goods • Finished goods

Accounting entries Materials Inventory

Debit (Dr) entries Credit (Cr) entries

= =

Increase in Decrease in



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inventory inventory

Material requirements In budgeting for the amount of materials to be purchased, a business must take into consideration the volume of sales expected, the level of finished goods required (which together determine the volume of production required) and the level of raw material required (closing balance). Methods of inventory valuation:

• FIFO (first-in-first-out); • LIFO (last-in-first-out); • Periodic; and • Weighted average

Accounting for labour costs

Labour Account Debit (Dr) entries Credit (Cr) entries

= = Labour costs incurred Transfer to P&L

Note: The transfer to the P&L takes place via the Work-In-Progress (WIP) account for direct labour costs and the production overheads account in the case of indirect labour costs. Remuneration methods There are two basic forms of remuneration:

• Time-based, and

• Output–based (e.g. piecework)

Effective incentive schemes are designed to ensure that the interests and behaviour of individual employees and groups of employees are in-line (i.e. consistent) with the company’s objectives.



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Accounting for other expenses a) Explain the process of charging indirect costs to cost centres and cost units and illustrate the process of cost apportionment for indirect costs (excluding reciprocal service) .[s] b) Explain and illustrate the process of cost absorption for indirect costs .[s] Direct and Indirect costs Traditionally, accountants maintain that costs have to be charged to whatever is being costed – the goal is ultimately to link costs to the units of product themselves:

Direct costs are not a problem as they are directly attributable to the product.

Indirect costs – in this context referred to as “overheads” -- are more difficult to link to products (e.g. a supervisor’s salary or a security guard).

KEY KNOWLEDGE Absorption costing at work

This is one method which seeks to make the link between overheads and (product) cost units. The diagram below provides a useful roadmap.

Total Production Costs

Direct Costs Indirect costs (overheads)

2. Allocate/Apportion to Cost Centres

Production A Production B Service C

1. Allocate

3. Reapportion from Service to Production Production A Production B

4. Absorb

Cost Unit



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The focus (above) is production. Overhead costs that are not incurred at the time of production do not find their way into inventory.

It is useful to think of production costs as being those that end up as part of the inventory (valuation) while other (non-production) costs are incurred outside, and normally after the product leaves inventory.

Allocation and Apportionment

Allocate, Apportion and Re-apportion indirect production costs (shown on the right side of the diagram) to cost units.

Our focus is on the first category (production); the other overhead costs are not incurred at the time of production and do not find their way into inventory. Always think of the costs going into inventory and those that occur after the product leaves inventory!

EXERCISE

A company producing refrigerators and toasters has identified the following overhead costs relating to production:

$ Rent 8,000 Indirect materials 1,500 Power 3,000 Equipment insurance 2,500 15,000 The company has 3 cost centres, 2 production workshops (A & B) and 1 warehouse (C, service centre).

1. Suggest the basis on which the costs shown above might be charged to the various cost centres.

Basis A B C

Rent 8,000 sq.m. 4000 2500 1500 Indirect materials 1,500 Specific 600 700 200 Power 3,000 kWh 1500 1000 500 Equipment 2,500 Book 1000 1400 100



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insurance value 15,000 sq.m. 7100 5600 2300

As a manager with cost centre responsibility, what could be your concerns with respect to the bases selected above?

2. Re-apportion the service centre costs to the production workshops.

Assumption: C is used by A (65%) and B (35%):

A B C

Costs apportioned to A, B, C: 7,100 5,600 2,300

Costs re-apportioned from C: 1,500 800 (2,300)

Total overheads: 8,600 6,400

3. Absorb the overheads into the units produced.

Assumption: The company absorbs overhead costs on the basis of direct labour hours

Total labour Overheads Overhead Absorption Hrs $ Rate (OAR) $ Workshop A 1,400 8,600 6.14 Workshop B 950 6,400 6.74 Each workshop uses its OAR to keep track of overhead costs as it produces. Alternatively, the company can use a “blanket” or company-wide OAR, calculated as: Total overhead costs = 15,000 Total labour hours 2,350

= 6.38

The company’s cost cards for toasters and refrigerators could look as follows:

Refrigerator (cost per unit) $

Direct materials (15kg @ $2/kg) 30.00 Direct labour (1.75hrs @ $15/hr) 26.25 Variable OHs 5.00 Fixed OHs (1.75hrs @ $6.38/hr) 11.17



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Total 72.42

Toaster (cost per unit) $

Direct materials (1kg @ $3/kg) 3.00 Direct labour (0.30hrs @ $15/hr) 4.50 Variable OHs 2.00 Fixed OHs (0.30hrs @ $6.38/hr) Total 11.41

1.91

Summary – Absorption costing

• Method of measuring the cost of products or services by including a fixed overhead “fair” share into the product manufacturing/service provision cost

• Results in reporting higher ending inventories and higher operating profits (as fixed factory overheads are taken to inventory cost instead of being expensed as incurred)

It addresses the problem of allocating factory overheads per product lines

• Step 1: Identify total factory overheads to be absorbed

• Step 2: Take the total quantity recorded for the absorption base

o The absorption base should be highly correlated with incurrence of overhead

o Most common absorption bases selected: direct labour hours, machine hours, units of output

• Step 3: Compute overhead absorption rate (OAR) as Step 1 / Step 2 ($/unit of absorption base)

• Step 4: Obtain unit overhead cost per product line, by multiplying the OAR with the absorption base quantity recorded per unit

• Step 5: For each product, multiply Step 4 by total output to determine factory overhead to absorb in the production cost.



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KEY KNOWLEDGE Job costing / Batch costing

This refers to the calculation of costs associated with a specific job or customer order. This is appropriate in situations where each product or service is distinct, and possibly unique, in its delivery. Batch costing is similar to job costing; the distinction lies in the identification of costs with specific batches, which are numbered (separately identified) for this purpose.

KEY KNOWLEDGE Process costing

Process costing is a technique that applies to the mass production of a large number of identical products, moving through a series of processing stages. The accumulated costs of production can be averaged over the number of items produced.

Illustration 1

Process B

units $

units $

Input units 1,000

20,000 Output to 1,000

30,000 from Process A

Process C

Additional:

Materials

5,000

Labour

3,000 Overheads 2,000

1,000 30,000

1,000 30,000

Avg.cost/unit: 30

The average cost is determined by the following formula:

Average cost per unit = No. of units of input – Normal loss

Total cost of inputs – Scrap value of rejected units



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The total cost of inputs refers to labour, materials and overhead costs of production. If losses occur along the way that necessitate the scrapping of defective units, then to the extent that these items fetch a scrap value, then that (scrap) value will reduce the total costs. Similarly, an accounting is made of the number of units introduced into a process with the expectation that a normal loss will be incurred. The number of good units emerging from a process will therefore be the number of units entering it, minus the expected number lost in processing. Illustration 2 Normal loss

10% of input

1,000 = 900 + 100

good NL

Avg. cost / unit 33.3

Conclusion: Average cost per unit = No. of units of input – Normal loss

Total cost of inputs

Process B

units $

units $

Input units 1,000

20,000 Output to 900


Process C

Additional:

Materials

5,000 Normal loss 100 0

Labour


1,000 30,000

1,000 30,000

Illustration 3 Scrap value

scrap/unit 5



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Avg cost/unit 32.78

Conclusion: Average cost per unit = No. of units of input – Normal loss

Total cost of inputs – Scrap value of normal loss units

Process B

units $

units $

Input units 1,000

20,000 Output to 900


Process C

Additional:

Materials

5,000 Normal loss 100 500

Labour


1,000 30,000

1,000 30,000

Equivalent units (EU) This refers to the way in which partially-completed output (“work-in-progress” or WIP) is expressed. If an unfinished unit of product contains 35% of the labour and materials costs of a complete unit, then the unit has a degree of completion of 35% in terms of value. It is therefore considered to have an EU of 35%, which is normally expressed in monetary terms. Illustration 5

Closing WIP

Assume 200 units are 100% complete with respect to materials, but 40% with respect to the conversion costs (labour + overheads)

Materials EU Conv. EU Total

Finished units 800 100% 800 100% 800 WIP units 200 100% 200 40% 80 Total units

(EU)

1000

880 Value

25,000

5000

Value/unit

25.00

5.68



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Finished units

20000

4545 24545 WIP units

5000

455 5455

25000

5000

Process B

units $

units $

Input units 1,000

20,000 Finished output 800

24,545

from Process A

to Process C Additional:

Materials

5,000 Closing WIP 200 5,455 Labour

3,000

Overheads 2,000

1,000 30,000

1,000 30,000



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Chapter 5

Providing Information

KEY KNOWLEDGE Information for comparison

The purpose of making comparisons Information is only really meaningful if it is looked at in relevant contexts and allows comparisons to be made. For example, a company with sales growth of 10% is impressive if the overall market has grown only 5%. If the growth of the market is 20%, then 10% looks modest. In analysing a company’s performance, one can use different bases of comparison:

1) Company performance with that of its competitors during the same period of time; 2) Company performance during the current period with a previous period (year,

quarter or month); 3) Company actual performance compared to its budget for the period.



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Budgeting: definition and purpose

A budget is a quantitative plan addressing the future. It is used to:

KEY KNOWLEDGE Forecasting/Budgeting

The process by which a budget is prepared can be a highly structured and even complex. It is based on the company’s strategy, a clear understanding of the company’s opportunities and capabilities, and identification of any limiting factors.

Master budget

The result of combining the budgets defined above, while ensuring consistency in assumptions made, is the company’s master budget, which sits atop a hierarchy of budgets.

Master budget

Operating Financial budgets budgets

b) Motivate Employees

b) Evaluate Performance

b) Control Activities

a) Communicate Objectives



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The master budget process features:

• Annual frequency, preferably revised on a regular basis (rolling budget) • Based on organization’s objectives, expressed in financial, quantitative and

qualitative measures

Operating budgets

These are budgets that quantify the revenues and costs relating to a company’s activities at a disaggregated level, meaning that there is direct input from department and functional levels. They require both volume (e.g. units of output, quantities, hours, etc.) and price specifications. Operating budgets are modelled on what will emerge as the company’s income statement.

Examples include:

• Sales budget

• Production budget

• Direct material usage

• Direct material purchases

• Direct labour budget

• Factory overhead budget

• Selling & distribution budget

• Administrative expenses budget

The “disaggregation” of budgets referred to above allows the practice of “responsibility” accounting. The operating budget sequence:

1. Sales budget 2. Production budget 3. Ending inventory budget 4. Direct materials budget, Direct labour budget, Factory overhead budget



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5. Cost of Sales budget 6. R&D budget, Marketing budget, Distribution budget, Customer service budget, Admin

budget 7. Pro-forma income statement

Financial budgets

The operating budgets, which cover future periods, feed into the company’s financial budgets, based on the balance sheet. These provide a “snap shot” view of the company’s assets and liabilities frozen at a moment in time.

The financial budget sequence

• Capital budget • Cash budget • Pro-forma balance-sheet and pro-forma statement of cash-flows

Principal budget factor

When a budget is prepared, management must identify any factors that will prevent the company from surpassing a certain level of activity. A bank, for example, may be constrained from developing an extensive branch network owing to the scarcity of suitably-skilled professional staff; or production may be constrained by the built capacity of the plant or by the level of demand for a company’s products. In each of these cases, there is a limiting factor at work.

Fixed vs. flexible budgets

Traditional budgets tended to be rigid, i.e. they were not subject to modification during the period to which they referred.

EXAMPLE

A producer of office equipment has a budget for the coming year:

Output: 1,000 units



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Costs: Materials 75,000 Labour 200,000 Fixed O/Hs Total 375,000

100,000

After 3 months, the company observes that sales are running ca. 20% higher than originally projected and it has therefore increased its production by a similar amount. In order to look back at what its budget would have been had the actual (higher) level of activity been anticipated, management can prepare a “flexed” budget; this is effectively a re-calibration of the original budget. It allows management to re-focus their efforts without losing time tracking “artificial” spending excesses according to the original budget.

Output: 1,200 units Costs: Materials 90,000 Labour 225,000 Fixed O/Hs Total 415,000

100,000

Prepare a flexed budget for an output level of 1,075 units.

Based on the data (below), the

• variable cost of labour is $125 per unit, and the • fixed cost of labour is $75,000

Output: 1000 1200

Mats 75,000 90,000

Labour 200,000 225,000

Fix 100,000 100,000

Total 375,000 415,000

The cost of labour at output of 1,075 units is $209,375. Variance analysis



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In the previous example, if 1,000 units are (originally) budgeted, actual output is 1,075 units, and actual labor costs are $205,000, then the following variances may be calculated with respect to labor costs:

(a) Original budget/labor costs: $200,000 Actual labor costs: $205,000 Difference: $ 5,000 (adverse)

(b) Flexed budget/labor costs: $209,375 Actual labor costs: $205,000 Difference: $ 4,375 (favorable)

Causes of variances

Material price

Favourable: Unanticipated discounts received, better purchasing/negotiation, cheaper (substandard) materials

Adverse: Price inflation, poor purchasing, better quality materials

Material usage Favourable: Better quality materials, more efficient processing Adverse: Substandard material, waste, poor quality control, theft Labour rate Favourable: Low pay rates, cheap workers Adverse: Wage inflation Labour efficiency Favourable: More efficient production, motivated/better trained workers, better materials and/or equipment



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Adverse: Poorly trained workers, deficient work organization, materials or equipment Exception reports

When transactions and processes run according to expectations, there is normally no need for management attention and intervention. This is beneficial when large numbers are involved (number of bottles filled in a bottling plant; number of credit card invoices issued in a month). In such cases, management needs to highlight exceptions to normal operations (defective bottles, or bottles dropped; number and amount of invoices not paid on time) so that corrective actions can be undertaken. Investigating variances

Variances need to be investigated when:

1. They involve a large amount of financial loss to the firm (materiality); 2. The cost of investigation does not exceed the amount that can be saved.

KEY KNOWLEDGE Reporting management information

Methods of analysing, presenting and communicating information

Information can be conveyed in a variety of ways:

• Formal reports, with tables and appendices attached; normally an “executive summary” is provided at the beginning for busy managers with short attention spans;



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• Means of transmission: The use of e-mail is increasingly dominating other ways of communication because it is efficient; printing reports, memos and letters may be considered wasteful, particularly if the item is not read;

• (On-line) databases: allowing managers to access and view information at their

discretion; this method requires that databases are organised in a purpose-driven manner and faithfully kept up to date with relevant information;

• Powerpoint presentations (favored by general managers);

• Informal: Oral reports, provided on an adhoc basis, usually to those who need to

know.



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Chapter 6

The Spreadsheet System

KEY KNOWLEDGE Use of spreadsheets

The use of spreadsheets is a basic skill that all accountants and business analysts should possess. A spreadsheet is a computer program that is organised in a tabular format. The vertical and horizontal arrangement of cells allows the input and processing of large amounts of data in a systematic way. Spreadsheets contain sophisticated formulae which can be used to operate on the data. Instead of merely adding up columns of numbers, spreadsheet formulae can handle discounting (i.e. net present value) calculations. Apart from processing a large volume of data quickly, spreadsheets permit analysis to be performed with great efficiency. Thus, if an assumption is modified, then the spreadsheet can automatically adjust all affected values (known as “what-if” analysis), meaning that the management acccountant can focus on interpeting the output.