tutorial letter 102/0/2017 - unisa.ac.za · apply an activity-based costing approach to costing...

Tutorial Letter 102/0/2017 APPLIED MANAGEMENT ACCOUNTING Year module Department of Financial Intelligence

This tutorial letter contains important information about your module.

MAC4862/102/0/2017

BARCODE

MAC4862

NMA4862

ZMA4862

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MODULE PURPOSE

INTRODUCTION AND OVERVIEW The purpose of this tutorial letter is to provide students with tutorial matter relating to Management Decision Making and Control topics (often referred to as Costing). This tutorial letter will build upon your prior knowledge and introduce a few new concepts relating to decision making and control. PRE-REQUISITES The parts and learning units in this tutorial letter build, to a large extent, upon prior knowledge obtained in your undergraduate Management Accounting studies and in the post-graduate Advanced Management Accounting module. It is therefore assumed that you have achieved the necessary prior learning. STRUCTURE OF THIS TUTORIAL LETTER This tutorial letter is structured in three parts, each containing several learning units. A learning unit is the main study area within a part, and each learning unit is further divided into sub learning units. You will find the outcomes, which you are required to achieve for each learning unit in this tutorial letter at the beginning of each learning unit. Self-assessment activities are provided at the end of each learning unit so that you can assess whether you have mastered the learning outcomes. These topics will be dealt with in two separate tutorial letters, of which this is the first. The syllabus will then be revised in a further two tutorial letters.

- WEEK from 25 January to 31 January 2017 (Topics 1 – 3)

- WEEK from 22 March to 28 March 2017 (Topics 4 – 7)

Dear student, we suggest that you allocate your time spent on this tutorial letter, according to the following approximate allocation.

This module is intended for students who are studying towards a Certificate in the Theory of Accounting (CTA), a prerequisite for the professional qualification of Chartered Accountant (SA) (registered with SAICA). This module will help you to develop some of the prerequisite competencies. The purpose of the module is to provide students with knowledge of Management Decision Making and Control (MDC); as well as Strategy, Risk Management (SRM), and Financial Management (FM). The module will create an understanding of and develop skills with regard to the following areas: Management and use of costs, control, decision-making and planning approaches and processes; strategy; risk management; function of financial management; as well as mergers and acquisitions, and business plans.

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Part 1 Cost accounting bases and allocation (30%) Part 2 Planning and control (40%) Part 3 Decision-making (20%) Part 4 Integrated self-assessment test (10%)

30%

40%

20%

10%

Proposed time allocation

Part 1 - Bases and allocation

Part 2 - Planning and control

Part 3 Decision-making

Part 4 - Integrated self-assessment

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CONTENT – THIS MODULE The diagram below contains a schematic presentation of the content of this module.

MAC4862 Applied Management Accounting

Tutorial letter 101

Tutorial letter 102 (this tutorial letter)

Planning and general

Management decision making

and control

Strategy, Risk, Management,

Financial Management

Prior exams, questions and

revision

Tutorial letter 104

Tutorial letter 103

Topics

TEST 1 – 14 March 2017 • Nature, classification and

allocation of cost (variable and absorption costing, ABC)

• Product costing systems • Planning, budgeting and

control • Cost-volume-profit analysis

TEST 2 – 25 April 2017

• Standard costing • Performance management • Transfer pricing • Information for decision-

making (relevant cost & revenues; pricing decisions & profitability analysis; decision-making under conditions of risk & uncertainty)

Tutorial letters in

the 3-series (3**)

Integrated self-assessment

Tutorial letter 105

TEST 1 – 14 March 2017

Topics 1 – 3, first four bullets.

TEST 2 – 25 April 2017

Topics 4 – 7, last four bullets.

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STUDY MATERIAL AND RESOURCES Prescribed study material The prescribed textbooks for this module are: • Management and Cost Accounting (including Student’s Manual), 9th edition (Drury, C) • Managerial Finance, 7th edition (Skae, FO.) Important note: This tutorial letter makes principle reference to the textbook Management and Cost Accounting (including Student’s Manual), 9th edition (Drury, C.) Note that the Management and Cost Accounting (Drury) textbook includes access to the online CourseMate system which offers interactive learning tools in line with the textbook and an interactive ebook. It is recommended that students register on CourseMate and use the tools available to assist them as they proceed with each chapter in the textbook. To register, please visit https://login.cengage.com and click on “New Student User?”. You will need the unique personal access code included in the front of the textbook (scratch open).

myUnisa resources Please make use of myUnisa (https://my.unisa.ac.za) as it contains further resources to help you master this module. The following resources are available on myUnisa (made available at appropriate times during the year): • your tutorial letters for this module • suggested solutions to the tests • postings under ‘Additional Resources’ • e-learning initiatives (optional) Supplementary literature/additional reading Refer to the Management Accounting Glossary and Bibliography at the end of Tutorial letter 102 (MAC4861) available on myUnisa under Additional Resources. Also refer to the recommended reading (including company websites) as indicated in the study material and myUnisa.

https://login.cengage.com/

https://my.unisa.ac.za/

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General information and CTA news For general information and CTA news please refer to the CTA Support Page. The CTA support page can be accessed from our CAS website landing page. The short URL for this page is: www.unisa.ac.za/cas/cta

STUDY SCHOOLS Please refer to follow-up tutorial letters in the SASALL 300-series for more details. If these classes are offered in your area, it is strongly recommended that you attend. These classes will support you with your studies and help you gain a better understanding of the module. TESTS The learning units assessed by Test 1 will cover predominately (but not exclusively) the content of Topics 1-3; and Test 2 the content of Topic 4 – 7. It is important to realise that the examination papers of this module will integrate between the various learning units and disciplines. In preparation for the exam, you can therefore also expect some level of integration in the tests.

http://www.unisa.ac.za/cas/cta

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STUDY PROGRAMME A study programme has been published in Tutorial Letter SASALL301. Please utilise this to plan you studies. Note If you struggle with any of the learning units we strongly recommend that you allocate additional time – above and beyond the time indicated in the study programme. CONCLUSION We trust that the preceding sections will assist you in approaching your studies (linked to this tutorial letter) in a methodical manner and with a greater level of understanding. We hope you enjoy this part of your studies! Regards, Your Applied Management Accounting lecturers

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MAC4862

APPLIED MANAGEMENT ACCOUNTING TUTORIAL LETTER 102 / 2017

Page

MODULE PURPOSE ......................................................................................................................... 2

PART 1 – COST ACCOUNTING BASES AND ALLOCATION ......................................................... 9

PART 1, TOPIC 1 – Nature, classification and allocation of cost ...................................................... 10 LEARNING UNIT 1.1 – Nature and classification of cost ........................................................... 11 LEARNING UNIT 1.2 – Variable and absorption costing ........................................................... 14 LEARNING UNIT 1.3 – Activity-based costing (ABC) ................................................................ 21 PART 1, TOPIC 2 – Product costing systems .................................................................................. 25 LEARNING UNIT 2.1 – Job costing ........................................................................................... 26 LEARNING UNIT 2.2 – Process costing... ................................................................................. 27 LEARNING UNIT 2.3 – Joint and by-product costing... .............................................................. 30

PART 2 – PLANNING AND CONTROL .......................................................................................... 32

PART 2, TOPIC 3 – Planning, budgeting and control ....................................................................... 33 LEARNING UNIT 3.1 – Budgeting and management control systems ....................................... 34 LEARNING UNIT 3.2 – Cost management techniques/principles .............................................. 36 LEARNING UNIT 3.3 – Cost-volume-profit analysis .................................................................. 38 PART 2, TOPIC 4 – Standard costing .............................................................................................. 44 LEARNING UNIT 4.1 – Variance analysis ................................................................................. 45 LEARNING UNIT 4.2 – Reconciliation of budget to actual ........................................................ 47 LEARNING UNIT 4.3 –Variance analysis reports ...................................................................... 48 LEARNING UNIT 4.4 – Pro-rating of variances and compliance with the relevant accounting standard .................................................................................................................. 49 PART 2, TOPIC 5 – Performance measurement ............................................................................. 50 LEARNING UNIT 5.1 – Divisional financial performance measures .......................................... 51 LEARNING UNIT 5.2 – Transfer pricing in divisional companies ............................................... 64

PART 3 – DECISION-MAKING ....................................................................................................... 68

PART 3, TOPIC 6 – Information for decision-making ...................................................................... 69 LEARNING UNIT 6.1 – Decision-making under conditions of risk and uncertainty ................... 70 PART 3, TOPIC 7 – Information application to decisions ................................................................ 75

LEARNING UNIT 7.1 - Relevant costs and revenues for decision-making .............................. 76 INTEGRATED SELF-ASSESSMENT .............................................................................................. 80 2016 TEST 1 & 2 WITH SUGGESTED SOLUTIONS ..................................................................... 84

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PART 1 - COST ACCOUNTING BASES AND ALLOCATION

PART 1 - PURPOSE The purpose of part 1 is to equip students with a critical and informed understanding of • Key terms and guidelines • Concepts and established principles in order to classify, to record and to present costs for the valuation of inventories and to compile Statements of Comprehensive Income on different bases.

DEEL 1 - DOEL Die doel met deel 1 is om studente toe te rus met ‘n kritiese en ingeligte begrip van die • Sleutelterme en riglyne • Konsepte en gevestigde beginsels ten einde koste te klassifiseer, te boek te stel en voor te lê vir die waardasie van voorraad en die opstel van State van Omvattende Inkomste op verskillende grondslae.

TOPICS: 1. Nature, classification and allocation of cost 2. Product costing systems Introduction Management accounting deals with accounting information within the organisation, focussing on critical information so that operational and strategic planning can be undertaken, decisions can be made, control can be exercised and problems addressed. There is no formal framework which regulates management accounting. A logical mind and approach is however required to deal with the aforementioned focus areas.

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PART 1, TOPIC 1 – Nature, classification and allocation of cost

TOPIC 1 LEARNING OUTCOMES After studying this topic, you should be able to: ● Describe the definitions relevant to costing terms and systems. ● Classify costs and apply cost concepts and cost estimation techniques in various scenarios. ● Apply knowledge of variable and absorption costing systems in a case study scenario. ● Advise on an applicable method when analysing a scenario. ● Apply results of the over- and under-recovery of overheads calculation to a practical case study and correctly account for it in the Statement of Comprehensive Income. ● Apply an activity-based costing approach to costing information in a scenario. ● Advise management on which type of costing system is appropriate and how the systems differ.

ONDERWERP 1 LEER UITKOMSTE Na bestudering van hierdie onderwerp behoort u in staat te wees om: • Die definisies relevant tot kostestelsels te omskryf. • Koste te klassifiseer en koste konsepte en kosteberamingstegnieke toe te pas in verskeie scenarios. • Advies oor ‘n gepaste werkswyse te gee wanneer ‘n scenario ontleed word. ● Kennis van veranderlike- en absorpsiekostestelsels in ‘n gevallestudie/scenario toe te pas. • Gevolge van die berekening van die oor- en onderverhaling van bokoste op ‘n praktiese gevallestudie toe te pas en dit korrek in die Staat van Omvattende Inkomste weer te gee. • Pas ‘n aktiwiteitsgebaseerde kostebenadering op koste inligting in ‘n scenario toe. • Adviseer bestuur aangaande die tipe kostestelsel wat toepaslik is en hoe die stelsels verskil.

LEARNING UNIT TITLE

LEARNING UNIT 1.1 Nature and classification of cost

LEARNING UNIT 1.2 Variable and absorption costing

LEARNING UNIT 1.3 Activity-based costing

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LEARNING UNIT 1.1 Nature and classification of cost

Prior Learning

This course assumes that students have already mastered the work equivalent to that presented in Unisa’s preceding postgraduate course, Advanced Management Accounting (‘Advanced’). Please ensure that you are up to date with the prior learning for the nature, classification and allocation of costs. If not, please refer to your undergraduate and advanced study material and revise the following indicated pages of the textbook, namely Drury, using the page numbers below:

Prior learning Drury 9th ed.

Before studying this topic, you should be able to: • Define and illustrate a cost. • Understand the meaning of the important

cost definitions. • Distinguish between variable and fixed

costs. • Apply and describe the different methods of

estimating costs. • Calculate regression equations using the

least-squares methods and evaluate the goodness of fit, using the coefficient of correlation and coefficient of determination.

• Apply the high-low method.

Applicable references:

Drury Chapter 2: An introduction to cost terms and concepts. Pages 25-41

Drury Chapter 23: Cost estimation and cost behaviour. Pages 628-639

Drury Chapter 8: Separation of semi-variable costs. Page 188-189 CourseMate: Glossary and flashcards: Chapter 2, 23 & 8

Introduction In this LEARNING UNIT you will revise the nature of costs and the methods used to classify them. You will specifically revisit the application of the high-low method to distinguish between fixed and variable costs.

Activity 1: Review

LEARNING UNIT 1.1 in MAC4861/102, available on myUnisa under Additional Resources.

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Activity 2 Attempt question: (Drury textbook) 9th ed: Question 23.14 p647 (Solution p801)

Feedback 2 The high-low method was used to determine the total cost for a specified quantity.

Activity 3 Attempt question: (Dury Student Manual) 9th ed: Question 2.2

Feedback 3 Specifically note the explanations of fundamental terms used throughout this tutorial letter.

Summary In this LEARNING UNIT, we revisited cost classification, behaviour and estimation with emphasis on applying the high-low method.

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Self-assessment activity Before you move on to the next LEARNING UNIT, please ensure that you have grasped the following concepts: Yes/No 1. What is a cost object? Explain how sales commission will be treated when

(i) the product is the cost object (ii) the customer is the cost object

2. Maintaining a cost database.

3. Cost estimation: Regression analysis and High-Low method. Explain under which circumstances a particular method may be more applicable.

4. Provide an example of a fixed and a variable cost in a

• Manufacturing environment • Retail environment • Service environment without using the same example more than once.

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LEARNING UNIT 1.2 Variable and absorption costing

Prior Learning

This course assumes that students have already mastered the work equivalent to that presented in Unisa’s preceding postgraduate course, Advanced Management Accounting (‘Advanced’). Please ensure that you are up to date with the prior learning for variable and absorption costing. If not, please refer to your undergraduate and advanced study material and revise the following indicated pages of the textbook, namely Drury using the page numbers below:


Before studying this topic, you should be able to: • Describe the various denominator levels

that can be used with an absorption costing system;

• Justify why budgeted overhead rates should be used in preference to actual overhead rates;

• Calculate and explain the accounting treatment of the volume and expenditure variances;

• Reallocate service departments’ overheads where service departments render services to each other and to production departments;

• Explain the differences between an absorption costing and a variable costing system;

• Prepare profit statements based on an absorption and variable costing system;

• Reconcile and explain the difference in profits between absorption and variable costing profit calculations;

• Explain the arguments for and against variable and absorption costing.

Applicable references:

• Drury: Chapter 3: Cost assignment. Pages

48 – 60.

• Drury: Chapter 3: Budgeted overhead rates and Under- and over-recovery of overheads. Pages 64 – 70.

● Drury: Chapter 3: Inter-service department reallocations. Pages 72 – 76.

• Drury: Chapter 7: Income effects of alternative cost accumulation systems. Pages 151 – 162.

● Now study IAS2 again.

Introduction In the previous LEARNING UNIT, we used the nature of a cost to classify it as either fixed or variable, although in practice many costs will have a dual nature or follow a step pattern. We will now use these classifications to assign overhead cost to products. In this LEARNING UNIT, we revisit types of cost accumulation systems, namely absorption costing and variable / direct costing systems, specifically those using traditional volume-based measures. In the next topic we will look at another absorption costing system, namely Activity-based-costing (ABC). Under absorption costing ALL manufacturing costs, including fixed overhead, are included in the cost of the product. Under variable costing only variable manufacturing costs (including variable overheads) are included in the cost of the product.

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International Accounting Statement (IAS2) makes absorption costing compulsory for external reporting. For internal use, variable costing gives a clearer picture for the evaluation of the performance of divisions and for certain short-term decision-making scenarios.

Critical topics: Bases of assigning overheads to cost objects • Absorption vs variable costing • Traditional volume-based measures • Selecting an appropriate denominator level for the allocation of fixed production

overheads • Accounting treatment of volume variances and expenditure variances Refer to the two different Statement of Comprehensive Income (SCI) below for an illustration of how the profits are determined under each basis and how the presentation differs. Illustration of the difference between absorption and variable/direct costing

Absorption costing R

Turnover 4 800 Less: Cost of sales (including fixed manufacturing overhead) (3 840) Opening inventory (fixed and variable manufacturing costs) 720 Production cost (fixed and variable manufacturing costs) 3 360 Less: Closing inventory (fixed and variable manufacturing costs) (240) 960 Volume variance (fixed manufacturing overheads / labour) (if treated as a period cost)

(60)

Expenditure variance (12) Gross profit 888 Less: All non-manufacturing costs (fixed and variable) (period cost) (375) Profit 513 Variable/Direct costing

Turnover 4 800 Less: Variable cost of sales (no fixed manufacturing overhead included) (2 880) Opening inventory (variable manufacturing costs) 540 Production cost (variable manufacturing costs) 2 520 Less: Closing inventory (variable manufacturing costs) (180) 1 920 Less: Other variable costs (non-manufacturing) (75) Contribution 1 845 Less: Fixed costs (manufacturing and non-manufacturing) (total actual amount) (1 212) Profit 633

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Additional information: • Contribution = Turnover – ALL variable costs

• When absorption costing is applied: Under- or over-recovery of overheads = Volume variance + Expenditure variance.

• When variable costing is applied: Under- or over-recovery of overheads = Expenditure variance. The volume variance is not applicable when variable costing is applied.

• An adverse volume variance means that actual production volume is less than the budgeted allocation base used. Favourable volume variance: actual production volume is more than the budgeted allocation base used.

• The volume variance for overhead/labour should be included ABOVE the gross profit line, as part of the production cost for the period under review (due to different teaching applications, volume variance below the line will still earn marks when clearly shown).

• The over/under recovery and expenditure variances are only calculated when doing a SCI on the absorption costing method. The expenditure variance is covered in tandem with the volume variance as they are often confused with one another.

How do we allocate manufacturing overheads to products?

Manufacturing overheads cannot be traced directly to products. They are assigned to products using cost allocations. A cost allocation is the process of estimating the cost of resources consumed by products that involves the use of surrogate rather than direct measures, as set out in LEARNING UNIT 2.

To calculate the budgeted overhead rate:

Budgeted overhead Overhead rate = Appropriate allocation base

Focus note:

Please study Drury (9th ed.) pages 159 – 162 in depth. The most appropriate allocation base (denominator) is the AVERAGE long-run (= life of the plant) capacity utilisation. In the absence of information on this, you may use the next period’s budgeted activity.

Refer to IAS2 par 13 on the dangers of over- or under costing products when using next period’s budgeted activity level. The following activities are popular for allocating overheads because they are simple to calculate: • Direct labour hours • Machine hours

Other traditional bases used may be: • Labour cost Rand • Units produced

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Activity 1 – Traditional bases applied The budgeted fixed production overhead for 20x2 are R900 000. The average long-run utilisation and related costs for this plant are: • Direct labour hours – 36 000 hours • Machine hours – 22 500 hours • Units produced – 45 000 units • Labour cost – R540 000

REQUIRED Calculate a budgeted fixed overhead rate for each of the traditional measures above.

Feedback 1 FOH rate based on direct labour hours = R900 000 ÷ 36 000 hours

= R25 per DLH FOH rate based on machine hours = R900 000 ÷ 22 500 hours

= R40 per MH FOH rate based on units produced = R900 000 ÷ 45 000 units

= R20 per unit FOH rate based on direct labour R cost = R900 000 ÷ R540 000

= R1,667 per R1 direct labour Or 166,67% of labour

Activity 2 Attempt question: (Drury Student Manual) 9th ed: Question 3.6

Feedback 2 Compare your answer to the solution posted on myUnisa. Note that the requirement was to calculate the costs for one unit.

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Activity 3 Attempt questions: (Drury Student Manual) 9th ed: Question 7.7

Question 7.10

Feedback 3 Note in question 7.7 the application of the fixed overhead volume variance before the high-low method is applied to split the production overheads. Question 7.10 covers the impact of fixed overhead and its allocation on the valuation of inventory. Where you have gone wrong, reflect upon why it has happened, as that will improve the learning process.

Summary In this LEARNING UNIT we covered the calculation of an appropriate fixed overhead rate and the preparation of the SCI using the absorption and variable costing methods.

It is critical that the relevant sections of MAC4861/102 be worked through thoroughly.

Self-assessment activity Before you move on to the next LEARNING UNIT please ensure that you understand and can apply the following concepts: Topic

Yes/No

1. Difference between variable and absorption costing 2. Definition of manufacturing overheads 3. Treatment of fixed labour costs 4. Calculation of appropriate fixed production overhead allocation rate 5. Proper accounting treatment of volume and expenditure variances 6. Present SCI on the variable and absorption costing basis 7. Reconcile profits derived from different costing bases

8. Calculation of volume variance for overheads/labour 9. Calculation of the expenditure variance.

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MR PRICE GROUP LIMITED (2015)

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SHOPRITE HOLDINGS (2015)

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LEARNING UNIT 1.3 Activity-based costing (ABC) and related concepts

Prior Learning

This course assumes that students have already mastered the work equivalent to that presented in Unisa’s preceding postgraduate course, Advanced Management Accounting (‘Advanced’). Please ensure that you are up to date with the prior learning for activity-based costing (ABC). If not, please refer to your undergraduate and advanced study material and revise the following indicated pages of the textbook, namely Drury using the page numbers below:


Before studying this topic, you should be able to: • Describe the differences between activity-

based and traditional costing systems; • Explain why traditional costing systems

can provide misleading information for decision-making;

• Identify and explain each of the four stages involved in designing ABC systems;

• Apply an activity-based costing approach to costing information;

• Describe activity-based budgeting.

Applicable references: • Drury: Chapter 11: Activity-based costing.

Pages 257 – 274. ● Drury: Chapter 3: Illustration of the two stage

process for an ABC system. Pages 60 – 64. • Drury: Chapter 15: Activity-based budgeting.

Pages 388 – 390.

Critical topics: • Activity-based-costing and cost drivers • ABC in service organisations • ABC profitability analysis • Activity-based budgeting and Activity based management (resource consumption models)

Introduction

Even though activity-based costing (ABC) is presented as a separate topic in management accounting, it is in reality an extension of the previous topic: ‘Absorption Costing’. The reason is that ABC is quite simply a different absorption costing method for the allocation of fixed manufacturing overheads to products. The only difference between ABC and the traditional methods is that ABC makes use of different activities as its allocation base, whereas the traditional methods made use of volume-related bases, such as machine or labour hours, for the allocation of overheads to products.

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Why do we use ABC?

ABC is used as it may lead to more accurate pricing of products, which will therefore influence all decision-making with regard to those products, e.g. whether or not to withdraw a product or what price to charge for it.

Traditionally, overhead costs were small in comparison to directly measurable and traceable costs, such as material costs, and the method of allocation of those costs to products was therefore largely unimportant. However, in the advanced manufacturing environment that companies are currently trading in, fixed overhead costs have escalated dramatically, and now make up a substantial portion of the cost of a product. It is therefore becoming increasingly important to allocate the cost of the overheads correctly to the products involved, to ensure the continued success and competitiveness of a firm. ABC is also useful in the costing of cost objects separate from products. When ABC is applied to support activity hierarchies, costs for diverse cost objects such as a whole product line a production plant, a customer, customer groups (geographic area) etc. can be computed. This is important for analyses of profitability of the diverse cost objects in support of management’s decisions regarding allocation (or withdrawing) of resources. ABC and its related concepts are therefore a very handy arrangement tool in optimising the fixed production and other support activity infrastructure of an entity.

Activity-based-costing and cost drivers

Review the study material in MAC4861/102 on myUnisa under Additional Resources.

Study Drury 9th ed. p60 – 64.

Activity 1 Attempt question: (Drury Student Manual)

9th ed: Question 11.7

Feedback 1 (Question 11.7 in 9th ed. of Drury Student Manual) The driver volume is the total per activity eg for planned maintenance visits: 1 200 + 4 800 + 6 000 = 12 000. (NOT: 4 + 6 + 12 = 22). This total is used to calculate the driver rate ($480 000 ÷ 12 000 = $40), which is then applied to the product. Although layouts may be different to the one presented, it is essential that calculations are shown clearly and can be followed by an examiner. Look carefully at the approach where statements are made: where possible the statement should be answered as being correct or incorrect with supporting motivation and then the implications/consequences listed.

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ABC in service organisations


Activity 2 Go to www.saica.co.za, then SAICA examinations, then 3. Past Exam Papers, then ● Part II – Financial Management. Attempt question 3 of 2005: Brown Bank Ltd.

Feedback 2 Compare your answer to the solution, reflect upon differences and use this process to improve your knowledge level and skill. Consider whether the current ATM environment is different to that presented in the question and reflect on the implications of such differences.

ABC profitability analysis


Activity-based management (ABM)


http://www.saica.co.za/

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Summary In this LEARNING UNIT we focussed on the application of activity-based costing and related concepts in terms of fixed overhead allocation, reduction and product pricing.

Self-assessment activity

Before you move on to the next LEARNING UNIT please ensure that you have grasped the following concepts:

Topic

Yes/No

1. An activity 2. Cost driver 3. Cost driver rate 4. Activity (resource) demand 5. Activity hierarchies 6. Profitability analyses using ABC 7. ABM and ABB

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PART 1, TOPIC 2 – Product costing systems

TOPIC 2 LEARNING OUTCOMES After studying this topic, you should be able to do the following in a case study/scenario:

• Record and account for material, labour and overhead costs in the general ledger. • Value purchased and manufactured inventory using the FIFO or weighted average cost

methods. • Cost specific jobs (manufacturing or service) • Value work-in-process in a process costing system involving more than one process • Determine whether separate products should be processed further after split-off point. • Apply backflush accounting in a JIT environment • Correctly account for the treatment of normal and abnormal losses. • Consider the allocation of joint costs and treatment of by-products and their proceeds.

ONDERWERP 2 LEER UITKOMSTE Na bestudering van hierdie onderwerp behoort u in staat te wees om die volgende in ‘n gevallestudie/scenario te doen:

• Teboekstelling en verantwoording van grondstowwe, arbeid en bokoste in die grootboek toe te pas.

• Gekoopte- en vervaardigde voorraad te waardeer met die gebruik van die EIEU of die geweegde gemiddelde metode.

• Bepaal die koste vir spesifieke take (vervaardiging of dienste). • Bepaal of afsonderlike produkte na die skeidingspunt verder verwerk moet word. • Terugvoer rekeningkunde in ‘n net-betyds omgewing toe te pas. • Die hantering van normale en abnormale verliese korrek te verantwoord. • Die toedeling van gesamentlike koste en hantering van neweprodukte en hul opbrengste te

oorweeg. LEARNING UNIT TITLE LEARNING UNIT 2.1 Job costing

LEARNING UNIT 2.2 Process costing

LEARNING UNIT 2.3 Joint and by-products

Introduction

This topic deals with the recording and allocation of costs using job, process and joint costing systems to value products manufactured or services rendered. It will largely follow a revision route with closer focus on areas where students’ past assessments indicated shortcomings in knowledge.

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LEARNING UNIT 2.1 Job costing

Prior Learning

This course assumes that students have already mastered the work equivalent to that presented in Unisa’s preceding postgraduate course, Advanced Management Accounting (‘Advanced’). Please ensure that you are up to date with the prior learning for job costing. If not, please refer to your undergraduate and advanced study material and revise the following indicated pages of the textbook, namely Drury using the page numbers below:


Before studying this topic, you should be able to: • Describe the materials recording procedure; • Distinguish between first-in-first-out (FIFO), and average

cost methods of stores pricing; • Describe the accounting procedure for labour costs; • Describe the accounting procedure for manufacturing and

non-manufacturing overheads; • Describe accounting procedures for jobs completed and

products sold.

Applicable references: • Drury: Chapter 4: Accounting entries for a job

costing system. Pages 85 – 98.

Summary In this LEARNING UNIT we reviewed the recording process in general and how it would apply in a job costing system.

Self-assessment activity Before you move on to the next LEARNING UNIT, please ensure that you have grasped the following concepts: Topic Yes/No 1. How to record materials, labour and overheads 2. The treatment of inventory for FIFO and weighted average cost methods. 3. The accounting treatment for jobs completed and products sold.

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LEARNING UNIT 2.2 Process Costing

Prior Learning

This course assumes that students have already mastered the work equivalent to that presented in Unisa’s preceding postgraduate course, Advanced Management Accounting (‘Advanced’). Please ensure that you are up to date with the prior learning for process costing. If not, please refer to your undergraduate and advanced study material and revise the following indicated pages of the textbook, namely Drury using the page numbers below:


Before studying this topic, you should be able to: • Explain when process costing systems are appropriate; • Explain the accounting treatment of normal and abnormal

losses; • Prepare process, normal loss, abnormal loss and abnormal

gain accounts; • Prepare a process costing statement; and value inventories.

Applicable references: • Drury: Chapter 5: Process Costing. Pages 107 – 127.

Introduction In the previous LEARNING UNIT we looked at job costing which is a costing system used when the cost of each unique unit produced needs to be calculated separately. On the other end of the scale are entities that continuously produce large quantities of homogeneous or similar products or services, making it unnecessary to assign costs to each unit produced. Process costing systems are therefore used to calculate the average cost per unit by dividing the total costs for a specific process for a period by the number of units passing through the process for that period, e.g. oil refineries, breweries and paper manufacturers. Measurement in a process costing system takes place by way of equivalent and completed units. To do this work-in-progress must be converted to the ‘equivalent’ of fully completed units. The LEARNING UNIT will be dealt with by way of revision.

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Feedback 1 Note the following: • Difference in layout of Quantity Statement and Production Cost Statement • Output is dependent on the initial input • Output includes reworked units • Reworked units are not subject to the normal 10% loss, being reworked • Completed and equivalent units are required • Possible integration with standard costing system

Summary In this LEARNING UNIT we revisited the determination of cost per completed and equivalent unit in a process costing system.

Self-assessment activity Before you move on to the next LEARNING UNIT, please ensure that you have grasped the following concepts: Topic

Yes/No

1. The difference between a job costing system and a process costing system 2. Equivalent units 3. Normal loss 4. Abnormal loss or gain 5. The FIFO and weighted average methods of inventory valuation 6. Allocation of normal loss – when to use “short” or absorption method and when to

use the “long” or allocation method. 7. Value output from the process. 8. Treatment of proceeds from the sale of normal and abnormal units scrapped or

“off-cuts” or by-products.

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Read the section below in conjunction with topic 3.1 and topic 4 to get a clear understanding of the concepts applied by York Timbers Ltd. YORK TIMBERS – PROCESSING DIVISION

COST OPTIMISING

A factor applied by York in determining the optimal volume which can be generated from logs, is called a log paying capability factor. Log paying capability reflects the ability of a sawmill to pay for the raw material (logs) based on the average value of the lumber produced. It is calculated as: Average Selling Price (ASP) for lumber/Delivered log price adjusted for recovery. If the mill recovery, for example, is 49,5% and the delivered log cost is R678/m 3 , then the raw material cost would be R678/49,5% = R1 370/m 3 . If the average ASP per m 3 is R2 382, then the log paying capability factor would be R2 382 / R1 370 = 1,74 times. Processing plants in York are evaluated by reference to the ability of the technology employed to pay for the logs utilised in the process. The current financial year has seen a slight improvement at most processing sites, but in York’s view optimal value will only be demonstrated once the Sabie integrated site, which will include a large sawmill and automated log merchandising yard, is in place. VOLUME RECOVERY Volume recovery is one of the most widely used efficiency measures in primary log processing worldwide. It is simply the volume percentage of a log that is turned into final product volume (excluding by-products like chips and sawdust). In South Africa the final product is considered to be the seasoned timber which has not been planned. Volume recovery is stated as follows: Volume recovery = (Product volume/Log volume) x 100 another variable having a large effect on the profitability of a primary log processor, is the log volume throughput. The main reason is that fixed costs stay fixed with an increase in log volume throughput. The income will thus increase due to higher product outputs, but one of the cost components (fixed costs) will remain constant. Variable costs (mainly log costs) will increase proportionately with volume throughput. VALUE MARGIN Value margin represents the value added through the production process. The calculation is based on the log costs as described above, together with the other variable costs per m 3. Log costs for example of R1 370 plus R48/m 3 would result in variable costs of R1 418/m 3. The value margin is then R2 382 – R1 418 = R964/m 3. The value margin is used to determine the break-even volume required to pay for fixed costs.

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LEARNING UNIT 2.3 Joint- and by-products

Prior Learning This course assumes that students have already mastered the work equivalent to that presented in Unisa’s preceding postgraduate course, Advanced Management Accounting (‘Advanced’). Please ensure that you are up to date with the prior learning for joint- and by-products. If not, please refer to your undergraduate and advanced study material and revise the following indicated pages of the textbook, namely Drury using the page numbers below: Prior learning Drury 9th ed.

Before studying this topic, you should be able to: • Distinguish between joint- and by-products; • Explain the alternative methods of allocating

joint costs to products; • Describe and apply the accounting treatment of

by-products; • Describe backflush costing.

Applicable references: • Drury: Chapter 6: Joint and by-product costing. Pages 134 – 143. • Drury: Chapter 4: Accounting entries for a job costing system

– Backflush accounting Pages 98 – 100.

Activity 1

Attempt question: (Drury Student Manual) 9th ed: Question 6.9

Feedback 1 Note the following: • The allocation of costs on weight and market values yield different profits. • All costs are joint and unavoidable, thus dropping a product will simply decrease revenue with no

impact on costs. • Further processing requires an incremental approach.

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Backflush accounting

Training costs to inventory

Large inventories

JIT (no or very low inventories)

Elaborate costing systems tracing Costs to products

Backflush accounting

Study

• Drury 9th ed. p98 – 100. Note the following from the studied information: • Backflush costing is used in a JIT manufacturing system • Accounting for completed units is triggered by:

○ the manufacture of finished goods – the most simple method ○ the purchase of raw materials and components

Summary In this LEARNING UNIT we focussed on the determination of joint and by-products, the allocation of joint costs and the accounting treatment of by-products. The circumstances for applying Backflush Accounting were described.


Before you move on to the next LEARNING UNIT, please ensure that you have grasped the following concepts: Topic Yes/No 1. Conversion costs 2. Identifying joint products 3. Allocating joint product costs 4. Further processing costs 5. Measures for allocating joint costs 6. Treatment of by-product and their sales value and further processing costs 7. Backflush accounting situations

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PART 2 – Planning and control

PART 2 PURPOSE The purpose of part 2 is to enable students to have a critical and informed understanding of the key terms, rules, concepts and established principles of planning and control techniques.

DEEL 2 DOEL Die doel van deel 2 is om studente in staat te stel om ‘n kritiese en ingeligte begrip van die sleutelterme, reëls, konsepte en gevestigde beginsels van beplannings- en beheertegnieke te verkry.

TOPICS: 3. Planning, budgeting and control 4. Standard costing 5. Performance measurement

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PART 2, TOPIC 3 – Planning, budgeting and control

TOPIC 3 LEARNING OUTCOMES After studying this topic, you should be able to

• Design and compile fixed and flexible budgets • Explain how costs are controlled using various management tools • Calculate and interpret the break-even point and margin of safety of a business under different

scenarios and advise management based on your calculations.

ONDERWERP 3 LEER UITKOMSTE Na bestudering van hierdie onderwerp, behoort u in staat te wees om • Vaste- en veranderlike begrotings te ontwerp en op te stel • Te verduidelik hoe koste beheer word deur verskeie bestuurstegnieke te gebruik • Die gelykbreekpunt en veiligheidsmarge van ‘n besigheid in verskeie scenarios te bereken, en

die bestuur op grond van u berekeninge raad te gee.

LEARNING UNIT TITLE LEARNING UNIT 3.1 Budgeting and management control systems LEARNING UNIT 3.2 Other cost management techniques / principles LEARNING UNIT 3.3 Cost-volume-profit analysis

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LEARNING UNIT 3.1 Budgeting and management control systems

Prior Learning

This course assumes that students have already mastered the work equivalent to that presented in Unisa’s preceding postgraduate course, Advanced Management Accounting (‘Advanced’). Please ensure that you are up to date with the prior learning for budgeting and management control systems. If not, please refer to your undergraduate and advanced study material and revise the following indicated pages of the textbook, namely Drury using the page numbers below:


Before studying this topic, you should be able to deal with: • Corporate strategy and long-term planning

o Competitive advantage o Porter’s models o Value chain o Supply chain

• Budgeting

o Master, capital, cash and subsidiary budgets o Fixed and flexible budgeting o Zero-base budgeting o Activity-based budgeting o Stages in planning functions etc. o Responsibility centres o Behavioural aspects

Applicable references: • Drury: Chapter 15: The budgeting process Pages 368 - 398. • Drury: Chapter 16: Pages 411 - 420. • Drury: Chapter 15: Criticisms of budgeting Pages 393 - 395

● Management control systems ● Rolling forecasts

Introduction

In your prior learning you covered both the short-term and long-term aspects of the planning and control process, with focus on: • Flexible budgeting • Control ability • Non-profit-making organisations • Zero-based budgeting and • Management control systems

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Study Drury 9th ed. p388 – 390: Activity-based budgeting


Feedback 1 The cost driver rates are determined using the budget information. The flexible budget is then set using the actual activity, where after the variances are determined. This enables management to narrow down responsibility.

Summary In this LEARNING UNIT we focussed on further aspects related to budgeting other than those covered at the undergraduate level. We studied the controllability principle, activity-based budgeting in non-profit organisations, zero-based budgeting and criticisms of budgeting. Lastly we investigated other management control systems and their influence on employee behaviour.

Self-assessment activity Attempt questions: (Drury textbook) 9th ed: Question 16.21 p427 (Solution p765)

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LEARNING UNIT 3.2 – Cost management techniques / principles

Prior Learning

Review LEARNING UNIT 3.2 of MAC4861/102 on my Unisa under Additional Resources. Benchmarking

External and internal benchmarking can be used to compare key activities or processes in order to improve them.

Study • Drury (9th ed.) p571 – 572 (Benchmarking)

Note the following from the studied information:

• The advantages and disadvantages of benchmarking.


Strategic management accounting (SMA)

CIMA defines strategic management accounting as “A form of management accounting in which emphasis is placed on information which relates to factors external to the entity, as well as non-financial information and internally generated information.”

Study • Drury (9th ed.) p598 – 601

Also refer to the LEARNING UNIT in Finance tutorial letter 103 regarding Strategy.

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Summary

In this LEARNING UNIT we looked at changes in the business environment and developments in cost management techniques and philosophies. The use of benchmarking was also explained.


Ensure that you can describe the following concepts briefly in a paragraph:

1 Action or behavioural controls 2 Personnel, cultural and social controls 3 Results or output controls 4 Cybernetic control systems 5 Feedback and feed-forward controls 6 Life-cycle costing 7 Target costing 8 Kaizen costing 9 Activity-based management 10 Business process re-engineering 11 Cost of quality 12 Cost management and the value chain 13 Environmental cost management 14 Just-in-time systems 15 Strategic management accounting 16 Benchmarking

Enrichment Activity

Google the following concepts and read about a company that employs them:

• Life-cycle costing

• Kaizen costing

• Just-in-time systems

• Activity-based budgeting

You can also look it up in Wikipedia at http://www.wikipedia.org for more background on the history and applications.

http://www.wikipedia.org/

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LEARNING UNIT 3.3 Cost-volume-profit analysis

Prior Learning

This course assumes that students have already mastered the work equivalent to that presented in Unisa’s preceding postgraduate course, Advanced Management Accounting (‘Advanced’). Please ensure that you are up to date with the prior learning for cost-volume-profit analysis. If not, please refer to your undergraduate and advanced study material and revise the following indicated pages of the textbook, namely Drury using the page numbers below:


Before studying this topic, you should be able to: Applicable references:

• Calculate a break-even point and margin of safety • Calculate sensitivities for changes in any variables

in the CVP model.

• Drury: Chapter 8: Cost-Volume-Profit analysis. Pages 172 – 190.

Introduction

In previous LEARNING UNITs, we have looked at cost accumulation for inventory valuation and profit measurement using different bases. In this LEARNING UNIT, we will consider the use of the same basic financial information for decision-making by means of cost-volume-profit (CVP) analysis. CVP is especially valuable during planning and budgeting as it gives a broad indication of expected outcomes at different levels for different variables in the CVP model. The breakeven analysis and margin of safety are also very useful tools in measuring the riskiness of various plans or scenarios in the budget.

Focus notes Why does a business have to calculate a break-even point? • When you start a business you want to determine what sales level is required for it to survive.

• For a typical start-up business, it is critical to ensure that ongoing operating costs are covered by sales revenue in the short-to medium-term.

• In the long-term, the business can focus on making a profit. Once again the breakeven point and margin of safety will indicate the riskiness or sensitivities of various plans or strategies.

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Application of CVP • Please note that ALL variable costs and ALL fixed costs (production AND non-production costs)

are included in the break-even calculation.

• Contribution per unit equals the sales price per unit less ALL variable costs per unit. The contribution margin ratio is the contribution expressed as a percentage of sales.

• The net profit figure in a break-even calculation is ALWAYS BEFORE TAX. Therefore if you are told in a question that you are trying to achieve a net profit AFTER tax of, for example R50 000, you must first convert the R50 000 to a BEFORE tax amount before you use it in the break-even calculation.

• Remember that a break-even point (in units) should always be ROUNDED UP as one less unit sold will lead to a small loss.

• Unit information usually indicates a break-even in units and value/monetary information (eg Rand or a ratio based on rand) a break-even in Rand.

• The net profit is derived from the units sold in excess of the breakeven point, i.e. the contribution from the margin of safety sales.

• The margin of safety % indicates by how much sales volume can decline before the entity makes NIL profit.

• Sensitivity % for other variables in the model indicates how big a change can be absorbed before the entity makes no profit.

- ∆ in selling price/unit - ∆ in variable cost/unit - ∆ in total fixed costs

Impact of factors

All other factors remaining the same:

• An increase in selling price per unit will increase the contribution per unit and decrease the break-even sales required.

• An increase in variable cost per unit will decrease the contribution per unit and increase the break-even sales required.

• An increase in total fixed cost will increase the sales required to break-even. Generally, you will first have to determine the nature of the costs before proceeding with the break-even calculation.

Study the following in your textbook: • Drury (9th ed.): Chapter 8: Multi-product Cost-Volume-Profit analysis. Pages 182 – 184.

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Activity 1 – Basic principle

Bubbles Ltd sells two products, namely product X and product Y. The budgeted sales are divided equally (C1) between these two products and the budgeted contribution is R10 per unit of product X and R6 per unit of product Y. The actual sales for the period consisted of 75% for product Y and 25% (C2) for product X. The annual fixed costs are R560 000. Actual costs and selling prices are identical to the budget.(C3)

REQUIRED (a) Calculate the unit break-even points for budgeted and actual sales. (b) Analyse your results.

Feedback 1

(a) Budgeted average contribution = (50% x R10) + (50% x R6) = R5 + R3 = R8,00 Budgeted break-even point

= Fixed costs / Budgeted average unit contribution = R560 000 / R8,00 = 70 000 units Actual average unit contribution

= (25% x R10) + (75% x R6) = R2,50+ R4,50 = R7,00 Actual break-even point

= Fixed costs / Actual average unit contribution = R560 000 / R7,00 = 80 000 units

C1: Budgeted = 50:50

C2: Actual = 75:25

C3: No change to contribution or FC

C1: Average base used, based on 50:50 split.

C2: New split lowers average as more with low contribution sold.

C3: BE now higher as average down.

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(b) The break-even point varies depending on the composition of

the sales mix.

The actual sales mix is different from the budgeted sales mix (see note above) and therefore the actual average unit contribution is different from that used in the budgeted break-even calculation.

Activity 2 Work through example: (Drury textbook) 9th ed: Example 8.2 p183 Attempt question: (Drury Student Manual) 9th ed: Question 8.9

Feedback 2

• Specific and general fixed costs. Some questions may specify breakeven in terms of the specific costs.

• Current mix implies total basis – individual b/e’s not required. • Average contribution used.

Activity 3 – ‘What if’s’ Paramountain Ltd manufactures and sells video equipment. Every video recorder sells for R1 150, and variable costs amount to R850 per unit. Total annual fixed costs amount to R150 000.

The following operating results for the previous year were given:

R Sales 1 265 000 Less: Variable costs 935 000 Contribution margin 330 000 Less: Fixed costs 150 000 Net income 180 000

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REQUIRED Mark (a) Determine the break-even point in units; (2) (b) Calculate the margin of safety based on sales units, if Paramountain expects to sell

1 200 video recorders this year;

(1) (c) Refer to the original data. Management would like to increase the net income from the

previous year. The marketing manager would like an additional amount of R25 000 set aside for advertising purposes. The sales manager believes that a 12,5% reduction in the selling price, combined with the additional advertising, should cause annual sales in units to increase by 25%. Prepare a contribution income statement, showing the results of operations if the changes are made. Advise management whether or not to adopt the suggested changes.

(6) (d) Refer to the original data. The financial manager does not want the selling price to

change, as it would lead to a lot of administrative work. Instead, he suggests that costs should be cut and advertising increased. He suggests negotiating with the suppliers for a price cut of R90 on a circuit used in the production of the video recorders, and improving productivity in order to save R25 on labour costs per recorder. The manager believes that additional advertising should also increase annual sales by 40%. By how much can advertising increase for profits to remain unchanged.

(3) (e) Refer to the original data. Assume that the company is only producing 850 video

recorders per year. An order has been received for 600 units on a special price basis. What unit price would have to be quoted to the buyer if Paramountain Ltd wants to earn an overall profit of R195 000 for the year? (You may assume that the present sales will not be affected by the special price order).

(3)

Feedback 3

Scenario analysis is often required as part of the decision-making process.

(a) Break-even point Break-even point = Fixed cost / Contribution = R150 000 / (R1 150 - R850) = 500 units (2) (b) Margin of safety = (Expected sales - Break-even sales) / Expected sales = (1 200 - 500) / 1 200) = 58,33% (1) (c) Proposal: Contribution income statement Calculation R

Sales (1 100 x [R1 150 - 12,5%] x 1,25 1 383 594 Variable costs (1 100 x R850 x 1,25) 1 168 750 Contribution 214 844 Fixed costs (150 000 + 25 000) 175 000 Net income 39 844 (4)

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Working:

Calculate last year’s number of units sold: R1 265 000 / R1 150 = 1 100 units sold (1) Management should not accept the changes, as it decreases net income. (1)

(d) Net income = Sales - Variable costs - Fixed costs NI = SP x - Varx - FC R180 000 = (1 100 x 1,4 x R1 150) - (1 100 x 1,4 x [850 - 90 - 25]) - R150 000 – advertising R180 000 = R1 771 000 - R1 131 900 - 150 000 - advertising R180 000 = R489 100 - advertising Advertising = R309 100 (3) Advertising may increase with R309 100, representing the incremental contribution margin, without affecting the net income.

(e) NI = SP x - VarCx - FC R195 000 = (R1 150 x 850) + (600 x SP) - (1450 x R850) - R150 000 R195 000 = R977 500 + 600SP - R1 232 500 - R150 000 600SP = R600 000 SP = R1 000 per unit (3)

Summary In this LEARNING UNIT we focused on the calculation of the break-even point, the margin of safety and the impact of changes in breakeven components on profit.

Self-assessment activity Knowledge check: Before proceeding to the next LEARNING UNIT, ensure that you are on par with the following concepts:

Yes/No 1. Classification of costs 2. Determination of fixed and variable costs 3. Definition and calculation of contribution 4. Calculation of the break-even point 5. Interpretation of margin of safety and other sensitivity percentages 6. Effect of change of a given factor on profit or other relevant issue.

END OF CONTENT FOR TEST 1

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PART 2, TOPIC 4 – Standard costing

TOPIC 4 LEARNING OUTCOMES After studying this topic, you should be able to

• Calculate and analyse variances • Provide suitable explanations for variances found • Reconcile budgeted income and expenses to actual income and expenses • Decide on the appropriate accounting treatment of material variances

ONDERWERP 4 – LEER UITKOMSTE Na bestudering van hierdie onderwerp behoort u in staat te wees om

• Afwykings te bereken en te ontleed • Geskikte verduidelikings vir verkreë afwykings te verskaf • Begrote inkomste en uitgawes met werklike inkomste en uitgawes te rekonsilieer • Te besluit oor die toepaslike rekeningkundige hantering van wesenlike afwykings

LEARNING UNIT TITLE LEARNING UNIT 4.1 Variance analysis LEARNING UNIT 4.2 Reconciliation of budget to actual LEARNING UNIT 4.3 Variance analysis for controlling purposes LEARNING UNIT 4.4 Pro-rating of variances and compliance with the relevant accounting

standard Introduction Standard costing is a financial control system that analyses deviations from budget in detail in order to control future costs and forms part of the process of management by exception. Standards are predetermined target costs and selling prices which represent a benchmark that should be achieved under normal conditions. Standard costs are the expected or budgeted costs for producing a single unit of a product or a service. Quantity standards and cost (price) standards are set for the materials, labour and overheads consumed in producing a unit of the product. In order to apply standard costing, standardised tasks or repetitive operations must be involved for which a standard time or quantity and cost can be determined.

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LEARNING UNIT 4.1 Variance analysis

Prior Learning

This course assumes that students have already mastered the work equivalent to that presented in Unisa’s preceding postgraduate course, Advanced Management Accounting (‘Advanced’). Please ensure that you are up to date with the prior learning for variance analysis. If not, please refer to your undergraduate and advanced study material and revise the following indicated pages of the textbook, namely Drury using the page numbers below:

Prior learning Drury 9th ed. Before studying this topic, you should be able to deal with: • Design of standard costing systems

Applicable references: Drury: Chapter 17, pages 434 – 463

• Variance analysis • Reporting on variance analysis Drury: Chapter 18, pages 471 – 482 • Reconciliation of budget to actual • Investigation of variances and exception reporting Drury: Chapter 18, pages 483 – 485 • Pro-rating of variances and compliance with the

relevant accounting standard Drury: Chapter 7, pages 159 – 162

• Cost estimation when the learning curve effect is present

Drury: Chapter 23, pages 640 – 643

Study

Recap by reviewing LEARNING UNIT 1.1 of MAC4861/103 on myUnisa under Additional Resources and then studying: • Ex post variance analysis / Distinguishing between planning and operating variances –

Drury (9th ed.) p482 – 483. • ABC variance analysis – Drury (9th ed.) p485 – 487.


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Feedback 1 The correct variance needs to be used in calculating actual quantities and costs. As a marginal costing system is used, fixed overhead is not relevant.


Feedback 2 The variance ‘formula’ is used to determine the required. Note the layout followed.

Summary In this LEARNING UNIT, we revisited the calculation and meaning of various standard cost variances for both variable and absorption costing systems. Some issues in calculating mix variances were also highlighted.

Self-assessment activity Attempt question: (Drury Student Manual) 9th ed: Question 18.3

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LEARNING UNIT 4.2 – Reconciliation of budget to actual

Prior Learning

Review LEARNING UNIT 1.2 of MAC4861/103 on myUnisa under Additional Resources.


Feedback 1 Because a JIT system is in use, it implies that production equals sales. Note specifically the approach from a sales volume angle.

Summary In this LEARNING UNIT we studied the reconciliation of budgeted profit to actual profit by means of adding the favourable to and deducting the adverse production and sales variances from the budgeted profit.

Self-assessment activity Attempt questions: (Drury Student Manual) 9th ed: Question 17.7

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LEARNING UNIT 4.3 – Variance analysis for controlling purposes Introduction In the prior LEARNING UNIT 4.1 we looked at the calculation of the various variances. In this LEARNING UNIT we will study the factors that should be considered when deciding whether it is worthwhile to investigate variances.

Study • Drury (9th ed.) p482 – 483 (Ex post variance analysis) / (Distinguishing between planning and

operating variances) • Drury (9th ed.) p483 – 485 (The investigation of variances) • Drury (9th ed.) p485 – 487 (The role of standard costing when ABC has been implemented) Note the following from the studied information: • The impact of controllability on variance reporting, i.e. flexing and planning variances. • The causes of variances and the methods used to determine whether an investigation is justified. • The types of costs for which an ABC system variance analysis is appropriate.


Feedback 1 The ex-post plan drives planning (uncontrollable) and operational variances.

Summary In this LEARNING UNIT we looked at the reasons for variances and the models used by organisations to ensure that the benefits from investigating variances exceed the costs. The use of standard costing when an ABC system is in use was also investigated.

Self-assessment activity Attempt question: (Drury textbook) 9th ed: Question 18.18 p492 (Solution p774 - 775)

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LEARNING UNIT 4.4 Pro-rating of variances and compliance with the relevant accounting standard

Prior Learning

Review LEARNING UNIT 1.4 of MAC4861/103 on my Unisa under Additional Resources.

Summary IAS 2 requires the use of absorption costing to value closing inventory for external reporting purposes. Furthermore, the allocation of fixed production overheads should be based on normal capacity. Standard costing is allowable for financial statements if the cost approximates actual cost. Usual variances should be investigated and a decision taken on whether the variance becomes a period cost, or whether the standard is adjusted and inventory is revalued.

Self-assessment activity Before moving on to the next topic, make sure that you have grasped the following: When a standard costing system can be used to value inventories - the accounting treatment of variances that arise between actual costs and standard (or allowed) costs - the treatment of an unusually high fixed production volume capacity variance.

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PART 2, TOPIC 5 – Performance measurement TOPIC 5 LEARNING OUTCOMES After studying this topic, you should be able to: • Have a critical understanding of appropriate performance measures within an organisation. • Distinguish between the managerial and economic performance of the division. • Explain the meaning of return on investment (ROI), residual Income (RI) and Economic Value Added (EVA). • Compute and apply the above performance measures.

ONDERWERP 5 LEER UITKOMSTE Na bestudering van hierdie onderwerp behoort u in staat te wees om

• ‘n Kritiese begrip van geskikte prestasiemaatstawwe binne ‘n organisasie te hê. • Te onderskei tussen die bestuurs- en ekonomiese prestasie van die afdeling. • Die betekenis van opbrengs op belegging (OOB/ROI) residuele inkomste (RI) en ekonomiese waarde toegevoeg (EWT/EVA) te verduidelik. • Bogenoemde prestasiemaatstawwe te bereken en toe te pas.

LEARNING UNIT TITLE LEARNING UNIT 5.1 Divisional financial performance measures LEARNING UNIT 5.2 Transfer pricing in divisionalised companies

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LEARNING UNIT 5.1 Divisional financial performance measures

Prior Learning

This course assumes that students have already mastered the work equivalent to that presented in Unisa’s preceding postgraduate course, Advanced Management Accounting (‘Advanced’). Please ensure that you are up to date with the prior learning for divisional financial performance measures. If not, please refer to your undergraduate and advanced study material and revise the following indicated pages of the textbook, namely Drury using the page numbers below:

Prior learning Drury 9th ed. Before studying this topic, you should be able to deal with:

Applicable references: Chapter 19:

• Divisionalised organizational structures Drury page 498 • Profit centres and investment centres Drury page 498 • Advantages and disadvantages of divisionalisation Drury page 499 • Pre-requisites for successful divisionalisation Drury page 499 • Distinguishing between the managerial and economic

performance of the division Drury page 499

• Alternative divisional profit measures Drury page 500 • Return on investment Drury page 502 • Residual income Drury page 503 • Economic value added (EVA™) Drury page 504 • Determining which assets should be included in the investment

base Drury page 508

• The impact of depreciation Drury page 509 • The effect of performance measurement on capital investment

decisions Drury page 510

• Addressing the dysfunctional consequences of short-term financial performance measures

Drury page 512

• Benchmarking Drury page 571 • Controls at different organizational levels • Responsibility centres

Drury page 405 Drury page 411 - 413

Introduction

In your prior learning the evaluation of divisional performance by employing appropriate performance measures and distinguishing between managerial and economic performance were covered. In this LEARNING UNIT we shall focus primarily on computing three financial performance measures viz. ROI, RI and EVA and discuss the influence of these measures on capital investment decisions. Finally, we shall discuss various approaches that can be employed to overcome the short-term orientation associated with accounting profit-related measures.

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Study

9th ed.

• Residual income Drury page 503 • Economic value added (EVA™) Drury page 504 • Determining which assets should be included in the investment base Drury page 508 • The impact of depreciation Drury page 509 • The effect of performance measurement on capital investment decisions Drury page 510 • Addressing the dysfunctional consequences of short-term financial

performance measures Drury page 512

• Benchmarking Drury page 571 • Controls at different organizational levels • Responsibility centres

Drury page 405 Drury page 411 - 413

Activity 1

Attempt question: (Drury textbook) 9th ed: Question 19.23 p521 (Solution p782)

Feedback 1

The calculated values use annuity factors. Ensure that you understand the principles.

• Financial performance measures should include only the factors directly controllable by the

manager. Therefore, distinguish between managerial and economic performance.

• Non – financial factors (e.g. competitiveness, productivity, quality, etc) should be incorporated in performance measures in order to mitigate the short – term orientation of managers.

• EVA adjusts for distortions introduced by generally accepted accounting principles into the divisional performance measure to measure economic performance (the starting point though, is the accounting profit based on historic costs and not future cash flows).

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3. Calculate the capital charge by multiplying the controllable investment (2) with the WACC (1).

4. Deduct the capital charge (3) from the adjusted profit or adjusted cash profit (1) to calculate the economic value added.

• If the EVA > 0, economic value is created/added. • If EVA < 0, capital is destroyed.

EVA = Adjusted Divisional – (Adjusted Capital Employed X Divisional WACC)

• The Capital Employed is adjusted as follows (figures imaginary and in R’000): Owner’s Equity (NAV) 4 333 Add Goodwill amortisation 253 Add Deferred tax and other Provisions 14 Add total Debt 467 Adjusted capital Employed

5 067

• Adjust the Net Profit as follows:

Operating profit before Tax 2 642 Add Interest expense 120 Minus Tax 469 Minus extra-ordinary gains 20 NOPAT 2 273

Above will be illustrated by working through activity 2.

Calculation of EVA:

1. Adjust for IFRS distortions (starting point – obtaining WACC and accounting profit)

• Add back expenses that will have value over a longer term than one year. • Amortise capitalised expenses over an appropriate lifespan. • Replace depreciation with economic holding gains/losses.

Note: You are required to calculate WACC.

2. Calculate the value of the controllable investment

• The term controllable investment refers to the net asset base that is controlled by divisional managers. If the purpose is to evaluate the performance of a divisional manager, then only those assets that can be directly attributed to the division and are controllable by the manager should be included in the asset base. This means that only assets that can be influenced by the divisional manager ought to be included in the measure. For instance, if debtors and cash are administered by central headquarters, they should be excluded because a divisional manager cannot influence these items.

• Use replacement values when available, else use as stipulated hereafter. • Non-current assets at market value plus net working capital at realisable values plus

capitalised expenses at amortised values.

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Activity 2 – EVA

Attempt question: (Drury textbook) 9th ed: Question 19.21 p520 (Solution p780 – 781)

Feedback 2

The discussions in part a regarding expenses that add value give good guidance on this issue.

Advantages of EVA: • EVA achieves goal congruence (as the interests of the company as a whole are considered) • Non-financial factors (e.g. competitiveness, productivity, quality, etc) should be incorporated in

performance measures in order to mitigate the short- term orientation of managers. • EVA adjusts for distortions introduced by generally accepted accounting principles into the divisional

performance measure to measure economic performance (the starting point though, is the accounting profit based on historic costs and not future cash flows).

• Managers are encouraged to ‘think” in the same way as shareholders: EVA actively encourages increasing shareholders’ wealth

• Under-utilised assets are identified. • Puts emphasis on the achievement of long-term goals and shows the benefits of research and

development expenditure, training and marketing costs. Disadvantages of EVA: • The EVA can only provide a rough approximation of economic profit as the starting point for

calculating EVA is the conventional accounting profits, based on historic costs and, not future cash flows.

• The EVA calculation involves making a number of adjustments to the profitability measure in order to convert the historic accounting data and thereby approximate economic profit and asset values.

• The use of estimates of economic profit in evaluating performance results in lack of precision and objectivity.

Activity 3

Attempt questions:

9th ed: (Drury Student Manual) Question 19.11 9th ed: (Drury textbook) Question 19.17

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Feedback 3

In question 19.11 the target structure and cash flows are relevant.

Share-based compensation

Refer to tutorial letter 103 of MAC4861, LEARNING UNIT 2.1.

Summary

In this LEARNING UNIT we focussed on further aspects related to performance measurement. We studied both short- and long-term performance measures.

Assessment / self-assessment


1. Economic performance 2. Economic value added 3. Managerial performance 4. Return on capital employed 5. Return on investment 6. Residual income

Enrichment activity 1

Google the term ‘Economic value added’ and read about a local company that employs it. You can also look it up in Wikipedia at http:/www.wikipedia.org.

Enrichment activity 2

Peruse and absorb the performance measures reported on in the following pages. Note the commonalities and focus areas of the different companies.

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LEARNING UNIT 5.2 Transfer pricing in divisionalised companies

Prior Learning

This course assumes that students have already mastered the work equivalent to that presented in Unisa’s preceding postgraduate course, Advanced Management Accounting (‘Advanced’). Please ensure that you are up to date with the prior learning for the topic of transfer pricing. If not, please refer to your undergraduate and advanced study material and revise the following indicated pages of the textbook, namely Drury using the page numbers below:

Prior learning Drury 9th ed. Before studying this topic, you should be able to:

Applicable references: Chapter 20:

• Discuss the purpose of transfer pricing Drury pages 526 – 527 • Apply alternative transfer pricing methods Drury pages 527 – 535 • Consider proposals for resolving transfer pricing conflicts Drury pages 535 – 538 • Recommend domestic transfer pricing Drury pages 538 – 539 • Evaluate international transfer pricing Drury pages 539 – 541 • Discuss the economic theory of transfer pricing

Drury pages 543 – 549

Introduction

In your prior learning various methods that can be employed in determining internal transfer pricing, achieve organisational objectives and the general goals of transfer pricing were discussed. In this section we shall focus primarily on resolving transfer pricing conflicts, setting international transfer pricing and finally, setting transfer prices when there is no external market for the intermediate product.

Study

9th ed.

• Proposals for resolving transfer pricing conflicts Drury pages 535 – 538 • Domestic transfer pricing recommendations Drury pages 538 – 539 • International transfer pricing Drury pages 539 – 541 • Appendix 20.1: Economic theory of transfer pricing Drury pages 543 – 549

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Focus notes Goals of transfer pricing system:

• To motivate the divisional managers to make decisions to the advantage of the company or group as a whole (goal congruence).

• To ensure that each division’s performance is reasonable, measurable and comparable (achieve equity).

• The system should be simple to operate and administer. • The managers should still have the ability to make autonomous decisions and enter into negotiations

with each other. • If possible, healthy competition between divisions should be encouraged by the transfer pricing

system.

Rule of thumb:

The following ‘rules of thumb’ may be applied when a question asks for the calculation of a transfer price that will lead to goal congruence within the company:

1. Minimum transfer price (that the supplying division will accept).

o The minimum transfer price should comprise the incremental cost (usually variable cost plus any increase in fixed costs) and opportunity cost.

o Opportunity cost exists only if there are sacrificed external sales due to the internal transfer of goods (and is the contribution thus lost).

2. Maximum transfer price (that the receiving division would pay)

o If there is an external market to buy from, the transfer price should be the Market price less savings on selling and transport expenses

3. The maximum negotiated profit

o This refers to the incremental profit that would be made by the receiving division on the ultimate sale of the goods.

4. The negotiated transfer price (normally obtained through negotiation between selling and buying divisions)

• It should lie between the minimum and maximum prices calculated. • Range of Acceptable transfer prices: The Upper limit (determined by the buying division) Lower limit (determined by the selling division)

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Advantages of negotiated transfer prices:

• Negotiated transfer prices preserve the autonomy of the divisions, which is consistent with the spirit of decentralization.

• The managers negotiating the transfer price are likely to have much better information about the potential costs and benefits of the transfer than others in the company.

Behavioural implications of transfer pricing

The selling division may refuse to supply due to the following:

• The price offered not being able to cover marginal cost (where marginal cost pricing is used).

• The price offered not being able to cover full costs (where full cost pricing is used). • The price offered not being able to give the supplying division optimum profitability (where

market related prices are used and divisional performance is judged on profitability). • Failure to agree a negotiated price.

The buying division may refuse to take supply due to the following:

• The price charged is considered excessive. • In cost based approaches this may be due to disputes relating to the supplying division’s

cost structure or the size of the mark – up. • In market based approaches there may be disputes as to the quantum of the discounts

for cost savings related to internal transfers.

Activity 1 - Transfer based on different cost bases Attempt question: 9th ed: (Drury textbook) Question 20.19

Feedback 1: Question 20.19 (9th ed.) Note the effect of the transfer pricing system on the optimum output level and profits for the company as a whole.

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Activity 2 - Transfer price and bonus Attempt question: (Drury Student Manual) 9th ed: Question 20.7

Feedback 2 Residual income used to measure performance. Consider the ‘what-if’ scenarios carefully.

Summary

In this LEARNING UNIT we looked at the purposes of a transfer pricing system, proposals to resolve conflict and the recommendations in respect of domestic and international transfer pricing.

Assessment / self-assessment Ensure that you can 1. Motivate a recommended transfer price 2. Apply transfer price principles to different cost bases 3. Distinguish between domestic and international transfer prices Enrichment activity Visit the JSE Industrial Sector companies’ annual financial statements and read about their application of transfer prices.

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PART 3 – Information for decision-making

PART 3 PURPOSE The purpose of part 3 is to enable students to have a critical and informed understanding of the key terms, rules, concepts and established principles of collecting and using information in making short-term decisions. DEEL 3 DOEL Die doel van deel 3 is om studente in staat te stel om ‘n kritiese en ingeligde begrip van die sleutelterme, reëls, konsepte en gevestigde beginsels van die insameling en gebruik van inligting in die neem van korttermynbesluite te hê. Topics 6. Decision-making under conditions of risk and uncertainty 7. Information application to decisions

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PART 3, TOPIC 6 – Decision-making under conditions of risk and uncertainty

TOPIC 1 LEARNING OUTCOMES After studying this topic, you should be able to: • Have a critical understanding of key concepts, rules and established principles of decision-

making. • Explain the meaning of the terms of standard deviation and coefficient of variation as

measures of risk and outline their limitations • Describe and calculate the value of perfect and imperfect information. • Explain and apply the maximin, maximax and regret criteria • Explain the implications of pursuing a diversification strategy • Apply the principles of decision-making.

ONDERWERP 1 LEER UITKOMSTE Na bestudering van hierdie onderwerp behoort u in staat te wees om: • ‘n Kritiese begrip van die sleutel konsepte, reëls en gevestigde beginsels van besluitneming

te hê. • Die betekenis van die terme standaard afwyking en koëffisiënt van variansie as maatstawwe

van risiko te verduidelik en hul beperkings te kan omlyn. • Die waarde van perfekte en nie-perfekte inligting te omskryf en bereken. • Die maximin, maximax en berou kriteria te verduidelik en toe te pas. • Die implikasies van die navolg van ‘n diversifikasie strategie te verduidelik. • Die beginsels van besluitneming toe te pas.

LEARNING UNIT LEARNING UNIT 6.1 Decision-making under conditions of risk and uncertainty

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LEARNING UNIT 6.1 – Decision-making under conditions of risk and uncertainty

Prior Learning

This course assumes that students have already mastered the work equivalent to that presented in Unisa’s preceding postgraduate course, Advanced Management Accounting (‘Advanced’). Please ensure that you are up to date with the prior learning for decision-making under conditions of risk and uncertainty. If not, please refer to your undergraduate and advanced study material and revise the following indicated pages of the textbook, namely Drury using the page numbers below:

Prior learning Drury 9th ed. Before studying this topic, you should be able to:

Define risk and uncertainty. Calculate probability distribution and expected value. Measure the amount of uncertainty/risk. Describe individuals’ attitudes to risk. Establish the buying of perfect and imperfect information Calculate maximin, maximax and regret criteria.

Applicable references: Chapter 12: Drury page 287 - 288 Drury page 289 - 290 Drury page 290 - 291 Drury page 291 - 293 Drury page 294 - 295 Drury page 296 - 297

Introduction In prior learning the impact of risk and uncertainty in business-decision making was examined. It was also mentioned that business decisions are influenced by managerial subjectivity as managers normally draw from their expert knowledge, past experience and existing situations likely to impact on future events due to the uncertain business environment. In this section we shall look at how the principle of probability theory enables management to consider the degree of uncertainty associated with each course of action when making business decisions. We shall also describe and calculate the value of perfect information, and finally explain the diversification strategy.

Study Drury 9th ed.

• Measuring the amount of uncertainty Drury page 290 - 291 • Buying perfect and imperfect information Drury page 294 - 295 • Maximin, maximax and regret criteria Drury page 296 - 297 • Risk reduction and diversification Drury page 297

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Focus notes

• The concept of expected value considers a range of possible outcomes rather that a single

estimate. It involves multiplying each outcome (say projected sales level) by its associated probability (likelihood that it will occur).

• The standard deviation calculates the degree of variability in the possible outcomes. • Though expected value, standard deviation and coefficient of variation sum up the characteristics

of alternative courses of action, these measures do not provide the decision – maker with all the relevant information as does the probability distribution.

• When it is difficult to assign reasonable probability to possible outcomes, management may employ the “maximin, maximax and regret” criteria to make decisions.

Activity 1

Calculating a portfolio return (expected value), standard deviation and coefficient of variation.

Consider the following:

State of economy

Probability of State of Economy

Rate of return Share A

Rate of return Share B

Rate of return Share C

Boom 0.15 0.30 0.45 0.33 Good 0.25 0.12 0.10 0.15 Poor 0.55 0.01 -0.15 -0.05 Bust 0.05 -0.20 -0.30 -0.09

Your portfolio is invested 40 per cent in A and C, and 20 per cent in B.

REQUIRED

Calculate the expected return, standard deviation and the coefficient of variation of the portfolio.

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Feedback 1 1. Calculate the expected return of the portfolio.

State

Prob Share A Weighting

(40%) Share B Weigh-

ting (20%) Share

C Weighting

(40%) Return Sum

Portfolio return

Return Return*40% Return Return*20%

Return Return*40% of weight returns

Weight* Prob

Boom 0.15 0.30 0.12 0.45 0.09 0.33 0.132 0.342 0.0513 Good 0.25 0.12 0.048 0.10 0.02 0.15 0.06 0.128 0.032 Poor 0.55 0.01 0.004 -0.15 -0.03 -0.05 -0.02 -0.046 -0.0253 Bust 0.05 -0.20 -0.08 -0.30 -0.06 -0.09 -0.036 -0.176 -0.0088

0.0492

Expected value 4.92%

2. Calculate the standard deviation (σ) of the portfolio.

State Probability Return (R)

Portfolio variances

Squared variances Weighted amount

R-EV (R-E)2

(R-E)2 * Probability

Boom 0.15 0.342 0.2928 0.085732 0.0128598 Good 0.25 0.128 0.0788 0.006209 0.0015524 Poor 0.55 -0.046 -0.0952 0.009063 0.0049847 Bust 0.05 -0.176 -0.2252 0.050715 0.0025358

σ2 0.0219326 σ 14.81%

3. Calculate the coefficient of variation (CV)

CV = σ/EV

= 0,1481/0,0492

= 3,01

= 301%

• The SD measures the dispersion of returns around the expected value (mean). The portfolio mean is low indicating low variance and thereby low risk.

• The CV measures the relative amount of dispersion by expressing risk in relation to the return. In this case for every 1 unit of risk there is more than 1 corresponding unit of return which indicates low risk.

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Activity 2 - Calculating the value of perfect information

Zabalaza (Pty) Ltd has to choose between its two machines that produce product Z. Machine Zamalek has low fixed costs and high variable cost/unit and is therefore suited to low volume production. Machine Zozo on the other hand, has high fixed costs and low variable cost/unit rendering it suitable for high volume production. The probability distribution for product Z is as follows:

State of production

Probability Machine Zamalek Profit

Machine Zozo Profit

Low 0.5 R100 000 R10 000 High 0.5 R160 000 R200 000

REQUIRED Zabalaza (Pty) Ltd could acquire perfect information regarding the state of nature by undertaking an extensive market research. What is the maximum price that the company should pay for this information?

Feedback 2 1. Calculate the expected value of each machine without perfect information.

Machine Zamalek: R130 000 [(0.5*R100 000) + (0.5*R160 000)] Machine Zozo: R105 000 [(0.5*R10 000) + (0.5*R200 000)] Machine Zamalek has the highest expected value and will be chosen based on expected

value only (i.e. no perfect information available). 2. Calculate the expected value with perfect information.

R150 000 [(0.5*R100 000) + (0.5*R200 000)]

The calculation uses the highest profit if there is low demand and the highest profit if there is high demand.

3. Calculate the value of perfect information. The amount to be paid should be limited to the difference between the expected value with and without perfect information: R20 000 [R150 000 – R130 000].

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Activity 3

Attempt question:

9th ed: (Drury textbook) Question 12.18

Feedback 3 Note the use of contribution and the application of capacity constraints.

Summary

In this LEARNING UNIT the calculation of risk indicators, the value of perfect information and risk diversification was covered.



1. Expected value 2. Co-efficient of variation 3. Perfect information 4. Risk diversification 5. Standard deviation

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PART 3, TOPIC 7 – Information application to decisions

TOPIC 2 LEARNING OUTCOMES

After studying this topic, you should be able to:

• Explain the meaning of relevance. • Distinguish between relevant and irrelevant costs and revenues. • Determine the product-mix that will maximize profit when capacity constraints apply. • Explain why the book value of equipment is irrelevant when making equipment replacement

decisions. • Describe the opportunity cost concept. • Explain the theory of constraints and throughput accounting.

ONDERWERP 1 LEER UITKOMSTE Na bestudering van hierdie onderwerp behoort u in staat te wees om: • Die betekenis van relevantheid te verduidelik. • Tussen relevante en irrelevante koste en inkomste te onderskei. • Die produkmengsel wat wins sal maksimaliseer wanneer kapasiteitsbeperkings van toepassing

is, te bepaal. • Te verduidelik waarom die boekwaarde van toerusting irrelevant is wanneer besluite oor die

vervanging van toerusting gemaak word. • Die konsep van geleentheidskoste te verduidelik. • Die teorie van beperkings en deurvoer rekeningkunde te verduidelik.

LEARNING UNIT LEARNING UNIT 7.1 - Relevant costs and revenues for decision-making

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LEARNING UNIT 7.1 – Relevant costs and revenues for decision-making

Prior Learning

This course assumes that students have already mastered the work equivalent to that presented in Unisa’s preceding postgraduate course, Advanced Management Accounting (‘Advanced’). Please ensure that you are up to date with the prior learning for relevant costs and revenues for decision-making. If not, please refer to your undergraduate and advanced study material and revise the following indicated pages of the textbook, namely Drury using the page numbers below:


Before studying this topic, you should be able to: • Describe the meaning of relevance. • Highlight the importance of qualitative factors. • Make special pricing decisions. • Make product-mix decisions when capacity constraints exist. • Consider outsourcing and make or buy decisions. • Make discontinuation decisions. • Determine the relevant costs of direct materials and direct labour. • Explain the relevant cost information that should be presented in

price setting firms for both short-term and long-term decisions.

Applicable references: Chapter 9: Drury page 199 Drury page 199 - 200 Drury page 200 - 204 Drury page 204 - 207 Drury page 208 - 211 Drury page 211 - 213 Drury page 213 - 214 Chapter 10: Drury page 231 - 245

Introduction In the previous module we dealt with the measuring of costs and benefits for non – routine decisions such as, deciding on making a component within the company or buying from an outside supplier, or introducing a new product and replacing existing equipment were dealt with. It was further mentioned that in non-routine decisions, only those costs and benefits relevant to the specific alternative courses of action should be considered. In this section we shall look at the key concept that should be applied in making product-mix decisions when capacity constraints exist and also discuss equipment decisions, explaining why equipment book values are irrelevant in such decisions. Finally, we shall describe the process of maximising operating profit when confronted with bottleneck and non-bottleneck operations, the theory of constraints (TOC).

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Study

Drury 9th ed. • The key concept that should be applied for presenting information

for product-mix decisions when capacity constraints apply. Drury page 204-207

• Replacement of equipment and the irrelevance of past costs. Drury page 207-208 • Appendix 9.1: The theory of constraints and throughput

accounting. Drury page 216-220

Information explanation

• Relevant cost or benefit - is a future cash flow arising or changing as a direct consequence of the decision under review.

• Costs and benefits that are independent of a decision are not relevant and need not be considered when making the decision. Only differential or incremental cash flows should be taken into account.

• Cash flows that will be the same for all alternatives are irrelevant. Cash flows that have already been incurred are sunk costs and irrelevant for decision-making.

• The total relevant cost of production is usually the variable cost per unit multiplied by the additional units produced plus (or minus) any change in the total expenditure on fixed costs.

• Committed costs cannot be relevant to a decision that a manager is making now to improve or maximise profits.

• Fixed Costs are irrelevant costs (Except for such costs as incremental and divisible fixed costs) • Total Variable Costs: Variable costs are often considered as relevant costs. Committed variable costs

are nevertheless irrelevant to decision making. Guidelines for determining material and labour relevancy

Material Purchased in the past

• Sunk cost

Ordered or received, not yet paid • Sunk cost (already committed to pay), unless able to return the goods to the supplier

No other use at present • No value (0) Could be sold directly • Net realisable value May be used on another job • Lost contribution (opportunity cost) Frequently used • Replacement cost Used as a substitute • Cost saved by not having to purchase other

material Must otherwise be disposed of • Opportunity saving

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Labour

Salaried labourers:

• Already working at business = No cost • Work overtime = Overtime cost

Additional labourers / wage workers:

• Employ additional labourers = Basic pay • New labourers work overtime = Basic pay plus overtime • Specialised labour (scarce) = Opportunity cost of projects sacrificed

Activity 1 - Revision

Attempt question:

9th ed: (Drury textbook) Question 9.22

Feedback activity 1

Note the initial requirement of the question 9.22 (9th ed.) for the evaluation of the outsourcing decision options from a financial perspective. Note the subsequent requirement to evaluate the non-financial aspects.

Activity 2 – Throughput accounting

Attempt questions: (Drury Student Manual)


Feedback activity 2

A sequential approach of profit, profit based on constraints and throughput is followed. This approach should also be followed in questions where such a detailed requirement was not presented.

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Activity 3 – Pricing

Attempt question: (Drury Student Manual)

9th ed: Question 10.4 Refer also to MAC4861 Tutorial letter 103 for the study material on pricing decisions which is a very important topic.

Feedback activity 3

Note specifically the approach used based on marginal cost and contribution.

Summary In this LEARNING UNIT we considered capacity constraints, irrelevance of past costs and throughput accounting.

Assessment / self-assessment Ensure that you can apply the following concepts in any given scenario: • Pricing of customized products • Pricing based on target costing • Cost-plus pricing • Customer profitability analysis • Pricing of special orders • Outsourcing • Make- or buy decisions • Discontinuation decisions • Relevance of material and labour • Constraints in business • Throughput accounting • Replacement of equipment

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Integrated self-assessments As mentioned in the introduction you will now have the opportunity to assess whether you can apply your technical knowledge of individual topics, in an integrated scenario. We will start with an easier case study and then progress to a more advanced one.

General Guidelines You should attempt the case studies under exam conditions. Time yourself. In real tests, you receive the scenario first and have reading time before receiving the required section. You should attempt the case studies in this tutorial letter in the same manner.

Read the information in the scenario at least twice

Ensure that you have read every line in the scenario. Remember that you have to use all the information that is given to you. Read the scenario line by line and highlight important information, relating this as far as possible to particular topics and principles even though you do not yet know the content of the required section. Read the ‘required’ very attentively. Note specifically what you should present in the answer, i.e.: - budget, actual or forecast amounts – what advice is required - for the year, month or week - standard or actual - costing basis (variable or absorption) This is the methodology that you should use for every question that you attempt. We will now take you through activities to illustrate the approach. You are also advised to work through as many questions as possible in the Drury Student Manual. Use information encountered for the first time to build up a data base of ‘info statements’ linked to ‘what to do’s’. This is what you need to look for when reading a test or examination scenario. Once you have read and understood the scenario and the ‘required’ you can start answering the question.

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Activity 1 Attempt question (Drury Student Manual)


Feedback 1

Note the general approach to fixed costs and it’s consequent application. An approach based on specific fixed costs will follow a different route.

Activity 2

Attempt question (Drury Student Manual)


Feedback 2

Relevancy, expectancy and constraints are the core of this question.

Activity 3



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Feedback 3

Consider the layouts and combining with qualitative aspects.

Activity 4



Feedback 4

A combination of absorption costing, variable costing and inventory required.

Activity 5



Feedback 5

The summaries are based on supporting calculations and a flowchart, all of which should be done before the final presentation is done.

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Activity 6

Attempt question 18 (South Ltd) in the Question Bank.

Activity 7

Attempt question 20 (Knysna Specialist Suppliers) in the Question Bank.

Activity 8

Attempt test 1 MAC4861 BEFORE attempting test 1 of MAC4862. Ensure that principles are understood clearly.

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MAC4862 - TEST 1 (2016) QUESTION 1 40 Marks THIS TEST CONSISTS OF TWO DEPENDENT PARTS, PARTS A AND B, AND ONE INDEPEN-DENT PART, PART C. ALL PARTS MUST BE ATTEMPTED Ignore Value-Added Taxation PART A Clothing World Limited is a wholesale clothing manufacturer with several factories located in the Cape Town area. Its Salt River factory manufactures two types of garments. In the one production line jeans are manufactured from denim fabric while in the other production line men’s trousers are manufactured from ordinary cotton fabric. The management of Clothing World are investigating the overhead production costs of the Salt River factory, specifically the costs associated with the forklifts used in the Storage department and the Shipping department. (A forklift is defined as a small industrial vehicle with a power-operated fork-like pronged platform which can be raised and lowered for insertion under a load, often on pallets, to be lifted and moved short distances.) In the storage department, the forklifts are used to unload large rolls of fabric from trucks and move them to the store during the receiving process. The forklifts are used again later to move the rolls of fabric from the store to the cutting area of the factory. In the shipping department the forklifts are used to load boxes of finished jeans or trousers from the staging area onto trucks for transport to the company’s central warehouse. Since the factory only ships products to the warehouse and not directly to customers, a box is packed with only one type of garment i.e. only jeans or trousers, not both. This also facilitates stock control at the warehouse. There is only one size of box which is used for both jeans and trousers. The budgeted annual fixed overhead costs associated with operating the forklifts can be analysed as follows for the most recent financial year, which just ended: R Operator salaries 1 120 000 Maintenance 112 000 Depreciation 105 000 Other 35 000 Total fixed forklift costs 1 372 000

The total budgeted annual fixed overhead for the factory is as follows: R Total fixed forklift costs 1 372 000 All other fixed factory overhead 19 600 000 Total fixed factory overhead 20 972 000

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The budgeted operational data are as follows: Jeans Trousers Production units 420 000 200 000 Direct labour hours per unit (sewing machine operator time) 0,16 0,20 Units per roll of fabric 240 312,5 Units per box shipped 8 10

Denim is also made from cotton but is a heavier, thicker fabric than ordinary cotton fabric and therefore fewer jeans are produced from a roll of denim fabric than trousers from a roll of ordinary cotton fabric. This also results in fewer jeans being packed per box than cotton trousers per box. Due to the greater automation on the jeans production line, jeans require less direct labour hours per unit (i.e. sewing machine operator time). A study by the production manager found that forklifts spend approximately 70% of their time in the shipping department and only 30% of their time in the storage department. Shortly after year-end, the financial manager sent an e-mail to the Chief Financial Officer (CFO) which included the following facts regarding the fixed factory overheads of the Salt River factory: • The factory still applied the traditional absorption costing method for the current financial year; • The actual production volume of jeans was 8% higher than the budgeted volume; • The volume variance was R660 380 favourable for the financial year; • The expenditure variance was R548 000 unfavourable for the financial year; • The direct labour hours per unit for both jeans and trousers was lower than budget due to

efficiencies by sewing operators. Unfortunately the financial manager was suddenly booked off due to illness and the CFO is urgently trying to determine the actual production volume of trousers and the actual fixed overhead amount spent for the financial year. PART B Clothing World has another factory in Maitland, Cape Town, that manufactures good quality pullovers and socks. The following information is available for the past financial year: 1. The budgeted production plan for the year included the following:

Pullovers Pairs of socks Opening balance 5 000 6 000 Production 270 000 605 000 Sales (265 000) (600 000) Closing balance 10 000 11 000

2. The actual production figures showed the following Pullovers Pairs of socks Opening balance 5 000 6 000 Production 240 000 530 000 Sales (225 000) (524 000) Closing balance 20 000 12 000

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3. The actual selling prices were R74,00 per pullover and R49,00 per pair of socks throughout the year.

4. Actual costs paid during the year were as follows: Per pullover Per sock R R Material 25,00 9,00 Variable overhead 3,00 1,00

5. Labour was paid at R50 per hour during the year. A pullover requires 16,8 minutes to manufacture, while a sock requires 4,8 minutes.

6. Fixed production overhead was calculated as R5,50 per pullover and R3,00 per sock for absorption costing purposes at the start of the financial year. The actual expenses for the past financial year were as follows: R Depreciation – Factory buildings and equipment 2 715 000 Other fixed production costs 2 500 000

7. The following actual expenses were also incurred for the financial year:

R Depreciation – Administration buildings and equipment 2 000 000 Marketing expenses (fixed cost) 2 300 000 Other administrative expenses (fixed cost) 6 500 000

8. In addition to the above marketing expenses, commission of 2% of the selling price is paid to

sales staff. 9. The current South African income tax rate for companies is 28%. The junior accountant at the Maitland factory, Frank Makoena, was tasked to prepare the actual break-even calculation for the Maitland factory for the past financial year. Management wanted to know the break-even level in terms of the quantity of pullovers and pairs of socks sold. He prepared the following calculation and notes: Fixed production costs:

R Notes Depreciation – Factory buildings and equipment - Excluded (non-cash) Other fixed production costs 2 500 000 TOTAL 2 500 000

Fixed cost per product: Split according to production volume (240 000 : 530 000)

Pullovers Pairs of socks R R Fixed cost 779 221 1 720 779

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Contribution per product:

Pullovers Pairs of socks R R Selling price 74,00 49,00 Material (25,00) (9,00) Variable overhead (3,00) (1,00) Labour (50,00) (50,00) Fixed overhead (5,50) (3,00) Profit before tax 9,50 14,00 Less tax (28%) (2,66) (3,92) 6,84 10,08

Average contribution = (R6,84 + R10,08) ÷ 2 = R8,46 Break-even: Pullovers = R779 221 ÷ R8,46 = 92 106,501 Pairs of socks = R1 720 779 ÷ R8,46 = 203 401,773

PART C This part is covered under the REQUIRED section only. REQUIRED CLOTHING WORLD LTD – SALT RIVER FACTORY PART A REQUIRED Marks (a) Calculate the budgeted forklift cost per unit for jeans as well as for trousers based on

the traditional absorption costing approach and using direct labour hours as base. Round Rand amounts to the nearest cent.

4 (b) Calculate the budgeted forklift cost per unit for jeans as well as for trousers based on

the activity-based costing (ABC) approach. Round Rand amounts to the nearest cent.

8

(c) Compare the various forklift costs per unit calculated in parts (a) and (b), and briefly discuss the reasons for the differences. Communication skills – logical argument

4 1

(d) Assume you are the Assistant Financial Manager. Calculate the following for the financial year to assist the CFO: • Actual production volume of trousers and • The actual fixed overhead amount spent. Round Rand amounts to the nearest cent.

6 1

Total 24

(Caplan adapted)

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PART B CLOTHING WORLD LTD – MAITLAND FACTORY REQUIRED Marks (e) Again assume you are the Assistant Financial Manager. Prepare an e-mail to the

junior accountant, Frank Makoena, identifying errors in his break-even calculations and explaining why they are errors. Give him guidance so that he can recalculate the break-even figures correctly. Communication skills – layout and structure; logical argument

13 1

Total 14 PART C REQUIRED Marks (f) Truck manufacturers often have premises situated next to highways or main roads

where they park rows and rows of their trucks. Briefly give possible reasons for this practice.

2

Total 2 TOTAL 40

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MAC4862 – TEST 1 (2016) SUGGESTED SOLUTION 40 marks

R/W – Right/Wrong mark C – Consequential mark PART A Part (a) Calculate the budgeted forklift cost per unit for jeans as well as for trousers based on the traditional absorption costing approach and using direct labour hours as base. Jeans Trousers Production units 420 000 200 000 Direct labour hours per unit 0,16 0,20 Direct labour hours (420 000 x 0,16; 200 000 x 0,20) 67 200 40 000 (1) r/w (½ each)

Budgeted forklift overhead rate R 1 372 000 (67 200 hrs + 40 000 hrs) = R 1 372 000 107 200 hrs = R12,80/hour (1) r/w

Budgeted forklift cost per unit Jeans Trousers R R Jeans: R12,80/hr x 0,16 hr/unit 2,05 (1) r/w Trousers: R12,80/hr x 0,20 hr/unit 2,56 (1) r/w

ALTERNATIVE: Jeans Trousers R R Split total forklift costs per product: Jeans: R1 372 000 x (67 200 / 107 200) 860 060 (½) r/w Trousers: R1 372 000 x (40 000 / 107 200) 511 940 (½) r/w Budgeted forklift cost per unit Jeans: R860 060 / 420 000 2,05 (1) r/w Trousers: R511 940 / 200 000 2,56 (1) r/w

(Available:4) Max 4

Markers’ comments: Many students obtained full marks for part (a). Part (b) Calculate the budgeted forklift cost per unit for jeans as well as for trousers based on the activity-based costing (ABC) approach. 1st stage allocation to activities: Storage Shipping R R Storage: R1 372 000 x 30% 411 600 (½) r/w Shipping: R1 372 000 x 70% 960 400 (½) r/w

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2nd stage allocation: Activity Jeans Trousers Total No. of rolls moved: 2 390 rolls Store: 420 000 units / 240 units per roll 1 750 rolls (1) r/w Ship: 200 000 units / 312,5 units per roll 640 rolls (1) r/w No. of boxes shipped: 72 500 boxes Store: 420 000 units / 8 units per box 52 500 boxes (1) r/w Ship: 200 000 units / 10 units per box 20 000 boxes (1) r/w Cost driver rates: Storage: R411 600 / 2 390 rolls = R172,22 per roll moved Shipping: R960 400 / 72 500 boxes = R13,25 per box moved Activity Jeans

R Trousers

R Total

R

Storage: 411 600,00 J: 1 750 / 2 390 rolls x R411 600 301 380,75 (½) r/w T: 640 / 2 390 rolls x R411 600 110 219,25 (½) r/w Shipping: 960 400,00 J: 52 500 / 72 500 boxes x R960 400 695 462,07 (½) r/w T: 20 000 / 72 500 boxes x R960 400 264 937,93 (½) r/w Total 996 842,82 375 157,18 1 372 000,00 Units 420 000 200 000 Forklift cost per unit – Jeans – Trousers

R2,37 R1,88

(½) c (½) c

Only if ABC applied above

(Available: 8) Max 8

Markers’ comments: Many students struggled to apply ABC correctly, e.g. they left out the 1st stage allocation of costs to activities or used only one of the drivers to allocate the costs instead of both. Several students used the analysis of the forklift costs (operator salaries, maintenance etc.) to allocate each item using different bases (e.g. labour hours, units etc.). Part (c) Compare the various forklift costs per unit calculated in parts (a) and (b), and briefly discuss the reasons for the differences. Forklift cost per unit Jeans

R per unit Trousers R per unit

Difference R per unit

Note

Traditional absorption costing 2,05 2,56 0,51 1 ABC 2,37 1,88 0,49 2 Difference 0,32 (0,68) 3

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1. The traditional costing method allocates R0,51 more forklift costs per unit to

trousers than to jeans (R2,56 – R2,05).

This is because the traditional method uses direct labour hours (sewing operator time) as base and trousers use more direct labour hours per unit than jeans.

(½)

(1)

2. The ABC method allocates R0,49 more forklift costs per unit to jeans than to trousers (R2,37 – R1,88).

This is because the ABC method uses activities (number of rolls of fabric moved and number of boxes moved) as allocation base and jeans require relatively more rolls to be moved and boxes to be moved than trousers due to denim being a heavier and bulkier fabric than cotton.

(½)

(1) 3. The forklift costs per unit increase with R0,32 per unit for jeans and decrease with

R0,68 per unit for trousers when ABC is applied instead of traditional costing.

This is because ABC uses activity cost drivers which are the actual cause of the cost of the activities and therefore a more accurate reflection of the consumption by the product of the specific overhead (activity) cost.

(½) (½)

(1)

Max 4 Communication skills – logical argument (nil if not discussed) – Comparison of Costs per unit done.

(1)

(Available: 6) Max 5

Markers’ comments: This section was not answered very well. Students did not compare the costs that they had calculated and instead gave vague discussions of the benefits and disadvantages of ABC and traditional absorption costing. Very few students could identify and explain the reasons for the differences in costs accurately. Part (d) Assume you are the assistant financial manager. Calculate the following for the financial year to assist the CFO: actual production volume of trousers and the actual fixed overhead amount spent. (i) Actual production volume of trousers Budgeted total overhead rate R 20 972 000 (67 200 hrs + 40 000 hrs) = R 20 972 000 107 200 hrs = R195,63/hour (1) r/w

Budgeted overhead cost per unit Jeans Trousers R R J: R195,63/hr x 0,16 hr/unit 31,30 (1) r/w T: R195,63/hr x 0,20 hr/unit 39,13 (1) r/w

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Actual volume of jeans produced: = 420 000 + (420 000 x 8%) = 453 600 units (½) r/w Therefore amount allocated to jeans: = 453 600 units x R31,30 = R14 197 680 (½) c Total amount allocated = budgeted overhead + favourable volume variance = R20 972 000 + R660 380 = R21 632 380 (1) r/w Therefore amount allocated to trousers = Total amount allocated – Amount allocated to jeans = R21 632 380 – R14 197 680 = R7 434 700 (½) c Therefore volume of trousers produced = Amount allocated to trousers ÷ Budgeted overhead cost per trouser = R7 434 700 ÷ R39,13 per unit = 190 000 units (½) c (ii) Actual fixed overhead: Actual fixed overhead = Budgeted fixed overhead + Unfavourable expenditure variance: = R20 972 000 + R548 000 = R21 520 000 (1) r/w

(Available: 7) Max 7 Markers’ comments: For learning purposes the proof for part (i) is as follows: R Allocated / Absorbed fixed overheads: 21 632 462 Jeans: 453 600 units x R31,30 14 198 357 Trousers: 190 000 units x R39,13 7 434 105 Less: Budgeted fixed overheads (given) 20 972 000 Volume variance (Favourable) (given) 660 462

Students generally did not perform well in part (d). Several students used only fixed forklift costs instead of total fixed factory overheads.

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PART B Part (e) Prepare an e-mail to the junior accountant, Frank Makoena, identifying errors in his calculations and explaining why they are errors. Give him guidance so that he can recalculate the break-even figures correctly. From: Assistant Financial Manager Sent: Tue 15 March 2016 09:30am To: Frank Makoena Subject: Break-even calculations Hi Frank I’ve had a look at the break-even calculations for the Maitland factory that you sent me. I would like to point out the following errors that I have identified and explain the correct approach that you should follow: 1. Calculation of total fixed costs

• You have incorrectly excluded Depreciation on factory buildings and equipment. (R2 715 000)

(1)

• You have also incorrectly excluded the non-production fixed costs (Depreciation on admin buildings and equipment; marketing expenses and other admin expenses = R2 000 000 + R2 300 000 + R6 500 000 = R10 800 000).

(1)

• You should include all the above-mentioned fixed costs since the break-even calculation should be based on all fixed costs, including all cash and non-cash fixed expenses and production and non-production fixed expenses.

(1)

• You have split the fixed costs between Pullovers and Pairs of socks. This is incorrect.

(1)

2. Contribution per product

• You have incorrectly deducted the cost of only one sock from the selling price of a pair of socks (i.e. two socks).

(1)

• You should multiply the costs by two (i.e. R9 x 2; R1 x 2; etc.). (1) • You have incorrectly included labour cost at R50 per product. R50 is the rate per

hour. (1)

• You should’ve multiplied the R50 with the number of hours per product. Remember that the minutes should be converted to hours by dividing by 60.

(1)

• You have incorrectly included fixed overhead (R5,50 and R3,00) as expenses. • (OR: You should exclude fixed overhead (R5,50 and R3,00) from the contribution

calculation.)

(1)

• You have omitted the commission of 2% of the selling price. Commission should also be deducted since it is a variable cost that varies with sales volume.

(1)

• You have shown a profit before tax for each product when in fact it is a loss for each product.

(1)

• You have incorrectly deducted tax. (1) • Contribution is calculated as the selling price less all variable costs before tax. (1) • You have calculated the average contribution which is incorrect for this break-even

calculation. (1)

• You should have calculated a weighted average contribution based on actual sales volume (225 000 : 524 000).

(½) (½)

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3. Break-even calculation

• You have incorrectly done two break-even calculations by dividing your two fixed costs figures by the average contribution.

OR • You should use only the one total fixed cost amount (as explained in note 1 above)

and divide it by the weighted average contribution per unit (as explained in note 2 above).

(1)

• The resultant break-even units calculated should then be split between the two products (pullovers and pairs of socks) using the actual sales volume of each product (225 000 : 524 000).

(1)

• The break-even volume (units) of each product must be rounded up to the next whole number.

(1)

Please recalculate the break-even quantities taking the above points into consideration and e-mail the revised calculations to me by tomorrow. Regards Assistant Financial Manager Note to markers: Must explain what the error is with reasons. No marks for redoing the break-even calculation.

(Available:18) Max 13 • Communication skills – layout and structure; logical argument (E-mail format) (Bonus

if headings used) (1)

Overall Max 14

Markers’ comments: The question did not require that the correct break-even calculations should be shown but for learning purposes the correct break-even calculation is supplied: Fixed costs:

R Depreciation – Factory buildings and equipment 2 715 000 Other fixed production costs 2 500 000 Depreciation – Administration buildings and equipment 2 000 000 Marketing expenses (fixed cost) 2 300 000 Other administrative expenses (fixed cost) 6 500 000 TOTAL 16 015 000

Contribution per unit:

Pullovers Pairs of socks

R R Selling price 74,00 49,00 Material (R9 x 2 socks) (25,00) (18,00) Variable overhead (R1 x 2 socks) (3,00) (2,00) Labour (R50 x (16,8/60)); (R50 x (4,8/60)) x 2 socks (14,00) (8,00) Commission (R74 x 2%); (R49 x 2%) (1,48) (0,98) 30,52 20,02

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Weighted average contribution per unit: = (R30,52 x 225 000 / 749 000) + (R20,02 x 524 000 / 749 000) Must use actual sales volume = R9,16 + R14,01

= R23,17 per unit Alternative: Weighted average contribution per unit = Total contribution / total units = [(R30,52 x 225 000) + (R20,02 x 524 000)] / 749 000 = (R6 867 000 + R10 490 480) / 749 000 = R17 357 480 / 749 000 = R23,17 per unit

Break-even = Fixed cost / Weighted average contribution per unit = R16 015 000/ R23,17 Must divide by = 691 070,075 weighted average = 691 071 units in total Break-even number of units per product: Pullovers = 691 070,075 x 225 000 / 749 000 Must use actual = 207 597,820 sales volume to split = 207 598 pullovers Pairs of socks = 691 070,075 x 524 000 / 749 000 Must use actual = 483 472,255 sales volume to split = 483 473 pairs of socks

Numerous students recalculated the break-even figures which did not earn them any marks. The Required explicitly stated that Frank Makoena should recalculate the break-even figures (not the Assistant Financial Manager). A surprisingly large number of students did not recognise that the split of fixed costs and subsequent two break-even calculations are incorrect principles. PART C Part (f) Truck manufacturers often have premises situated next to highways or main roads where they park rows and rows of their trucks. Briefly give possible reasons for this practice. • This serves as a marketing exercise to display their products and demonstrate that

they are a large manufacturer. (Advertising) (1)

• Trucks take some time to manufacture. By having some inventory of trucks on hand, customers who purchase trucks can be supplied immediately / sooner.

(1)

Max 2 Markers’ comments: Most students recognised that there are marketing / advertising advantages. Many students however did not realise that the trucks are the inventory of the truck manufacturers and assumed that the trucks were delivery trucks.

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TEST 2 (2016) QUESTION 1 40 Marks THIS TEST CONSISTS OF THREE INDEPENDENT PARTS. Ignore Value-Added Taxation PART A [17] Boundless Coffee (Pty) Ltd (BC) currently operates three spesialised coffee boutiques situated in Gauteng, priding itself on serving only premium brand coffee. The company has been growing steadily over the past few years. It has now decided to appoint a full time management accountant as it wants to franchise the concept across the country. One of the first priorities of the management accountant will be to implement proper controls, as well as to calculate and implement accurate costing prices. After some research, the management accountant recorded the following standard costs for a 350ml ‘Lanky’ (a basic cup of coffee served by BC), for the financial year ending 28 February 2017: R Coffee beans 9g at R200/kg 1,80 Milk 130ml 1,17 Standard cup 1,20 Total variable costs 3,31 Budgeted Sales price R15,00 The actual results for ‘Lanky’ for the company for the month ended 31 March 2016 are as follows:

Description Actual Notes Sales (Units) 14 400 1 Beans purchased 130 kg 2 Milk purchased 1 872 ℓ 3 Cups used (units) 14 500 4 Fixed Overhead (R) 62 211 5

Notes: 1. There was a 4% negative variance based on budgeted sales quantity. Due to the intense

drought in Africa and consequent increase in coffee input costs the company had to increase prices on all its coffee products by 5,5%. All units produced were sold.

2. 10% of beans purchased were not used. As mentioned in point 1, the drought has increased the bean price per kilogram. There was a 6% negative variance on the price per kilogram.

3. A new dairy farm has approached Boundless Coffee and offered to provide milk at a 10% discount for the first year compared to what they are currently paying. Since their current contract has expired, the Managing Director (MD) suggested that they sign a 6 month contract on a test basis from 1 March 2016. All milk purchased was used except for one incident of a fridge failure where milk equivalent to 7% of the month’s purchase was lost before being delivered to the boutiques.

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4. 10 Batches of 1 500 cups each were bought to qualify for a 7% quantity discount.

5. The fixed overhead amount reflects an average cost per boutique per quarter. Included in the

amount is depreciation amounting to R6 211. Fixed overhead excluding depreciation in March was higher than other months by 5%. Fixed overhead are allocated to products based on volume sold.

6. When finalising her calculations, the management accountant discovered that the ‘Lanky’ actually comprised 54% on average for all products sold within each boutique for the month against a budgeted 60%. The ‘Lanky’ is the cheapest product in BC’s product range.

PART B [20]

The Coffee (Pty) Ltd (TC) is a well-established South African-based roaster. TC is known for the production of roasted, ground and packaged single-origin coffee with a maximum capacity of 200 tons per annum. The plant company was recently acquired by McCups Coffee (Pty) Ltd, with Mr Monate, the general manager (GM) of McCups Coffee ensuring that the goals and objectives of the company are met. Current customers include coffee boutiques, hotels, bars, cafés and households.

The primary raw material required for the plant is clean green coffee beans which are bought in 60kg bags. Upon roasting, green coffee beans lose 20% of the initial weight mainly due to evaporation of water content in the green beans.

Coffee farmers were hit very hard by the current drought and production has been severely affected. Since demand remains strong amidst the lower supply, green coffee beans are in very high demand both locally and internationally. Giant coffee roasters and other major players, have secured the majority portion of what could be produced of high grade Arabica coffee beans directly from the farmers. Luckily, a friend of an acquaintance, a coffee farmer from Ethiopia, has agreed to supply TC but can only satisfy 50% of TC’s production requirements. No other supplies can currently be sourced. The market price for the clean green beans for the month of January 2016 is currently quoted at US $3,20/kg.

Below is a snap shot of the 2016 year’s projections:

Quantity Total amount Green coffee beans (bags) ? ? Paper bag, for 250g coffee 200 000 R330 000 Cardboard box ? ? Paper bag, for 1 000g (1 kg) coffee 100 000 R465 000 Gumming paper tapes (units) 100 R35 000 The above, with exception of clean green beans and cardboard boxes are already committed. The packing materials to be used by the production plant are paper bags, cardboard boxes, and gumming paper tapes. All these auxiliary materials are sourced from local suppliers. The proposed package sizes of printed paper bags for packing of roasted and ground coffee are 250g and 1 000g, which are planned to constitute 40% and 60% of the total roasted and ground coffee, respectively.

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A cardboard box fits forty (40) units of 250g coffee bags or eight (8) units of 1 000g coffee bags.

The cardboard box supplier charges R20 per box and provides the following discount rates on specific bulk purchases: 5 000 – 7 000 boxes

5%

7 001 – 10 000 boxes 7,5% 10 001 – more boxes 10%

The gummed paper tape (currently each unit contains 125m – now discontinued) is used to seal the box and will be replaced during the year by a more advanced tape that will only use 50cm instead of 1m on each box. The existing market inventory of discontinued tape is priced at R312,50 a roll and the normal price of the new advanced tape is R800 per roll of 75m each. A pre-determined production overhead recovery rate (including variable and fixed overheads) of R36 per kilogram of roasted coffee is budgeted for the year and is based on 50% capacity being normal. The fixed portion makes up 75% of the total overheads.

The current market price for high grade roasted Arabica coffee is R65,00 per 250g bag and R200,00 per 1000g bag, which has allowed an average 30% profit margin for distributors and retailers.

One of the roastery’s customers, Mr Dube, sent an email to Mr Monate, GM of TC in order to secure his supply needs with the following proposal:

Dear Mr Monate

I fully understand the circumstances facing the coffee industry. Our management has made a decision to mix the high-grade beans that you supply us, with an order of low grade-beans. The blend/mixing will ensure that supply meets our coffee beans quantity requirements for the year and this would be once-off arrangement or until your high grade supply meets our requirements.

We have already engaged with coffee farmers and 50 tons of low grade green coffee beans are on its way to our warehouse.

As your loyal customer we request that you roast the stock for us and propose a fee of R2 100 000 for the service, which will only include roasting, packaging into 1 000g packs and boxing the packs in a specially printed boxes to indicate quality.

We trust that you would favourably consider our proposal.

Yours sincerely, Mr Dube

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The GM discussed the proposal with the directors, indicating that placing client branding on the boxes would be R7,10 per box. The directors would only be interested if profit margin is of at least 65% achieved.

The GM also suggested the incorporation of low quality coffee beans as a temporary solution for the current shortage of high-grade coffee beans. The blend would be a company secret, the packaging will retain the high grade statement and will not indicate that it contains a blend.

The estimated exchange rate for the month of January 2016 for South African rand (ZAR) to USD is: ZAR15,50 : USD1. PART C – This part will be dealt with in the REQUIRED section. REQUIRED PART A Boundless Coffee (Pty) Ltd REQUIRED Marks (a) Calculate the fixed overhead variances for the Gauteng boutiques for the month

ended 31 March 2016 in as much detail as possible. 3

(b) From a management information perspective, briefly motivate whether or not, mix and yield variances will in this case add value to the understanding of the quantity cost variances.

2

(c) Discuss the operational risks of opening a new coffee shop in South Africa 5 (d) This section relates to the notes 1 – 6 of Part A. Select and list the most likely

outcome for each of the questions posed. Read the note in Part A and then exercise your choice, from the underlined options. Questions on note listed (i) Note 1: The impact of note 1 will be that the company’s (BC) turnover for March

2016 decreased/increased. (ii) Note 2: The holding of bean inventory will increase/decrease BC’s profit for the

month. (iii) Note 2: The holding of the bean inventory will be favourable/unfavourable to

BC’s future operations. (iv) Note 3: The milk loss experienced due to the fridge failure should be treated as

a normal/abnormal loss in the management accounts for March 2016. (v) Note 4: From a finance perspective the discount obtained will be cheaper/more

expensive than an overdraft facility carrying interest at prime plus 3%. (vi) Note 5: The given fixed overhead allocation base is in line/not in line with the

normal bases prescribed. (vii) Note 6: The actual sales of ‘Lanky’ during March 2016 is favourable/

unfavourable to BC’s performance for the month. 1 each

7

Total for Part A 17

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PART B

The Coffee (Pty) Ltd

(a) Calculate the budgeted quantity of cardboard boxes and green coffee bean bags with the corresponding expenditure amounts to be included in the annual budget of the company.

5

(b) As a finance manager of the company, Mr Monate has requested you to write an email to the members of the Board of Directors: (i) evaluating and commenting on the proposal made by the customer, Mr Dube. (ii) discussing all relevant issues to be considered by the management of The

Coffee (Pty) Ltd acceptance of the proposal. Communication skills - layout and presentation

6 2 1

(c) Briefly discuss the strategic and ethical implications of Mr Monate’s suggestion to keep the high grade statement on company packages neglecting to mention the blend of low and high quality beans.

2

PART B (continued)

(d) The coffee boutiques owned by the company has been purchasing boxes containing 1 kg coffee bags from the plant at R200/kg. The directors are discussing increasing the market share of their coffee boutiques next year and they consider transfer pricing as one tool to effect this. Calculate the minimum transfer price of a box of coffees, containing 1 kg coffee bags, assuming the current supply situation prevails, and comment on how it would assist management in its next year’s objective.

4

Total for Part B 20

PART C

General

(a) You and your life partner buy take-away cappuccinos every other day from different suppliers. You wonder whether it will not be more cash efficient to buy your own pod-based coffee machine to make your own cappuccinos. List all relevant detail information you would require to make a formal decision in this regard.

½ each

3

Total for Part C 3 TOTAL 40

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TEST 2 - SUGGESTED SOLUTION (2016) PART A Section (a) Fixed overhead variances Depreciation is excluded [1] Expenditure: 62 211 – 6 211 = R56 000 x 5% = R2 800 A [1] Volume: 6%[60%- 54%] X 62 211 = 3,732.66 A [1]

MAX [3] Section (b) Motivate w het her or not , mi x and yi eld vari ances w il l add value… Yes/No – with applicable motivation (no marks for no motivation) [1] Motivation [1] Yes: It will give us a better understanding on the causes of the usage variance No: As customers receives the product in the correct proportions, all variances will be due spillage

MAX [2]

Section (c)Discuss the operational risks (1 MARK EACH)

• Drought in Africa may cause a steep hike in prices / greater demand than supply • Less demand for coffee due to hard economic conditions • Coffee is imported and the high exchange rate further increase prices • Although coffee industry is growing, the market is getting saturated with the overseas entrants into the market like StarBucks • Startup funding/capital is difficult to come by for new entrants • Choosing the incorrect location may be leathel • Poor controls leading to theft • Attracting qualified staff • Difficulty in registering a company for taxes / other statutory • One other valid point

MAX [5] Section (d) . Select and list the most likely outcome(1 MARK EACH) (i) Note 1: The impact of note 1 will be that the company’s (BC) turnover for March 2016 increased [Budget: 14400 x 15 = R216 000; Actual: 14400 x96% x(R15x1.055) = R218 765] (ii) Note 2: The holding of bean inventory will increase BC’s profit for the month. (iii) Note 2: The holding of the bean inventory will be favourable to BC’s future operations.

(iv) Note 3: The milk loss experienced due to the fridge failure should be treated as an abnormal loss in the management accounts for March 2016.

(v) Note 4: From a finance perspective the discount obtained will be cheaper than an overdraft facility carrying interest at prime plus 3%.

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=

=

(vi) Note 5: The given fixed overhead allocation base is in line with the normal bases prescribed. (vii) Note 6: The actual sales of ‘Lanky’ during March 2016 is unfavourable to BC’s performance for the month.

MAX [7]

PART B Section (a) Calculate the budgeted quantity of cardboard boxes and green coffee bean bags • 60% of the production capacity = 60 000 kg • The box packs 8 of the 1000g (1kg), = 60

000kg 8kg

= 7500 boxes required for 1OOOg product. [½]r/w • The other 40%, which is equivalent to 40 OOOkg (40% x 100 000kg).

• The box packs 40 of the 250g, therefore 40 000kg (40 x 250g)

= 4 000 boxes required for the 250g product. [½]r/w • Therefore the total boxes needed for the year = 7500 + 4000 [½]c = 11500 boxes • The planned box expenditure for the year should be: 11500 x R20 x 90% = R207 000,00 [1]c • The roasted coffee beans currently attainable =50% x 200 tons = 100 tons of roasted coffee beans [1]r/w • Roasted bean weight = 80% green bean weight • Therefore green beans sourced from the farmer

100 ton 80%

• Expenditure = 125 000kg X 3.20 15.50

= 125 tons of green beans

= R6 200 000 [½]c

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Section (b) write an email to the members of the Board of Directors MAX [5] (i) evaluating and commenting on the proposal made by the customer, Mr Dube [6]

TO: Board members FROM: DATE: Dear Members of the Board……. Clean green beans - Provided for by customer, not relevant Rnil [½] Manufacturing overheads - Total overheads= R36 x 100 000 = R3 600 000 per annum Fixed portion of 75% x R3 600 000 = R2 700 000 irrelevant -the required supply is within relevant range, hence no effect on the cost. The variable portion of R900 000 translated to per kg = R9/kg Therefore total variable costs = R9 x 40 000kg

Rnil R360 000

[1h] [1]

1000g packs used- replacement value 50 tons x 80% = 40 tons = 40 OOOkg ..40 000 bags at R465 000 / 100000

R186 000

[1]

Boxes - replacement value and incremental cost of printing (R20+R7.1) 40 000 bags 40 000 / 8 = 5000 boxes at R27.10 5000 boxes at R27.10

R135 500 [1] [1]c

Tape in stock at cost price – sunk cost Gumming tapes- opportunity cost 12500m - 11500m (from (a) ) = 1000m 1000m / 125m = 8 rolls at R312.50 Purchases of new rolls 5000 -1 000 = 4 000 x 0.5 = 2 000m 2000m / 75m = 26.666 = 27 rolls at R800

Rnil R2 500 R21 600

[1] [1] [1]

Transport- not relevant, the customer will bear all other costs. Rnil [½] Total cost R 705 600 Profit (65% profit margin) R 1 310 400 [1] Acceptable offer price R 2 016 000 The offer made of R2 100 000 by the hotel manager can be accepted, it provides a profit margin >65% and the owners would therefore be interested. [1] Possible 8.5 marks, Max 6 marks Communication skills - layout and presentation – email format [1]

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(ii) discussing all relevant issues [2]

1. It may create an expectation and a practice in the future, for the customers, where clients bring their own green beans and packaging materials, which would translate into lost markup on cost items. [1] 2. It may provide a platform for the customers to negotiate further discounts. [1] 3. Other customers would follow suit. [1] 4. The roasting times of low quality and high quality may not the same. [1] 5. Reputational damage [1] Section (c) discuss the strategic and ethical implications (1 each) Max 2 1. The act would constitute a deliberate misleading by the company and would imply lack of integrity. 2. The company reputation, if found may be at risk and this would threaten the companies existence. 3. The company could accrue legal action 4. Loss of customers due to low/poor/substandard quality Section (d) Calculate the minimum transfer price Max 4

Variable overheads costs (R9 x 8) R72.00 Coffee beans ($3.2x15.5) x 8kg R396.80 PackaQinQ - 1OOOg bags (R4.65 x 8) R37.20 Packaging - boxes (R20) R20.00 Gumming tape [(R800/75m)*0.5m] R5.33 Total variable costs R531.33 [1] Total variable cost per kg (divided by Skg) R66.41/kg Opportunity cost (R200- R66.41- (30% x R200))

R73.59 [1]

Total minimum transfer price R140.00 per kg And (R140 x Skg) R1 120.00 per box [1]

Alternative: Selling price R200 [1]

Distributors and retailers margin Minimum transfer price

(R 60) R140 per kg

[1]

Therefore, R140 X 8 R1 120 per box [1] At the price of R1120 per box of 8 x 1000g coffees

Max 3 marks

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• The coffee shop would now save R60 per kg and this could be used to drop the coffee cup price in order to penetrate the market. [1] • 350ml cappuccino selling price could be reduced by up to R0.54 per cup and coffee shops would still achieve the budgeted profit. [1]

Max 1 mark Section (e) cash efficient to buy your own pod-based coffee machine… (½ each) max [3]

• Period Applicable • Number of purchases • Probability of buying at a supplier • Different prices of pods at suppliers • Cost of Nespresso machines • Own input costs • Discount rate • Loss of convenience at shop

PART C -

• Period applicable • Number of purchases • Probability of buying at a supplier • Different prices of suppliers • Cost of Nespresso machine • Replacement value/time of machine • Own input costs (Milk, pods, electricity, water) • Discount rate • Loss of ‘café feeling’ (friendliness, cosiness etc) • Saving on traveling • Saving time • Quality for home vs shop • Time saved • Traveling cost saved

½ each, MAX [3]

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COMMENTARY PART A Most students did quite well in this Section. Section (a) fixed overhead variances Students generally did well with this section, and most student did the calculation to exclude depreciation. Most students however did not attempt, or did not get the volume variance correct. Section (b) Motivate whether or not, mix and yield variances will add value … Students generally did well with this section. Some students comments are still to generic and not relevant to the case study Section (c) Discuss the operational risks Students did poorly here. As explained above, the answers were too generic and not made relevant to the case study. Some student literally only listed the risks, eg. Business risk, exchange rate risk. This will never score you marks. We want to know if you can identify valid risks and comprehend the impact on the company. Section (d) . Select and list the most likely outcome Students did excellent in this section. The question was however very straight forward and the same level should not be expected in the exam. PART B

This section was not well executed by many students.

Section (a) – Budgets This section was not approached in an appropriate manner. Budgets by its very nature takes into account what is expected, and it is from that premise that budgets are prepared. Following the narratives of the scenario to the question, green beans that are expected to be sourced from farmers constitute only 50% of TC capacity, hence the resulting budget will be based on 50% capacity. Students sadly missed the abovementioned fundamental. Students also could not identify that there are two packages (250g and 1000g) that have different box requirements. The other important aspect that was not well executed, was the dealing with normal loss in production, 20% was the expected loss in terms of the scenario provided and students were finding it difficult calculate the material input (green beans).

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Section (b) – proposal evaluation This question exposed a lack of understanding of the required, which remains as one of significant reasons students find our subject difficult. Students were required to evaluate the proposal made, evaluation involves appraising and assessing the value of something, it involves number crunching to figure(s) that informs the eventual commentary. The approach by many students was a discussion that was not guided by any calculation and hence negative performance. The other worrying trend is the discomfort shown by students when dealing with profit margin % and markup %, and it will not be tolerated at this level of study. NB: Do not use any name on all the reports that you may be required to draft, rather use the position assumed to occupy in the question. Section (c) – strategic and ethical implications Whenever dealing with ethics question on this nature, identify the ethical principle that is in question explaining why and interpret the effect thereof on the profits and company as a whole. Strategic speaks long-term goals and game plan of achieving them. Students found it challenging to express strategic implications because maybe the term is not well understood. Section (d) – Transfer pricing The section was not attempted by a noticeable number of students. The marks were easily attainable once attempted. Just remember, where the product has a market it would have an opportunity cost on those products sacrificed when calculating the minimum. Section (e) – relevant costing principles It was a sheer lack of proper reading and understating of the required by students who performed bad in this section. The analysis was for household consumption and not for business as many have put in their discussions. General Finally, ensure that you properly read and understand the required and prior to writing anything invest in some planning to your solution. Remember what you write has to inform us in your absence, and has to make sense to another person who is not you.

tutorial letter 102/0/2017 - unisa.ac.za · apply an activity-based costing approach to costing...

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