Accounting for Decision Making

Management accounting is the process of identifying, measuring, analysing, interpreting and communicating financial and non-financial information to managers so that they can plan, control operations and make decisions. It is meant for internal users and is not bound by statutory accounting standards.

Product cost is the cost that is directly or indirectly attached to the manufacture of a product, namely direct materials, direct labour and manufacturing overhead. It is inventoriable: it stays in stock as an asset until the goods are sold, and is then charged as cost of goods sold.

A cost sheet is a statement that shows the various elements of cost (prime cost, factory cost, cost of production, cost of goods sold, cost of sales) of a product or job for a period, along with the total cost, cost per unit and, where required, the profit and selling price.

Using the high-low method:

$\text{Variable cost per unit}=\frac{90{,}000-60{,}000}{7{,}000-4{,}000}=\text{Rs }10$

$\text{Fixed cost}=60{,}000-(4{,}000\times 10)=\text{Rs }20{,}000$

$\text{Total cost for 5,000 units}=20{,}000+5{,}000\times 10=\textbf{Rs 70,000}$

$\text{P/V ratio}=\frac{\Delta\text{Profit}}{\Delta\text{Sales}}\times100=\frac{3{,}00{,}000-2{,}00{,}000}{12{,}00{,}000-10{,}00{,}000}\times100=\frac{1{,}00{,}000}{2{,}00{,}000}\times 100=\textbf{50\%}$

Cumulative cash inflows: year 1 = Rs 11,000; year 2 = Rs 23,000; year 3 = Rs 33,000.

The investment of Rs 30,000 is recovered during year 3. Balance after two years = 30,000 - 23,000 = Rs 7,000.

$\text{Payback period}=2+\frac{7{,}000}{10{,}000}=\textbf{2.7 years}$

Job order costing is a costing method used where products are made to the specific order of customers, so that each job is different and can be identified separately (for example printing, furniture making, construction, repair work). A separate job cost sheet is opened for every job, and direct materials, direct labour and an applied share of overhead are accumulated against it. When the job is complete, the total cost is divided by the units in the job to get unit cost, and profit is added to fix the price.

Overhead is applied using a predetermined rate:

$\text{Overhead rate}=\frac{\text{Estimated overhead}}{\text{Estimated base (e.g. direct labour hours)}}$

Example. A printer receives Job No. 101 to print 1,000 brochures. Direct materials are Rs 6,000, direct labour is 100 hours at Rs 40 = Rs 4,000, and overhead is applied at Rs 20 per labour hour = Rs 2,000.

Cost per brochure = 12,000 / 1,000 = Rs 12. With a 25% mark-up on cost, the price quoted is Rs 15,000 (Rs 15 per brochure).

Reconciliation statement (financial loss to cost profit)

Variable manufacturing cost per unit = 10 + 8 + 5 = Rs 23. Production (28,000 units) is below sales (30,000 units), so the 2,000 extra units sold come from opening stock, which is assumed to carry the same variable cost. Fixed manufacturing overhead is a period cost = 30,000 x Rs 5 = Rs 150,000 (rate at normal capacity).

Income statement under variable costing

Per-unit variable costs at 8,000 units:

• Direct materials = 120,000 / 8,000 = Rs 15; direct labour = 80,000 / 8,000 = Rs 10
• Factory overhead: fixed = 40% x 80,000 = Rs 32,000; variable = Rs 48,000 (Rs 6 per unit)
• Selling and administrative overhead: fixed = 60% x 60,000 = Rs 36,000; variable = Rs 24,000 (Rs 3 per unit)

Flexible budget

Salaries are taken as office (administration) salaries.

Cost sheet (10,000 units)

Cost per unit = Rs 30.50; selling price per unit = Rs 36.60. The company earns a profit of Rs 61,000.

Break-even analysis (cost-volume-profit analysis) finds the level of sales at which total revenue equals total cost, so there is neither profit nor loss:

$\text{BEP (units)}=\frac{\text{Fixed cost}}{\text{Contribution per unit}},\qquad \text{BEP (Rs)}=\frac{\text{Fixed cost}}{\text{P/V ratio}}$

Profit planning means deciding in advance the profit to be earned and the sales, cost and prices needed to earn it. Break-even analysis is a useful device for this purpose in the following ways.

1. Target profit. Sales needed for a desired profit = (Fixed cost + Target profit) / Contribution per unit (or P/V ratio).
2. Margin of safety. Actual sales less break-even sales shows how far sales can fall before losses begin, which tells management how safe the planned profit is.
3. Pricing decisions. The effect of a change in selling price on the break-even point and profit can be tested before the change is made.
4. Product mix. Products with a higher P/V ratio can be given priority, which raises the total profit.
5. Cost control. It separates fixed and variable costs, so that management can see which costs to reduce to lower the break-even point.
6. Make-or-buy, expansion and plant-shutdown decisions. The effect on contribution and fixed costs is easy to see.
7. Graphic presentation. The break-even chart shows the profit or loss at every level of output at a glance.

Limitations. It assumes that fixed cost stays constant, variable cost per unit and selling price are constant, and that production equals sales. These assumptions hold only within a relevant range, and the analysis is hard to apply to multi-product firms without a fixed sales mix.

Thus, within these limits, break-even analysis is a sound and practical tool for profit planning.

Management reporting is the system of preparing and presenting reports and statements, based on accounting and other data, to the different levels of management at regular intervals so that they can plan, control and decide. The statement is correct, because reports supply the information each level needs.

How it serves each level

• Top management receives summarised reports on overall profitability, return on investment, financial position and long-term performance, which support strategic planning and policy decisions.
• Middle management receives departmental reports (budget versus actual, cost and sales analysis, variance reports) to coordinate and control departments.
• Lower (operating) management receives detailed, frequent reports on production, wastage, labour use and material consumption for day-to-day control.

Features of good reports. They are timely, accurate, clear and concise, relevant to the receiver, and issued at regular intervals (daily, weekly, monthly). They follow the principle of exception, which highlights large deviations from plan so that managers act where it matters. They are also cost-effective, since the benefit of the report should exceed the cost of making it.

Importance. Reporting links the decision makers with information, helps in measuring performance and fixing responsibility, gives early warning of problems, improves coordination between departments and supports control through corrective action.

So, management reporting does provide adequate information to all levels, provided that the reports are designed to match the needs of each level.

Working notes. Sales: Ashadh 150,000; Shrawan 100,000; Bhadra 200,000; Aswin 250,000. Collections = 50% of the current month's sales + 50% of the previous month's sales. The opening cash of Shrawan is taken as the usual Rs 20,000 balance. Interest at 12% a year is charged on repaid loans for the months they were outstanding (1 month = 1%).

Cash budget

In Shrawan the deficit to reach the minimum balance is 20,000 + 5,000 = Rs 25,000, which is borrowed as Rs 30,000 (multiple of Rs 10,000). The loan is repaid in Bhadra, because cash is sufficient, and no borrowing is needed in Aswin.

Working notes.

• Units: transferred from A 7,000 + added with material 2,500 = 9,500 units. Normal loss = 10% x 9,500 = 950 units; scrap value 950 x Rs 8 = Rs 7,600.
• Transferred to C = 8,700 units, so actual loss = 9,500 - 8,700 = 800 units, which is less than normal loss: abnormal gain = 150 units.
• Costs: Process A output 7,000 x 12 = 84,000; materials 30,600; labour 102,000; overhead 2,500 x 5 = 12,500. Total = Rs 229,100.

$\text{Cost per unit}=\frac{229{,}100-7{,}600}{9{,}500-950}=\frac{221{,}500}{8{,}550}=\text{Rs }25.906$

(a) Process B account

(b) Normal loss account

(c) Abnormal gain account

Working notes. Normal loss is taken at the weight-loss percentage of units put into each process (P1: 5% of 5,000 = 250; P2: 10% of 3,140 = 314; P3: 20% of 1,385 = 277). Transfers to the next process are at cost. Profit is shown on the portion sold at the given selling price.

Process P1 (units: 5,000 input; normal loss 250; actual output 4,710; abnormal loss 40)

$\text{Cost per unit}=\frac{127{,}500+78{,}800+30{,}000-250\times20}{5{,}000-250}=\frac{231{,}300}{4{,}750}=\text{Rs }48.695$

Output: 2/3 = 3,140 units transferred to P2 at cost Rs 152,901; 1/3 = 1,570 units sold at Rs 40 = Rs 62,800 against cost 1,570 x 48.695 = Rs 76,451.

Profit/(loss) of P1 = 62,800 - 76,451 = Rs (13,651) loss (the abnormal loss of Rs 1,948 is also written off to costing profit and loss).

Process P2 (input 3,140 units from P1; normal loss 314; actual output 2,770; abnormal loss 56)

$\text{Cost per unit}=\frac{152{,}901+69{,}640+25{,}000-314\times15}{3{,}140-314}=\frac{242{,}831}{2{,}826}=\text{Rs }85.928$

Output: 1/2 = 1,385 units transferred to P3 at cost Rs 119,010; 1/2 = 1,385 units sold at Rs 150 = Rs 207,750.

Profit of P2 = 207,750 - 119,010 = Rs 88,740 profit (the abnormal loss of Rs 4,812 is written off separately).

Process P3 (input 1,385 units from P2; normal loss 277; actual output 1,120; abnormal gain 12)

$\text{Cost per unit}=\frac{119{,}010+30{,}000+10{,}550-277\times100}{1{,}385-277}=\frac{131{,}860}{1{,}108}=\text{Rs }119.007$

Sales = 1,120 x Rs 200 = Rs 224,000. Profit of P3 = 224,000 - 133,288 = Rs 90,712 profit (this includes the abnormal gain of Rs 1,428).

Summary: P1 loss Rs 13,651; P2 profit Rs 88,740; P3 profit Rs 90,712.