COSTING AN INTRODUCTION

COSTINGAN INTRODUCTION

COLIN DRURY

SPRINGER-SCIENCE+BUSINESS MEDIA, B.V.

First edition 1987 Reprinted 1988, 1989 Second edition 1990 Reprinted 1991 (twice), 1992, 1993

© 1987, 1990, 1994 Colin Drury

Originally published by Chapman & Hall in 1994

Typeset in 10/12 pt Palatino by Best-set Typesetter Ltd., Hong Kong Printed and bound in Hong Kong

ISBN 978-0-412-58780-1 ISBN 978-1-4899-6880-7 (eBook) DOI 10.1007/978-1-4899-6880-7

Apart from any fair dealing for the purposes of research or private study, or criticism or review, as permitted under the UK Copyright Designs and Patents Act, 1988, this publication may not be reproduced, stored, or transmitted, in any form or by any means, without the prior permission in writing of the publishers, or in the case of reprographic reproduction only in accordance with the terms of the licences issued by the Copyright Licensing Agency in the UK, or in accordance with the terms of licences issued by the appropriate Reproduction Rights Organization outside the UK. Enquiries concerning reproduction outside the terms stated here should be sent to the publishers at the London address printed on this page.

The publisher makes no representation, express or implied, with regard to the accuracy of the information contained in this book and cannot accept any legal responsibility or liability for any errors or omissions that may be made.

A catalogue record for this book is available from the British Library Library of Congress Catalog Card Number: 93-074895

Contents

Preface xi

Part One: Introduction to Management and Cost Accounting

1 The scope of management accounting 3 The users of accounting information 3 Comparison between management accounting and financial

accounting 5 The decision-making process 5 The management process 10 The role of the management accountant in the management process 12 Cost accounting and management accounting 14 Summary of the contents of this book 15

2 Cost and revenue classification 18 Cost objectives 18 Classification of costs 19 Cost accounting: classification of costs for stock valuation and

profit measurement 20 Classification for decision-making and planning 24 Classification for control 32

Part Two: Cost Accumulation for Stock Valuation and Profit Measurement 3 Accounting for materials and labour 43

Materials control procedure 44 Pricing the issues of raw materials 48 Treatment of stores losses 53 Treatment of transportation costs 53 Treatment of material handling costs 54 Just-in-time purchasing 54 Accounting for labour 55 Labour cost accounting 55 Payroll accounting 56 Incentive schemes 57 Accounting treatment of various labour cost items 58 Decision-making and cost control 60 Appendix 3.1 Stores pricing methods 63

4 Accounting for overhead expenditure 73 An overview of the procedure for allocating overheads to products 75 Blanket overhead rates 76 Procedure for calculating cost centre overhead rates 77 An illustration of the overhead allocation procedure 80 Predetermined overhead rates 84

CONTENTS v

Under- and over-recovery of overheads 85 Overhead absorption rates and new manufacturing technology 86 Non-manufacturing overheads 86 Overheads for decision-making 87 Overheads for control 88 Appendix 4.1 Inter-service department transfers 92 Appendix 4.2 Overhead absorption rates 95

5 Accounting entries for a job costing system 109 Control accounts 109 Recording the purchase of raw materials 110 Recording the issue of materials 111 Accounting procedure for labour costs 114 Accounting procedure for manufacturing overheads 116 Non-manufacturing overheads 117 Accounting procedures for jobs completed and products sold 118 Costing profit and loss account 118 Interlocking accounting 119 Contract costing 120 Work in progress valuation and amounts recoverable on contracts 124

6 Process costing 138 Flow of costs in a process costing system 139 Normal and abnormal losses 140 Accounting for the sale of scrap 142 Abnormal gains 144 Opening and closing work in progress 146 Previous process cost 148 Opening work in progress 150 Weighted average method 151 First-in, first-out (FIFO) method 153 Equivalent production and normal losses 155 Equivalent production and abnormal losses 158 Process costing for decision-making and cost control 159 Batch costing 161

7 Joint product and by-product costing 174 Methods of apportioning joint costs to joint products 175 Limitations of joint cost allocations for decision-making 180 Accounting for by-products 181 By-products, scrap and waste 184 Defective units 185

8 Absorption costing and variable costing 195 External and internal reporting 196 Variable costing and absorption costing: a comparison of their

impact on profit 199 Some arguments in support of variable costing 201 Some arguments in support of absorption costing 203 Current cost accounting 204

vi CONTENTS

Part Three: Information for Decision-making

9 Cost-volume-profit analysis 215 The economist's model 216 The accountant's cost-volume-profit model 218 A mathematical approach to cost-volume-profit analysis 220 Margin of safety 223 Constructing the break-even chart 224 Alternative presentation of cost-volume-profit analysis 224 Cost-volume-profit analysis assumptions 225 Cost-volume-profit analysis and computer applications 228

10 Special studies: measuring relevant costs for decision-making 245 Measuring relevant costs and benefits 246 Quantitative and qualitative factors 249 Deleting a segment 250 Special selling-price decisions 252 Decision-making and the influence of limiting factors 254 Make or buy decisions 256

11 Activity-based costing 273 The emergence of activity-based costing systems 274 A comparison of ABC and traditional product costs 274 Activity-based cost systems 275 An illustration of ABC and traditional product costing systems 277 Impact of volume diversity 279 Resource consumption models 281 A comparison of activity-based systems with decision-relevant costs 281 Activity-based cost management 282

12 Capital investment decisions 289 The opportunity cost of an investment 290 Compounding and discounting 291 The concept of net present value 293 Calculating net present values 294 Constant annual cash inflows 296 The internal rate of return 296 Relevant cash flows 300 Timing of cash flows 300 Payback method 300 Accounting rate of return 302 Surveys of practice 303 Qualitative factors 304

Part Four: Information for Planning and Control

13 The budgeting proces 319 Why do we produce budgets? 320 Conflicting roles of budgets 322 The budget period 322 Administration of the annual budget 323 Stages in the budgeting process 324 A detailed illustration 327

CONTENTS vii

Sales budget 330 Production budget and budgeted stock levels 331 Direct materials usage budget 331 Direct materials purchase budget 332 Direct labour budget 332 Factory overhead budget 333 Selling and administration budget 333 Departmental budgets 334 Master budget 335 Cash budgets 336 Final review 337 Computerized budgeting 337

14 Operational control and performance measurement 354 Control systems 355 Feedback and feed-forward controls 356 Responsibility accounting and cost control 357 Flexible budgeting 360 Activity-based cost management 361 Non-financial performance measures 364

15 Standard costing and variance analyse 375 Operation of a standard costing system 376 Establishing cost standards 378 Types of cost standards 381 Purposes of standard costing 382 Variance analysis 383 Material variances 385 Material price variances 385 Material usage variance 386 Total material variance 387 Labour variances 388 Wage rate variance 388 Labour efficiency variance 389 Total labour variance 389 Variable overhead variances 390 Variable overhead expenditure variance 390 Variable overhead efficiency variance 391 Similarities between materials, labour and overhead variances 391 Fixed overhead expenditure or spending variance 392 Sales variances 393 Total sales margin variance 393 Sales margin price variance 394 Sales margin volume variance 394 Reconciling budgeted profit and actual profit 394 Standard absorption costing 395 Volume variance 397 Volume efficiency variance 398 Volume capacity variance 398 Summary of fixed overhead variances 399 Reconciliation of budgeted and actual profit for a standard absorption

costing system 400

viii CONTENTS

Performance reports 401 Appendix 15.1 Accounting entries for a standard costing system 406

16 Planning and control of stock levels 426 Relevant costs for quantitative models under conditions of certainty 426 Determining the economic order quantity 427 Assumptions of the EOQ formula 430 Application of the EOQ model in determining the length of a

production run 431 Determining when to place the order 431 Control of stocks through classification 432 Other considerations 434 Materials requirements planning 434 The just-in-time approach 437

Part Five: Current Developments in Management Accounting

17 Current developments in management accounting Criticisms of management accounting practice The future of management accounting

Appendices Appendix A - Present value of £1 Appendix B - Present value of £1 received annually for N years

Answers to self-assessment questions

Index

447 447 452

457 459 460

461

487

CONTENTS ________________________________ ix

Preface

The aim of the third edition of this book is to provide an introduction to the theory and practice of cost and management accounting. A cost accounting system accumulates financial information for stock valuation and profit measurement, whereas a management accounting system accumulates, classifies and reports information that will assist managers in their decision-making, planning and control activities. This book is concerned with both cost and management accounting, with equal em­phasis being placed on both systems.

Intended primarily for students who are pursuing a one year cost and management accounting course, the book is ideal for those approaching this subject for the first time. The more advanced topics contained in the final stages of the cost and management accounting syllabuses of the professional accountancy bodies and final year of degree courses are not included. These topics are covered in the author's successful Management and Cost Accounting, the third edition of which is also published by Chapman and Hall.

Feedback from teachers in a large number of colleges and universities indicates that they have found the structure and presentation of Manage­ment and Cost Accounting extremely satisfactory and most appropriate for students pursuing a two year management accounting course at an ad­vanced professional or degree level. It was also indicated that there was a need for a book (based on Management and Cost Accounting) tailored to meet the specific needs of a one year introductory course in cost and management accounting. Many lecturers, in particular those running introductory accounting courses, felt there was a need for an introductory text which covered the required ground in an academically sound manner and which was also appropriate for students on non-advanced courses. This book is aimed specifically at students who are pursuing a one year non-advanced course and is particularly suitable for the following courses:

Foundation preliminary professional (ACCA, CIMA and one year college foundation courses)

Association of Accounting Technicians BTEC higher and national diploma A first level costing course for undergraduate degree students

An introductory course in financial accounting is not a prerequisite, although many students will have undertaken such a course.

Major changes in the content Feedback from teachers in many colleges and universities has indicated that the structure of the first two editions was most satisfactory. The organizational structure of the book has therefore remained unchanged. The notable alterations are:

PREFACE __________________________________ xi

xii

1. Chapters 11 and 17 are entirely new chapters. Chapter 11 describes activity-based product costing systems and contrasts activity-based costing with traditional product costing and decision-relevant costs. Chapter 17 describes current and potential future developments in management accounting. This chapter describes the major criticisms that have been made against existing management accounting practices and briefly discusses the impact of advanced manufac­turing technologies.

2. A greater emphasis on survey findings and company practice. In particular the findings of a survey, undertaken by the author, of 303 UK manufacturing companies, are recorded throughout the book.

3. A substantial number of new end-of-chapter problems has been added from examinations subsequent to the second edition.

4. New text on activity-based cost management in Chapter 14. 5. New text in Chapter 16 on just-in-time manufacturing and ma­

terials requirement planning. 6. New text in Chapter 2 emphasizing the importance of the time

horizon in classifying a cost as fixed or variable. 7. Extensive rewriting of Chapter 4 describing how traditional product

costing systems allocate overheads to products to meet the finan­cial accounting requirements. This revised chapter provides the foundation for a comparison, in Chapter 11, of traditional and activity-based product costing systems.

8. Extensive rewriting of the material on decision-relevant costs in Chapter 10. In particular, greater emphasis is placed on indicating that the decision-relevant approach adopts whichever planning time horizon the decision-maker considers appropriate for a given situation. The dangers of focusing excessively on the short-term and the need to focus on maximizing long-term cash inflows are emphasized .

9. The title of Chapter 14 (Chapter 13 in the second edition) has been changed from 'Control in the organization' to 'Operational control and performance measurement'. As the change in the title sug­gests, a greater emphasis is placed on operational control and performance measurement. New text has been added on non­financial performance measures.

10. An extensive revision and simplification of the text on standard costing (Chapter 15). To simplify the introduction to standard costing Chapter 15 focuses initially on a variable standard costing system. It is stressed that the additional variances reported by an absorption costing system are required to meet financial accounting requirements and are not required for cost control.

Structure and plan of the book In writing this book I have adopted the same structure as that in Manage­ment and Cost Accounting. The major theme is that different financial information is required for different purposes. The framework is based on the principle that there are three ways of constructing accounting infor­mation. One is conventional cost accounting with its emphasis on pro­ducing product costs for stock valuation and profit measurement. The second is the notion of relevant costs with the emphasis on providing

PREFACE

information to help managers to make good decisions. The third is responsibility accounting which focuses on the costs and revenues of responsibility centres.

The book has 17 chapters divided into five parts. Part One consists of two chapters and provides an introduction to cost and management accounting. The following three parts reflect the three different ways of constructing accounting information. Part Two has six chapters and is entitled 'Cost Accumulation for Stock Valuation and Profit Measurement'. The focus here is on cost accounting, with the emphasis on allocating manufacturing costs to products to separate costs between the cost of goods sold and the closing stock valuation. We also consider briefly the extent to which product costs accumulated for stock valuation and profit measurement are suitable or unsuitable for decision-making and respon­sibility accounting. Part Three consists of four chapters and is entitled 'Information for Decision-Making'. Here we consider the notion of re­levant cost and the information which should be presented to help man­agers make good decisions. Part Four consists of four chapters and is entitled 'Information for Planning and Control'. We emphasize here the process for integrating the decisions into a meaningful, coordinated package via the budget process. We also focus on responsibility accounting and the assignment of costs to managers . The emphasis here is on the accounting process as a means of providing information to help managers control the activities for which they are responsible. Finally, in Part Five we focus on current developments in management accounting. The major criticisms that have been made against existing management accounting practices are described and the impact of advanced manufacturing tech­nologies and potential future developments in management accounting are discussed.

In devising a framework around the three methods of constructing financial information there is a risk that the student will not appreciate that the three categories use many common elements, that they overlap, and that they constitute a single management accounting system, rather than three separate systems. I have taken steps to minimize this risk in each section by emphasizing why financial information for one purpose should or should not be adjusted for another purpose. In other words, each section of the book is not presented in isolation and an integrative approach has been taken.

Assignment materials and supplementary manuals Throughout this book I have kept the illustrations simple. Students can check their understanding of each chapter by answering the seIf­assessment questions, answers to which are contained in a separate sec­tion at the end of the book. More complex problems are set at the end of each chapter to enable students to pursue certain topics in more depth. A Students' Manual and a Teachers' Manual accompany this book. The former provides suggested answers to the problems which are marked with an asterisk immediately after the question number and the latter answers to the remaining questions. Students are strongly recommended to purchase the accompanying manual which complements this book and contains suggested answers to approximately 100 questions. Both manuals have been revised and extended. New answers have been added and the con-

PREFACE __________________________________ xiii

tent of both manuals has been substantially increased. Where possible, problems are arranged in ascending order of difficulty.

Acknowledgements I wish to acknowledge the valuable assistance of Alan Nelson from Chapman and Hall and my wife Bronwen whose task it has been to con­vert my original manuscripts into one final typewritten form. My appreci­ation also goes to the Chartered Institute of Management Accountants, the Chartered Association of Certified Accountants, the Institute of Chartered Accountants in England and Wales, the Association of Accounting Tech­nicians, the Institute of Chartered Secretaries and Administrators, the Associated Examining Board and the Joint Matriculation Board for per­mission to reproduce examination questions. Questions are designated as follows:

Chartered Institute of Management Accountants (CIMA) Chartered Association of Certified Accountants (ACCA) Institute of Chartered Accountants in England and Wales (lCAEW) Association of Accounting Technicians (AAT) Joint Matriculation Board' A' Level (JMB 'A' Level) Associated Examining Board 'A' Level (AEB 'A' Level) Institute of Chartered Secretaries and Administrators (lCSA)

The answers in the accompanying teachers' and students' manuals are my own and are in no way the approved solutions of the above examining bodies.

xiv - _________________________________ PREFACE