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Chapter 7

Management Accounting

7.1 Introduction 81 7.2 Financial v Management Accounting 82 7.3 Main Purposes of Management Accounting 83 7.4 Cost Accounting 88 7.5 Job and Service Costing 99 7.6 Summary 104

Learning Objectives

After completing this unit of study you should be able to:

• explain the differences between financial and management accounting

• appreciate the role that management accounting plays in business today

• classify costs for management accounting purposes

• perform basic job and service costing calculations.

7.1 Introduction

The material covered in Units 1−6 predominantly falls under the heading of financial account- ing. Financial accounting is primarily concerned with the provision of historical information to external parties outside the organisation. Shareholders, lenders and suppliers have no day-to-day involvement in the running of the company or daily access to the financial results. However, as stockholders to the organisation, they clearly have a vested interest in the success, or otherwise, of the business, and the financial reporting mechanism services their needs.

The focus of the remaining units is management accounting, which exists to provide internal parties with the necessary information for decision-making, and for planning and controlling the business. The board of directors, line managers and shop-floor supervisors are all required to make decisions on a daily basis, albeit at different levels, and the success of those decisions can often hinge on the costing or budgeted information provided by the management accountants.

In its broadest sense, management accounting adopts the following approach.

• Establish the overall company objectives.

• Consider the actions required to meet these objectives.

• Collect all relevant data.

• Select the appropriate short- and long-term courses of action.

• Implement the decisions made.

• Compare the actual performance to the targets set and, if necessary, take corrective action.

Unit 7 outlines the key functions of management accounting, particularly with regard to cost accounting, while Units 8−12 will provide the detail required for good decision-making and effective budgeting.

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7.2 Financial v Management Accounting

The differences between financial and management accounting effectively arise because of the distinct needs of the user groups that the two sides seek to address. The key differences are given below.

7.2.1 Legal Requirements/Regulations

Financial reporting is subject to legal and accounting regulations. It is a statutory requirement for large organisations to report annually to their shareholders and the accounting information included in these reports is governed by international accounting standards. These regulations, imposed by the law and the accounting profession, ensure that annual reports are produced in a standard format with standard content, thus aiding the comprehensibility and comparability of the information to the user groups.

Because management accounting reports tend to be for internal use only, they are not subject to any external regulation. The important thing for management accounting reports is that they are designed in such a way as to best meet the needs of the particular managers who will be making use of the information.

7.2.2 Level of Detail/Accuracy

Financial accounting reports provide their users with a broad overview of the company’s financial performance for the trading period and the financial position at the end of the trading period. Having been subjected to the legal and accounting regulation mentioned above and also having come under the scrutiny of the external auditors, financial accounting information should be reasonably accurate . . . after all it deals with historic information and if its main purpose is to to help users of the information make decisions (for example should I invest in the company or should I supply to the company) then it is not unreasonable to expect this information to be accurate.

Management accounting reports, however, are likely to be prepared in much greater detail because the information provided might well be used to help managers make key operational decisions. Although this information might be more detailed in terms of content, the accuracy of the figures is likely to depend on the timescale covered by the report. Clearly, a lot of management accounting information involves planning for the future, so estimates might well have to be made on issues such as future material prices or labour rates.

7.2.3 Nature of the Reports

Allied to the comments made above on content, financial accounting reports contain inform- ation that is likely to be useful to a broad range of users who might be making a wide range of business decisions. They tend to be more general-purpose reports rather then be geared towards an individual user-group.

The nature of a management accounting report, however, is that it exists in order to aid a particular decision that needs to be made or it is for a particular manager. These reports are, therefore, produced for a much more specific purpose.

7.2.4 Reporting Timescale

By law, financial accounting reports are required at least annually but quite often, particularly if the company is quoted on its local Stock Exchange, a six-monthly interim report is also produced.

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Management accounting reports are produced as frequently as managers require them; for example a production manager might require a report

• daily for production output

• weekly for machine efficiency/labour productivity

• monthly for stocktake figures

• quarterly for projected material requirements

• annually for budgeted financial results.

These reports enable the managers to check progress on a regular basis.

7.2.5 Time Horizon

Primarily, financial accounting reports are backward looking because they report on the historic events that impacted on the performance and the financial position of the company over the past trading period.

In addition to providing information to managers on past performance, management accounting reports often focus on future information. Just think back and remind yourself of all the work you did on cash budgeting in Chapter 4.

7.2.6 Range of Information

It is really only information that can be quantified in monetary terms that you will find in a financial accounting report. Management accounting reports will also contain a lot of monetary information; however, they are also likely to include other quantifiable data, for example employee absences, percentage scrap, stock quantities, and health and safety records.

Management accounting is a lot less constrained than financial accounting because it is not governed by the same amount of external regulation. Its information may not be quite as accurate at times but as long as it enables managers to continue to improve the quality of their decision-making, then it will have served its true purpose.

7.3 Main Purposes of Management Accounting

Management accounting provides information to help companies in the areas of planning, control and decision-making. The thought process that company managers go through in considering these areas is no different from the thought process that we would go through as individuals. So indirectly we are all management accountants. Companies manage their business whilst we as individuals manage our lives.

Consider the following questions.

• How is planning relevant to you as an individual?

Just ask yourself what you are going to do next Friday night. Perhaps you fancy a game of golf or maybe you would prefer a nice meal in the local restaurant. This is short-term planning.

Where would you like to be in ten years time? Maybe you have ambitions to be on the board of directors or maybe you would like to take early retirement to try and improve that golf handicap. This is longer-term planning.

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• How might control be relevant to you?

Whenever you make a plan you automatically provide yourself with a control mechanism against which you can measure your actual performance. Perhaps the first stage to achieving your seat on the board of directors is to pass this MBA. Will you achieve this within the timescale that you set for yourself? This is control.

• How is decision-making relevant to you?

On a daily basis you are making decisions. Should I spend 50p on a newspaper or simply read the news on the internet? This is a decision that you will make based on all the facts at your disposal.

7.3.1 Planning in Management Accounting

Stage 1: Set the strategic long-term aims and objectives

Most companies have a ‘mission statement’, which highlights briefly the overall aims of the business. Here at Edinburgh Napier University our mission statement is:

‘to be a world class modern university that will focus on students in order to help them to realise their full potential.’

Service industries often focus on offering high standards of service and quality within their mis- sion statements, while profit-oriented businesses see the creation of value to the shareholder as a key component of their long-term strategy.

Whilst the mission statement itself may be broad, it is important that there are specific, quantifiable objectives supporting the achievement of this mission statement, for example a specified percentage return on capital employed might help convince shareholders of added value within the business.

Stage 2: Break down these long-term objectives into shorter-term requirements

It is vital for the business to identify possible courses of action that will enable it to achieve its objectives. These courses of action are often determined after having carried out a position audit and a SWOT analysis.

A position audit simply lets the business see how well, or otherwise, it is placed relative to the environment within which it is operating.

A SWOT analysis enables a company to assess internally the strengths and weaknesses that are attributes of the business while at the same time considering externally any potential opportunities or threats that are currently present in the environment.

Some of the following might be typical factors for a business.

• Strengths − an experienced board of directors; a skilled workforce.

• Weaknesses − reliance on a sole supplier; ageing plant and machinery.

• Opportunities − new international markets; new product developments.

• Threats − new competition in the marketplace; new government legislation.

Having considered the alternative strategies available, the company will then implement the course of action required to achieve these objectives.

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Stage 3: Construct an annual budget

The annual budget is the first step towards achieving the company’s long-term goals. This will involve planning next year’s activities and calculating the financial effect that they will have on the organisation.

Stage 4: Break down the annual budget into detailed short-term operational budgets

To help control the budgeting process, the annual financial target is likely to be broken down into monthly operational targets. You would expect most organisations to prepare a monthly income statement and a monthly cash budget as control mechanisms.

7.3.2 Control and Performance in Management Accounting

You should note the link between planning, control and performance.

• You firstly make a plan.

• That plan then becomes your control mechanism.

• When you compare your actual performance to the target set then you have a perform- ance measurement.

Managers can then see at a glance if things are going according to plan or not. Where actual performance appears to be deviating from the original target, some form of corrective action will need to be taken in order to get things back on track.

The area of management control, and strategic management control systems, is one which is well researched. I would suggest that you review the papers listed at the end of the unit if you want to get up to speed with what has happened in this field.

Chapter 5 briefly discussed performance measurement involving comparisons or benchmarks, as they are sometimes known. These benchmarks can be both internal and external.

7.3.3 Internal Benchmarking

The most obvious internal benchmark is to compare actual performance to the annual budget whether it be in terms of sales, production or even cash position.

However, we might also choose to compare actual performance this year to the previous year’s performance, for example, how did the actual sales in July this year compare with last July’s sales?

Managers might also get some useful information by comparing performances between differ- ent segments of the business, for example, how did the production quantities of the day shift compare to that of the night shift? Or, how did absenteeism for Department A compare with absenteeism for Department B?

7.3.4 External Benchmarking

To assess your organisation’s overall standing in the environment within which you operate, you may wish to measure your performance against your major competitors, although gaining access to information can be quite tricky.

Some companies try to compare themselves with other ‘good quality’ organisations who are perhaps market leaders in their field or are highly quoted on the local Stock Exchange.

Perhaps it is most important in today’s environment to compare yourself with customers’ expectations. Companies are almost totally customer-driven nowadays, and it is vital to focus

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on the following key success factors if you are hoping to achieve a high level of customer satisfaction.

7.3.5 Cost Efficiency

In an equal world, the customer will probably buy the cheapest product. A strong management accounting system can provide you with the cost efficiency you need to maintain a competitive advantage.

7.3.6 Quality

Total quality management (TQM) is all about getting things right first time. The Western world in the past tended to see quality as an additional cost and perhaps curtailed spending in such areas as training. Now the belief is that quality saves money and it is much better to design and build quality than it is to inspect and repair, i.e. it is cheaper to produce items correctly first time than to waste resources on reworking goods returned by the customer.

7.3.7 Cycle Time

It is important to minimise the product cycle time wherever possible because customers want a quick reaction to delivery or new product development. Companies should try to cut out the processes that do not add value, for example moving, waiting and inspecting, and focus on those processes that do add value.

7.3.8 Innovation/Flexibility

You need to be in a position to adapt quickly to ever-changing customer requirements. If you doubt this then just ask yourself what your mobile phone looked like five years ago compared with the one that you use now!

As you can see, customers now demand continuous improvement in all the above key success factors. It is, therefore, important for organisations to have a management accounting system which can support this framework because if you cannot provide customers with what they want, you can rest assured that your competitors can.

7.3.9 Non-Financial Performance Indicators

The focus so far in this module has been the external reporting of financial information by companies. However, you should also consider that the financial information offered to external users in the annual report, and internally to management, in no way gives the full picture of what is happening within the organisation.

Financial information is:

• historical

• open to different interpretations

• possibly open to manipulation

• biased or window-dressed in its reporting.

Increasingly nowadays, companies are turning more to non-financial indicators to assess how their operations are functioning, perhaps because they give a more timely indicator of per- formance. A selection of non-financial performance indicators that could be used by all types of business on a regular basis is as follows.

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1. Non-financial performance indicators for manufacturing include:

• volume of output

• scrap percentage

• machine efficiency

• manufacturing lead times

• shop floor absenteeism

• customer returns.

2. Non-financial performance indicators for selling/marketing include:

• market share percentage

• customer visits per salesperson

• customer complaints

• sales volumes

• promotional activity compared with sales volume

• number of new customers.

3. Non-financial performance indicators for human resources include:

• staff turnover

• lost working days

• training days per employee

• staff absenteeism.

4. Non-financial performance indicators for purchasing include:

• number of suppliers

• stock levels per materials

• exchange rate movement

• purchase price index.

7.3.10 Decision-Making in Management Accounting

Management accounting information is broadly required to help managers in the following decision-making areas.

1. Strategic planning

The financial information provided by the management accounting reports can lay the foundations for selecting the most suitable courses of action to include in the strategic plans.

2. Control

The creation of the original budget and the subsequent comparison of the budget against the company’s actual financial performance can often lead to significant differences, which need to be investigated and corrective action taken where necessary.

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3. Resource allocation

The resources available to a business are often restricted. It is, therefore, important that the optimum use is made of these resources and management accounting information can help to determine:

• the optimum level of output

• make or buy decisions

• capital investment decisions

• the optimum product mix.

4. Cost/benefit analysis

A lot of management decisions hinge on knowing the financial pros and cons of pursuing a particular course of action. The management accountant’s expertise in calculating the costs and benefits of such decision-making can help to ensure that the correct decisions are usually made.

7.4 Cost Accounting

Although there are a number of differences between financial and management accounting, there is one clear area of overlap . . . accounting for stock.

Financial accounting requires that we match costs with revenues to calculate profit. Therefore, for a manufacturing company, if at the end of a trading period we have some unsold finished product or we have some partly completed stock (work in progress), the costs involved will not appear as an expense in the income statement. These will form part of the closing inventory to be included in the company balance sheet. Cost accounting was developed to trace costs to individual jobs or products so that the costs incurred can be correctly allocated between the cost of goods sold and the inventories. It is only by classifying costs correctly that the company will get an accurate performance measurement.

7.4.1 Classifying Costs

You are the manager of a small factory, Batty Limited, which manufactures wooden tennis racquets and would welcome some help in classifying the costs of your organisation.

1. Direct materials

The direct material cost encompasses all material that can be physically identified with a product, job or process unless the material is of such small value that it needs to be treated as an indirect material.

Batty’s direct materials:

• wood to make the frame

• gut or nylon stringing

• leather grip for the handle

• packaging materials.

2. Indirect materials

These are the materials which cannot be specifically identified with one individual product, but which are used for the benefit of various products. Or, as mentioned above, material

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used in such negligible amounts and/or having negligible costs. These will be included as part of your production overheads.

Batty’s indirect materials:

• varnish and paint for the frame

• tacks or glue to apply the leather grip

• oil for the frame making machine.

Note: The first two above are direct materials, but, because their cost per racquet would be fractions of a penny, it is easier to treat them as indirect materials and include them as part of production overheads (where their budgeted annual cost will be used).

3. Direct labour

All wages paid for labour incurred in altering the condition or composition of a specific product can be termed direct labour. Some indirect wages (those paid to a foreman or supervisor), which can be accurately identified with a specific product, may also be considered as a direct charge to the product and included as direct labour.

Batty’s direct labour:

• wages paid to the frame-makers, stringers, grippers and packers

• wages of the supervisor who solely controls the department manufacturing the Product Y.

4. Indirect labour

These are the wages of employees who assist in the manufacturing process but who do not work specifically on an individual product. Indirect labour costs are included as part of production overheads.

Batty’s indirect labour:

• raw material storeman

• material handlers

• production manager responsible for all the different products.

5. Direct expenses

Any other expense incurred on a specific product (other than direct material and direct labour) is a direct expense.

Batty’s direct expenses:

• hire of a specialist machine to string Racquet Z only

• design costs incurred on the new de-luxe model of Racquet M.

6. Production overhead

All indirect costs incurred in the factory, from receipt of the order until its completion, are included in the production overhead.

Batty’s production overhead costs:

• indirect materials

• indirect labour

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• rent, rates and insurance in relation to the factory

• depreciation, fuel, power, repairs and maintenance of factory plant, machinery and buildings

• factory services such as training, housekeeping, first-aid and canteen.

7. Selling and distribution overhead

These are the costs involved in the selling and distribution of the product.

Batty’s selling and distribution overheads are:

• salesmen’s salaries, commission, travel costs and general expenses

• advertising

• bad debts

• running costs of the distribution vehicles

• finished goods warehousing costs

• freight and insurance costs.

8. Administration overhead

These are the indirect costs usually related to the direction, control and administration of the organisation.

Batty’s administration overheads:

• office salaries

• depreciation of office/computer equipment

• printing and stationery

• rent, rates and insurance of general office

• audit fees.

7.4.2 Period and Product Costs

The above cost classification has provided us with the information needed to carry out the major function of cost accounting− the valuation of closing inventory. Remember that financial accounting requires that you match costs with revenues to calculate profits. Therefore, any unsold finished goods or partly completed stock (work in progress) needs to be valued and deducted in the calculation of the cost of goods sold figure to be matched against sales revenue for the period.

1. Product costs

Legislation on stock valuation requires that manufacturing costs only are included in the calculation of product costs. Product costs are those costs identified with goods produced or purchased for resale, namely the direct costs (material, labour and expenses) and the production overheads.

2. Period costs

Costs which are not included in the stock valuation (selling, distribution and administration overheads, primarily) are treated as expenses in the period in which they are incurred and are referred to as period costs.

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7.4.3 Cost Analysis

Using the breakdown given above, you can break the costs of any individual process, product or department into the categories listed and allow the managers more control within the organisation. A typical cost analysis is as follows:

Direct materials 20,000

Direct labour 10,000

Direct expenses 2,000

Prime cost 32,000

Production overhead 16,000

Product cost 48,000

Selling and distribution overhead 6,000

Administration overhead 8,000

Total cost 62,000

Selling price 80,000

Profit 18,000

Note: The direct elements of the product are known as the prime cost of the product.

7.4.4 Overheads

It is relatively easy to allocate the material costs directly to a job or to a product because you should know the quantities and prices of the materials used. Similarly, you should be able to allocate the direct labour costs because you know the hours worked and the labour rates paid.

However, it is not quite so straightforward with overheads.

Overheads are those costs which are not directly attributable to a specific product and include the costs of indirect materials, indirect labour as well as indirect expenses. It is important, for accurate stock valuation, that a company has control over its overhead costs.

The five-stage procedure used for accounting for overheads is shown in Table 7.1.

Table 7.1 Five-stage procedure used for accounting for overheads

1. Collect all overhead costs.

2. Allocate/apportion costs to departments.

3. Reallocate service departments.

4. Calculate overhead absorption rates.

5. Charge overheads to jobs and products.

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7.4.5 Collecting Overhead Costs

There are two types of overhead cost that need to be collected:

• The overhead cost which is directly identifiable to a department or cost centre. These overheads can be estimated by the manager responsible for that particular work area.

• The overhead cost which is incurred as a single figure, but benefits various different departments throughout the organisation, for example rates bill.

7.4.6 Allocate/Apportion Costs to Departments

A typical manufacturing organisation will have three types of departments: production, service and operating.

Production departments are involved directly with the manufacture of the product, for example a tennis racquet manufacturing company might have:

• frame-making department

• stringing department

• gripping department

• packaging department.

Service departments exist to provide essential services that primarily support the produc- tion areas, but also help out other sectors of the organisation. They include:

• purchasing

• housekeeping

• stores

• canteen

• engineering.

Operating departments are departments not directly involved in manufacturing, but never- theless are essential to the smooth running of the company. They are the departments which effectively gather our ‘period’ costs. They include:

• sales/marketing

• administration

• distribution

• personnel.

Having divided the organisation into its departments or cost centres as they are typically known, the company now needs to allocate the overhead costs to the correct departments.

1. Allocation

A lot of the overhead costs are easy to calculate because the whole of the cost can be allocated to the one cost centre.

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Cost Department

Salary of supervisor in the stringing department Stringing

Food and other consumables Canteen

Cleaning materials Housekeeping

Depreciation on the frame-making machine Frame-making

Purchasing manager’s company car Purchasing

Glue for applying the grips Gripping

Repairs to the fork lift trucks Stores

2. Apportionment

Certain overhead costs, however, cannot be allocated to specific cost centres because they are incurred for the benefit of many departments. For these costs we need to use a logical basis for apportioning the overheads, one which apportions the overheads to departments in relation to the benefit received.

Cost Method of apportionment

Rent and rates by floor area

Salary of the health and safety officer by number of employees

Insurance on machinery by value of machinery held

Heat and light by floor area

Power usage by machine horse power

Depreciation on factory building by floor area

Cost of annual company dance by employee

Worked example 7.1

Chadwick Ltd. is divided into three departments A, B and C. The estimated costs for the following period are as follows:

Rent 9,000

Depreciation of plant 4,500

Employers’ liability insurance 600

Power 1,500

Heat and light 1,200

Annual company dance 2,100

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The following additional operational information is available:

Department

A B C

Area sq m 1,200 1,800 600

Number of employees 12 24 24

Value of plant £40,000 £20,000 none

Horsepower of plant 20 40 none

Total wages £15,000 £35,000 £70,000

Required

Prepare an overhead analysis sheet for the period using the information available to apportion the overheads on the most logical basis.

Solution

Chadwick Limited

Department Method

A B C

Rent 3,000 4,500 1,500 Area

Depreciation 3,000 1,500 Plant value

Employers liability 75 175 350 Wages

Power 500 1,000 Horsepower

Heat and light 400 600 200 Area

Annual company dance 420 840 840 Employees

Total apportionment 7,395 8,615 2,890

7.4.7 Reallocate Service Departments

After the previous stages, all overhead costs should have been either allocated or appor- tioned to a specific department. The manufacturing overheads should be in the production departments. The non-manufacturing overheads should be in the operating departments and the service overheads should be in the service departments. Because the service department exists primarily to support manufacturing, the service department costs which have in some way aided the manufacturing process must be allocated into the final product cost to comply with accounting standards.

Note: Not all service departments need necessarily be fully allocated to a production cost centre. For example, the purchasing department, in addition to buying raw materials for production, will also have responsibility for buying stationery for administration and perhaps business cards for sales/marketing.

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Again, the method which is chosen to apportion service department costs to production departments should be related to the benefits which the production departments derive from the service rendered.

Service department Method of apportionment

Stores Number of material requisitions

Engineering Time record of maintenance

Canteen Number of on-site employees

Purchasing Number of purchase orders

Housekeeping Floor area

Once the service department costs have been apportioned to either production or operating departments, all the factory overhead expenditure should have been allocated to production departments. This will enable us later to calculate overhead absorption rates for each of the production departments, which can be used to charge out jobs or price products.

Unfortunately, as well as providing services for production and operating departments, service departments also provide assistance to other service departments. For example, employees from purchasing will eat in the canteen and the purchasing department could buy the cleaning materials for housekeeping. This severely complicates the process as you can see from worked example 7.2.

Worked example 7.2

The allocated overheads for the four departments in Milligan plc are as follows:

Department A £100,000

Department B £70,000

Canteen £30,000

Housekeeping £10,000

Past records dictate that the canteen usage is 45% each for the two production depart- ments and 10% for housekeeping. The housekeeping timesheets indicate that 80% of time is spent in Department A, 15% in Department B and 5% in the canteen.

Required

Calculate the total overheads chargeable to Departments A and B after the two service departments have been reallocated.

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Solution

Milligan plc

Dept A Dept B Canteen Housekeeping

Allocated 100,000 70,000 30,000 10,000

Reallocate canteen 13,500 13,500 (30,000) 3,000

113,500 83,500 0 13,000

Reallocate housekeeping 10,400 1,950 650 (13,000)

123,900 85,450 650 0

Reallocate canteen 293 292 (650) 65

124,193 85,742 0 65

Reallocate housekeeping 52 10 3 (65)

124,245 85,752 3 0

Reallocate canteen 2 1 (3) 0

124,247 85,753 0 0

This method of reallocation is the ‘repeated distribution’ method which continues to reallocate the overhead costs of the two service departments until they become negligible.

Once the service department costs are zero, all overhead costs should either be in the production departments (in which case they will be charged to jobs and could be part of stock valuation) or in the operating departments (where they will be charged as expenses in the year).

7.4.8 Calculate Departmental Overhead Absorption Rates

Having collected all the overhead costs into the different departments, we need to calculate, for each production department, a departmental overhead absorption rate which will, as fairly as possible, spread the overheads to each job that passes through the department. These overheads are frequently allocated based on some form of input factor, which could be one of the following:

• direct labour hours

• machine hours

• direct wages percentage

• units of output

• direct materials percentage

• prime cost percentage.

The input factor selected should be the one which corresponds most closely with the total overhead expenditure of each department. The two most common methods are direct labour hours and machine hours. If you have a capital intensive department then it is likely that a lot of the overhead costs arise from using capital equipment, for example depreciation, insurance,

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rent and rates because of the floor space utilised, and so on. Therefore the longer each job spends on a machine, the higher the share of overheads it deserves to attract. See worked example 7.3.

Worked example 7.3

Budgeted information for the stringing department is as follows:

Overheads £100,000

Direct labour hours 25,000 hours

Machine hours 20,000 hours

During the period, racquet M20G was produced at the following costs:

Direct material £50

Direct labour (2 hours) £10

Machine hours 2 hours

Required

Calculate the cost of racquet M20G using

a. Direct labour hours

b. Machine hours.

Solution

a. Direct labour hours

Overhead absorption rate determined by the formula:

Budgeted overheads / Budgeted direct labour hours

£100,000 / 25,000 hours = £4 per direct labour hour

This implies that every input of direct labour hour requires a charge of £4 for overheads.

The racquet M20G cost under this method would be:

Direct material 50

Direct labour 10

Overheads (2 hours × £4) 8

Total product cost 68

b. Direct machine hours

Budgeted overheads / Budgeted machine hours

£100,000 / 20,000 hours = £5 per machine hour

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Racquet M20G’s cost would now become:

Direct material 50

Direct labour 10

Overheads (2 hours × £5) 10

Total product cost 70

7.4.9 Blanket Overhead Rates

A blanket overhead rate refers to the occasion when a single overhead rate is established for the whole factory and used to charge all jobs irrespective of the number of production departments the job may have passed through.

Although administratively this method is very straightforward, it is not a satisfactory method of overhead allocation if the factory has a number of production departments and all jobs spend different amounts of time in each department. To ensure jobs are charged with their fair share of overheads, it is necessary to establish separate overhead rates for each production department.

7.4.10 Charge Overheads to Jobs and Products

The final stage in the process is simply to apply the overhead absorption rate per input factor to all the jobs passing through the department.

Overhead rates are always based on the estimated overheads and the estimated activity, and these rates are then applied to actual activity as it happens. It is simply not practical to wait for the information because of the following:

• All the job cost calculations would have to be delayed until the end of the accounting period because it would only be at that stage that the actual overhead information becomes available.

• It is not administratively viable to calculate overhead rates at more frequent intervals. A lot of the overhead costs are fixed and, with activity varying month on month, there would be large fluctuations in the overhead rates.

• A lot of the overhead costs do not occur evenly throughout the year; for example, would it be fair to charge the heating costs only to goods produced in the winter months?

It is very unlikely that the actual overhead and expense will be the same as the budgeted figures in which case there will be an over- or under-absorption of overheads. See worked example 7.4.

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Worked example 7.4

The estimated and actual annual information of the frame-making department for last year was as follows:

Estimated Actual

Overheads £100,000 £110,000

Activity: machine hours 25,000 hours 30,000 hours

The overhead absorption rate applied to all jobs would have been £4 per machine hour (£100,000/25,000 hours).

With an actual usage of 30,000 hours, total overheads charged to jobs would have been £120,000 (30,000 × £4).

As the actual overhead expense was only £110,000, there is an over-absorption of overheads of £10,000 (£120,000 − £110,000).

Any over- or under-absorption can be explained between movements in expense and movements in volume.

In the example above, actual overheads were £10,000 more than those estimated, giving us a £10,000 deficit against the budget. However, the actual activity was 5,000 hours more than estimated and each of those additional hours would have been charged at £4, giving us a volume gain of £20,000. The volume gain netted against the expense loss explains the over-absorption of overheads by £10,000.

Any under- or over-absorption of overheads should simply be written off to the profit and loss account for the year in question.

7.5 Job and Service Costing

7.5.1 Job Costing

This type of costing involves a single order for a job to be undertaken to a customer’s specific individual requirements. It is important to establish the costs of each job separately, either for the purposes of fixing a selling price or ensuring that costs incurred are kept within some previously quoted job estimate. Job costing is a simpler method of controlling costs than some of the other costing systems because:

• work in progress at any time is the total of costs charged to uncompleted jobs

• any wastage of materials on a job is treated as part of the cost of the job.

7.5.2 Procedure

1. The customer indicates what job is required.

2. Detailed agreement is reached between the customer and supplier on the precise details of the job. This will include quantity, quality, size, colour and date of delivery.

3. A job cost estimate will then be prepared, which will include:

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• direct materials − an estimated ‘bill of materials’ will be drawn up and valued either at replacement cost, if items required are held in stock, or at quoted prices obtained from outside suppliers

• direct labour − this is calculated after the work study engineers have studied the job specification and agreed labour times and skill levels required

• direct expenses − estimated prices should be obtained for these special items

• production overhead − appropriate overhead absorption rates should be calculated for each operation performed on the job and applied to the other estimated data

• non-manufacturing overheads − the company needs to estimate a realistic share of selling, distribution and administration overheads and select a method of absorbing those overheads into the job, for example as a percentage of production cost perhaps

• profit margin − whatever return the business requires will be added on to the estimated costs to arrive at the quotation price.

4. When this quotation has been accepted by the customer, a works order/job number will be raised and used to collate all the costs relevant to the job.

5. When the job commences, all the actual costs can be gathered − materials from requis- itions, labour from time sheets and overheads as previously determined. The difference between the agreed quotation price and the total actual job cost is the supplier’s profit.

Note: Batch costing is another form of job costing where a job estimate is prepared for a batch of identical items being produced.

Worked example 7.5

Marios Ltd. undertake engineering work on a contract basis. Their factory is organised into three departments − foundry, assembly, and painting. In the foundry, machines make the basic shape of each piece of equipment. In the assembly department, components are added and the job is assembled by skilled engineers. Jobs are finished in the painting department which uses a highly mechanised painting process.

Fixed overheads are budgeted quarterly, and in the present quarter are estimated to be:

Foundry £75,000

Assembly £72,250

Painting £64,500

The budget also plans machine and labour hours to be:

Machine hours Labour hours (direct)

Foundry 20,000 8,000

Assembly 5,000 17,000

Painting 30,000 4,000

Job No. T627 is now complete.

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Material requisitions show that materials cost £4,680 in the foundry, components costing £950 were added in the assembly department and paint cost £211.

From time sheets, direct labour hours worked on the job were 17 hours in the foundry, 59 hours in assembly and 11 hours in the painting department.

The job also used 26 hours of machine time in the foundry, 6 hours of machine time in assembly and 11 hours of machine time in the painting department.

Wage rates per hour, for direct labour paid by the company are:

Foundry £7.00

Assembly £9.00

Painting £5.00

Required

1. Calculate the production cost of Job T627.

2. Calculate the selling price for the job if administration costs are absorbed by adding 10% of prime cost and selling/distribution costs are absorbed by adding 5% of production costs. A profit margin of 15% of the selling price is to be provided.

Solution

Stage 1 − calculate overhead absorption rates

Foundry £75,000/20,000 = £3.75 per machine hour

Assembly £72,250/17,000 = £4.25 per labour hour

Painting £64,500/30,000 = £2.15 per machine hour

Stage 2 − calculate job cost

£ £

Material

Foundry 4,680

Assembly 950

Painting 211

5,841

Labour

Foundry 17 hours @ £7 119

Assembly 59 hours @ £9 531

Painting 11 hours @ £5 55

705

Prime cost 6,546

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Production overheads

Foundry 26 machine hours @ £3.75

97.50

Assembly 59 labour hours @ £4.25 250.75

Painting 11 machine hours @ £2.15

23.65

371.90

Production cost 6,917.90

Administration overhead 10% × £6546 654.60

Selling / distribution overhead 5% × £6917.90 345.89

Total cost 7,918.39

Profit margin £9315.75 − £7918.39 1,397.36

Selling price £7918.39/0.85 9,315.75

7.5.3 Service Costing

This type of costing applies where the provision of a service rather than a physical unit of output is the primary focus. It could either be used for a specialist service to external customers, such as:

• road haulage

• hospitals

• universities

• leisure services

• hotels.

or the provision of an internal service within an organisation:

• maintenance

• computer services

• canteen.

In any type of service costing, it is the choice of cost per unit of the service provided that is important. Using the examples quoted above, the cost per unit could be:

• road haulage − cost per tonne, cost per cubic metre or cost per mile

• hospitals − cost per patient bed-days available

• universities − cost per university student

• leisure − cost per swimmers attending or cost per court usage

• hotels − cost per bed-nights available

• maintenance − cost per hourly service

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• computer services − cost per hour of computer time

• canteen − cost per number of staff.

In some cases you may need to calculate a number of costs per unit where variations of the service are provided. It may not be sufficient to calculate an overall cost per university student. You might need to calculate such information by individual degree. See worked example 7.6.

Worked example 7.6

Farmers in Southshire are to be offered mechanised assistance by Macrentals plc who propose to hire out their power driven Scroppers. A 40-hour week is envisaged for 50 weeks of the year, and one operator will be required for each Scropper at a wage rate of £3 per hour. This cost will be incorporated into the rental charge. Other costing information is as follows:

Insurance per machine per annum 600

General supervision per annum 8,000

Depot general overhead per annum 5,000

Supplies per machine per week 50

Maintenance per machine per week 15

Scropper machine cost (each) 20,000

The estimated useful life of a Scropper is 10 years, at the end of which it is expected to have no residual value. Five of them are purchased and approximately 15% of their time will be taken up by transits and other interruptions. The company require a margin of 20% for the service they provide.

Required

Calculate a rental charge per hour based on the information available and estimated by Macrentals plc.

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Solution

Macrentals plc

Annual costs £

Direct wages (40hrs × 50wks × £3 × 5 operators) 30,000

Insurance (£600 × 5 machines) 3,000

Supervision 8,000

Depot overhead 5,000

Supplies (£50 × 50wks × 5 machines) 12,500

Maintenance (£15 × 50wks × 5 machines) 3,750

Depreciation (£20,000 / 10 years × 5 machines) 10,000

72,250

Margin 18,062

Total return required (£72,250 / 0.8) 90,312

Total hours of operation (40hrs × 50wks × 85% × 5) 8,500

Required hourly rate (£90,312/8,500) £10.62

7.6 Summary

You should now be aware that management accounting is primarily about providing information to help managers with planning, controlling and making key decisions within the business. Management accounting reports differ from financial accounting reports for the following reasons:

• they are not subject to the same level of regulation

• they are often more detailed because they are prepared for specific purposes, although they can be reliant on estimated figures

• they are much more likely to include non-financial as well as financial information.

Management accounting helps to set out the future plans of the business and involves making decisions to meet those plans. Having a plan in place immediately offers you a control mech- anism against which you can measure your actual performance. Performance measurement is, therefore, a key aspect of management accounting reporting whether it be

• internally between departments

• internally against targets

• internally against past performance

• externally against competitors

• externally against customer expectations.

However, if all performance reports included only those items which could be expressed in monetary terms, managers would concentrate solely on those variables and ignore other

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key indicators simply because they could not easily be quantified in monetary terms. A good performance report should, therefore, be widened to include other factors which can help its user to assess the efficiency and effectiveness of the operations.

In today’s competitive worldwide environment where customer satisfaction is the overriding priority, companies not only compete in terms of cost efficiency but also need to consider quality, delivery, reliability, flexibility and after-sales service as key variables in the feedback process.

Cost accounting is an aspect of management accounting, which helps to classify costs for decision-making and stock valuation purposes. In this unit, we classified costs between

• direct and indirect costs

• product and period costs

and used these classifications to help with job and service costing.