Financial and Management Accounting notes, Appunti di Cost Accounting

Scarica Financial and Management Accounting notes e più Appunti in PDF di Cost Accounting solo su Docsity! FINANCIAL ACCOUNTING Accounting consists of three basic activities: it identifies, records and communicate the economic events of an organization to interested users. As a starting point to the accounting process, a company identifies the economic events relevant to the business. Once this, it records those events in order to provide a history of its financial activities. Recording consists of keeping a systematic, chronological diary of events, measured in monetary units. Finally the company communicates the collected information to interested users by means of accounting reports (financial statements). A vital element in communicating economic events is the accountant’s ability to analyze and interpret the reported information. Interpretation involves explaining the uses, meaning, and limitations of reported data. In total, accounting involves the entire process of identifying, recording, and communicating economic events. The specific financial information that a user needs depends upon the kinds of decisions the user makes. There are two broad group of users of financial information: - Internal users: managers who plan, organize, and run the business. Managerial accounting provides internal reports to help users make decisions about their companies. - External users: are individuals and organizations outside a company who want financial information about the company. Investors use accounting information to make decisions to buy, hold, or sell ownership shares of a company. Creditors use accounting information to evaluate the risks of granting credit or lending money. Financial accounting is the preparation and presentation of financial statements to allow a range of users to make economic decisions about the entity – “general purpose financial statements” Financial statements consist of ➢ Income statement ➢ Balance sheet ➢ Statement of cash flows ➢ (Statement of changes in equity) Financial accounting is about the past, whereas Management accounting is about the future forecast. Financial information is about talking about money. Financial accounting is the process of identifying, measuring and communicating economic information about an entity to a variety of users for decision making purposes. Any transaction has two effects on the business, for any transaction you have to record what money are used for (use) and where money come from (source), if we sum the two we must obtain an equal number. Totals on each side have to balance. Capital is the money invested into a business. Step 1: Entity concept: transaction of the business should be recorded separately from the transactions of its owner. If the owner goes out for dinner (ex) she doesn’t have to record it in the company balance, because it is a personal expense. If she uses part of the flat as an office she could locate part of the rent to the business. Step 2: to grow the company she understands that she has to invest some more capital. Raw materials are also called purchases. Step 3: eventually we start selling the product. Sales are a source of money. Step 4: wages of employees are recorded in the use section. Step 5: Trade payables: amounts that the business has not paid to suppliers yet Step 6: Sales on credit: you pay an amount immediately and the rest within a specific span of time. Trade receivable: amounts that customers have not paid to the business yet, these will become cash within 60 days. Revenue recognition principle: revenues are recorded when earned, not necessarily when cash is received. Historical cost principle: dictates that companies record asset at their cost. The fair value principle: asset and liabilities should be reported at fair value (the price received to sell an asset or settle a liability. Monetary unit assumption: requires that companies include in the accounting records only transactions data that can be expressed in money terms. Economic entity assumption: the activities of the entity are kept separate and distinct from the activities of its owner and all other economic activities. 1 Identifying Measuring Communi cating Decision making Transaction s that must be able to be reliably measured & recorded Analysis, recording & classifying transactions Via income statements, balance sheets & statements of cash flows Used for a range of decisions by external & internal users Use Source Capital Assets Capital + liabilities Revenue /current Expenditur e Income The trial balance The trial balance is a record of all account balances at a point in time and is used to prepare the final accounts. The double-entry bookkeeping system is the method of recording the two entries for each and every transaction. A trial balance is drawn up at the end of a financial period, usually at the end of each financial year. The trial balance should always balance, the total of the debit balances should equal the total of the credit balances. Use (or debit side) includes: • Expenses: amounts incurred by the business to operate on a day-to-day basis (purchases, wages) • Assets: items owned by the business (machines, van, office, cash, trade receivables) • (Drawings: amounts withdrawn by the owners for their own personal use) Source (or credit side) includes: • Capital: the amount of money that the owner puts into the business • Income: the amount earned by the business (Sales) • Liabilities: claims by outsiders, an amount owed by the business (Loan and trade payables) Capital vs revenue/current items CAPITAL ITEMS • Capital income: money invested by the owner(s) [capital] and money from third parties [liabilities] • Capital expenditure: expenditures from which the business will benefit more than one accounting period [assets] CURRENT ITEMS • Current (revenue) income: money that is earned by the business by carrying out operating activities i.e. Sales • Current (revenue) expenditure: day to day expenditures Statement of Profit & Loss (current items): it shows the revenue income less revenue expenditure for a financial period and computes the profit and loss generated. Income=Expend.+Profit OR Profit=Income-Expenditure (money you make - money you spend) (+) Sales (-) Cost sales or cost of goods sold (=) Gross profit (1st margin) (Amount of sales you retain after accounting for costs of goods sold) (-) Different expenses by function or kind (=) Operating profit (2nd margin) (The higher the operating profit, the more profitable a company's core business is (EBIT: earnings before interests and taxes)) (-)Financial income and expenses (=)Profit after financial items (3rd margin) (Not related to the core business: Income→Dividends; Expenses→Interest!) (-) Taxes = Net profit Cost of sales Cost of goods sold in a period, taking into account movements in inventories between the beginning and the end of the period. Cost of sales = opening inventories (Inventories (stock) are goods for resale held in stock by the business.) + purchases - closing inventories Gross profit = sales – cost of sales Matching concept: expenses incurred by an organization must be charged to the income statement in the accounting period in which the revenue, to which those expenses relate, is earned. The Statement of Financial Position (capital items): Assets=Capital+Liabilities Assets=(capital at the beginning of the year+profit of the year) + liabilities Non-current assets are items that are difficult to turn into cash. Current assets are items that are easily turnable into cash. Shows the assets, liabilities and owners’ capital at a given date Content and structure 2 Preference shares: - Entitle their owners to receive dividends at a fixed rate, before ordinary dividends are paid - No vote at general meetings - Optimal alternative for risk-averse equity investors The full set of statements 1. Income statement (statement of profit and loss) 2. Retained earnings statement 3. Statement of financial position 4. Statement of cash-flow (class 9) 5. Statement of comprehensive income - Complement to I.S. with revaluation of assets 6. (Statement of changes in equity) ● Retained profits, dividends, share issues, revaluation + extended notes: Principles and specifications ● Extended requirements for large corporations ● International standards (IFRS) for listed in EU VENTURE CAPITAL: is a long-term capital for small and medium-sized businesses for whom a stock exchange listing would not be appropriate. In addition to providing capital for the business, the venture capitalist will also expect to have a representative on the board of directors. STOCK EXCHANGE: is a market where new capital can be raised and existing shares can be bought and sold. Balance sheet and income statement are needed to prepare statement of cash flows. Assets - Resources a business owns. - Provide future services or benefits. - Cash, Inventory, Equipment, etc. Liabilities - Claims against assets (debts and obligations). - Creditors (party to whom money is owed). - Accounts Payable, Notes Payable, Salaries and Wages Payable, etc. Equity - Ownership claim on total assets. - Referred to as residual equity. - Share Capital—Ordinary and Retained Earning Investments by shareholders represent the total amount paid in by shareholders for the ordinary shares they purchase. Revenues result from business activities entered into for the purpose of earning income Common sources of revenue are: sales, fees, services, commissions, interest, dividends, royalties, and rent. Expenses are the cost of assets consumed or services used in the process of earning revenue. Common expenses are: salaries expense, rent expense, utilities expense, property tax expense, etc. Dividends are the distribution of cash or other assets to shareholders. Dividends reduce retained earnings. However, dividends are not expenses. Transactions are a business’s economic events recorded by accountants. ◆ May be external or internal. ◆ Not all activities represent transactions. ◆ Each transaction has a dual effect on the accounting equation. TRANSACTION 1: you add both in the assets and in equity. TRANSACTION 2: everything happens in the asset side but the balance still remains the same TRANSACTION 3: purchase on credit, the purchase is recorded both in supplies (in the asset side) and in account payable in the equity side, being it on credit. TRANSACTION 4: how do we record revenue? We add both in cash in assets side and in the equity side we put it in the retained earnings. TRANSACTION 5: add 250 in the accounts payable and subtract 250 from the expenses so the total of the equity doesn’t changes. TRANSACTION 6: 3500 in revenues, then you add 1500 in cash and 2000 in account receivable. TRANSACTION 7: deduct the expenses in the equity side and subtract on cash on the asset side. TRANSACTION 8: we cancel the account payable and we deduct the cash by the amount of the account payable. 5 After these transactions we can see that ASSETS = EQUITY + LIABILITIES The account - Record of increases and decreases in a specific asset, liability, stockholders’ equity, revenue, or expense item. - An account consists of three parts: a title, a left or debit side and a credit or right side. - Debit = “Left”, if you want to add and entry on this side is called debiting - Credit = “Right”, if you want to add and entry on this side is called crediting Debits and Credits If the sum of Debit entries are greater than the sum of Credit entries, the account will have a debit balance. If the sum of Credit entries are greater than the sum of Debit entries, the account will have a credit balance. DEBIT AND CREDIT PROCEDURES Double-entry system Each transaction must affect two or more accounts to keep the basic accounting equation in balance. Recording done by debiting at least one account and crediting at least one other account. For each transaction DEBITS must equal CREDITS. Assets - Debits should exceed credits. Liabilities – Credits should exceed debits. Normal balance is on the increase side. Issuance of share capital and revenues increase equity (credit). Dividends and expenses decrease equity (debit). If you want to increase share capital you credit it, if you want to decrease it you debit it. If you want to increase dividends you debit them, if you want to decrease them you credit them. The purpose of earning revenues is to benefit the shareholders. The effect of debits and credits on revenue accounts is the same as their effect on equity. Expenses have the opposite effect: expenses decrease equity. Relationship among the assets, liabilities, and equity of a business: the equation must be in balance after every transaction; total Debits must equal total Credits. Business documents, such as a sales receipt, a check, or a bill, provide evidence of the transaction. • Asset accounts normally show debit balances; • Liability accounts show credit balances • Equity accounts: - Share capital - ordinary shows credit balance; - Retained earnings have a credit balance; - Dividends have a debit balance; - Revenues have credit balance; - Expenses have a debit balance. Steps in the recording process The Journal Book of original entry. Transactions recorded in chronological order. Contributions to the recording process: 1. Discloses the complete effects of a transaction. 2. Provides a chronological record of transactions. 3. Helps to prevent or locate errors because the debit and credit amounts can be easily compared. JOURNALIZING - Entering transaction data in the journal. Companies make separate journal entries for each transaction . A complete entry consists of: the date of the transaction, the accounts and the amounts to be debited and credited, and a brief explanation of the transaction. It is important to use correct and specific account titles in journalizing. The Ledger General Ledger contains all the asset, liability, and equity accounts. The ledger provides the balance in each of the accounts and keeps track of changes in these balances. Standard form of account: date; explanation of the transaction; debit; credit and balance. Transferring journal entries to the ledger accounts. Key: I. Post to debit account-date, journal page number, and amount. II. Enter debit account number in journal reference column. III. Post to credit account-date, journal page number, and amount. IV. Enter credit account number in journal reference column. 6 The Recording Process Illustrated Follow these steps: 1. Determine what type of account is involved. 2. Determine what items increased or decreased and by how much. 3. Translate the increases and decreases into debits and credits. The purpose of transaction analysis is first to identify the type of account involved, and then to determine whether to make a debit or credit to the account. The trial balance A trial balance is a list of accounts and their balances at a given time. It proves the mathematical equality of debits and credits after posting. The trial balance is a sum up of all the individual balances of each posting. On the basis of a trial balance you can do the statement of financial position and the profit and loss. The steps for preparing a trial balance are: 1. List the account titles and their balances. 2. Total the debit and credit columns. 3. Prove the equality of the two columns. Trial balance may balance even when: - A transaction is not journalized. - A correct journal entry is not posted. - A journal entry is posted twice. - Incorrect accounts are used in journalizing or posting. - Offsetting errors are made in recording the amount of a transaction. An error is the result of an unintentional mistake; it is neither ethical nor unethical. An irregularity is an intentional misstatement, which is viewed as unethical. There are three ways to locate errors: 1. If the error is $1, $10, $100, or $1000, re-add the trial balance columns and recompute the account balance; 2. If the error is divisible by 2, scan the trial balance to see whether a balance equal to half the error has been entered in the wrong column; 3. If the error is divisible by 9, retrace the account balances on the trial balance to see whether they are incorrectly copied from the ledger. Reversing the order of numbers is called a transposition error. Currency Signs and Underlining Currency Signs Do not appear in journals or ledgers. Typically used only in the trial balance and the financial statements. Shown only for the first item in the column and for the total of that column. Underlining A single line is placed under the column of figures to be added or subtracted. Totals are double-underlined. Timing Issues Accountants divide the economic life of a business into artificial time periods (Time Period Assumption). Generally a month, a quarter, or a year. Also known as the “Periodicity Assumption” Fiscal and Calendar Years Accounting time periods are generally a month, a quarter, or a year. Monthly and quarterly time periods are called interim periods. Most large companies must prepare both quarterly and annual financial statements. Fiscal Year = Accounting time period that is one year in length. Calendar Year = January 1 to December 31. Accrual- versus Cash-Basis Accounting Accrual-Basis Accounting Transactions recorded in the periods in which the events occur. Companies recognize revenues when they perform services (rather than when they receive cash). Expenses are recognized when incurred (rather than when paid). Cash-Basis Accounting Revenues are recorded when cash is received. Expenses are recorded when cash is paid. Cash-basis accounting is not in accordance with International Financial Reporting Standards (IFRS). 7 ENHANCING QUALITIES - Comparability results when different companies use the same accounting principles. - Information is verifiable if independent observers, using the same methods, obtain similar results. - Information has the quality of understandability if it is presented in a clear and concise fashion. - Consistency means that a company uses the same accounting principles and methods from year to year. - For accounting information to have relevance, it must be timely. Assumptions in Financial Reporting Monetary Unit Requires that only those things that can be expressed in money are included in the accounting records. Economic Entity States that every economic entity can be separately identified and accounted for. Time Period States that the life of a business can be divided into artificial time periods. Going Concern The business will remain in operation for the foreseeable future. Principles of Financial Reporting MEASUREMENT PRINCIPLES Historical Cost Or cost principle, dictates that companies record assets at their cost. Fair Value Indicates that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). REVENUE RECOGNITION PRINCIPLE Requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. EXPENSE RECOGNITION PRINCIPLE Dictates that efforts (expenses) be matched with results (revenues). Thus, expenses follow revenues. FULL DISCLOSURE PRINCIPLE Requires that companies disclose all circumstances and events that would make a difference to financial statement users. Cost Constraint Accounting standard-setters weigh the cost that companies will incur to provide the information against the benefit that financial statement users will gain from having the information available. Closing the Books At the end of the accounting period, the company makes the accounts ready for the next period. Temporary accounts relate only to a given accounting period. The company closes all temporary accounts at the end of the period. In contrast permanent accounts relate to one or more future accounting periods. Permanent accounts are not closed from period to period. Preparing Closing Entries Closing entries formally recognize in the ledger the transfer of net income (or net loss) and Dividends to Retained Earnings. Companies generally journalize and post closing entries only at the end of the annual accounting period. Closing entries produce a zero balance in each temporary account. Journalizing and posting closing entries is a required step in the accounting cycle. Companies close the revenue and expense account to another temporary account, Income Summary, and they transfer the resulting net income or net loss from this account to Retained Earnings. Companies record closing entries in the general journal. 1. Debit each revenue for its balance, and credit Income Summary for total revenues. 2. Debit Income Summary for total expenses, and credit each expense account for its balance. 3. Debit Income Summary and credit Retained Earnings for the account of net income. 4. Debit Retained Earnings for the balance in Dividends account, and credit Dividends for the same amount. The balance in Retained Earnings represents the accumulated undistributed earnings of the corporation at the end of the accounting period. This balance is shown on the statement of financial position and is the ending amount reported on the retained earnings statement. 10 Preparing a Post-Closing Trial Balance Lists permanent accounts and their balances after the journalizing and posting of closing entries. Purpose is to prove the equality of the permanent account balances carried forward into the next accounting period. Only contains balances for permanent—statement of financial position—accounts. All temporary accounts will have zero balances. A post-closing trial balance provides evidence that the company has properly journalized and posted the closing entries. It also shows that the accounting equation is in balance at the end of the accounting period. Statement of Financial Position Presents a snapshot at a point in time. To improve understanding, companies group similar assets and similar liabilities together. A classified statement of financial position groups together similar assets and similar liabilities, using a number of standard classifications and sections. Intangible Assets Assets that do not have physical substance, yet they are very valuable. One significant intangible asset is goodwill; others include patents, copyright, and trademarks or trade names that give the company exclusive right of use for a specified period of time. Property, Plant, and Equipment Assets with relatively long useful lives that a company is currently using in operating the business. Depreciation is the practice of allocating the cost of assets to a number of years. Companies do this by systematically assigning a portion of an asset’s cost as an expense each year. The assets that the company depreciated are reported on the statement of financial position at cost less accumulated depreciation. Accumulated depreciation account shows the total amount of depreciation expensed thus far in the asset’s life. Long-Term Investments Investments in ordinary shares and bonds of other companies that are normally held for many years. Investments in non-current assets such as land or buildings that a company is not using in its operating activities. Current Assets Assets that a company expects to convert to cash or use up within one year or the operating cycle, whichever is longer. Supplies is a current asset because the company expects to use it up in operations within one year. Operating cycle is the average time it takes from the purchase of inventory to the collection of cash from customers. Except when noted, we will assume that companies use one year to determine whether an asset or liability is current or non-current. Common types of current assets are: prepaid expenses, inventories, receivables, short-term investments, and cash. On the statement of financial position, companies usually list these items in the reverse order in which they expect to convert them into cash. Equity • Proprietorship - one capital account. • Partnership - capital account for each partner. • Corporation – Share Capital and Retained Earnings. Non-Current Liabilities Obligations a company expects to pay after one year. Liabilities in this category include bonds payable, mortgages payable, long-term notes payable, lease liabilities, and pension liabilities. Current Liabilities Obligations company is to pay within the coming year or its operating cycle, whichever is longer. Usually list notes payable first, followed by accounts payable. Other items follow in order of magnitude. The relationship between current asses and current liabilities is important in evaluating a company’s liquidity-its ability to pay obligations expected to be due within the next year. Merchandising Operations Merchandising Companies Buy and Sell Goods, this that purchase and sell directly to consumers are called retailers, whereas those that sell to retailers are known as wholesalers. The primary source of revenues is the sale of merchandise, and it is referred to as sales revenue or sales. Cost of goods sold is the total cost of merchandise sold during the period. Operating Cycles The operating cycle of a merchandising company ordinarily is longer than that of a service company 11 Flow of Costs The flow of costs for a merchandising company is as follows: beginning inventory plus the cost the cost of goods purchased is the cost of goods available for sale. As goods are sold, they are assigned to the cost of goods sold. Those goods that are not sold by the end of the accounting period represent ending inventory. Companies use either a perpetual inventory system or a periodic inventory system to account for inventory. PERPETUAL SYSTEM Maintain detailed records of the cost of each inventory purchase and sale. Records continuously show inventory that should be on hand for every item. Company determines cost of goods sold each time a sale occurs. PERIODIC SYSTEM Do not keep detailed records of the goods on hand. Cost of goods sold determined by count at the end of the accounting period. To determine the cost of goods sold under a periodic inventory system, the following steps are necessary: determine the cost of goods on hand at the beginning of the accounting period; add it to the cost of goods purchased; subtract the cost of goods on hand at the end of the accounting period. ADVANTAGES OF THE PERPETUAL SYSTEM Traditionally used for merchandise with high unit values. Shows the quantity and cost of the inventory that should be on hand at any time. Provides better control over inventories than a periodic system. Recording Purchases of Merchandise Made using cash or credit (on account). Normally record when goods are received from the seller. Every purchase should be supported by business documents that provide written evidence of the transaction. Companies record cash purchase by an increase in inventory and a decrease in cash. Purchase invoice should support each credit purchase. Companies record purchases of assets acquired for use and not for resale, such as supplies, equipment, and similar items, as increases to specific asset accounts rather than to inventory. Freight Costs The sales agreement should indicate who is to pay for transporting the goods to the buyer’s place of business. FOB (free on board) shipping point means that the seller places the goods on board the carrier and the buyer pays the freight cost; ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller.. FOB destination means that the seller places the goods free on board to the buyer’s place of business, and the seller pays the freight; ownership of the goods remains with the seller until the goods reach the buyer. When the buyer incurs the transportation costs, these costs are considered part of purchasing inventory. Therefore, the buyer debits the Inventory account. Inventory should include all costs to acquire the inventory, including freight necessary to deliver the good to the buyer. Freight cost incurred by the seller on outgoing merchandise are an operating expense to the seller. Thee costs increase an expense account titled Freight-Out. When the seller pays the freight charges, the seller will usually establish a higher invoice price for the goods to cover the shipping expense. Purchase Returns and Allowances Purchaser may be dissatisfied because goods are damaged or defective, of inferior quality, or do not meet specifications. Purchase Return: return goods for credit if the sale was made on credit, or for a cash refund if the purchase was for cash. Purchase Allowance: may choose to keep the merchandise if the seller will grant a reduction from the purchase price. Purchase Discounts Credit terms may permit buyer to claim a cash discount for prompt payment. Advantages: - Purchaser saves money. - Seller shortens the operating cycle by converting the accounts receivable into cash earlier. Credit terms specify the amount of the cash discount and time period in which it is offered. Passing up the discount may be viewed as paying interest for use of the money. Recording Sales of Merchandise Made using cash or credit (on account). Sales revenue, like service revenue, is recorded when the performance obligation is satisfied. Performance obligation is satisfied when the goods are transferred from the seller to the buyer. A business document should support every sales transaction, to provide written 12 AVERAGE-COST Allocates cost of goods available for sale on the basis of weighted-average unit cost incurred. Applies weighted-average unit cost to the units on hand to determine cost of the ending inventory. Financial Statement and Tax Effects of Cost Flow Methods Either of the two cost flow assumptions is acceptable for use. For example, adidas (DEU) and Lenovo (CHN) use the average-cost method, whereas Syngenta Group (CHE) and Nokia (FIN) use FIFO. A recent survey of IFRS companies, approximately - 60% use the average-cost method, - 40% use FIFO, and - 23% use both for different parts of their inventory. STATEMENT OF FINANCIAL POSITION EFFECTS A major advantage of the FIFO method is that in a period of inflation, the costs allocated to ending inventory will approximate their current cost. In the period of raising prices FIFO reports a higher net income than average-cost. If prices are falling the results from the use of FIFO and average-cost are reversed, FIFO will report the lower net income and average-cost the higher. A major shortcoming of the average-cost method is that in a period of inflation, the costs allocated to ending inventory may be understated in terms of current cost. TAX EFFECTS Both inventory and net income are higher when companies use FIFO in a period of inflation. (the bigger the ending inventory, the smaller COGS, the higher the net income) Average-cost results in the lower income taxes (because of lower net income) during times of rising prices. Using Cost Flow Methods Consistently Method should be used consistently, enhances comparability. Although consistency is preferred, a company may change its inventory costing method. Inventory Errors Errors are caused by failure to count or price the inventory correctly. In other cases, errors occur because companies do not properly recognize the transfer of legal title to goods that are in transit. Inventory errors affect the computation of cost of goods sold and net income in two periods. If the error understates beginning inventory, cost of goods sold will be understated. If the error understates ending inventory, cost of goods sold will be overstated. An error in the ending inventory of the current period will have a reverse effect on net income of the next accounting period. Statement Presentation and Analysis Presentation Statement of Financial Position - Inventory classified as current asset.   Income Statement - Cost of goods sold is subtracted from sales. There also should be disclosure of the 1. major inventory classifications, 2. basis of accounting (cost or LCNRV), and 3. costing method (specific identification, FIFO, or average-cost). Analysis Inventory management is a double-edged sword 1. High Inventory Levels - may incur high carrying costs (e.g., investment, storage, insurance, obsolescence, and damage). 2. Low Inventory Levels – may lead to stock-outs and lost sales. Inventory turnover measures the number of times on average the inventory is sold during the period. Days in inventory measures the average number of days inventory is held. MANAGEMENT ACCOUNTING MAS - The formal procedures and routines an organisation puts in place to collect and communicate information in order to support the implementation of business strategy.  This information is used to assist: - effective planning - effective monitoring - effective influence on employees’ behaviour - quality decision-making What is an MAS? MAS’s provide information to assist the following functions: 15 • Effective planning: the development of plans that support the strategic objectives of a business → Preparation of a Production Cost Budget. • Effective monitoring: the checking of performance to ensure plans are being met → Variance Analysis based on the Production Cost Budget. • Effective influence on employees’ behaviour: the means by which managers influence other members of the organisation to perform in ways that support the organisation’s strategies → Budget and variance- based performance measures. • Quality decision making: decisions are made that support achievement of strategic objectives → CVP analysis. The common theme in all definitions is “Supporting Strategy”. The fundamental role of a MAS is to provide information to support strategy implementation and achievement. Why do organisations need MAS’s? Because the elements that make up organisations (personnel, scares resources, complex and diverse activities)  need to be managed and organised. - Very few organisations will be able to achieve strategic objectives without some formal process to manage the complex and diverse elements it comprises - The MAS provides relevant, timely information essential for successful INTERNAL management  Why can't businesses use Financial Accounting System information for internal management? Financial Accounting information has a different purpose. Used in the preparation of Financial Reports for business governance NOT internal management. Financial Accounting information is too aggregated, not timely, often not relevant for internal management. Therefore internal management requires it’s own Accounting System - the MAS Identifying costs Cost: monetary measure of the resources needed for a goal, most people consider it as monetary amount. The cost measures the employment of resources. It is always referred to a cost object (a product, a service, an event, a client, a unit, a program, a department), which is anything for which a separate measurement of costs is desired. A cost driver is any factor that affects the costs of a cost objet. A costing system typically accounts for costs in two basic stages: it accumulates costs by some “natural” classification; it assigns these costs to cost objects. Cost accumulation is the collection of cost data in some organized way through an accounting system. Cost assignment is a general term that encompasses both tracing accumulated costs to a cost object, and allocating accumulated costs to a cost object. Costs that are traced to a cost object are direct cost, and costs that are allocated to a cost object are indirect costs. Managers assign costs to designated cost objects to help decision making. Direct and indirect costs Direct costs are those costs that are related to the particular cost object and that can be traced to it in an economically feasible (cost-effective) way. Indirect costs are those costs that are related to the particular cost object but cannot be traced to it in an economically feasible (cost-effective) way. They are often called overheads. Cost tracing is the assigning of direct costs to the chosen cost object. Cost allocation is the assigning of indirect costs to the chosen object. Cost assignment encompasses both cost tracing and cost allocation. Factors affecting direct/indirect cost classification 1. Materiality of the cost in question: the higher the cost in question, the more likely the economic feasibility of tracing that cost to a particular cost object. 2. Available information-gathering technology: barcodes. 3. Design of operations: classifying a cost as direct is helped if an organisation’s facility is used exclusively for a specific product or customer. → The direct/indirect classification depends on the cost object. The salary of an assembly department supervisor may be a direct cost of the assembly department but an indirect cost of a product. 16 Cost drivers and cost management The continuous cost reduction efforts of competitors create a never-ending need for organizations to reduce their own costs. Cost reduction efforts frequently identify two key areas: focusing on value-added activities, that is, those activities that customers perceive as adding value to the products or services they purchase; efficiently managing the use of the cost drivers in those value-added activities. A cost drives is any factor that affects total cost. That is, a change in the level of the cost driver will cause a change in the level of the total cost of a related cost object. Some cost drivers are financial measures found in accounting systems, while others are non-financial variables. Cost management is the set of actions that managers take to satisfy customers while continuously reducing and controlling costs. Cost behaviour Management accounting systems record the cost of resources acquired and track their subsequent use. Tracing these costs allows managers to understand how these costs behave. • Fixed costs: those costs whose amount does not change regardless of changes in the level of activity (e.g.: rents, some salaries, insurances, some taxes, advertising, depreciation rates…). NB: these costs are not stable: they modify in the mid-long term, but not always because of changes of the level of activity. • Variable costs: costs that vary, in total, in direct proportion to changes in the level of activity (e.g.: direct materials, direct labour, shipping costs, supplies…). If volumes of activity increase by 10%, also variable costs increase by 10. Important to clarify which activity determines the cost increase (“cost driver”). Major assumptions: costs are defined as variable or fixed with respect to a specific cost object; the time span must be specified; total cost are linear; there is only one cost driver; variations in the level of the cost driver are within a relevant range. Labour cost:  Is the cost of labour variable or fixed? • Purely variable if workers are paid on a piecework basis (by the unit). • Fixed where employment conditions restrict an organization’s flexibility to assign workers to any area that has extra labour requirements. Relevant range A cost is fixed only in relation to a given relevant range and a given time span. A relevant range is the range of the cost driver in which a specific relationship between cost and the level of activity or volume is valid. Fixed/variable & direct/indirect How do variable costs differ from direct costs? How do fixed costs differ from indirect costs? Different costs for different purposes: - Cost behaviour (level of activity): FIXED and VARIABLE - Cost of a product (how easy it is to associate costs to products): DIRECT and INDIRECT Most variable costs are direct but there are exceptions: CLEANING COST. Indirect costs are often fixed but remember the RELEVANT CHANGE. Total and unit Costs A unit (or average) cost is calculated by dividing total costs by number of units. The units might be expressed in various ways. Unit costs are useful to valuate stock/inventory in income statement and statement of financial position. Financial statements cost terminology Capitalised costs: - Recorded as assets; - Presumed to provide future benefits to the company either as new benefits or improved benefit. Revenue/current costs: - Recorded as expenses when they are incurred; - Tend to be periodic; - Necessary to the organization’s operations; - Don’t increase the value of assets. Costs in different industries Service-sector companies Produce service or intangible products (tax, legal advise). Labour cost is the most significant cost category among operating costs. Other operating costs include rent, depreciation. No Cost of goods sold in income 17 Operating leverage: Total contribution margin (for any given level of sales)/Operating profit The degree of operating leverage at a given level of sales helps managers calculate the effect of fluctuations in sales on operating profits. A critical assumption of CVP analysis is that costs can be classified as either variable or fixed. This classification can be affected by the time period being considered. The shorter the time horizon we consider, the higher the percentage of total costs we may view as fixed. Effects of revenue mix on profit Revenue mix is the relative combination of quantities of products or services that constitutes total revenues. If the mix changes, overall revenue targets may still be achieved. However, the effects on operating profit depend on how the original proportions of lower or higher contribution margin products have shifted. Contribution margin and gross margin Contribution margin = Revenues - All variable costs Gross margin = Revenues - Cost of goods sold Cost of goods sold in the merchandising sector is made up of goods purchased for resale. - Service-sector companies can calculate a contribution margin figure but not a gross margin figure. Service-sector companies do not have a cost of goods sold in their income statement. - Merchandising sector: contribution margin is calculated after all variable costs have been deducted, whereas gross margin is calculated by deducting only cost of goods sold from revenues. - Manufacturing sector: the two areas of difference between contribution margin and gross margin for companies in the manufacturing sector are fixed manufacturing costs and variable non-manufacturing costs. Fixed manufacturing costs are not deducted from revenues when computing contribution margin but are deducted when computing gross margin. Cost of goods sold in a manufacturing company includes entirely manufacturing costs. Variable non-manufacturing costs are deducted from revenues when computing contribution margins but are not deducted when computing gross margins. Absorption costing The overhead costs incurred by the business need to be shared fairly between all the products. If a product is to be fully costed, its costs needs to include a proportion of all the indirect manufacturing costs incurred by the business or organization. Absorption costing tries to find the fairest way of achieving this but without creating a complex and costly accounting system. Direct costs are those costs directly associated with a product, such as material and labour costs. Indirect costs are those costs which cannot be directly associated with a product, such as rent and depreciation. They are often called overheads. Full costing takes into account both direct and indirect costs associated with the manufacture of a product. Absorption costing is a management accounting technique where indirect manufacturing or overhead costs are spread fairly across the range of products made by the business. (Marginal or variable costing is a method which only takes into account variable costs and ignores fixed costs.). The simplest way of sharing overhead or indirect manufacturing costs between products is to create a blanket rate which can be charged out to each product. At the beginning of the financial year, the total budgeted overhead costs can be estimated and then divided by the budgeted number of products to be produced. This will create a rate or cost per product. This can then be charged to each product as it is produced. Usually, the calculation of the rate is based on estimated production volumes and costs at the beginning of the financial year. If the volumes have been higher than estimated, more overhead will have been “recovered” or charged out, as the absorption rate is multiplied by a higher volume number. If the actual costs in total are higher than estimated but the volumes in line with the estimates, then there will be an “under” recovery, as insufficient costs have been “recovered” or charged to the product. An accounting adjustment will need to be made in the accounts to compensate for the “over” or “under” recovery. An over recovery of overheads:  occurs after an absorption rate has been applied throughout the year and products have been charged with more than the actual overhead incurred by the year-end. An under recovery of overheads occurs after an absorption rate has been applied throughout the year and products have been charged with less than the actual overhead incurred by the year-end. Over-recovery & Income statement Under-recovery & Income statement 20 Why do these costs have to be based on estimated costs (predetermined cost) at the beginning of the year and not actual (historic) cost? A rate needs to be determined at the beginning for the year, to enable the business to make decisions throughout the year ahead. For example, if the rate was determined after the actual costs were known, it would be too late to re-negotiate selling prices with customers as the product would have already been sold. Calculating a departmental rate to fully cost the product To arrive at a more accurate method of charging out indirect manufacturing costs to products, a rate must be calculated for each manufacturing department in the business or organization. To calculate departmental rates, costs need to be collected by manufacturing departments in three stages: 1. Stage 1: any costs that can be clearly identified with a specific department can be allocated. 2. Stage 2: any costs that are general to all departments can be apportioned or shared. This can be done by taking each type of expense and finding an appropriate method of spreading the costs across departments. 3. Stage 3: if there are service departments that provide support to other departments, their costs need to be reapportioned over the manufacturing departments. Allocated costs are those indirect costs that are directly associated with a manufacturing department. Apportioned costs are those indirect manufacturing costs, such as rent, that cannot be directly associated with a department and need to be shared between departments on a fair basis. Reapportioned costs are the indirect costs of a service department that are shared out between manufacturing departments on a fair basis. Once costs have been collected by each manufacturing department, a rate needs to be calculated to reflect the characteristics of that department. A rate can be calculated by taking the total departmental costs and dividing it by an appropriate measure. This rate can then be used to calculate the overheads that need to be charged to an individual product. Relevant revenues or costs Decision making is about looking to the future and assessing the impact that a decision will have on the cash position of the business as a whole. Relevant revenue and costs are those that are incurred as a direct result of a specific decision. They will be the extra or incremental costs and revenues that would not have been received or spent if the decision had not been made. A relevant revenue is one that results from a specific management decision and will affect the future cash position of the business by receiving incremental revenue. A relevant cost is one that results from a specific management decision and will affect the future cash position of the business by incurring incremental costs, costs that were not there before. An opportunity cost is the amount of benefit lost when a certain course of action is taken. This is a relevant cost for decision making purposes. Non-relevant revenue or costs Non-relevant revenue or costs are those that remain unchanged, following a specific management decision. Those revenues and costs that are unaffected by a managerial decision and should not be included in the decision-making. A sunk cost is one that has already been spent and is not a relevant cost as it will not change as a result of a management decision. A committed cost is one that has to be paid for, whether or not management make a specific decision. It is a non-relevant cost. Relevant and non-relevant revenues/costs Relevant: - Future, Incremental, Cash - Opportunity costs Non relevant: - Sunk costs - Committed costs - Non-cash (depreciation) - Non-Incremental costs (fixed-overheads) Make or buy Businesses may consider whether they should make components themselves or buy (outsourcing) them in from a third party supplier. Only the relevant costs need to be considered. As revenue is the same in both cases, it does not need to be taken into account. Non-manufacturing overheads (allocated costs) can be ignored. 21 - Salaries and fringe benefits of selling, general and administrative personnel. This would include the company president, vice presidents, managers, and other employees in the non-manufacturing functions of the company. - Rent, property taxes, utilities for the space used by the non-manufacturing functions of the company. - Insurance for areas outside of the factory. - Interest on business loans. - Marketing and advertising. - Depreciation and maintenance of equipment and buildings outside of manufacturing. - Supplies for the offices. Limiting factors & optimum production plan If a business is growing fast, it may be forced with not being able to meet all its sales demand. It is important that managers make the appropriate decisions about which product or service is restricted, so that the maximum contribution is made. A limiting factor is any resource that is in scarce supply - capacity of a machine - supply of certain raw material - availability of skilled labour When the business is not able to meet all its sales it has to decide which products to restrict. - Looking at contribution (revenues-variable costs) is not enough - Look at Contribution per limiting factor  To carry out a comprehensive analysis, the following steps need to be taken: 1. Calculate the contribution per unit for each product; 2. Calculate the usage of limiting factor per unit; 3. Divide the contribution by the limiting factor. This will show the contribution per limiting factor for each product. 4. Prioritize the products according to their contribution per limiting factor; 5. Calculate how much each product uses of the limiting factor, starting with the highest priority product. Upgrading equipment Companies face choices about upgrading processes to make costs savings. In these situations, companies need to balance increasing fixed costs against savings in variable costs. This can be done by assessing the number of units which would need to be produced to justify the increased fixed costs as a result of upgrading the business’ processes. Number of units = Additional fixed costs/savings in variable costs If number of units needed to cover additional fixed costs are smaller than the budgeted units, then upgrading equipment is economically feasible. Site or product closure Marginal costing techniques can also be used to assess whether products should be discontinued, factories closed, or other operations shut down. To assess whether a product should be discontinued or a site closed, only the relevant costs and revenues should be taken into account. Allocated costs are not relevant if they will not change as a result of closure. A profitability analysis looks at the profitability of a sector of a business, such as it products or operations. This usually includes an allocation of shared costs. A contribution analysis looks at what each sector of the business contributes to the overheads. This excludes any allocated costs. Decisions regarding site or product closure should be taken on the basis of contribution analysis, not the profitability analysis. Pricing Major influences on pricing • Customers: managers must always examine problems through the eyes of their customers. A technology-driven revolution is under way where organisations are embracing “dynamic pricing”. Firms can price dynamically to respond to demand, to reduce waste and to turn over stock more rapidly. Many businesses use customer profiling and targeted pricing to refine product offerings to match individual customers’ price sensitivities. Customer knowledge becomes a core technological-driven strength which helps render prices opaque, invisible to the price crawlers that trawl through websites indiscriminately. - Customer profiling • Competitors: competitors’ reactions influence pricing decisions. At one extreme, a rival’s prices and products may force a business to lower its prices to be competitive. At the other extreme, a business without a rival in given situation can set higher prices. A business with knowledge of its rivals’ technology, 22 Advantages of using full cost 1. Full product cost recovery: ensure that the company continue in business rather than shutting down. If you base your price on variable costs the temptation is to cut prices until the contribution margin remains positive; 2. Price stability; 3. Simplicity. But…Allocating fixed costs to products is arbitrary → Calculating fixed costs per unit requires an estimate of future sales quantities. If actual sales fall short of this estimate, the actual full product cost could exceed price! Life-cycle product budgeting and costing The product life cycle spans from initial R&D to the time at which support to customers is withdrawn. Using life-cycle budgeting, managers estimate the revenues and costs attributable to each product from its initial R&D to its final customer servicing and support in the marketplace. Life-cycle costing tracks and accumulates the actual costs attributable to each product from start to finish. Life-cycle budgeted costs can provide important information for pricing decisions. Life cycle costing: accumulates the actual costs attributable to each product from start to finish. Life cycle budgeting: estimating revenues and costs for initial R&D phases to final customers servicing. A product life-cycle budget highlights the importance of setting prices and budgeting revenues to recover costs in all the value-chain business functions rather than costs in only some functions. The life-cycle budget also indicates the costs to be incurred over the life of the product. Why is it important? For some products, the highest costs are not the manufacturing ones, but R&D and design (software development, pharmaceutical companies). Prices must be set to recover costs in all the value-chain business functions! Life-cycle reporting makes non-manufacturing costs visible. High early stage costs (R&D) design signal the importance of develop accurate predictions of the revenues of a product. Life cycle reporting highlights cause and effects: low R&D, design; high customer service costs? A product life-cycle reporting format offers at least three important benefits: 1. The full set of revenues and costs associated with each product become visible; 2. Differences among products in the percentage of their total costs incurred at early stages in the life cycle are highlighted. The higher this percentage, the more important it is for managers to develop, as early as possible, accurate predictions of the revenues for that product; 3. Interrelationships among business function cost categories are highlighted. Other considerations in pricing decisions Price discrimination: charging some customers a higher price that is charged to other customers. Peak-load pricing: charging a higher price for the same product or service when demand approaches physical capacity limits. Under price discrimination and peak-load pricing, prices differ among market segments even though the outlay costs of providing the product or service are approximately the same. Customer-profitability analysis Customer-profitability analysis refers to the reporting and analysis of customer revenues and customer costs. Managers need to ensure that customers contributing sizably to the profitability of an organisation receive a comparable level of attention from the organisation. The marketing efforts of companies aim to attract and retain profitable customers. Revenue differences across customers are due to: - The number of products purchased, and - The magnitude of price discounting. →Tracking price discounts by customer and by salesperson helps to improve customer profitability. Customer revenues are inflows of assets from customers received in exchange for products or services being provided to those customers. The analysis of customer profitability is enhanced by retaining as much detail as possible about revenue. A key concern here is price discounting, which is the reduction of selling prices below listed levels in order to encourage an increase in purchases by customers. Cost differences across costumers may be due to the number of: - Order - Delivery - Visits - Rush orders 25 A customer hierarchy categorises costs related to customers into different cots pools on the basis of different types of cost drivers (or cost-allocation bases) or different degrees of difficulty in determining cause-and-effect (or benefits received) relationships. Categories of customer cost hierarchy: 1. Customer output-unit-level costs - resources scarified on activities performed to sell each unit to a customer. 2. Customer batch-level cost - resources sacrificed on activities that are related to a group of units sold to a customer. 3. Customer-sustaining costs - resources scarified on activities undertaken to support individual customers. 4. Distribution-channel costs - resources on activities that are related to a particular distribution channel rather than to each unit of product, batches of product, or specific customer. 5. Corporate-sustaining costs - resources sacrificed on activities on activities that cannot be traced to individual customers or distribution channels. Customer-level costs include cost of goods sold and costs incurred in the first three categories of the customer cost hierarchy: customer output unit-level costs, customer batch-level costs and customer- sustaining costs. Customer profitability profiles Customer profitability profiles are a useful tool for managers. Cumulative customer profitability profiles provide information that shows what percentage of operating income each additional customer contributes. Customers are presented in order of contribution to operating income so any customers in a loss position are highlighted at the bottom of the analysis. Managers must explore ways to make unprofitable customers profitable.  When doing so, they should include factors other than the current profitability level including: - Likelihood of customer retention. - Potential for sales growth. - Short-run and long-run customer profitability. - Increases in overall demand from having well-known customers (if applicable). - Ability to learn from customers. Budget and master budget A budget is a financial plan, prepared and approved by management, usually for the year ahead. It is a quantitative expression of a proposed plan of action by management for a future time period and is an aid to the coordination and implementation of the plan. It can cover both financial and non-financial aspects of these plans. Budgets covering financial aspects quantify management’s expectations regarding future income, cash flows and financial positions. Many organisations adopt the following budgeting cycle: 1. Planning the performance of the organisation as a whole as well as subunits. 2. Providing a frame of reference, a set of specific expectations against which actual results can be compared. 3. Investigating variations for plans. 4. Planning again, considering feedback and changed conditions. Master budget: operating budget     (acquisition and use of scarce resources) + financing budget   (how we obtain funds to acquire resources → CASH) The master budget coordinates all the financial projections in the organisation’s individual budgets in a single organisation-wide set of budgets for a given time period. It embraces the impact of both operating decisions and financial decisions. Operating decisions are about the acquisition and use of scarce resources. Financing decisions centre on how to obtain the funds to acquire resources. The term master in master budget refers to it being a comprehensive, organisation-wide set of budgets. The master budget summarises the financial projections of all the organisation’s individual budgets. The operating budget is the budgeted profit statement and its supporting budget schedules. The supporting budget schedules cut across different categories of the value chain from R&D to customer service. The financial budget is that part of the master budget that comprises the capital budget, cash budget, budgeted balance sheet, and budgeted statement of cash flows. It focuses on the impact of operations and planned capital outlays on cash. Budgeted financial statements are sometimes called pro forma statements. Roles of budget Budgets are a major feature of management control systems in general. Current thinking concerning budgetary control system suggests two opposite views. On the one hand, there is the view that espouses incremental improvement to budgetary processes in terms of linking such processes more closely to operational requirements and planning systems and increasing the frequency of budget revisions and 26 deployment of rolling budgets. conversely, an alternative view advocates the abandonment of budgetary control and its replacement with alternative techniques to enable firms to become more adaptive and agile. • Strategy and plans: a budget translates strategy and plans into numbers. Budgeting is most useful when done as an integral part of an organisation’s strategic analysis. Strategy can be viewed as describing how an organisation matches its own capabilities with the opportunities in the marketplace to accomplish its overall objectives. • A framework for judging performance: budgeted performance can be used to judge actual results. Advantages of using budgeted performance instead of past results: past results incorporates past mistakes; past results refer to past scenarios. • Coordination and communication: Coordination: a budget forces executives to think about relationships among departments and business functions. Coordination is the mashing and balancing of all factors of production or service and of all the departments and business functions so that the company can meet its objectives - The purchasing officers makes material purchase plans based on production requirements; - The production manager can make better production schedules if s(he) interacts with the marketing managers. Communication: is getting those objectives understood and accepted by all departments and functions; for coordination to succeed communication is essential. eg. The production manager must know the sales plan….the purchasing manager must know the production plan… • Motivation: budget-related measures can motivate managers to perform well when targets for performance are attached to these measures. Top management has the ultimate responsibility for the budgets of the organisation they manage. Management at all levels, however, should understand and support the budget and all aspects of the management control system. Top management support is especially critical for obtaining active line participation in the formulation of budgets and for successful administration of the budgets. If line managers feel that top management does not believe in the budget, these managers are unlikely to be active participants in the budget process. Budgetary control entails more than the simple application of rules and calculative procedures and the quantitative evaluation of performance. Budgeting activities achieve specific significance depending on the organisational process through which budgetary pressures and demands arise. Situations where decision makers agree about the aims of particular organisational actions or over the activities of particular or organisational units sometimes coincide with certainty about what will ensure if certain actions are taken. Budgets can become synonymous with ammunition in that they determine what is regarded as relevant and worthwhile or problematic. The design and functioning of budgetary control systems will reflect the realities of organisational process. Disagreement over objectives and consequences of action is a fact of organisational life. Accounting reflects and influences conflict resolution.……………………………… … Role of Performance Targets: to encourage individuals to set work goals. Performance tends to be higher when work goals are set, compared to when individuals have no set goals. As long as goals are perceived as: clearly understood, challenging but achievable. Time coverage  The purpose for budgeting should guide the time period chose for the budget. The most frequently used budget period is one year. The annual budget is often subdivided by months for the first quarter and by quarters for the remainder of the year. The budgeted data for a year are frequently revised as the year unfolds. A rolling budget is a budget or plan that is always available for a specified future period by adding a month, quarter or year in the future as the month, quarter or year just ended us dropped. How to develop a budgeted profit statement 1. Revenue budget; 2. Production budget (in units); 3. Direct material usage budget and direct materials purchased budget; 4. Direct manufacturing labour budget; 5. Manufacturing overhead budget; 6. Closing stock budget; 7. Cost of goods sold budget; 8. Other (non-production) costs budget. Organisational structure and responsibility Organisational structure is an arrangement of lines of responsibility within the entity. The managers of the individual groups each have decision-making authority concerning all the business functions within the group. To attain the goals described in the master budget, an organisation must coordinate the efforts to all its employees - from the top executive through all levels of management to every supervised worker. Coordinating the organisation’s efforts means assigning responsibility to managers who are accountable for 27