Management& Cost

Accounting

F I F T H E D I T I O N

Colin Drury

THOMSON*

LEARNING

Australia • Canada • Mexico • Singapore • Japan • United Kingdom • United States

© 2008 AGI-Information Management Consultants

May be used for personal purporses only or by libraries associated to dandelon.com network.

Contents

Preface xxi

Part OneIntroduction to Management and CostAccounting 1

1 Introduction to management accounting 3The users of accounting information 4Differences between management accounting and financial accounting 5The decision-making process 5Changing competitive environment 10Changing product life cycles 11Focus on customer satisfaction and new management approaches 11The impact of the changing environment of management accounting systems 14Functions of management accounting 15Behavioural, organizational and social aspects of management accounting 17Summary of the contents of this book 17Guidelines for using this book 18Summary 19Key terms and concepts 19Key examination points 20

2 An introduction to cost terms and concepts 21Cost objects 21Direct and indirect costs 22Period and product costs 24Cost behaviour 24Relevant and irrelevant cost and revenues 29Avoidable and unavoidable costs 30Sunk costs 30Opportunity costs 31

VII

vi i i CONTENTS

Incremental and marginal costs 31Job costing and process costing systems 32Maintaining a cost database 32Self-assessment questions 35Summary 35Key terms and concepts 36Recommended reading 36Key examination points 36Questions 36

Part TwoCost Accumulation for Inventory Valuationand Profit Measurement 43

3 Cost assignment 45

Assignment of direct and indirect costs 46Different costs for different purposes 47Cost—benefit issues and cost systems design 48Assigning direct costs to cost objects 49Blanket overhead rates 50Cost centre overhead rates 51The two-stage allocation process 52An illustration of the two-stage process for a traditional costing 55An illustration of the two-stage process for an ABC system 60Extracting relevant costs for decision-making 63Budgeted overhead rates 64Under- and over-recovery of overheads 65Maintaining the database at standard costs 66Non-manufacturing overheads 66Self-assessment questions 69Summary 71Key terms and concepts 72Recommended reading 72Appendix 3.1: Inter-service department reallocations 72Appendix 3.2: Other allocation bases used by traditional systems 77Key examination points 79Questions 80

4 Accounting entries for a job costing system 97Materials recording procedure 98Pricing the issues of materials 98Control accounts 100Recording the purchase of raw materials 101Recording the issue of materials 103Accounting procedure for labour costs 104Accounting procedure for manufacturing overheads 106Non-manufacturing overheads 107

CONTENTS ix

Accounting procedures for jobs completed and products sold 108Costing profit and loss account 108Interlocking accounting 109Accounting entries for a JIT manufacturing sytem 110Contract costing 112Work in progress valuation and amounts recoverable on contracts 117Self-assessment question 119Summary 120Key terms and concepts 120Recommended reading 121Key examination points 121Questions 121

5 Process costing 133

Flow of production and costs in a process costing system 134Process costing when all output is fully complete 135Process costing with ending work in progress partially complete 141Beginning and ending work in progress of uncompleted units 144Partially completed output and losses in process 149Process costing for decision-making and control 149Batch/operating costing 150Surveys of practice 151Self-assessment questions 153Summary 154Key terms and concepts 155Appendix 5.1: Losses in process and partially completed units 155Key examination points 160Questions 161

6 Joint and by-product costing 173

Distinguishing between joint products and by-products 173Methods of allocating joint costs 175Irrelevance of joint cost allocations for decision-making 182Accounting for by-products 184By-products, scrap and waste 185Self-assessment question 187Summary 188Key terms and concepts 188Recommended reading 188Key examination points 189Questions 189

7 Income effects of alternative cost accumulation systems 201

Problem of terminology 202External and internal reporting 202Variable costing 204Absorption costing 205Variable costing and absorption costing: a comparison of their impact on profit 206

X CONTENTS

A mathematical model of the profit functions 208Some arguments in support of variable costing 209Some arguments in support of absorption costing 211The variable costing versus absorption costing debate 212Relevant costing 213Alternative denominator level measures 214Self-assessment question 219Summary 220Key terms and concepts 221Appendix 7.1: Derivation of the profit function for an absorption costing system 221Key examination points 221Questions 222

Part ThreeInformation for Decision-making 233

8 Cost-volume-profit analysis 235The economist's model 236The accountant's cost—volume-profit model 239Application to longer-term time horizons 241A mathematical approach to cost-volume-profit analysis 242Margin of safety 246Constructing the break-even chart 246Alternative presentation of cost-volume-profit analysis 246Cost-volume-profit analysis assumptions 248Cost-volume-profit analysis and computer applications 253Self-assessment questions 255Summary 255Key terms and concepts 257Appendix 8.1: CVP analysis applied absorption costing 257Key examination points 260Questions 261

9 Measuring relevant costs and revenues for decision-making 279The meaning of relevance 280Importance of qualitative factors 280Special pricing decisions 281Product-mix decisions when capacity constraints exist 286Replacement of equipment - the irrelevance of past costs 288Outsourcing and make or buy decisions 290Discontinuation decisions 295Determining the relevant costs of direct materials 297Determining the relevant costs of direct labour 297Misconceptions about relevant costs 299A comprehensive example 300Self-assessment questions 305

CONTENTS xi

Summary 307Key terms and concepts 307Recommended reading 307Appendix 9.1: The theory of constraints and throughput accounting 308Key examination points 311Questions 311

10 Activity-based costing 335The role of a cost accumulation system in generating relevant cost information fordecision-making 336Types of cost systems 337A comparison of traditional and ABC systems 338The emergence of ABC systems 338Errors arising from relying on misleading product costs 340Designing ABC systems 342Activity hierarchies 345Activity-based costing profitability analysis 346Resource consumption models 349Selecting the cost driver denominator level 351Cost versus benefits considerations 353Periodic review of an ABC database 353ABC in service organizations 354ABC cost management applications 354Pitfalls in using ABC information 355Self-assessment question 359Summary 360Key terms and concepts 360Recommended reading 361Key examination points 361Questions 361

11 Pricing decisions and profitability analysis 371Economic theory 372Calculating optimum selling prices using differential calculus 376Difficulties with applying economic theory 377The role of cost information in pricing decisions 378A price setting firm facing short-run pricing decision 378A price setting firm facing long-run pricing decision 379A price taker firm facing short-run product-mix decision 385A price taker firm facing long-run product-mix decision 385Cost-plus pricing 387Pricing policies 390Customer profitability analysis 391Self-assessment question 395Summary 396Key terms and concepts 396Recommended reading 397Key examination points 397Questions 397

xi i CONTENTS

12 Decision-making under conditions of risk anduncertainty 411A decision-making model 412Risk and uncertainty 412Probabilities 414Probability distributions and expected value 415Measuring the amount of uncertainty 416Attitudes to risk by individuals 419Decision-tree analysis 420Cost-volume-profit analysis under conditions of uncertainty 422Buying perfect and imperfect information 423Maximin, maximax and regret criteria 424Portfolio analysis 425A more complex illustration 426Self-assessment question 431Summary 432Key terms and concepts 433Recommended reading 433Appendix 12.1: Cost-volume—profit analysis under conditions of uncertainty 433Key examination points 437Questions 438

13 Capital investment decisions: 1 453Objectives of capital budgeting 454A decision-making model for capital investment decisions 454The theory of capital budgeting 456The opportunity cost of an investment 457Compounding and discounting 458The concept of net present value 460Calculating net present values 461The internal rate of return 462Relevant cash flows 465Timing of cash flows 466Comparison of net present value and internal rate of return 466Profitability index 470Techniques that ignore the time value of money 471Payback method 471Accounting rate of return 474The effect of performance measurement on capital investment decision 475Qualitative factors 476Self-assessment question 479Summary 480Key terms and concepts 480Recommended reading 480Key examination points 481Questions 481

CONTENTS x i i i

14 Capital investment decisions: 2 493

The evaluation of mutually exclusive investments with unequal lives 494Capital rationing 496Taxation and investment decisions 498The effect of inflation on capital investment appraisal 501Calculating risk-adjusted discount rates 504Calculating the required rates of returns on a firm's securities 508Weighted average cost of capital 508Traditional methods of measuring risk 509A summary of risk measurement techniques 514Authorization of capital investment proposals 517Review of capital investment decisions 518Self-assessment question 523Summary 525Key terms and concepts 525Recommended reading 525Key examination points 526Questions 526

Part FourInformation for Planning, Control andPerformance Measurement 543

15 The budgeting process 545

Stages in the planning process 546The multiple functions of budgets 549Conflicting roles of budgets 551The budget period 551Administration of the budgeting process 552Stages in the budgeting process 553A detailed illustration 557Sales budget 557Production budget and budgeted stock levels 560Direct materials usage budget 561Direct materials purchase budget 561Direct labour budget 562Factory overhead budget 562Selling and administration budget 563Departmental budgets 564Master budget 564Cash budgets 566Final review 566Computerized budgeting 567Activity-based budgeting 567The budgeting process in non-profit-making organizations 571Zero-based budgeting 574Self-assessment question 577

xiv CONTENTS

Summary 578Key terms and concepts 578Recommended reading 579Key examination points 579Questions 579

16 Management control systems 593

Control at different organizational levels 594Different types of controls 594Results or output controls 597Cybernetic control systems 598Feedback and feed-forward controls 599Harmful side-effects of controls 599Advantages and disadvantages of different types of controls 601Management accounting control systems 602Responsibility centres 603The nature of management accounting control systems 605The controllability principle 607Setting financial performance targets 612Participation in the budgeting and target setting process 617Side-effects arising from using accounting information for performanceevaluation 620Self-assessment questions 623Summary 625Key terms and concepts 626Recommended reading 626Key examination points 626Questions 627

17 Contingency theory and organizational and social aspects ofmanagement accounting 647

Contingent factors 648Types of controls in relation to the transformation process and outputmeasurement 654Scorekeeping and uncertainty 656Programmed and non-programmed decisions 658Accounting information, decision-making and uncertainty 658Purposes of management accounting 661Summary 667Key terms and concepts 668Recommended reading 669Key examination points 669Questions 669

18 Standard costing and variance analysis 1 671

Operation of a standard costing system 672Establishing cost standards 675Types of cost standards 678

CONTENTS XV

Variance analysis 680Material variances 682Material price variances 682Material usage variance 684Joint price usage variance 685Total material variance 686Labour variances 687Wage rate variance 687Labour efficiency variance 688Total labour variance 688Variable overhead variances 689Variable overhead expenditure variance 689Variable overhead efficiency variance 690Similarities between materials, labour and overhead variances 690Fixed overhead expenditure or spending variance 691Sales variances 691Total sales margin variances 692Sales margin price variance 693Sales margin volume variance 693Difficulties in interpreting sales margin variances 693Reconciling budgeted profit and actual profit 694Standard absorption costing 694Volume variance 696Volume efficiency variance 697Volume capacity variance 698Summary of fixed overhead variances 698Reconciliation of budgeted and actual profit for a standard absorption costingsystem 700Performance reports 700Self-assessment questions 705Summary 706Key terms and concepts 707Key examination points 708Questions 708

19 Standard costing and variance analysis 2: furtheraspects 729

Direct materials mix and yield variances 729Sales mix and sales quantity variances 734Recording standard costs in the accounts 738Accounting disposition of variances 745Ex post variance analysis 747Variance analysis and the opportunity cost of scarce resources 750The investigation of variances 754Types of variances 755Simple rule of thumb cost investigation models 756Statistical models not incorporating costs and benefits of investigation 757Decision models with costs and benefits of investigation 759Quantity variances 761Criticisms of standard costing 763

XVJ CONTENTS

The future role of standard costing 765Self-assessment question 771Summary 771Key terms and concepts 772Recommended reading 772Key examination points 772Questions 773

20 Divisional financial performance measures 791

Divisional financial performance measures 791Functional and divisionalized organizational structures 792Profit centres and investment centres 793Advantage of divisionalization 794Disadvantages of divisionalization 795Pre-requisites for successful divisionalization 795Distinguishing between the managerial and economic performance of thedivision 796Alternative divisional measures 796Return on investment 799Residual income 800Economic value added (EVA™) 801Determining which assets should be included in the investment base 802The impact of inflation 803The impact of depreciation 803The effects of performance measurement on capital investment decisions 804Determining the divisional cost of capital charge 808Addressing the dysfunctional consequences of short-term financial performancemeasures 808Self-assessment question 813Summary 814Key terms and concepts 815Recommended reading 815Appendix 20.1: Reconciling short- and long-term residual income measures 815Key examination points 820Questions 821

21 Transfer pricing in divisionalized companies 837

Process of transfer pricing 838Alternative transfer pricing methods 839Market-based transfer prices 841Marginal cost tansfer prices 844Full-cost transfer prices 846Cost-plus a mark-up transfer prices 846Negotiated transfer prices 847An illustration of transfer pricing 848Proposals for resolving transfer pricing conflicts 852Domestic transfer pricing recommendations 855International transfer pricing 856Economic theory of transfer pricing 857

CONTENTS XVii

Self-assessment question 865Summary 866Key terms and concepts 867Recommended reading 867Appendix 21.1: Economic analysis of transfer pricing 867Key examination points 873Questions 873

Part FiveCost Management and Strategic ManagementAccounting 887

22 Cost management 889

Life-cycle costing 890Target costing 891Kaizen costing 896Activity-based management 896Business process re-engineering 900Cost of quality 900Cost management and the value chain 904Benchmarking 906Management audits 906Just-in-time systems 907Summary 913Key terms and concepts 914Recommended reading 915Key examination points 915Questions 915

23 Strategic management accounting 923

What is strategic management accounting? 923The balanced scorecard 928Establishing objectives and performance measures 931The financial perspective 931The customer perspective 932The internal business perspective 934The learning and growth perspective 938Performance measurement in service organizations 939Summary 943Key terms and concepts 943Recommended reading 944Key examination points 944Questions 944

xviii CONTENTS

Part SixThe Application of Quantitative Methods toManagement Accounting 951

24 Cost estimation and cost behaviour 953

General principles applying to estimating cost functions 954Cost estimation methods 955Multiple regression analysis 962Factors to be considered when using past data to estimate cost functions 964Relevant range and non-linear cost functions 966A summary of the steps involved in estimating cost functions 966Cost estimation when the learning effect is present 968Estimating incremented hours and incremental cost 971Learning curve applications 972Cost estimation techniques used in practice 973Self-assessment questions 975Summary 976Key terms and concepts 977Recommended reading 977Appendix 24.1 Tests of reliability 977Key examination points 984Questions 984

25 Quantitative models for the planning and control ofstocks 993

Why do firms hold stocks? 994Relevant costs for quantitative models under conditions of certainty 994Determining the economic order quantity 995Assumptions of the EOQ formula 998Application of the EOQ model in determining the length of a production run 999Quantity discounts 1000Determining when to place the order 1001Uncertainty and safety stocks 1002The use of probability theory for determining safety stocks 1004Control of stocks through classification 1005Other factors influencing the choice of order quantity 1007Materials requirements planning 1008Just-in-time purchasing and manufacturing 1010Self-assessment questions 1013Summary 1013Key terms and concepts 1014Recommended reading 1014Key examination points 1014Questions 1015

CONTENTS Xix

26 The application of linear programming to managementaccounting 1029

Single-resource constraints 1029Two-resource constraints 1030Linear programming 1031Graphical method 1032Simplex method 1038Interpreting the final matrix 1042Opportunity cost 1043Substitution process when additional resources are obtained 1043Uses of linear programming 1044Self-assessment questions 1047Summary 1049Key terms and concepts 1049Appendix 26.1 The application of linear programming to capital budgeting 1049Key examination points 1052Questions 1052

Notes 1067

Bibliography 1073

AppendicesAppendix A 1080Appendix B 1084Appendix C 1088Appendix D 1089Appendix E 1090

Answers to self-assessment questions 1093

Case study problems 1143

Index 1189