sma study pack - apc315

Strategic ManagementAccounting (Professional)APC315Martin QuinnLecturer in AccountingDublin City University Business School

Published byThe University of Sunderland 2011 The University of Sunderland First published September 2011All rights reserved. No part of this publication may bereproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without permission of the copyright owner.While every effort has been made to ensure that references to websites are correct at time of going to press, the world wide web is a constantly changing environment and the University of Sunderland cannot accept any responsibility for any changes to addresses.The University of Sunderland acknowledges product, service and company names referred to in this publication, many of which are trade names, service marks, trademarks or registered trademarks.All materials internally quality assessed by the University of Sunderland and reviewed by academics external to the University.Instructional design and publishing project management by Wordhouse Ltd, Reading, UK.

Copyright 2011 University of SunderlandiiiContentsIntroductionviUnit 1 An introduction to strategic managementaccounting1Introduction11.1 The decision-making process21.2 Users of management accounting information41.3 The purpose of management accounting61.4 The competitive environment71.5 So what is strategic management accounting?15Self-assessment questions17Feedback on self-assessment questions18Summary19Unit 2 Relevant costs for decision making20Introduction202.1 Relevant cost212.2 Qualitative factors232.3 Relevant costs in various scenarios23Self-assessment questions36Feedback on self-assessment questions38Summary40Unit 3 Activity-based costing41Introduction413.1 Costing products and services423.2 Applying absorption costing techniques433.3 Applying ABC techniques47Self-assessment questions53Feedback on self-assessment questions55Summary58

ivCopyright 2011 University of SunderlandUnit 4 Pricing decisions60Introduction604.1 Economic theory and pricing614.2 The role of cost information in pricing decisions644.3 Short- and long-term pricing644.4 Pricing policies for new products70Self-assessment questions71Feedback on self-assessment questions73Summary77Unit 5 Budgets78Introduction785.1 Management control systems795.2 The traditional approach to budgeting825.3 Conflicting roles of budgets835.4 Administering budgets845.5 Preparing budgets855.6 Alternatives to traditional budgeting approaches995.7 Behavioural aspects of budgeting102Self-assessment questions110Feedback on self-assessment questions114Summary119Unit 6 Management control systems and performancemanagement120Introduction1206.1 Responsibility centres1216.2 Profit and investment centres1246.3 Managerial or divisional performance measures?128Self-assessment questions130Feedback on self-assessment questions131Summary133

Unit 7 Standard costing and variance analysis134Introduction1347.1 What is standard costing?1357.2 Variance analysis1397.3 Performance measures1527.4 The standard cost operating statement1547.5 Benefits and drawbacks of standard costing158Self-assessment questions159Feedback on self-assessment questions162Summary171Unit 8 Working capital management172Introduction1728.1 The meaning of working capital1738.2 The working capital cycle1758.3 The working capital components185Self-assessment questions198Feedback on self-assessment questions199Summary201Unit 9 Transfer pricing202Introduction2029.1 Transfer pricing2039.2 Transfer pricing methods2039.3 Negotiated transfer prices2079.4 International transfer pricing211Self-assessment questions217Feedback on self-assessment questions218Summary219References220Index222Copyright 2011 University of Sunderlandv

viCopyright 2011 University of SunderlandIntroductionEvery organisation, large or small, has managers. What constitutes the precise role of a manager is often up for debate, but by and large the work of managers can be classified in three categories; 1) planning, 2) directing and motivating and 3) controlling. Planning involves selecting a course of action and planning how the course of action can be achieved. Directing and motivating means enabling people to carry out the plans, and controlling implies ensuring the plan is carried out and modified according to changing circumstances.Managers need information to assist them to make decisions in all three facets of their roles outlined above. This is where management accounting comes in. The function of management accounting is to provide information to managers to help them make decisions. The management accountant may provide informa tion of a financial nature (for example, product costs) or non-financial nature (for example, number of customer complaints), or help non-accountants in the design of planning and control systems. Information provided can be highly summarised or detailed, very frequent or infrequent, highly accurate or best estimate. The one common characteristic of management accounting information is that it is primarily for internal use by managers.The information provided through management accounting can be used to make short-term and longer-term decisions. The term strategic management account ing is often used to describe that part of management accounting which is more involved with providing information for the longer-term decision making and controls of an organisation. Such decisions include planning and budgeting decisions, pricing, investment as well as designing, implementing and using management control and performance systems. This learning pack will help you to appreciate some of the basic techniques used in the realm of strategic management accounting. Units 1 to 5 introduce the basic techniques like understanding costs and cost allocations, together with planning and price setting. Units 6 and 7 address management control and performance manage - ment issues and techniques. Unit 8 looks at the management of working capital in an organisation, and finally Unit 9 addresses the somewhat complex issue of transfer pricing. Combining the learning from these units and the recommended reading from the core text, you will have a firm grasp of management accounting as used at the strategic level in organisations.How to use this packThe learning pack will take you step by step in a series of carefully planned units and provides you with learning activities and self-assessment questions to help you master the subject matter. The pack should help you organise and carry out your studies in a methodical, logical and effective way, but if you have your own study preferences you will find it a flexible resource too.Before you begin using this learning pack, make sure you are familiar with any advice provided by the University of Sunderland on such things as study skills, revision techniques or support and how to handle formal assessments.

Copyright 2011 University of SunderlandviiIf you are on a taught course, it will be up to your tutor to explain how to use the pack in conjunction with a programme of face-to-face workshops and seminars when to read the units, when to tackle the activities and questions, and so on.If you are on a self-study course, or studying independently with remote tutor support, you can use the learning pack in the following way: Scan the whole pack to get a feel for the nature and content of the subject matter. Plan your overall study schedule so that you allow enough time to complete all units well before your examinations in other words, leaving plenty of time for revision. For each unit, set aside enough time for reading the text, tackling all the learning activities and self-assessment questions and for the suggested further reading. Your tutor will advise on how they will plan activities around these materials and opportunities to network with other students.Now lets take a look at the structure and content of the individual units.Overview of the unitsThe learning pack breaks the content down into nine units, which vary from approximately eight to ten hours duration each. However, we are not advising you to study for this sort of time without a break! The units are simply a convenient way of breaking the syllabus into manageable chunks. Most people would try to study one unit a week, taking several breaks within each unit. You will quickly find out what suits you best.You will see that each unit is divided into sections. It is assumed, for the most part, that you will study the units in the order presented. What is more important is that you try to study each section of each unit in the order presented. Each unit is written on the strict assumption that you will understand the material in each section before moving to the next.Each unit begins with a brief introduction which sets out the areas of the syllabus being covered and explains, if necessary, how the unit fits in with the topics that come before and after.After the introduction there is a statement of the unit learning objectives. The objectives are designed to help you understand exactly what you should be able to do after youve studied the unit. You might find it helpful to tick them off as you progress through the unit. You will also find them useful during revision. There is one unit learning objective for each numbered section of the unit.Following this, there are prior knowledge and resources sections. These will let you know if there are any topics you need to be familiar with before tackling each particular unit, or any special resources you might need, such as calculator, graph paper or specific books.

viiiCopyright 2011 University of SunderlandThen the main part of the unit begins, with the first of the numbered main sections. At regular intervals in each unit, we have provided you with learning activities, which are designed to get you actively involved in the learning process. You should always try to complete the activities before reading on. You will learn much more effectively if you are actively involved in doing something as you study, rather than just passively reading the text in front of you. The feedback or answers to the activities are provided immediately following the activity. Do not be tempted to skip the activity.Throughout the unit key terms are highlighted in bold with the definition appearing in the margin.Each unit contains recommended reading which also appears in the margin and which refers you to relevant chapters of supporting textbooks including the core textbooks. It is essential that you do this reading, since it is not possible to put everything you need to know in a single learning pack. At level 3 of a degree, wider reading is key to developing deeper subject learning through a contemporary, contextual and critical perspective. This is important to consider when approaching the related assessment of the module.We provide a number of self-assessment questions at the end of each unit. These are to help you to decide for yourself whether or not you have achieved the learning objectives set out at the beginning of the unit. As with the activities, you should always tackle them. The feedback or answers follow immediately after at the end of the unit. If you still do not understand a topic having attempted the self-assessment question, always try to re-read the relevant passages in the textbook readings or unit, or follow the advice on further reading given. Your allocated tutor will be available to deal with questions arising from the material and will assist your study through the unit.At the end of the unit is the summary. Use it to remind yourself or check off what you have just studied, or later on during revision.Finally, where possible, we have made reference to material on the internet since this is easy to access. You may find that addresses change. This is annoying; but with a bit of effort you will be able to track the material down (nothing disappears completely from the web). And by searching you will learn even more! Good luck and enjoy it.Core textbookThe essential text is: Management Accounting for Business, Colin Drury, 4th edition, published by Cengage Learning in 2009. The main strength of this book is that it covers management accounting subject matter in a manner which conveys a reasonable level of depth, but at the same time does not over-burden the reader with complex technicalities. It is thus very suited to a more general business course at undergraduate level or to postgraduate introductory manage - ment accounting. The text supports the vast majority of units in this learning pack, the exception being Unit 8. The text includes a number of case studies, ample exercises and other assessment material and has further resources available on an accompanying website. Drury has also published two other management accounting textbooks and is one of the leading English language

Copyright 2011 University of Sunderlandixtexts in the discipline. Youll find more information and resources at .AcknowledgementsWe are grateful to the following for permission to reproduce copyrighted material:Tesco Stores Ltd, for the use of the Tesco Steering Wheel in Unit 1.The EVA symbol as used in Unit 6 is a registered trademark of Stern Stewart & Co.

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An introduction tostrategic managementaccounting

In real life, strategy is actually verystraightforward. You pick a generaldirection and implement like hell.Jack Welch (2005)IntroductionStrategic management accounting has evolved from management accounting and has come about as a direct result of the competitive environment that firms are now facing. Johnson and Kaplans 1987 publica tion, Relevance Lost, ignited a debate on the potential develop - ment of traditional management accounting, for instance, via new and advanced management accounting techniques. Johnson and Kaplan stated that almost all management accounting techniques in use at their time of writing had been in operation for over 60 years (1987: 125). They also stressed that a financial accounting mentality had for many decades persisted throughout organisations, whereby an organisations principal measurement, control and performance systems have a short-term perspective. They proposed that performance measurement should focus on both financial and non-financial aspects. However, Johnson and Kaplan observed that information systems (at that time) were incapable of delivering the envisaged and more all-encompassing performance measurement reports. Otley, in a review of the writings of Johnson and Kaplan 20 years on, described management accounting as being more innovative in the 20 years since than in the previous 50 (2008: 230). He stated that the advent of Relevance Lost subsequently ignited a debate over the relevance of management accounting, including its ability to deliver and meet the information requirements of business managers.The work of Johnson and Kaplan is one factor which prompted a move from traditional management accounting techniques under management accounting (for example, absorption costing) to new techniques under strategic management accounting (like activity-based costing and the balanced scorecard). The unit starts by looking at management account - ing in relation to the decision-making process, the users of manage ment accounting information, and the functions of traditional management accounting. It then maps the evolution of management accounting and its techniques through the competitive environment to strategic manage - ment accounting.

Unit1strategic management accountingmanagement accountingbalanced scorecard (BSC)Copyright 2011 University of Sunderland1

Strategic Management Accounting

2Copyright 2011 University of SunderlandUnit learning objectivesOn completing this unit, you should be able to:1.1 Identify and describe the elements involved in the decision-making, planning and control processes.1.2 Identify the users of management accounting information and the function of management accounting.1.3 Explain the factors that have influenced the changes in the com - petitive environment.1.4 Identify how strategic management accounting helps manage ment to manage the competitive environment.1.5 Explain what strategic management accounting is. Prior knowledgeNo prior knowledge is required for this unit, but it may be useful if you can think of some organisations you are familiar with and relate them to the material in the unit.

1.1Recommended reading: Introduction to Management Accounting in Drury (2009).The decision-making processManagement accounting information should be judged in the light of its ultimate effect on the outcome of decisions. A necessary precedent to an under - standing of management accounting is an understanding of the decision-making process. Below is a traditional decision-making diagram (Figure 1.1).

Planning processControl process4. Select alternative courses of actionSearch for alternative courses of actionGather data about alternativesCompare actual and planned outcomesRespond to divergences from plan1. Identify objectives5. Implemant the decisionsFigure 1.1: Traditional decision-making diagram.

Unit 1An introduction to strategic management accountingCopyright 2011 University of Sunderland3Explanations for the steps in the process, as shown in Figure 1.1, are:1. Identifying objectives: The first phase in the decision making, plan - ning and control process is concerned with establishing aims and objectives an organisation needs to know where it wants to go. These objectives may be: maximisation of profit maximisation of shareholders wealth satisfactory profit maximisation of sales revenue.Conflict may occur between other parties of the organisation, such as various user groups, who will undoubtedly have vested interests of a different nature compared with those, for example, of shareholders.2. Identifying strategies: This stage involves asking what strategies a company must pursue in meeting its objectives. A strategy can be considered as the matching of the capabilities of an organisation to the opportunities presented in the market, with the aim of achieving the objectives of the organisation. Formulating a strategy will involve gathering information both internally and externally to determine possible strategic options.3. Evaluating strategies: The company must review strategies which have the greatest chance of success.4. Choosing alternative courses of action and coordinating them into a long-term plan: This is the implementation of long-term plans through, for example, budgets.5. Implementing the decision: This involves taking the actual courses of action as set out in the longer-term plans and budgets, for example, cut costs by 10% or increase sales volumes by 20% in the next three years.6 and 7. Comparing actual and planned outcomes and responding to diver - gences from the original plan.Stages 6 and 7 of the process represent the firms control process. The managerial function of control consists of the measurement, reporting and subsequent correction of performance in an attempt to ensure that: (a) the firms objectives and plans are achieved, and (b) that the process is dynamic, and stresses the interdependencies between the various stages in the process. The feedback loop shown in Figure 1.1 between stages 7 and 2 indicates that the plans should be regularly reviewed, and if they are no longer attainable then alternative courses of action should be considered. The loop in Figure 1.1 stresses the corrective actions, taken so that actual outcomes conform to planned outcomes.Figure 1.1 reflects the levels of decision making made by managers. Stages 1 to 3 reflect decision making over a long-term, or strategic timeframe. Of course, strategies for the long term need to be converted to operational plans (for example, budgets), as reflected in stage 4, which may be more medium term (for example, 1 to 3 years). These operational plans support the organisational

1a1aHow would the presentation of management accounting information vary between the user groups of employees, junior/senior management and trade unions?It is likely that both employees and trade unions (as their representatives) would prefer summarised rather than detailed information, perhaps in a graphic or visual format. Senior managers also tend to want summarised information. On the other hand, junior managers are more likely to be dealing with day-to-day matters and require more detailed information. It can be argued that useful management accounting information should possess the following attributes: Relevance: the information must have an overall effect on the decision, and it must be timely. Reliability: the information must be correct and be able to be checked as correct. Comparability: the information must be able to be compared and therefore help managers evaluate the performance of the business.4Copyright 2011 University of Sunderland


strategy. In turn, decisions need to be taken on a daily basis to ensure opera - tional plans are implemented, controlled and corrected if necessary (stages 57). Such regular decisions are referred to as tactical management decisions. Thus, a link from strategic management to tactical management via operational plans should ensure organisational objectives are achieved.1.2 Users of management accounting informationUnlike users of financial accounting, those of management accounting infor - mation are internal, such as employees, trade unions or junior or senior management.A table showing the various groups and their interest in management account - ing information is shown below. As can be seen, each user group has its own information requirements. The information supplied by manage ment accounting is primarily for managers use.User groupAims/objectives/vested interests

CustomersReliability of supply of an organisations products and/or services; type of credit facilities available.

GovernmentCollection of taxes and duties; enforcement of legal requirements.

EmployeesTrade union activities; wages bargaining/settlements.

ManagementPersonal career ambitions; divorce of ownership from control; internal departmental struggles/conflicts.

Unit 1An introduction to strategic management accountingcontinued1b1a1bComparability is achieved by treating items in the same manner for management accounting purposes. Understandability: management accounts should be clear so that the management may comprehend the information. Materiality: the information provided must be important in terms of the overall decision. For example, inventory losses which amount to 10,000 might seem a material amount, but if the overall inventory value is 300m, then this is immaterial.From your knowledge of your own organisation or one with which you are familiar, identify which functions of the organisation need to receive accounting information. Give a brief example and assess which of these functions will, in particular, need to receive this information in an easily understood form.You could argue that almost any function or department of an organisation will receive accounting information. Here are some examples: Design/engineering department will receive information on costs of production or the sales price to aim for. Sales department will receive information such as customer profitability, costs of servicing customer, or product profitability. Production department will receive accounting information such as costs of production (that is, labour and material costs), costs of running a production facility or machine. Human resources department will receive data on the cost of employees (salary and additional costs). Senior management will receive reports on product/segment/region profitability.It would normally be assumed that senior management, for example, can readily understand accounting information and reports. However, other functions may be less exposed to regular accounting reports. With this in mind, accounting information should be presented as a summary or in a less detailed format and be relevant to the purpose of the department in question. Management accountants may, for example, work closely with product design engineers to design products at the lowest cost.Features of management accounting informationHaving looked at the users of management accounting information, letssummarise the key features of this information: Management accounting reports and models are used to aid managementand to record, plan and control activities.Copyright 2011 University of Sunderland5

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There is no legal requirement to prepare or disseminate management accounting information. The format of management accounting information is at management discretion. There are no strict rules that govern the way they are prepared or presented. Management accounting information can focus on specific areas of an organisations activities at the discretion of the organisations management. Management accounting information is both a historical record and a forward-looking planning tool.

1c1cAs a manager of a company you are presently considering launching a new product. What management accounting information do you require?The following accounting information might be relevant to a managerlaunching a new product or service: The intended level of return that will be required for the project to beconsidered successful. An accurate costing of the production and delivery of each unit of theproduct to the market. The capital investment that will be necessary to enable the business toproduce the product. Financial details of any other project forgone if resources are directedtowards production of this product.1.3 The purpose of management accountingDrury (2008) argues that management accounting has three key functions:1. Allocation of costs between cost of goods sold and stock for internal and external profit reporting.2. Providing relevant and important accounts information to help managers make better decisions.3. Providing information for planning, control and performance measurement, and continuous improvement.CIMAs (The Chartered Institute of Management Accountants) official termin - ology prescribes the following definition in explanation of what it perceives to be the detailed role of management accounting:Management accounting is the application of the principles of accounting and

Recommended reading: Introduction to Management Accounting in Drury (2009).

Unit 1An introduction to strategic management accountingfinancial management to create, protect, preserve and increase value for the stakeholders of for-profit and not-for-profit enterprises in the public and private sectors. It requires the identification, generation, presentation, interpretation and use of relevant information to: inform strategic decisions and formulate business strategy plan long, medium and short-run operations determine capital structure and fund that structure design reward strategies for executives and shareholders inform operational decisions control operations and ensure the efficient use of resources. measure and report financial and nonfinancial performance to management and other stakeholders safeguard tangible and intangible assets implement corporate governance procedures, risk management and internal controls. (CIMA, 2005)The next section discusses the competitive environment in which the manage - ment accountant provides information.1.4 The competitive environmentFirms have always been subjected to competition, and this competition has only become more dynamic. In particular, the following changes have occurred: (a) globalisation of world trade; (b) privatisation of government-controlled companies and deregulation in various industries; (c) changing product life cycles; (d) changing customer tastes that demand ever-improving levels of service in cost, quality, reliability, delivery and the choice of new products; and (e) the continued development of information technology and systems.As a result of these various changes new management themes have emerged which in turn have resulted in the development of strategic management accounting.Emerging management themesManagement accounting is intended to help managers make better decisions. Changes in the way managers operate means that the management accounting systems themselves require re-evaluation. Figure 1.2 illustrates some key emerging themes in management.The themes identified in Figure 1.2 are expanded upon below: Innovation: companies must pursue a policy of innovation in their product so as to create and maintain success. Continuous improvement: this involves a process of the company continually seeking to reduce costs, eliminate waste and improve quality so as to eventually lead to an increase in customer satisfaction.Copyright 2011 University of Sunderland7

Strategic Management AccountingKey success factors Cost, Time, Quality, InnovationTotal Value Chain AnalysisCUSTOMER SATISFACTIONContinuous ImprovementDualExternal/Internal Focus8Copyright 2011 University of SunderlandFigure 1.2: Some key management themes. Benchmarking: this means comparing performance to taken-for-granted or best-practice performance in the same or another industry. Benchmarks on cost revenues, quality or time are quite common. Employee empowerment: employees have been provided with information so as to enable them to make continuous improvement to the output process.

value chainThe value chainThe term value chain was first used by Michael Porter (1985). Coordinating the individual parts of the value chain together to work as a team creates the conditions to improve customer satisfaction, particularly in terms of cost efficiency, quality and delivery. It is also appropriate to view the value chain from the customers perspective, with each link, if each link in the value chain is designed to meet the needs of its customers.The aim is to manage the linkages in the value chain better than competitors and thus create a competitive advantage.Primary activities: Inbound logistics: receiving goods from suppliers, and storing and handling them until they are required. Operations: production (may be many departments). Outbound logistics: storage and distribution of the finished product to customers. Marketing and sales: determining what customers want, advertising products and selling them. Service: product and customer support.

Unit 1An introduction to strategic management accountingSecondary activities: Procurement, that is, obtaining resources (materials, finance, and so on). Technology development, that is, research and development (R&D). Human resource management, such as recruitment, training budget, and so on. The firm infrastructures, such as planning and control, and accounting.Key questions for assessing strengths and weaknesses in the value chain and value system are: Where is value added? How effective are the links between primary activities? How effective are the links between secondary activities? How effective are the links between primary and secondary activities?Businesses can rarely produce without relying on other businesses to provide inputs, and/or distribute the product to the end-consumer.

Support activitiesFigure 1.3 shows a diagram of a value chain.Firm infrastructureHuman resource managementProcurementInbound logisticsOperationsOutbound and salesMarketing and salesTechnology developmentServicesPrimary activitiesFigure 1.3: A value chain.Over time, new management themes will emerge. If management accountants are to remain useful to managers they must keep abreast of changes in manage - ment and respond accordingly. One area presently drawing attention is the relevance of traditional management accounting techniques to companies like Google and Facebook, who dont offer products for sale in a traditional sense (see Bromwich and Bhimani, 2010).Copyright 2011 University of Sunderland9


1d1dInformation systems have, to an extent, taken away the day-to-day transaction processing work of management accountants. Enterprise resource planning (ERP) systems such as SAP (a market leader in ERP software) can provide many and varied reports and even incorporate newer management accounting techniques like activity-based costing/budgeting and balanced scorecards (see later in this unit). This means the role of the management accountant is more of an information analyst/business advisor than a traditional bean-counting role.How do you think improved information systems have affected the work of management accountants?

10Copyright 2011 University of SunderlandHow has management accounting responded to the changes in business operations?To answer this question, management accounting has responded by introducing new techniques that tend to fall under the umbrella of strategic managementaccounting. Some of the newer techniques are: activity-based techniques customer account profitability life cycle costing target costing variance/performance measurement balanced scorecard benchmarking just-in-time backflush costing.Please note that some of these areas will be discussed further later in the learning pack and you may like to return to this section when you have completed the final unit.A brief review of some of the current techniques and their relevance to the business environmentTraditional overhead apportionmentTraditional overhead apportionment and absorption methods were developed around the time of the Industrial Revolution when organisations were trying to determine the cost of their industrial production. Production processes at the time were labour intensive, had a low level of overheads compared to direct costs, and were relatively non-competitive.

Unit 1An introduction to strategic management accountingThe characteristics of the modern production environment however are quite different. They are capital intensive in a machine-paced environment. They have a higher level of overheads compared to direct costs, and compete in a highly competitive global market.Due to the change in the environment, traditional methods have been criticised as not producing useful or accurate information for decision making.

Activity-based costing (ABC)

Recommended reading: Innes etal (2000).The inadequacy of traditional absorption costing as practised in the UK and the USA has been known for several years and was the first area to undergo radical reform. In 1988, Cooper and Kaplan proposed a more refined approach for assigning overheads to products and computing product costs activity-based costing (ABC). It is claimed that ABC provides product cost information that is useful for decision-making purposes.A study by Innes et al (2000) reported that 25% of respondents had imple - mented, or were in the process of implementing, ABC. ABC emphasises the need to obtain a better understanding of the behaviour of overhead costs and ascertains what causes these costs and how they relate to products.ABC causes a change in the product costing of high volume and low volume products. This is because traditional overhead allocation methods use volume-related measures (for example, machine hours) to apportion overheads to products. In reality, many overheads are not volume related for example setup costs and ordering costs.It has been argued that ABC tries to improve on traditional costing techniques by looking for better methods of overhead allocation. But to say that it produces an accurate product cost and that this can be used for pricing and strategic purposes is an oversimplification of business issues and may result in poor management decisions. It can be argued that it is this process of ABC that forces managers to understand cost drivers and thereby manage them better.Others have argued that ABC is time-consuming and expensive to apply, and not justified by the possible improvement in the quality of information. Innes et al (2000), for example, mention that the poor uptake of ABC by British companies can be attributed more to design, implementation and change issues, rather than to the technique itself.Budgeting

Recommended reading: Hope andFraser (2003).The majority of organisations still rely heavily on traditional incremental budgeting. Other traditional methods used include zero-base budgeting, flexible budgeting, probabilistic budgeting, and so on.The process of ABC can offer a better understanding of the behaviour of costs it is now realised that most costs are not fixed in the long term and fluctuate in relation to an activity (see Unit 3 for further detail). Activity-based budgeting may address this issue. The Swedish bank Handelsbanken scrapped its formal process of budgeting in the 1970s and went on to expand and perform successfully. Not many accountants appear to have been prepared to accept

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this view probably due to the time and effort already invested in the budgeting process. However, during the 1990s a number of Swedish companies (IKEA, Volvo, Scania) followed Handelbankens lead. IKEA has since effectively abolished all control of its managers and now sets managers a ratio of profit to sales, which they must meet in any way they see fit. Outside of Scandinavia, Philips, UBS and Siemens are other examples (Hope and Fraser, 2001). Operating without a traditional budget is often referred to as the Beyond Budgeting debate. Organisations like the Beyond Budgeting Roundtable (BBRT) promote this approach to performance management.Performance managementThe effect of advanced manufacturing technology is that a greater emphasis is placed on automation and much less emphasis on direct labour. Traditional direct labour efficiency variances are therefore of limited use. The overhead absorption rates on which overhead variances are based are also traditionally calculated using direct labour hours. This becomes meaningless when labour hours are an insignificant part of the operation.Another criticism of traditional variance analysis is the timing. Standards are set some time prior to the beginning of the budget period. In a dynamic business these standards may have become outdated by the start of the budget period and as a consequence incorrect variances may be reported and decisions made on these. Planning and operational variances take care of this criticism.Return on investment (ROI) is a popular method of measuring the performance of a division/investment centre. It is seen as a ratio that is easily understood by managers. It is a relative measure (unlike residual income) which makes comparison of divisions easier.However, in an inflationary situation ROI overestimates the rate of return as it not only overstates profits but also understates the capital employed. ROI also discourages investment in new plants and processes, as this would lower the value of the ratio.Managers tend to reject investments with a relatively low ROI even when the return is greater than the cost of capital invested in the division. This leads to sub-optimisation, which may not be in the interest of the group as a whole.Traditional performance measurement relies heavily on internally set financial measures such as ratio analysis, variances, meeting of targets and budgets. For a business to have sustained competitive advantage it has to be responsive to its customers, produce a quality product/service, and be flexible, innovative and competitive. Financial measures alone are insufficient measure of an organisations progress in these areas.Both financial and non-financial measures are required to give a complete appraisal of an organisations performance. The balanced scorecard is largely a non-financial performance measurement system which overcomes issues of using solely financial measures.

Unit 1An introduction to strategic management accountingFinancialTo succeed financially, how should we appear to our shareholders?InitiativesInitiathTargetsMeasuresMeasuresTargetsObjectivesVision and StrategyThe balanced scorecard (BSC)The need to integrate financial and non-financial measures of performance, and to identify key performance measures that link measurements to strategy, led to the emergence of the BSC, first mentioned by Kaplan and Norton in the 1990s. This is an integrated set-up performance measure derived from the companys strategy that gives top management a fast but comprehensive view of the organisational unit.

Recommended reading: Kaplan and Norton (1993,1994).

The BSC philosophy assumes that an organisations vision and strategy is best achieved when the organisations performance is viewed from the following four perspectives:1. customer2. internal business process3. learning and growth4. financial.Figure 1.4 shows the BSC in visual form.

CustomerTo achieve our vision, how should we appear to our customers?InitiativesInitiathTargetsMeasuresMeasuresTargetsObjectivesInternal Business ProcessesTo satisfy our shareholders and customers, what businessprocesses must we excel at?ObjectivesMeasuresMeasuresTargetsTargetsInitiativesInitiathLearning and GrowthTo achieve ourvision, how should we sustain our ability to change and improve? ObjectivesObjectives MeasuresMeasuresMeasuresTargetsInitiativesInitiath T tTargets

Copyright 2011 University of Sunderland13Adapted from Robert S. Kaplan and David P. Norton, Using the Balanced Scorecard as a Strategic Management System, Harvard Business Review (JanuaryFebruary 1996): 76.Figure 1.4: Kaplan and Nortons balanced scorecard.


14Copyright 2011 University of Sunderland1e1eThe general idea of a balanced scorecard can be adopted to suit the needs of an organisation. For example, if you searched online for Tesco Steering Wheel, you would have seen that their four perspectives are customer,operations, finance and people. Each perspective is sub-divided into several segments. Figure 1.5 shows the Steering Wheel with some of the objectives listed.Do you think the four performance perspectives of Kaplan and Nortons BSC are suitable for all organisations? Run an online search for the Tesco Steering Wheel to help you with this activity.Figure 1.5: The Tesco Steering Wheel.Drury (2009: 383) has argued that the benefits of the BSC approach are that it: brings together, in a single report, different perspectives on a company performance provides a comprehensive framework for translating a companys strategic goals into a coherent set of performance measures by developing the major goals for the perspectives and then translating these goals into specific performance measures helps managers to consider all important operational measures together improves communications within the organisation and prompts the active formulation and implementation of organised strategy.The limitations of the BSC approach also include the following: Is there really a cause-and-effect relationship between the various com - ponents? There needs to be some actual coherence between the metrics used in each of the four perspectives of the BSC. Is it simply a list of metrics with no guidance or bottom-line score?

Unit 1An introduction to strategic management accountingCopyright 2011 University of Sunderland151.5 So what is strategic management accounting?

Recommended reading: Strategic performance management in Drury (2009) Drury (2009) argues that strategic management accounting has several strands.These include: The extension of traditional management accountings internal focus to include external information about competitors. The relationship between the strategic position chosen by a firm and the expected emphasis on management accounting (that is, accounting in relation to strategic positioning). Gaining competitive advantage by analysing ways to decrease costs and/or enhance the differentiation of a firms products, through exploiting links in the value chain and optimising cost drivers.CIMAs official terminology (2005) defines strategic management accounting as a form of management accounting in which emphasis is placed on information which relates to factors external to the firm, as well as non-financial infor mation and internally generated information. Therefore, strategic manage ment accounting aims to provide relevant information to an organisa tions manage ment to enable them to make strategic plans and decisions. The emphasis is on external informa - tion on competitors, customers, market, environment, and so on.

Organisations cannot rely on financial information alone non-financial infor - ma tion plays an important part. It can be argued that strategic management accounting has a positive role of supporting the financial needs of management in their task of directing and controlling the business in the best interest of its owners and other stakeholders.The table below summarises the main differences between traditional manage - ment accounting and strategic management accounting:Traditional managementStrategic management

accountingaccounting

FocusMainly internalMainly external

Reporting unitEntire organisationMore focused on business units

Profitability and cost analysisIndividual products or servicesProducts and services, but also customers, market segments, regions

Cost allocation and analysisCosts assumed as mainly volume based and focused within the organisationMultiple drivers of costs assumed; longer-term cost focus; costs along value chain

Performance appraisalShorter-term profit basedMulti-dimension appraisal

OwnershipTypically accountants onlyBroader management and organisational ownership


1f1fFor an organisation with which you are familiar, identify the range of financial and non-financial information that would be required as part of strategic management accounting, and identify the sources of the different information streams.Your answer will depend on the organisation you selected. Remember that non-financial information may exist inside and outside an organisation, soyou might have to look to information sources such as: internal quality information customer satisfaction industry benchmarks or standards operations information technology/systems suitability management and financial accounting systems external competitors (for example, on prices and/or products) general economic statistics industry averages or benchmarks analyst reports social and environmental responsibility.

16Copyright 2011 University of SunderlandThe strategic management accounting systemThe following are critical factors that need to be considered/addressed when designing a strategic management accounting system (that is, a system to provide management accounting information that supports strategic decision making): Aiding strategic decisions: two types of information are required: One-off information to support and evaluate particular strategic decisions. Information to monitor strategies and the firms overall competitive position. Closing the communication gap between managers and accountants: financial data is off-putting to most people. Avoid technical jargon. Provide relevant information only in a user-friendly format. Identifying the type of decision: despite strategic decisions being one-off decisions, most strategic decisions fall into one of three main types: Changing the balance of resource allocation. Entering a new business area. Exit decisions either closing down or selling part of the business as an ongoing concern.

Unit 1An introduction to strategic management accounting Offering appropriate financial indicators but these alone are not sufficient. For example, customers drive a business and competitors are the greatest threat to a business. Monitoring key performance variables on these two stakeholders is crucial to the success of an organisation. Distinguishing between economic and managerial performance, between controllable and non-controllable costs, and charging only controllable costs when measuring managerial performance. Providing relevant information: use management by exception principle. Only include relevant costs in financial statements. Each report should be tailored to its recipient/requirement. Separating committed from discretionary costs. Distinguishing discretionary from engineered costs. Using standard costs strategically: engineered standard costs can be useful for control purposes. Standard costs are a useful way of analysing the cost structure of the business, particularly in trying to understand the impact of changes in cost structure in relation to competitor costs. Allowing for changes over time: strategic objectives can change over time. Relationships between input and output can change as manufacturing technology changes. Information system should be flexible to cope with such changes.It is vital for the strategic management accounting system to use a range of internal and external sources to gather both financial and non-financial information to aid strategic decisions and planning.Self-assessment questions1.1 Describe what is meant by the following: continuous improvement benchmarking employee empowerment.1.2 What are the four main areas on which Kaplan and Nortons balanced scorecard is based?1.3 Put the following steps of the planning and control cycle into the correct order: evaluate strategies feedback from implementation implement the long-term plan identify objectives choose alternative courses of action identify potential strategies.1.4 What are the main differences between management accounting and financial accounting?1.5 Thinking about low-cost airlines like Ryanair and easyJet, and the dynamic business environment they operate in, what kind of management accounting information might they use?Copyright 2011 University of Sunderland17



1.6 Define strategic management accounting in your own words. 1.7 How can management accounting have a strategic focus?Feedback on self-assessment questions1.1 Continuous improvement is an ongoing process to reduce costs, eliminate waste and improve the quality and performance of activities that increase the customer value of the sales factor. Benchmarking is a continuous measuring of a firms products, services or activities against best performances, either internal or external to the firm. Employee empowerment is the process of giving employees relevant information so that they will be able to react faster to customers, increase process flexibility, reduce cycle time and improve morale.1.2 The four main areas in Kaplan and Nortons balanced scorecard are: Finance: targets for measures such as return on capital employed will be stated. Customer: the market/customer that the business will aim for is estab - lished, as are its targets for such things. Internal business process perspective: an organisation must strive to excel in regard to its internal operations management to ensure maxi - mum efficiency and effectiveness. Learning and growth perspective: this perspective should be forward looking, preparing the organisation and its members for the future, rather than just the present, challenges and opportunities.1.3 The correct order of the planning and control cycle is: identify objectives identify potential strategies evaluate strategies choose alternative courses of action implement the long-term plan feedback from implementation.It must be recognised that to be strategically effective the development of an ongoing strategic plan requires a logical and structured approach where each of the above steps interconnect and support each other. Ongoing planning and control requires that the above is operated as a constant cycle with no end point.

Management accountingFinancial accountingFocusExternal legal requirementsInternal costs, benefits, evaluationAccuracyBusiness focusPreciseBusiness sectorsEstimations, less preciseIndividual products, processes, markets1.4 The differences between management and financial accounting

Unit 1An introduction to strategic management accountingManagement accountingFinancial accountingIFRS, FRSRegulationNo regulationTimelineReportingPast, historicAnnualForward lookingAnnual, monthly, weekly, daily, and so on1.5 Low-cost airlines like Ryanair and easyJet keep tight control of costs and want regular reports on underlying running costs. In fact, low-cost airlines try to standardise as much as possible to reduce costs, for example, using one aircraft type means holding one set of spare parts. Information on revenue is also of crucial importance. Complex yield management systems are in place to ensure revenue per flight is maximised. Regular reports on flight load factors (that is, percentage of seats sold) would be a vital piece of information for a low-cost airlines management.1.6 Strategic management accounting provides information to support strate - gic decisions in organisations. This involves alignment with the objectives detailed by Drury (2009) and CIMA (2005) as noted in this unit, and is carried out via concepts, models and techniques as detailed in the brief review of current techniques and throughout the subsequent chapters.1.7 The objective of strategic management accounting is to provide informa - tion to managers that will help them run their business in a way to achieve their strategic objectives. Traditional management accounting is not necessarily so much different, but lacks the clear focus on the achievement of strategic objectives. Given its focus, strategic management accounting necessarily needs to be more outward looking and more competitive. It must also monitor a firms strategies and be concerned with these to find a successful conclusion.SummaryIn this unit, the basic concepts of how management accounting can assist the strategic decision making in an organisation have been introduced. You now have a good appreciation of the reasons why managers need accounting information to help guide an organisation and you have seen some examples of techniques often used. In later units you will learn more on some of these topics, but for now the key points you need to take from this unit are: the decision-making process the user of management accounting information and the function of management accountants the competitive nature of the business environment the evolution of new management techniques to respond to the strategic and competitive challenges of organisations.Copyright 2011 University of Sunderland19

Relevant costs fordecision making

The only relevant test of the validity ofa hypothesis is comparison of predictionwith experience.

Unit 21relevant cost20Copyright 2011 University of SunderlandMilton Friedman, EconomistIntroductionIn decision making not all costs are relevant. This unit argues that it is the future cost (that is, the relevant cost) that needs to be considered when decision making. The past can be responded to through our future actions but it cannot in itself be changed. As such, past costs can provide useful information but it is the future, as yet uncommitted, costs that are relevant as these are controllable. That which we cannot control may inform our decision making by making us aware of the environment in which we exist but the decisions that managers make must focus on the controllable to be relevant. To this end, a variety of scenarios are pre - sented in the unit, as well as the important qualitative factors.Unit learning objectivesOn completing this unit, you should be able to:2.1 Distinguish between relevant and irrelevant costs and revenues. 2.2 Explain the importance of qualitative factors in relevant costs.2.3 Apply relevant costs in various situations, such as: direct costs (for example, material and labour costs) plant and equipment limiting factors outsource or in-house continue or discontinue accept or reject special orders.Prior knowledgeThis unit requires no prior knowledge, but you may find it useful to read the earlier pages of An introduction to cost terms and concepts in Drury (2009).

Unit 2Relevant costs for decision making2.1Recommended reading: An introduction to cost terms and concepts in Drury (2009.21Copyright 2011 University of Sunderlandsunk costMuch will depend upon the circumstances in the decision as to whether a cost is relevant or irrelevant.Julian Ltd was making a machine to order for a customer, but the customer2ahas decided it does not want the machine any more. There may be subsequent legal remedies which have not been considered yet. Costs incurred to date are 60,000. Fortunately, the sales department has found another company willing to buy the machine for 40,000 once it has been completed. To complete the work, the following costs would be incurred:(a) Materials: these have already been bought at a cost of 7,000. They have no other use, and if the machine is not finished, they will be sold for scrap for 3,000.Relevant costOne of the main problems facing organisations is how to identify and evaluate the relevant costs and benefits resulting from alternatives. These must be those that are affected by the decision. Other non-relevant costs and benefits should therefore be ignored. The first principle is therefore: Only future costs are relevant.Past or committed costs do not affect the decision. This concept is often difficult to grasp as human nature dictates to us that we should attempt to recover past costs. This is particularly relevant where someone has purchased an asset in the past. Note, however, that this principle is not saying that all future costs are relevant, which is conveyed in the second principle: Only those costs which differ between the available alternatives are relevant.Hence, if you are attempting to decide which is the cheapest to run between two similar cars, you could ignore motor tax and insurance as these will be incurred even if you never drive the car. The third principle is thus: Only cash costs are included.

avoidable costopportunity costvariable costincremental costfixed costDepreciation should be ignored as it is only a book-keeping entry and an accountants attempt to find the value of an asset in the future. It does not represent the cash paid or received for an asset. There are some additional terms which you may have come across before, which are useful in discussions of relevant costs: Avoidable costs: costs that would not occur if the activity they are related to did not occur. Opportunity costs: the benefit which could have been earned, but which was given up, by choosing one option instead of another. Variable costs will usually be relevant costs. Incremental costs: an additional cost incurred as a result of choosing a particular course of action.Irrelevant costs are therefore: Fixed costs: unless directly attributable fixed costs. Depreciation. Any sunk cost (a cost that has already been incurred).

Strategic Management Accountingcontinued2a2a(d) The company has general overheads of 9,000.What you need to determine are the relevant costs/revenues and whether the new customer offer should be accepted. Try to determine whether each of points a to d are relevant or not, and then bring all relevant costs together with the revenue to see if a gain or loss occurs.Further labour costs to complete the machine would be 9,000. Labour is in short supply and if the machine is not finished, the work force will be switched to another job, which will earn 20,000 in revenue, and incur direct costs of 13,000 and an absorbed (fixed) overhead of 8,000.There are consultancy fees of 5,000 if the job is to be completed. If the machine is not completed, the consultants contract will be cancelled at a cost of 1,000.Note: The costs of 60,000 were incurred in the past and are not relevant because they will not affect a decision.7,000, the price paid in the past for the materials, is irrelevant. 3,000 is the opportunity cost of the revenue from scrap, which would be forgone, and is therefore relevant.4,000 is an incremental cost. That is, the incremental cost of consultancy from completing the work is the difference between the cost of completing the work and the cost of cancelling the contract (5,000 1,000 = 4,000).General overheads are irrelevant. Therefore the relevant costs are:Revenue from completing work40,000Relevant costsLabour: opportunity costs7,000Materials: opportunity costs3,000Labour: basic pay9,000Incremental cost of consultant4,00023,000Gain from special order17,000The absorbed overhead is not relevantOpportunity costs: contribution forgoneby losing other workRelevant cost of labourLabour costs required to complete work7,000(20,00013,000)16,0009,00022Copyright 2011 University of Sunderland

Unit 2Relevant costs for decision making2.2 Qualitative factors

Recommended reading: Measuring relevant costs and revenues for decision making in Drury (2009).Qualitative factors are those that cannot be expressed in monetary terms yet are important to a final decision. An example would be a decline in employee morale resulting from redundancies, which in turn arose from a closure. It is essential that qualitative factors be brought to the attention of a management team during the decision-making process, otherwise there may be a danger that a wrong decision will be made. For example, the cost of manufacturing a component internally may be more expensive than purchasing from an outside supplier. However, the decision to purchase from an outside supplier could result in the closing down of the companys facilities for manufacturing the component. Some of the examples that follow will consider qualitative factors.

Copyright 2011 University of Sunderland232.3 Relevant costs in various scenariosRelevant costs for materialsRule: The relevant cost is the current replacement cost, assuming materials will be re-purchased. However, if the materials have already been purchased then the relevant cost is the higher of: the alternative use value, or the current resale value.Work through the following examples:Material IA job requires Material I. The job requires 2,000 units. There are no stocks of Material I, nor is there a book value or realisable value for the material. Material I has, however, a replacement cost of 8 per unit. This material will be used regularly by the company.Answer: The relevant cost is 16,000. Each unit costs 8, so 2,000 8 = 16,000.Material JA job requires 1,500 units of Material J. There are 900 units in stock. The book value of the material is 3 per unit, the realisable value is 3.50 and its replacement cost is 7. If used, Material J would need to be replaced. What is the relevant cost?Answer: Material J is used regularly by the company. There is existing stock (900 units) but if this is used on the contract under review a further 900 units would have to be bought to replace the stock. The relevant cost is 10,500: 1,500 units at the replacement cost of 7 per unit = 10,500.Material KA job requires 1,500 units of Material K. Already in stock are 800 units, as a result of overbuying. These 800 units will not need to be replaced. Material K has a book value of 4, a realisable value of 2.55 and a replacement cost of 6 per unit. Material K has no other use. What is the relevant cost?Answer: If the existing 800 units are used for the contract, a further 700 units must be bought at 6 each. If the existing stock of 800 (which will not be replaced) were used for the contract, they could not be sold at 2.55 each. The realisable value of these 800 units is an opportunity cost of sales revenue forgone, thus (700 6) + (800 2.55) = 6,240.



Material MA job requires 100 units of Material M. There are 100 units already in stock as a result of overbuying. If used, the existing stock will not be replaced. The book value of Material M is 5 per unit, the realisable value is 7 per unit and its replacement cost is 4. Material M could be used in another job as a substitute for 200 units of Material Z. Material Z currently costs 8 per unit. There is no stock of Material Z. What is the relevant cost?Answer: The required units of Material M are already in stock and will not be replaced. There is an opportunity cost of using M in the contract because there are alternative opportunities either to sell the existing stock for 7 per unit (700) or to avoid other purchases (of Material Z) which would cost 200 8 = 1,600. Since substitution for Z is more beneficial, 1,600 is the opportunity cost.

2bFrancis Ltd regularly uses Material X and currently has 600 kg in stock, for2bwhich it paid 1,600 two weeks ago. If this were to be sold as raw material it could be sold today for 2 per kg. You are aware that the material can be bought on the open market for 4.25 per kg but it must be purchased in quantities of 1000 kg.The material is in regular use and if used will have to be replaced at a cost of 2,550 (600 x 4.25). Therefore, the relevant cost is 2,550.Determine the relevant cost of 600 kg of Material X.Relevant costs for plant and equipmentThe following are irrelevant: The purchase price of the plant and equipment, as it is a sunk cost. Depreciation is only a book entry there is no movement of cash. The relevant costs will therefore be incremental costs.ExampleA machine which originally cost 13,000 has an estimated life of 10 years and is depreciated at a rate of 1,300 a year. The machine has been unused for the last 5 years. James, a young whiz-kid in the sales department, has now won a special order which requires the use of the machine. The current net realisable value of the machine is 9,000. If it is used for the job, its value is expected to fall to 8,500. The net book value of the machine is 6,000.Calculate the relevant cost of using the machine for the order.Answer: Loss in net realisable value of the machine by using it on the order is: (9,000 8,500) = 500.

Unit 2Relevant costs for decision makingLimiting factors

limiting factorA limiting factor is a scarce resource which limits the company from maxi - mising its profit: it could be sales, materials or labour. Profits are maximised when contribution is maximised per limiting factor. The calculation involves the determination of the contribution for each product per unit of limiting factor and then determining the production mix.ExampleSamuel Ltd makes two products, the Ace and the King. Variable costs are as follows:

AceKing

Direct materials24

Direct labour (3 per hour)63

Variable overhead22

Total109

The sales price per unit is 20 for Ace and 15 for King. During August the available direct labour is limited to 8,000 hours. Sales demand in August is expected to be 3,000 units for Ace, and 5,000 units for King.Determine the profit-maximising production levels, assuming that monthly fixed costs are 25,000 and that opening stocks of finished goods and work in progress are nil. The calculation involves three steps:Answer:Step 1 Confirm what the limiting factor is:

AceKing

Total

Labour hours per unit2 hours1 hour

Sales demand3,000 units5,000 units

Labour hours needed6,000 hours5,000 hours11,000 hours

Less labour hours available8,000 hours

Shortfall3,000 hours

Direct labour is the limiting factor on production.Step 2 Calculate the contribution earned by each product per unit of scarce resource:

KingAce

Sales price2015

Variable cost109

Unit contribution106

Labour hours per unit2 hours1 hour

Contribution per labour hour (= unit of limiting factor)56

Rank (that is, produce in this order)(2)(1)


2cwhich are given below:ABC Ltd manufactures three products, the selling price and cost details ofSelling price per unit85105105Direct materials (5/kg)10515Direct labour (4/hour)152319Variable overhead91311Fixed overhead243630In a period when direct materials are restricted in supply, calculate the contribution per limiting factor and rank the products according to contribution per limiting factor.Product PProduct QProduct R26Copyright 2011 University of SunderlandStrategic Management AccountingAlthough Ace has a higher unit contribution than King, it is more profitable to make King because labour is in short supply.Step 3 Work out the budgeted production and sales. Sufficient King will be made to meet the full sales demand, and the remaining labour hours available will then be used to make Ace:RankProductHoursHoursTotal contributionrequired

1King5,0005,00030,000(6 5,000 hours)

2Ace6,0003,00015,000

(balancing((5 ,3000 hours)

hours)3,000/6,000 hrs)

Total available11,0008,00045,000

Less fixed cost25,000

Profit20,000

Thus, King should be produced first as it maximises contribution per limiting factor. The balance is the amount of Ace produced. Given that there are only 8,000 hours available, the balance is 3,000.

Unit 2Relevant costs for decision makingProduct RProduct P2cProduct QSelling price per unit85105105Direct materials (5/kg)10515Direct labour152319Variable overhead91311Total variable cost per unit344145Contribution per unit516460Materials kg per unit2 (10/5)1 (5/5)3 (15/5)Contribution per kg25.56420Rank(2)(1)(3)James Ltd makes two products, A and B, for which there is unlimited2ddemand at the budgeted selling prices. A takes 3 hours to make and has a variable cost of 23 and a selling price of 35. B takes 2 hours to make and has a variable cost of 15 and a selling price of 25. Both products use the same type of labour, which is in short supply.Determine the product which should be made to maximise profits, and describe the other considerations which might alter your decision.2dBASales ()3525Variable costs ()2315Contribution per unit ()1210Labour (hours)32Contribution per labour hour (limiting factor) ()45Rank21Decision: Produce B, as it maximises contribution per hour of labour. Other qualitative factors: Will selling price change? Will variable cost change? Who are the competitors?Copyright 2011 University of Sunderland27


2e2eA company has the following costs and revenues relating to a product:Selling price63.50Labour @ 7.50 per hour22.50Raw materials @ 4 per kg20Variable overhead6Fixed cost per unit3Profit per unit12What is the contribution per labour hour?What is the contribution per kilogram of raw materials?Labour hours needed: 22.50/7.50 = 3, therefore 15/3 = 5 contribution per labour hour.Raw materials 20 / 4 = 5kgContribution per kilogram of raw material = 15/5kg = 3.CostSelling price63.50Labour cost22.50Materials20Variable overhead6Total variable costs48.50Contribution15Cost

28Copyright 2011 University of SunderlandOutsource or in-houseFor various reasons it may suit a manufacturer to make the product itself (in-house) or to outsource (buy) it. The relevant costs for such a decision are the differential costs between the two options.ExampleJameson Ltd makes four components (A, B, C and D) for which costs in theforthcoming year are expected to be as follows:

Unit 2Relevant costs for decision makingACBD2,0003,0004,0005,0005635101168322318191116Production (units)Unit variable costs Direct materialsDirect labourVariable production overheadsDirectly attributable fixed (incurred as a direct consequence of buying) costs per annum are: A: 2,000; B: 7,000; C: 7,000; D: 9,000. Other fixed costs are 3,000. A subcontractor can supply units of A, B, C and D for 10, 23, 17 and 18, respectively.Decide whether Jameson Ltd should outsource its product or make it in-house.Answer: The relevant costs are the differential costs between making and buying. Subcontracting will result in some fixed cost savings:ABCD

Unit variable cost of making18191116

Unit variable cost of buying10231718

Cost difference(8)462

Annual requirements (units)2,0003,0004,0005,000

ABCD

Extra variable cost of buying(16,000)12,00024,00018,000

Fixed cost of buying2,0007,0007,0009,000

Extra total cost of buying(18,000)5,00017,0001,000

The company would save 18,000 subcontracting to A.

2f2fWhich qualitative factors would you consider in this Jameson Ltd decision? Spare capacity, how should it be used? Could there be an industrial dispute as a result of the companys action? Quality of buying in. Reliable figures? Estimates may not be accurate.



2g2gVariable cost2.5085Fixed cost2.008.303.75Total cost4.5016.308.75Buy-in price475.50The fixed costs will be present irrespective of the make or buy decision. Which components should Sahai Ltd buy in (if any)?Variable cost2.5085Variable cost buy475.50Cost difference1.50(1)0.50Therefore, Sahai Ltd should choose to buy in Component B as the variable cost to purchase is less.Assuming that fixed costs will remain unchanged whether the company makes or buys the components, the relevant cost of manufacture will be the variable cost. Under these circumstances the company should only purchase components if the purchase price is less than the variable cost.Sahai Ltd makes three components: A, B and C. The following costs have been recorded:A(unit cost, )AB(unit cost, )BC(unit cost, )C

30Copyright 2011 University of SunderlandOutsource or in-house with scarce resourcesRule: If a company has to subcontract to make up a shortfall in output, then the company needs to minimise its total costs of subcontracting. The units bought must have the lowest extra variable cost of buying per unit of scarce resource saved.ExampleMR Ltd manufactures products A and B using the same material for each. Annual demand is 9,000 units for A and 13,000 units for B. The variable production cost of A is 11 and that of B is 16. A requires 3.5 kg of raw material per unit, B requires 8 kg of raw material per unit. Supply of raw material will be limited to 90,000 kg during the year. A subcontractor is willing to supply the products and has quoted prices of 18 per unit for A and 26 per unit for B.How many of each product should MR Ltd manufacture in order to maximise profits?

Answer:

A, per unitB, per unit

Variable cost of making1116

Variable cost of buying1826

Extra variable cost of buying710

Raw material saved by buying3.5 kg8 kg

Extra variable cost of buying per kg saved21.25

Priority for internal manufacture/ranking(1) (2)

Priority for external manufacture(2) (1)

Unit 2Relevant costs for decision makingProduction plan:Make 31,500 kg of Product A: (9,000 3.5 kg)Make 58,500 kg of Product B: (7312.5 8 kg)Balancing figure is 90,000 kg58,500 kg/8 kg per unit of B means 7,313 units of B will be produced.The remaining 5687 units (13,000 7,313 units) of B should be purchasedfrom the external manufacturer.

2hBronze Ltd manufactures two components in its machine division, in which2hcapacity per month is limited to 3,500 machine hours. Production costs are as follows:Machine hours per unit23Total machine hours per month needed2,0003,0005,000Machine hours available3,500The fixed costs will be present irrespective of the make or buy decision. Component A can be bought from an external supplier for 31 per unit and Component B can similarly be bought for 47 per unit.What are the minimum total costs per month of the machining division and external purchases, given that all the monthly requirements for units of each component must be either manufactured or purchased?Variable costTotal costFixed overheadHours per unitMonthly requirementA ()20302101,000 unitsAB40253B ()151,000 unitsTotal


Strategic Management AccountingABC2ilabour force. The budgeted data is as follows:Johnson Ltd manufactures three products (A, B and C) using the same directSales price per unit102024Variable cost per unit6.501215Fixed cost per unit0.504.504Total cost per unit716.5019Profit per unit33.505Direct labour per unit0.5 hours1.5 hours2 hoursBudgeted monthly sales500 units300 units400 unitsThere are 1,200 direct labour hours available in normal working hours each month. The direct labour employees are paid 4 per hour in normal time. Confirm that the limiting factor is direct labour, identify the best use of the direct labour hours, and state which contribution would be earned by this strategy.2h20253147continued11222 per unit3 per unit5.57.35,000B (1,000 25)25,00030,00017,50047,50023,25070,750The company should therefore buy 750 units of A per month.Variable cost per unitVariable cost of:A (1,000 750) 20In-house production costsExternal purchase costExtra cost of purchase per unitHours saved by purchasingExtra cost per hour savedFixed costs 3,500 hrs 5 per hourExternal purchase costs of A (750 31)32Copyright 2011 University of Sunderland

Unit 2Relevant costs for decision makingHours2i500 x 0.5250300 x 1.5450400 x 28001500ABCRankingHoursSelling price102024Variable cost (labour)6.51215Contribution3.589Hours0.51.52.0Contribution per limiting factor75.34.5Ranking(1)(2)(3)A250500 x 3.501,750B450500300 x 8 250 x 92,400C (Balance)2,2501,2006,400The direct labour is the limiting factor with 1,200 hours.Production plan:Product (units x hours)Contribution(units x contribution)Total contribution ()Copyright 2011 University of Sunderland33Continue or discontinueWhether a company ceases production depends in practice on long-term decisions. In this type of decision, one should consider the contribution made to the business as a whole rather than just the contribution of the product/ factory to be discontinued.ExampleA company is concerned about its poor profit performance, and is considering whether to cease selling YY. It is felt that selling prices cannot be raised or lowered without adversely affecting net income. Of the fixed costs of YY, 5,000 are direct fixed costs which would be saved if production ceased. All other fixed costs, it is considered, would remain the same. A summary of the overall company performance is:


XXYY

ZZ

Total

34Copyright 2011 University of SunderlandSales50,00040,00050,000140,000

Variable costs30,00025,00025,00080,000

Contribution20,00015,00025,00060,000

Fixed costs17,00018,00020,00055,000

Profit/loss3,000(3,000)5,0005,000

By stopping production of YY, the consequences would be a 10,000 fall in profits:

Loss of contribution(15,000)

Saving in fixed costs5,000

Incremental loss(10,000)

It does not therefore seem a good idea to stop producing YY.Rule: A company should continue producing a product as long as it contributes to the overall profitability of the company, that is, while it makes a positive contribution. Qualitative factors should also be considered.

2j2jWhat are the qualitative factors in the above decision? If the company decided to close, what would be the effect on demand for other products? Pricing: is YY a loss leader?Accept or reject orders (special orders)Special pricing decisions relate to pricing decisions outside the normal market of a company. Typically they involve one-time orders or orders at a price below the prevailing market price.If a company has spare capacity then the rule is to accept an order if the product makes a contribution to fixed costs and profit. If there is no spare capacity then existing business should only be turned away if the contribution from a special order is greater than the contribution from the business which must be sacrificed.ExampleSymister Ltd makes a single product for which there is great demand. The labour force is currently working at full capacity producing the product that earns a contribution of 4 per labour hour. A customer has approached the

Unit 2Relevant costs for decision makingcompany with a request for the manufacture of a special order and is willing to pay 5,500. The costs of the order would be 2,000 for direct materials, and 600 labour hours at 3 per hour will be required. Decide whether the order should be accepted.Answer:Labour is a limiting factor. By accepting the order, work would have to be diverted from the standard product and contribution would be lost. That is, there is an opportunity cost of 600 hours at 4 per hour = 2,400.

Selling price5,500

Direct materials2,000

Direct labour (600 3)1,800

Opportunity cost

600 4 (contribution lost)2,4006,200

Profit/loss(700)

Although accepting the order would earn a contribution of 5,500 (2,000 + 1,800) = 1,700 this contribution would reduce the contribution earned elsewhere by 2,400 and so the order should not be accepted.

35Copyright 2011 University of SunderlandNorthampton has three divisions (A, B and C). Information for the year2kending 30 September is as follows:A ()B ()C ()Total ()Sales350420150920Variable cost280210120610Contribution7021030310Fixed cost262.5Net profit47.5Of the fixed costs, 40% is allocated to each division on the basis of sales revenue. The other 60% is split equally between each division. Using relevant costs, determine which divisions should remain open if Northampton wishes to maximise profits.Essentially, special orders are seen as short-term decisions. It could be argued that if special-order decisions are always evaluated as short-term decisions, a situation can arise whereby the decision to reduce capacity is continually deferred. If demand from normal business is considered to be permanently insufficient to utilise existing capacity, then a long-term capacity decision is required. It can also be argued that by utilising unused capacity to increase the range of products produced, the production process becomes more complex and thus fixed costs of managing additional complexity will eventually increase. Long-term considerations should therefore always be taken into consideration when evaluating special pricing decisions.


2kContribution7021030Specific fixed cost52.552.552.5Profit/(loss)17.5157.5(22.5)The specific avoidable fixed overheads per division = 262.5 60%= 157.5/3= 52.5.Only divisions A and B should remain open since they both provide positive contributions to fixed costs.ABC

36Copyright 2011 University of SunderlandSelf-assessment questions2.1 Bevel Ltd is an English company that assembles tables and sells them to a wholesaler in Europe. It manufactures four different types of table: W,X, Y and Z. It has a labour-intensive factory where all staff are skilled in the manufacture of all four types of table. Staff can be moved immediately from the production of one table to another at no additional cost. The budgeted figures for the forthcoming month are as follows (all figures are in per unit except for sales volume):

WxYZ

Selling price25303530

Costs:

Direct labour at 10 per hour56810

Raw materials

Brass fittings1124

Nails at 30 per kg3653

Sundries: glue1123

Overheads:

Variable overhead2222

Fixed overhead12121212

Estimated demand (units)10,0007,0006,0008,000

Ceasing to produce any product would mean that its share of the fixed costs would be transferred to the remaining three products.(a) Calculate whether the company should drop product Z as it is currently making a loss.

(b) Unit 2Relevant costs for decision makingIf the company could only manufacture 20,000 units per month due to limited total production space being available, show how the company could maximise its profitability under this constraint.(c) If the company could only acquire 3,150 kg of nails, show how the company could maximise its profitability under this constraint.(d) What other factors would you take into account before finally making a decision about the production mix?2.2 Mokia Ltd is currently reviewing its manufacturing operations. Currently, four products are produced: X1, X2, X3 and X4. It has been suggested that products X3 and X4 should be dropped from production as they are creating financial losses. The forecast financial results are detailed below:

X1X2

X3

X4

Copyright 2011 University of Sunderland37Sales450,000550,000200,000260,000

Variable costs300,000250,000210,000220,000

Fixed costs: general60,000105,00025,00050,000

Fixed costs: specific20,00015,0005,00010,000

Profit/(Loss)70,000180,000(40,000)(20,000)

General fixed costs have been absorbed on a direct labour hour basis.(a) Based on the information given, advise management whether X3 and X4 should be dropped. Support your advice with appropriate calculations.(b) The production manager has informed senior management that because of skills shortages, she is unlikely to have enough machine operators to provide all the labour requirements. How would this affect your analysis?(c) The purchasing manager is outraged at the suggestion that X3 should be dropped as a special machine with no alternative use was purchased 12 months ago for 30,000, specifically for the X3 production line. The disposal will result in a book loss of 20,000. What impact would this information have on your analysis?2.3 What qualitative factors need to be considered when evaluating a special order request from a customer?2.4 Provide four examples of possible limiting factors.2.5 All future costs are relevant to a decision. Do you agree or disagree?2.6 In your own words, define what a relevant cost is.2.7 Define what is meant by a limiting factor. Give an example.2.8 AVC Partners are a pensions and investment consulting firm to large multinationals who provide employee and executive pensions as part of remuneration packages. The firm is quite busy and has a new contract under consideration which requires 600 consulting hours to complete. There are 350 hours of spare consulting capacity for which consultants would be paid their normal rate of pay. The remaining hours for the contract can be found either by weekend overtime working paid at double the normal rate of pay or by diverting consultants from other projects.



Currently, other projects are making a contribution, net of labour cost, of 10 per consulting hour. The normal rate of pay is 18 per consulting hour.What is the relevant labour cost for the new contract ?Feedback on self-assessment questions2.1 (a) Z makes a positive contribution to fixed costs and a profit of 30 (10 + 4 + 3 +3 + 2) = 8 per unit. Dropping the product would lose Bevel Ltd 8,000 8 = 64,000 contribution and divert the fixed costs onto the other 3 products.(b) Contribution per limiting factor:

Rank

W 25 (5 + 1+ 3+ 1 + 2) = 133

X 30 (6 + 1+ 6+1 + 2) = 142

Y 35 (8 + 2+ 5+ 2 + 2) = 161

Z 30 (10 + 4 + 3 + 3 + 2) = 84

Manufacture in this order up to 20,000 units:

ProductContributionNo. of unitsper unit x Totalcontribution

Y166,00096,000

X147,00098,000

W137,000 (limit)91,000

20,000285,000

Less overheads372,000

Loss(87,000)

Note: Fixed overheads are calculated as 31,000 units 12 = 372,000.(c) Nails required for full capacity:

Unitskg per unitkg required

W10,0000.11,000

X7,0000.21,400

Y6,0000.16671,000

Z8,0000.1800

Available nails = 3,150 kg.Note: In the table on the facing page, each kg of nails yields multiple units of product. For example, in product W, 1 kg of nails will yield 10 units (1kg/0.1 kg per unit):

Copyright 2011 University of Sunderland39Rank

W 13 10= 130(1)

X 14 5 =70(4)

Y 16 6 =96(2)

Z 8 10 =80(3)

ProfitabilitykgTotal kgContribution Per kgContribution

W1,0001,000130130,000

Y1,0002,0009696,000

Z8002,8008064,000

X3503,1507024,500

314,500

Fixed overhead372,000

Profit/(Loss)(57,500)

Unit 2Relevant costs for decision making(d) Usual marketing implications: product range, loss leaders, valued custo mers, large orders, company image, and so on.2.2 (a) General fixed costs are unlikely to be reduced by dropping products X3 and X4. Directly attributable or specific fixed costs will be avoided as will variable costs. Sales revenue will obviously be lost.

Lost sales(200,000)

Variable cost savings210,000

Specific fixed costs5,000

Net saving(15,000)

X3 should be dropped as it is currently yielding a negative contribution. Possible future sales/demand elasticity should be considered before a final decision is made.The effects of dropping X4 would be:

Lost sales(260,000)

Variable cost savings220,000

Specific fixed costs10,000

Net loss of contribution(30,000)

Therefore, X4 should not be dropped.(b) Existence of scarce resource: optimal production plan found by ranking products according to contribution per hour of machine operator. As X3 has a negative contribution it would still be dropped.


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