1. CHAPTER 13 Cost Analysis for Planning and Control

2. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-2 Overview Budgeting in general Cost classifications The budgeting process The sales budget and other operating budgets Standard costs Performance reports The flexible budget Reporting for segments of an organisation Residual income The balanced scorecard

3. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-3 Control Steps taken by management to ensure that objectives are attained. Planning Developing objectives for acquisition and use of resources. A budget is a comprehensive financial plan for achieving the financial and operational goals of an organisation. Budgeting

4. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-4 Budgeting Management philosophy is reflected in how the budget is prepared and used: Top down Highly structured (carved in stone) Top down Highly structured (carved in stone) Participative Flexible Participative Flexible The budget should be seen as a guide that reflects management’s best thinking at the time of preparation. It may have to change if circumstances change.

5. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-5 Budgeting Financial accounting concepts, as the results of an organisation’s activities are reported via financial statements Management accounting techniques, especially knowledge about cost behaviour patterns. A budget involves the use of:

6. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-6 Cost classifications Variable costs -- change with the volume of activity -- unit costs constant. Variable costs -- change with the volume of activity -- unit costs constant. Fixed costs -- do not change within a relevant range. Fixed costs -- do not change within a relevant range. Recap of cost behaviour patterns: Mixed costs -- a certain amount of cost can be expected regardless of activity. Mixed costs -- a certain amount of cost can be expected regardless of activity.

7. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-7 Cost Classifications According to time frame perspective Committed Incurred to carry out long range policy decisions to which the firm is committed Discretionary Costs that can be adjusted in the short run after evaluation of resources In the long run, every cost is controllable. Fixed costs

8. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-8 The Budget Time Frame Single period budget – prepared in the months preceding the beginning of the year, but estimates must be made more than a year in advance. Rolling budget – planning for segments of a year on a repeat basis. Continuous budget – the final budget for any quarter should be much more accurate as it has been prepared more recently, but time, effort and money are required.

9. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-9 The Budgeting Process 1.Develop and communicate a set of broad assumptions about the economy, industry and organisational strategy. 2.Prepare operating (master) budget made up of a number of detailed budgets: Prepare sales budget -- estimated unit prices and unit sales. All other budgets are a function of sales activity.

10. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-10 The Budgeting Process Direct Materials Budget Production Budget Operating Expense Budget Direct Labor Budget Manufacturing Overhead Budget Sales Budget Cost of Goods Sold Budget Budgeted Balance Sheet Budgeted Income Statement Budgeted Statement of Cash Flows

11. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-11 The Production or Purchases Budget The basic inventory flow model is used for production and purchases budgets. Goods available for sale Beginning inventory Beginning inventory + Purchases or production Cost (or quantity) of goods sold = Ending inventory Ending inventory -

12. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-12 The Production or Purchases Budget Production or purchases must be adequate to meet budgeted sales and to provide sufficient ending inventory. Budgeted sales in units +Desired units in ending inventory =Total product units needed – Beginning inventory =Units to produce or purchase

13. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-13 The Production or Purchases Budget Once quantities have been determined, they can be converted to dollars. When the number of units to be produced is known, the quantity of each raw material input to be purchased can be forecast using the same model. Raw materials Direct labour Manufacturing overhead Determining these budgeted amounts often involves the use of a standard cost system.

14. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-14 The Cost of Goods Sold Budget Summarises changes in inventory accounts, as indicated by: sales budget purchases and production budget required ending inventory levels as determined by management.

15. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-15 Operating Expense Budget The cost behaviour patterns of selling, general, administrative and other operating expenses are determined May be a function of sales or influenced by management strategy Budget slack or ‘padding the budget’ Tendency of managers to submit budget estimates that are slightly higher than expected costs

16. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-16 Budgeted Income Statement Production Budget Operating Expense Budget Sales Budget Cost of Goods Sold Budget Budgeted Income Statement May be prepared after completion of other budgets

17. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-17 The Cash Budget Similar to a budgeted statement of cash flows, but with shorter time frame. Cash collections from customers? How long does it take the firm to collect its receivables? Short-term borrowing requirements? Cash payments to suppliers? What credit terms is the firm subject to? How often does the firm pay its employees?

18. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-18 Budgeted Balance Sheet May be prepared after completion of other budgets Operating Expense Budget Depreciation and amortisation Budgeted Balance SheetBudgeted Income Statement Production Budget Sales Budget Cost of Goods Sold Budget Budgeted Statement of Cash Flows Inventory balances Retained earning balance Accounts receivable, accounts payable, equipment, dividends

19. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-19 Standard costs are: based on carefully predetermined amounts used in planning and control phases of the management process, particularly budgeting used in financial accounting to value inventory benchmarks for measuring performance. Standard Costs

20. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-20 Standard Costs A standard cost has two elements: 1.Quantity of input (weight, volume, hours) 2.Cost per unit of input StandardUnit budget Used extensively in the budget preparation process Used to plan for input that will be needed to make the product

21. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-21 Performance Reporting The performance report compares actual results to budgeted amounts. Those activities that are performing differently from expectations are highlighted and variances investigated.

22. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-22 Performance Report Characteristics Activity Favourable Actual revenues > Budget revenues Actual costs < Budget costs Unfavourable Actual revenues < Budget revenues Actual costs > Budget costs Favourable Actual revenues > Budget revenues Actual costs < Budget costs Unfavourable Actual revenues < Budget revenues Actual costs > Budget costs Budget Amount Actual Amount – = Variance Explanation ?

23. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-23 Responsibility Reporting Amount of detail varies according to level in organisation. Performance Report Characteristics Involves successive degrees of summarisation. Each layer of management receives detailed reports for their layer, but summarised reports for lower layers. Involves successive degrees of summarisation. Each layer of management receives detailed reports for their layer, but summarised reports for lower layers.

24. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-24 Management by exception: Management concentrate their attention on only those activities that are not performing according to plan. Usually only those variances in excess of a certain percentages (say 10%) are investigated. Performance Report Characteristics

25. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-25 The Flexible Budget improve performance evaluation. may be prepared for any activity level in the relevant range adjusts the original budget to reflect budgeted amounts for actual activity reveal variances due to good cost control or lack of cost control

26. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-26 To a budget for different activity levels, we must know how costs behave with changes in activity levels (variable costs and fixed costs). Fixed Variable The Flexible Budget Variable costs / unit Actual level of activity Actual costs x Flexible budget Compared with

27. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-27 Reporting for Segments of an Organisation A segment of an organisation is a division, product line, sales territory or other organisational unit. For management reports, total company results may be reported by segment. Segment income statements should reflect the contribution to the common fixed expenses and company profit.

28. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-28 Reporting for Segments of an Organisation Profit Centre A part of the business that has control over both costs and revenues, but no control over investment funds. Profit Centre A part of the business that has control over both costs and revenues, but no control over investment funds. Investment Centre A profit centre where management also has autonomy for investing in assets to conduct operations. Investment Centre A profit centre where management also has autonomy for investing in assets to conduct operations. Cost Centre A business section that has control over the incurrence of costs, but does not generate revenue. Cost Centre A business section that has control over the incurrence of costs, but does not generate revenue.

29. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-29 Methods of Evaluating Segments Cost Centre Actual costs compared to budgeted costs Profit Centre Investment Centre Actual return on assets compared to budgeted return on assets Evaluation Measures Actual segment margin compared to budgeted segment margin Segment

30. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-30 Analysis of Investment Centres Return on investment (ROA) is the ratio of segment EBIT to the investment used to generate the segment EBIT. ROA = Segment EBIT Divisional operating assets As investment centre managers have a much higher level of responsibility, appropriate measures of performance are important.

31. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-31 Analysis of Investment Centres Sales Operating assets ROA = Segment EBIT Operating assets ROA = Segment EBIT Sales × Margin Turnover

32. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-32 As division manager, I wouldn’t invest in that project because it would lower my pay! Gee... I thought we were supposed to do what was best for the company! ROA and Dysfunctional Behavior A performance evaluation system needs to be carefully designed so that it doesn’t lead to dysfunctional behaviour.

33. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-33 Residual income encourages managers to make profitable investments that would be rejected by managers using ROA. Residual Income ROA should not be the sole measure of investment centre performance. Managers should be evaluated on their ability to generate a minimum ROA and to maximise the amount of earnings above that minimum ROA.

34. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-34 An integrated set of performance measures that highlight and communicate an organisation’s strategy, goals and priorities. EmployeestakeholdergroupInvestorstakeholdergroup The Balanced Scorecard This approach shows an organisation’s performance in meeting its responsibilities to various stakeholders.

35. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 13-35 Financial Perspective How do we look to the firm’s owners? Learning and Growth Perspective How can we continually improve and create value? Internal Business Process Perspective In which activities must we excel? Customer Perspective How do our customers see us? Integrated measures The Balanced Scorecard